Account-Audit-Finance

Significance Of The Concept Of Time Value Of Money

2012-05-26T20:23:00.004-07:00

Time value of money is a widely used concept in literature of finance. Financial decision models based on finance theories basically deal with maximization of economic welfare of shareholders. The concept of time value of money contributes to this aspect to a greater extent. The significance of the concept of time value of money could be stated as below:

Investment Decision

Investment decision is concerned with the allocation of capital into long-term investment projects. The cash flow from long-term investment occur at different point in time in the future. They are not comparable to each other and against the cost of the project spent at present. To make them comparable, the future cash flows are discounted back to present value.

The concept of time value of money is useful to securities investors. They use valuation models while making investment in securities such as stock and bonds. These security valuation models consider time value of cash flows from securities.

Financing Decision

Financing decision is concerned with designing optimum capital structure and raising funds from least cost sources. The concept of time value of money is equally useful in financing decision, especially when we deal with comparing the cost of different sources of financing. The effective rate of interest of each source of financing is calculated based on time value of money concept. Similarly, in leasing versus buying decision, we calculate the present value of cost of leasing and cost of buying. The present value of costs of two alternatives are compared against each other to decide on appropriate source of financing.

Besides, the concept of time value of money is also used in evaluating proposed credit policies and the firm's efficiency in managing cash collection under current assets management.

Concept Of Time Value Of Money

2012-05-26T20:01:00.003-07:00

The concept of tome value of money suggests that the money received at different point of time has different value. The financial manager must appreciate this fact and understand why they are different and how they are made comparable.

Time value of money is a concept to understand the value of cash flows occurred at different point of time. If we are given the alternatives whether to accept $ 100 today or one year fro now, then we certainly accept $ 100 today. It is because there is a time value to money. Every sum of money received earlier has reinvestment opportunity. For example, if we deposited $ 100 in saving account at 5% annual rate of interest, it will increase to $ 105 at the end of one year. Money received at present is preferred even if we do not have reinvestment opportunity. The reason is that the money that we receive in future has less purchasing power than the money that we have at present due to the inflation. What happens if there is no inflation? Still, money received at present is preferred, it is because most of us have a fundamental behavior to prefer current consumption to future consumption. Thus, i) The reinvestment opportunity or the earning power of the money, ii) the risk of inflation, and iii) an individual's preference for current consumption to future consumption are the reasons for the time value of money.

The concept of time value of money is useful in addressing our real life problems relating to planning for future family expenditure. For instance, if we need $ 50,000 after the retirement from job in 15 years, the amount we need to deposit at interest every year from now until the retirement is conveniently determined by using the time value of money concept.

Many financial decisions of the firm require a consideration regarding time value of money. The corporate manager must always concentrate on maximizing shareholders wealth. Maximizing shareholders wealth, to a larger extent, depends on the timing of cash flows from investment alternatives. In this regard, time value of money concept deserves serious considerations on all financial decisions.

Determinants Of Investment In Receivables

2012-05-07T23:33:00.007-07:00

The size of investment in receivables is influenced by number of factors. Among them two factors, the volume of credit sales, and the average length if time between sales and collection are important.

To illustrate, suppose National Enterprise, a newly established firm makes a credit sales of $ 5000 per day and its customers are allowed 15 days of credit. At the start of business i.e. in the first day, it sold $ 5000 on credit so that its end-of-day accounts receivables stand $ 5000 in the firm's book. During the second day, it sold another $ 5000 on credit increasing the book receivables to $10,000. If it goes on granting a credit of $ 5000 per day for 15 days, its account receivable will increase to $ 75,000 at the end of 15th day. However in 16th day it will make another $ 5000 credit sales, but payments for sales made on first day will reduced receivables by $ 5000, so that total account receivable will remain constant at $ 75000 in 16th day and the each day thereafter throughout the year. The average account receivable the firm must carry during the year is, therefore $ 75000.

Account receivable = Credit sales per day X Average length of collection period

= $ 5000 X 15 days = $ 75000.

Above illustration shows that the change in credit sales or change in collection period or both will affect the investment in account receivable. However in turn, the volume of credit sales and collection is affected by several factors such as industrial norms, credit standards, credit terms, collection policy, payment habits of customers, nature of business, size of enterprise, cost of investment in receivables and so on. Therefore, the financial manager must be able to look in depth and analyze the impact of these factors in volume of sales and the cost-benefit trade off associated to credit decisions.

Costs Of Maintaining Receivables And Their Calculation

2012-05-07T23:10:00.004-07:00

Maintaining receivables bears cost. It includes cost of investment in receivables, bad debt losses, collection expenses and cash discount. Costs related with receivables and their calculation are as follows:

1. Cost Of Investment In Receivables

This is the opportunity cost of funds being tied up in receivables, which would otherwise have not been incurred if all sales were in cash. The cost of investment in receivable is calculated as:

Cost of receivables = Investment in receivables X Opportunity costs

Here,

investment in receivables = (FC+ VC)/Days in year) X DSO

Where, FC = Fixed Cost, VC = Variable Cost and DSO = Days sales outstanding.

2. Bad Debt Losses

This is the loss due to default customers. Extension of credit to low quality-rate customers results into increase in bad debt losses. Bad debt losses are calculated as a percentage on sales as shown in equation below:

Bad debt losses = Annual credit sales X Percentage default customer

3. Collection Expenses

This is the cost incurred for operating and managing the collection and credit department of a firm. This includes the administrative cost of credit department, salary and commission paid to collection staff, cost paid for telephone and communication and so on.

4. Cash Discount

It is the cost incurred to induce the customer for early payments of their accounts. A firm can offer cash discount to its customers to reduce the average collection period, bad debt losses, and the cost of investment in receivables. The discount cost is calculated as cash discount percentage multiplied by sales to discount customers as given below:

Discount Cost = Annual credit sales X Percentage discount customer X Percentage cash discount

Roles Of The Credit Manager

2012-05-06T23:26:00.004-07:00

Investment in account receivable of any firm depends on how much it sells in credit and how long it takes for collection of receivables. Efficiency of receivable management is judged against its capacity to expand sales and profitability with reasonable investment in receivables. The credit manager is expected to play a significant role for this purpose. The roles of credit manager in receivable management are as follows:

1. Setting Up Credit Standard And Terms

The credit manager has to set up credit standards to grant the credit. Credit standard refers to the minimum criteria for the extension of credit to customers. The credit standards set by the credit manager may vary from firm to firm. It may be loose or tight as per the condition of the firm. The credit manager should set such a standard, which minimizes the bad debt expenses and increases firm's profitability. Having determined the credit standard, the credit manager should also fix the credit terms. The credit terms include, credit period, discount, if any, for early payment and discount period. The length of credit period has significant impact on the cost of investment in accounts receivables. Longer credit period increases both cost of investment in account receivables and bad debt losses. Therefore, the credit manager may offer cash discount to stimulate customers for early payment.

2. Credit Analysis And Evaluation

Another important role to be played by credit manager is to analyze and evaluate very carefully the credit proposals. Any credit proposal involves some sort of risk and profitability. If not analyzed well, a good customer may be misclassified as a poor credit risk customer and a bad customer as a good credit risk customer.

3. Credit Granting Decision

Once creditworthiness of a customer is analyzed and evaluated on the basis of available information, the credit manager should decide upon whether to grant credit or not. This depends on the result obtained from credit evaluation. Credit granting decision involves certain degree of risk. This risk is perhaps the risk of default. When credit is granted the credit manager either receives the payment in some future date or does not receive at all. If customers pay, firm is benefited by the amount equal to difference between sales revenue and cost. If customers do not pay than amount equal to cost of sales will have to be sacrificed, which otherwise would have been eliminated by refusing credit. Considering these profitabilities, the credit manager make credit-granting decision.

4. Controlling Account Receivables

Once credit is granted to customers, the role of credit manager becomes more important and challenging because the risk of default and cost of investment in account receivables begins with credit granting decision. Therefore, the credit manager should monitor and control accounts receivables periodically. Monitoring and controlling of account receivables involves different techniques, such as preparation of aging schedule, collection matrix and schedule of day's sales outstanding. The credit manager, on the basis of these techniques, should look at the receivable positions and compare it with the past position. If any customer is found to be stretching out the payment, the credit manager should make collection efforts through sending letter, telephone calls, emails, personal visit or legal action against default customers.

Introduction To Receivable Management And Its Purpose And Significance

2012-05-06T22:57:00.004-07:00

Introduction To Receivable Management

Receivables, also termed as trade credit or debtors are component of current assets. When a firm sells its product in credit, account receivables are created.

Account receivable are the money receivable in some future date for the credit sale of goods and services at present. These days, most business transactions are in credit. Most companies, when they face competition, use credit sales as an important tool for sales promotion. As a sales promotion tool, credit sale enhances firm's sales revenue and ultimately pushes up the profitability. But after the credit sale has been made, the actual collection of cash may be delayed for months. As these late payments stretch out over time, they may cause substantial drop in a company's profit margin. Since the extension of credit involves both cost and benefits, the firm's manager must be able to measure them to determine the ultimate effect of credits sales. In this prospective, we define the receivable management as the aspect of a firm's current assets management, which is concerned with determining optimum credit policy associated to a firm, such that the benefit from extension of credit is greater than the cost of maintaining investment in accounts receivables.

Significance And Purpose Of Receivable Management

The basic purpose of firm's receivable management is to determine effective credit policy that increases the efficiency of firm's credit and collection department and contributes to the maximization of value of the firm. The specific purposes of receivable management are as follows:

1. To evaluate the creditworthiness of customers before granting or extending the credit.

2. To minimize the cost of investment in receivables.

3. To minimize the possible bad debt losses.

4. To formulate the credit terms in such a way that results into maximization of sales revenue and still maintaining minimum investment in receivables.

5. To minimize the cost of running credit and collection department.

6. To maintain a trade off between costs and benefits associated to credit policy.

Factors Affecting The Size Of Investment In Inventories Or Determinants Of Inventories

2012-05-04T23:23:00.008-07:00

The size of investment in inventories is affected by a number of factors. Some of them are as follows:

1. Level Of Safety Stock

If a firm maintains high level of safety stock because of relatively larger degree of uncertainty associated to production and sales, the size of investment in inventories is also higher.

2. Carrying Costs

If the costs of holding inventories in stock is relatively low, the firm keeps larger stocks of inventories.

3. Economy in Purchase

If the firm is likely to receive certain benefits in the form of cash discount for purchase made currently, the size of investment in inventories is also likely to be larger because of larger quantity purchase.

4. Possibility Of Price Rise

If the price of materials is likely to rise in near future, the firm makes larger quantity purchase at present.

5. Cost And Availability Of Funds

If the cost of funds to be invested in inventories is relatively cheaper and they are conveniently available at present, the firm makes large purchase of inventories.

6. Possibility Of Rise In Demand

If the firm has anticipated the increased demand of its products in future, it maintains larger stocks of inventories at present.

7. Length Of Production Cycle

If the length of production cycle is relatively longer, the firm has to maintain investment in work-in-progress inventories for longer duration of time as a result of which the size of investment in inventories increases.

8. Availability Of Material

If certain kind of materials are only available in a particular season only, the firm has to increase the investment in inventories to keep larger stocks in the season.

9. Nature And Size Of Business

If the firm deals with the business of perishable products, the size of investment in inventories become lower. For a firm with relatively larger size and wide market coverage, the investment in inventories is larger.

Objectives Of Holding Inventories

2012-05-04T23:06:00.004-07:00

Every firm must hold adequate inventory. The main objective of holding inventories is to reduce the cost associated with investment in inventory and maintaining efficiency in production and sales operations. If a firm does not hold sufficient inventory, and makes purchases only when it is needed for production and sale arises, then the firm will not be able to offer timely delivery according to customers order.

Objectives of holding inventory may be specified as below:

1. To Avoid Losses Of Sales

One of the objectives of holding inventory is to avoid the losses of sales. If the firm holds inadequate inventory of finished goods, the form could not satisfy customer's demand timely. As a result, the customers requiring immediate supply of goods will move to the competitors, which is known as stock-out problem.

2. To Gain Quantity Discounts

Suppliers usually offer a quantity discount on bulk purchase of materials. Therefore, if a firm has relatively lower holding cost of material, it could maintain relatively larger investment in inventories to gain from the quantity discount offered by suppliers. However, it should be noted that the benefit from quantity discount must be greater than the cost of maintaining inventories.

3. To Reduce Order Costs

If a firm's ordering cost is relatively higher for order placed each time, frequent purchasing in small quantity is not economical. Therefore, placing lessor number of orders in relatively large quantity each time could reduce the variable costs associated to ordering of material.

4. To Achieve Efficient Production Run

When a firm schedules production. the firm has to maintain a fixed production set up costs for each time. Therefore, by maintaining adequate inventories the firm can set up relatively longer run of the machines so as to reduce set up cost per unit.

Introduction And Importance Of Inventory Management

2012-05-04T22:38:00.008-07:00

Introduction To Inventory Management

The term inventory refers to the goods or materials used by a firm for the purpose of production and sale. It also includes the items, which are used as supportive materials to facilitate production.

There are three basic types of inventory: raw materials, work-in-progress and finished goods. Raw materials are the items purchased by firms for use in production of finished product. Work-in-progress consists of all items currently in the process of production. These are actually partly manufactured products. Finished goods consists of those items, which have already been produced but not yet sold.

Inventory constitutes one of the important items of current assets, which permits smooth operation of production and sale process of a firm. Inventory management is that aspect of current assets management, which is concerned with maintaining optimum investment in inventory and applying effective control system so as to minimize the total inventory cost.

Importance Of Inventory Management

Inventory management is important from the view point that it enables to address two important issues:

1. The firm has to maintain adequate inventory for smooth production and selling activities.

2. It has to minimize the investment in inventory to enhance firm's profitability.

Investment in inventory should neither be excessive nor inadequate. It should just be optimum. Maintaining optimum level of inventory is the main aim of inventory management. Excessive investment in inventory results into more cost of fund being tied up so that it reduces the profitability, inventories may be misused, lost, damaged and hold costs in terms of large space and others. At the same time, insufficient investment in inventory creates stock-out problems, interruption in production and selling operation. Therefore, the firm may loose the customers as they shift to the competitors. Financial manager, as he involves in inventory management, should always try to put neither excessive nor inadequate investment in inventory. The importance or significance of inventory management could be specified as below:

* Inventory management helps in maintaining a trade off between carrying costs and ordering costs which results into minimizing the total cost of inventory.

* Inventory management facilitates maintaining adequate inventory for smooth production and sales operations.

* Inventory management avoids the stock-out problem that a firm otherwise would face in the lack of proper inventory management.

* Inventory management suggests the proper inventory control system to be applied by a firm to avoid losses, damages and misuses.

Functions Of Cash Management

2012-05-03T23:43:00.004-07:00

Cash management is concerned with the management of cash inflows, outflows and cash flows within the firm. It also includes the matters relating to financing of deficit and investment of surplus cash so as to maintain optimum cash balance. The functions of cash management start when a customer writes cheques to pay the firm on its account receivable. The function ends when a supplier, an employee or the government realizes funds from the firm on an account payable or accruals. The basic issue of cash management is to enable a firm to maintain sufficient liquidity and also at the same time improve its profitability.

If cash flows were accurately predicted, the firm would not have to give much attention on management of cash. Cash outflows to some extent are certain but cash inflows cannot be predicted accurately. There is no perfect synchronization between cash inflows and cash outflows.Sometimes, cash outflows exceeds cash inflows due to unusual payment of obligation and non-seasonal build up in inventories and receivables. And sometimes cash inflows will be more due to excessive sales than expectation and rapid conversion of receivables into cash.

To overcome the uncertainty about cash flow prediction and to maintain coincidence in cash inflow and outflow, the firm's cash management function should consist of following strategies:

1. Turn over inventory as quickly as possible, avoiding stock-out that may result in a loss of sales.

2. Pay accounts payable as late as possible without deteriorating the firm's credibility, but take advantage of any favorable cash discount.

3. Collect account receivables as quickly as possible without loosing future sales due to high-pressure collection techniques. Cash discounts, if any are economically justifiable, may be used to accomplish this objectives.

4. Involve in cash planning to determine deficit or surplus cash in each period.

5. Surplus cash must be invested into marketable securities.

Advantages Of Holding Adequate Cash

2012-05-03T23:20:00.004-07:00

Cash should not be hold more or less than requirement and it must be just adequate. The holding of cash in adequate amount offers the following advantages:

1. Advantage Of Cash Discount

Most business purchases are made in credit basis. The duration of credit period generally ranges from 15 days to 90 days. Suppliers of trade credit must be paid within the due date. But sometimes the suppliers may offer cash discount for the early payment. Therefore, adequate cash balance needs to be held to take the benefit of cash discount offered by suppliers. Whether to take or forgo the cash discount depends on the comparative cost benefit analysis of cash discount foregone. Generally, forgoing the cash discount involves higher opportunity cost than the cost of short-term bank loan.

To be more clear, let us suppose a firm makes credit purchase under the credit term 3/10, net 40. This states that the payment of credit purchase must be made within 40 days. If the payment is made within 10 days, the firm gets 3% cash discount. With this discount offer, if the firm fails to pay within 10 days discount period, it will be paying extra 3% for using the funds for an additional 30 days. The annual cost of fund used for additional 30 days is calculated as:

Percentage cost = (Discount %/100 - Discount %) X 360/Final due date - Discount period

= (3/100-3) X 360/40-10 = 0.3763 = 37.63%

Thus annual cost of cash discount foregone is 37.63 percent, which is much higher than the cost of short-term borrowing. Hence paying the trade credit within the discount period, the firm could take the benefit of cash discount offer. For this reason, the holding of adequate cash is beneficial as it enables the firm to take this benefit.

2. Favorable Credit Rating

Holding adequate cash also enables a firm to maintain favorable credit rating. Short-term credit standing of a firm is determined mostly on the basis of current and quick ratio position. Suppliers of short-term funds evaluate the firm's short-term solvency position in terms of its ability to meet the standard line of business. Holding of adequate cash maintains the current and quick ratio at favorable position so that the firm will be able to meet the standard of credit analysis of the supplier of short-term funds.

Besides, these benefits, holding of adequate cash helps the firms to take the advantage of reduced price offer at immediate cash payment, and also maintain precaution against some emergencies such as strikes and lock-up, flood, fire, malpractices of competitors etc.

Motives For Holding Cash

2012-05-03T22:50:00.004-07:00

Cash is known as most liquid and less productive assets of a firm. If cash remains idle, earns nothing but involves cost in terms of interest payable to finance it. Although cash is least productive current assets, firm should hold certain amount of cash for marketable securities. Mainly, there are three motives for holding cash.

1. Transaction Motive Of Holding Cash

Transaction motive refers to the need to hold cash to satisfy normal disbursement collection activities associated with a firm's ongoing operation. Transaction means the act of giving and taking of cash or kinds in the ordinary course of business. A firm frequently involves in purchase and sales of goods or services. A firm should make payment in terms of cash for the purchase of goods, payment of salary, wages, rent, interest, tax, insurance, dividend and so on. A firm also receives cash in terms of sales revenue, interest on loan, return on investments made outside the firm and so on. If these receipts and payments were perfectly synchronized, a firm would not have to hold cash for transaction motive. But in real, cash inflows and outflows cannot be matched exactly. Some times receipts of cash exceeds the disbursement whereas at other time disbursement exceeds the receipt. Because of this reason, if disbursement exceeds the receipt, a firm should hold certain level of cash to meet current payment of cash in excess of its receipt during the period.

2. Precautionary Motive Of Holding Cash

Precautionary motive refers to hold cash as a safety margin to act as a financial reserve. A firm should hold some cash for the payment of unpredictable or unanticipated events. A firm may have to face emergencies such as strikes and lock-up from employees, increase in cost of raw materials, funds and labor, fall in market demand and so on. These emergencies also bound a firm to hold certain level of cash. But how much cash is held against these emergencies depends on the degree of predictability associated with future cash flows. If there is high degree of predictability, less cash balance is sufficient. Some firms may have strong borrowing capacity at a very short notice, so that they can borrow at the time when emergencies occur. Such a firm may hold very minimum amount of cash for this motive.

3. Speculative Motive Of Holding Cash

The speculative motive refers to the need to hold cash in order to be able to take advantage of bargain purchases that might arise, attractive interest rates and favorable exchange rate fluctuations. Some firms hold cash in excess than transaction and precautionary needs to involve in speculation. Speculative needs for holding cash require that a firm possibly may have some profitable opportunities to exploit, which are out of the normal course of business. These opportunities arise in conditions, when price of raw material is expected to fall, when interest rate on borrowed funds are expected to decline and purchase of inventory occurs at reduced price on immediate cash payment.

Importance Of Cash Management

2012-04-23T00:28:00.005-07:00

Cash management is concerned with management of cash in such a way as to achieve the generally accepted objectives of the firm- maximum profitability with maximum liquidity of the firm. It is the management's ability to recognize cash problems before they arise, to solve them when they arise and having made solution available to delegate someone carry them out.

An effective and efficient cash management is considered to be important for the following reasons:

1. Cash management ensures that the firm has sufficient cash during peak times for purchase and for other purposes.

2. Cash management helps to meet obligatory cash out flows when they fall due.

3. Cash management assists in planning capital expenditure projects.

4. Cash management helps to arrange for outside financing at favorable terms and conditions, if necessary.

5. Cash management helps to allow the firm to take advantage of discount, special purchases and business opportunities.

6. Cash management helps to invest surplus cash for short or long-term periods to keep the idle funds fully employed.

Concept Of Cash Management

2012-04-23T00:08:00.006-07:00

The term 'cash' constitutes the most readily acceptable item of current assets to a firm. It includes currencies, coins, checks, and also some near cash items such as marketable securities and bank time deposits. Some items of cash such as currencies, coins checks are readily available in term of cash whereas, other items such as treasury bills, commercial papers and other marketable securities are readily convertible into cash. The finance manager must ensure that there is sufficient cash in the business. If there is excessive cash, the financial manager must seek to invest in low-risk highly liquid money market instruments that are conveniently convertible into cash. If there is inadequate cash the financial manager must manage it to avoid payment problem.

Cash is regarded as both input and output of a business operation. Cash serves as input in a sense that all business activities are carried on without any obstructions with the availability of cash. All business works begin with the provision of sufficient cash to do business. At the same time, the cash is the thing that a businessman ultimately wants to achieve through the sale of goods and services. Cash as a means and ends of business operation must be held in sufficient quantity. Holding of cash both in excess and insufficient amount may lead a firm to problems. Shortage of cash puts obstruction in the production process whereas excessive cash than requirement contributes nothing to the profitability of the firm as idle cash earns nothing. Therefore, a financial manager faces a challenge of maintaining optimum level of cash, which bypass the risk and also does not put negative impact on firm's profitability. The basic issue in cash management is to maintain adequate level of cash and investment of excess cash in low risk opportunities.

The Importance Of Financial Management

2012-04-22T23:38:00.004-07:00

Financial management is important mainly because it helps to make decisions towards the maximization of value of the firm . The importance of financial management to a firm are as follows:

1. Financial Management Helps Setting Clear Goal
Clarity of the goal is important for any firm. Financial management defines the goal of the firm in clear terms (maximization of the shareholders wealth). Setting goal helps to judge whether the decisions taken are in the best interest of the shareholders or not. Financial management also direct the efforts of all functional areas of business towards achieving the goal and facilitates among the functional areas of the firm.

2. Financial Management Helps Efficient Utilization Of Resources
Firms use fixed as well as current assets which involve huge investment. Acquiring and holding assets that do not earn minimum return do not add value to the shareholders. Moreover, wrong decision regarding the purchase and disposal of fixed assets can cause threat to the survival of the firm. The application of financial management techniques (such as capital budgeting techniques) helps to answer the questions like which asset to buy, when to buy and whether to replace the existing asset with new one or not.
The firm also requires current assets for its operation. They absorb significant amount of a firm's resources. Excess holdings of these assets mean inefficient use and inadequate holding exposes the firm into higher risk. Therefore, maintaining proper balance of these assets and financing them from proper sources is a challenge to a firm. Financial management helps to decide what level of current assets is to be maintained in a firm and how to finance them so that these assets are utilized efficiently.

3. Financial Management Helps Deciding Sources Of Financing
Firms collect long-term funds mainly for purchasing permanent assets. The sources of long term finance may be equity shares, preference shares, bond, term loan etc. The firm needs to decide the appropriate mix of these sources and amount of long-term funds; otherwise the firm will have to bear higher cost and expose to higher risk. Financial management (capital structure theories) guides in selecting these sources of financing.

4. Financial Management Helps Making Dividend Decision
Dividend is the return to the shareholders. The firm is not legally obliged to pay dividend to the shareholders. However, how much to pay out of the earning is a vital issue. Financial management (dividend policies and theories) helps a firm to decide how much to pay as dividend and how much to retain in the firm. It also suggests answering questions such as when and in what form (cash dividend or stock dividend) should the dividend be paid?

The importance of financial management is not limited to the managers who make decisions in the firm. Proper financial management will help firms to supply better product to its customers at lower prices, pay higher salary to its employees and still provide greater return to investors.

Meaning And Scope Of Finance

2012-04-21T22:25:00.004-07:00

Meaning Of Finance
The term finance should be understood in two perspectives - finance as a resource and finance as a discipline. Finance, as a resource, refers to monetary means of financing assets of an entity. Finance as a discipline or subject of study, describes how individuals , governments and corporate organizations manage the flows of money through an organization. In other words, finance tells how people make decisions about the collection and allocation of resources in organizations like corporation, school, bank or government agency. Therefore, it is important for all individuals, businesses, governments and non-government organizations to appreciate the significance of finance in their day-to-day businesses.
Finance was a branch of economics till the closure of nineteenth century. Finance as a separate academic discipline is still evolving. Practicing managers and academicians have been contributing in its expansion and enrichment.

Scope Of Finance
At the present state, the academic discipline of finance includes the following specialized areas in its scope.

1. Public Finance
Like business organizations, governments(local, state or federal) raise and spend large sum of money, but unlike business organizations, they pursue non-profit goals. To deal with governmental financial matters, a separate and specialized field of finance has emerged as public finance.

2. Securities And Investment Analysis
This area is of interest to individuals and institutional investors. It covers mainly measurement of risk and return on investment in securities.

3. Institutional Finance
Institutional finance deals with issues of capital formation and the organizations that perform the financing function of the economy. Therefore, it mainly studies saving and capital formation and institutions involved in this process such as banks, insurance companies, provident and pension funds, etc.

4. International Finance
International finance studies economic transactions among nations, corporations and individually internationally. It is concerned with flows of money across international boundaries.

5. Financial Management
Business firms face problems dealing with acquisition of funds and optimum methods of employing the funds. Thus, financial management studies financial problems in individual firms, seeks low-cost funds and seeks profitable business activities.

The popularity of finance is increasing day by day. It is because the study of finance offers rewarding careers opportunities mainly in above areas.

Concept Of Pricing Decision And Objectives Of Pricing Policy

2012-04-09T01:54:00.006-07:00

Pricing Decision

Organizations producing goods and services need to set the price for their product. Setting the price for an organization's product is one of the most important decisions a manager faces. It is one of the most crucial and difficult decisions a firm's manager has to make. Pricing is a profit planning exercise. Cost is one of the major considerations in price determination of the product. It is one of the three major factors which influence ricing decision. The two other factors are customers and competitors.

Customer: In a situation where the product has many substitutes, customers decide the price. That is, the demand of customers are the paramount importance in setting the price of the product. In such a situation, the firm should try to deliver the value, in the form of product and/or service, at the target cost so that a reasonable profit can be earned. Similarly, under competitive condition, price is determined by market forces and an individual firm or an individual customer can not influence the price.

Competitors: When there are only few players in the market, competitors usually, react to the price changes and, therefore, pricing decisions are influenced by the possible reaction of competitors. As such management must keep watchful eye on the firm's competitors. That is, knowledge of competitors' strategy is essential for pricing decision in an oligopoly situation.

Cost: Cost is the third major factor. Its role in price setting varies widely among industries. Some industries determine price by market forces and in some industries, managers set prices a on the basis of production costs. Firms want to charge a price that covers its costs like production costs, distribution costs and costs relate with selling the product and also including a fair return for its effort.

Objectives Of Pricing Policy

Formulation of pricing policy begins with the classification of the basic objectives of the firm. Pricing objectives have to be in conformity with overall organizational objectives. In most of the situation, profit maximization is the main objective of price policy, but it is only one objective. Following may be other objectives of pricing policy in an organization:

1. Pricing the goods based on reasonable costs.

2. Increase the market share or growth rate at the expense of immediate profits.

3. Avoid adverse public reaction consequent on charging high price.

4. Ethical consideration not to reap high profit.

5. Immediate survival of the firm.

6. Charge reasonable price so as to have good relations with government and public at large.

7. Maximization of prestige of the firm rather than profit, and

8. To safeguard against the emergence of new producers in same line.

Although its importance varies from firm to firm, pricing is one of the tools that a firm has at its disposal in its attempt to reach the stated objectives.

Advantages And Disadvantages Of Leasing

2012-04-07T23:43:00.006-07:00

Advantages Of Leasing

Acquisition of long-term assets requires huge cash outlay which is some times quite beyond the financial capacity of the actual user. In such a situation, the user can lease such capital assets. Leasing serves as a long-term funding that can be used for acquisition of capital assets. The advantages of leasing are as follows:

1. Leasing Permits Alternative Uses

A leasing arrangement provides a firm with the use and control over the assets without incurring huge capital expenditure and requiring to make only periodical rental payments. Thus, leasing saves funds for alternative uses.

2. Leasing Arrange Faster And Cheaper Credit

Leasing companies are generally more accommodating than banks and other financial institutes in respect of terms of financing. As such, it has generally been found that acquisition of assets under leasing arrangement is cheaper and faster as compared to acquisition of assets through other sources of financing.

3. Leasing Increases Lessee's Capacity To Borrow

Leasing arrangements enable the lessee to use more of its own funds for working capital purposes instead of using low yielding fixed assets. The debt-equity ratio of lease does not alter because of assets acquired under lease arrangements. As such lease arrangements can resort to further borrowings in case the need arises.

4. Leasing Protects against Obsolescence

Lease arrangements helps to protect the lessee against the risk of obsolescence in respect of the assets which become obsolete at a faster pace.

5. Boon For Small Firm

Acquisition of assets through a leasing arrangement is particularly beneficial to small firms which can not afford to raise their capacity on account of scarcity of financial resources.

6. Absence Of Restrictive Convenience

The financial institution while lending money usually attach several restrictions on the borrowers as regards management, debt-equity norms declaration of dividends etc. Such restrictions are absent in the case of lease financing.

7 Trading On Tax Shield

In case of a non-tax paying lessee, the cost of financing an asset is much higher as compared to a tax-paying lessee. However, when tax-paying owns the assets, he generally passes a part of the tax benefit to the lessee by means of lower rental charge. As a result of this favor, the real cost of the asset to the lessee, work out to be lower than that what it would have been if he were the owner of the assets.

Disadvantages Of Leasing

Major disadvantages of leasing are as follows:

1. Deprived On Ownership

In a leasing arrangement, the lessee does not get the ownership of the asset. it gives only the right to use. As such, the lessee, cannot pledge the asset for securing loan from financial institutions.

2. Deprived Of The Asset IN Case Of Default

In case the lessee makes a default in rental payment, the lessor is entitled to take over the asset and the lessee has no right to prevent him from doing so.

Concept Of Lease Or Purchase Decision And Its Evaluation Process

2012-04-07T23:09:00.006-07:00

Lease Or Purchase

Leasing is a contract between the owner(lesser) and the lessee for the hiring of a specific assets. Leasing can apply to any fixed assets and quite commonly used for plant and machinery, office equipment and motors vehicles. Instead of acquiring these assets for itself, the company enters into an agreement with a leasing company whereby the latter purchase the assets in question and then lease them ( rent or hire them) on a long-term basis to the former. No initial funds are required but there is instead a regular charge for lease payments to be charged in th

e profit and loss account. The lessee obtains possession and use of the asset in

exchange for the lease rentals, while the lessor retains legal ownership.

Leases are of two types:

a) operating Leases, and

b) finance leases

Operating lease is one where an asset leased or hired for a period of time substantially less than that of its useful life. A finance lease is one which last for the whole of an asset's useful life and where the lessee effectively takes all the risks and benefits associated with ownership.

Leasing an asset from the lessor or purchase of asset by borrowing the full purchase price of asset should be compared as financing alternatives that are dependent on the investment decision. As such, such investment have been evaluated as part of a company's capital budgeting process and mostly use the NPV method by analysis using the after tax cost of debt as the discount rate for decision making. It means a firm should evaluate whether to purchase an asset or acquire by leasing. Lease rental payments are similar to the payments of interest on debt so leasing may be an good alternative to borrowing for the firm. Thus, lease financing is made using NPV method using the after-tax cost of debt as the discount rate.

Steps Involve In Evaluating The Lease Or Purchase For Decision Making

1. Determine the after tax cash outflow for each year under lease alternative as under:

(Lease payment amount - tax benefit on lease payment=$..) tax rate X lease payment

2. Determine the NPV of after tax cash outflow amount using after tax cost of capital (cost of capital X tax rate) or Cost of capital(1-tax rate). That is, determine PV of cash flows associated with the leasing alternative.

3. Determine the after tax cash outflow under buying alternative based on borrowing (PV of purchase price - PV of tax benefits of depreciation provided). That is, PV of cash flow associated with the buying alternative will be ascertained.

4. The decision between buying or leasing will be made by comparing the NPV under each of the alternatives. The alternative having lower NPV will be preferred

Note: Principle and interest payments when discounted at the appropriate borrowing rate will always be equal to the amount borrowed. Therefore, there is no need to consider the principal and interest repayments.

Select the alternative with low present value of cash outflows.

Concept Of Sell Or Process Further Decision

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Joint products have common process and joint cost of production up to a split-point. At split-off point they become distinguishable. That is, after completing common process, the joint products will be separated. Often joint products are sold at the separation/split-off point. But sometimes, it is more profitable to process a joint product further beyond the split-off point, prior to selling it.Such additional processing adds value to a product and increases its selling rice above the amount, for which it can be sold at split-off. Manager has to decide whether a product is sold at split-off point or sold after further processing. That is, determining whether to sell or process further is an important decision that a manager must take.

Further processing not only increase the total revenues but also incurred additional costs. Therefore, the process further decision depends on whether the increase in total revenue exceeds the additional cost incurred for processing beyond split-off point. That is, incremental analysis provide the solution to sell or process further decision. Joint cost incurred prior to split-off point have no effect on the decision. The cost incurred before split-off point are past costs, sunk cost or irrelevant cost for sell or process further decision. Only future incremental revenue and differential cost should be considered. And incremental revenue is to be compared with incremental costs. The alternative which gives more benefit(incremental revenue- incremental cost) must be adopted.

Concept Of Equipment Replacement Decision

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Some time choice to be made between retention or replacement of equipment. Basically, replacement of machine or equipment is a capital investment or long-term decision requiring use of discounted cash flow technique. But, here discussion is confined to short range problems. Therefore, only one aspect of replacement will be dealt with, i.e. how to deal with written down/book value of old equipment. And differential cost approach is primarily followed because replacement will invariably involve additional fixed cost. Major considerations relevant to decision are given below:
- Determine relevant items of cash outflows and inflows due to the decision.
- Book value or written down value is irrelevant for the decisions- loss on sale of old machinery is irrelevant for this decision.
- Sales proceeds of old equipments is relevant for the decision and be considered for this analysis.
- Replacement of machinery may bring down the cost per unit, but it may involve capital outlay. Here the firm may have to decide at what point replacement will be justified.
- Profit or loss on sales of assets being replaced may affect tax payment and this taxation effect should be included in analysis.
Items Of Differential Cost:
- Capital equipment and associated cost, viz, interest and depreciation.
- Loss on sales of old equipment ( if affect by tax)
- Increase in fixed overhead cost.
Items of Differential Benefits:
- Saving in operating cost - tax benefits if any
- Increase volume and value of production
- Realizable value of old machine.

Concept Of Decision Making And Tactical Decision Making Process

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Concept Of Decision Making

Business have limited resources . One of the most important tasks of management is to allocate these resources effectively and efficiently to achieve the company's goals and objectives. Accounting information can improve managements understanding of the results of alternative resource allocation. That is , one of the major roles of the cost management information system is to supply cost and revenue data that are useful to tactical decision making. Decision making is one of the major functions of management. It is very important and difficult task of management.

Decision making can be defined as making choice between future uncertain alternatives. A short term practical decision making consists of choosing among alternatives with an immediate or limited end in view. It must be emphasis that all decision making relates to the future and that a decision is a choice between alternatives in pursuit of objectives. Where no alternatives exist no decision can be made and nothing can be done now that will alter the past. Therefore, decision making is concerned with the future and involves the act of selecting one course of action from various courses of action.

Tactical (Short-Term) Decision Making Process

The tactical decision making process involve following steps:

1. Recognize and define the problem.

2. Identify alternatives which are possible solution to the recognized problem and eliminate alternatives that are not feasible.

3. Identify the predicted cost and benefits associated with each feasible alternative. .

4. Compare the relevant costs and benefits for each alternatives and relate each alternative to the overall strategic goals of the firm and other qualitative factors.

5. Select the alternative with greatest benefit which also supports the organization's strategic objectives.

Concept Of Drop Or Continue Decision

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The management of the company may face a problem of dropping/shutdown or continuing the manufacturing and marketing facilities. It is always in the interest of company to continue to operate facilities as long as products or services sold to recover variable cost and make a contribution toward recovery of fixed cost.
But the problem of drop or continue arise when the income statement regarding the product shows a loss. Then management of the company attempts to find out the reasons for loss and makes decision regarding drop or continue the manufacturing and marketing facilities.
In deciding whether to continue or drop, expected future revenue should be compared with the relevant cost. For this, the relevant cost must be separated into variable/avoidable and fixed/unavoidable cost. Certain cost- fixed cost- does not eliminate by dropping facilities, like depreciation, interest, property tax and insurance. These costs continue during complete inactivity also.
If operations are continued, certain expenditure connected with shutting down will be saved. Such expenditure includes reopening cost.expenses, cost for recruiting and training to new workers etc.
For taking decision to drop or continue the facilities, income statement should be prepared under contribution margin format. Income statements for drop or continue facilities will show:
- Contribution margin
- Net profit and,
- Percentage of net income to net sales

Alternative which has higher contribution margin should be chosen as it will absorb the fixed cost and gives higher profit. Facilities with high amount of fixed cost cannot be dropped as the fixed cost is irrelevant cost and fixed cost will not decrease by dropping the particular facilities.
Fixed cost imposed by dropping the facilities will have to be paid cumulatively in total resulting extra burden of fixed cost to continuing facilities and thereby reduced overall profit of the company.
So, the decision of dropping or continuing the facilities should be judged on the basis of overall company profit.

Concept Of Special Order Decision

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The decision to accept or reject a specially priced order is common in both service industry and manufacturing firms. Manufacturers are often faced with decisions about selling products in a special order at less than full price. The correct analysis of such decisions focuses on the relevant costs and benefits.
The correct analysis of cost and revenue employs the relevant cost approach. Irrelevant costs should be avoided from the analysis. Fixed costs, which often are allocated to individual unit of product or service, are usually irrelevant. Fixed costs typically will not change in total, whether the order is accepted or rejected. But incremental fixed cost is relevant cost. But there is no harm in including such irrelevant item in an analysis so long as they are included under every alternative being considered.
When excess capacity exists, the only relevant cost usually will be the variable costs associated with the special order. When there is no excess capacity, the opportunity cost of using the firm's facilities for the special order are also relevant to the decision.
The decision to accept or reject special order depends upon how the acceptance of the order will affect the short term financial result.
The overall profit will increase if the future total revenue from the special order exceeds the relevant cost. If the future total revenue is lower than the relevant cost, the special order should not be accepted.

Concept Of Make Or Buy Decisions

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Make Or Buy Decisions
A firm may be manufacturing a product by itself. It may receive an offer from an outside supplier to supply that product. Similarly, a firm may be buying a product from outside., it may be considering to manufacturing that product in the firm itself.
Such problem of make or buy be faced by companies which manufactures the goods assembling various sort of components parts like Television, Motor car, Watch, Computer etc. manufacturing companies. Make-or-buy decisions are not short-run in nature but fall into the small-scale tactical decision category. The decision to make or buy may be motivated by cost leadership and/or differentiation strategies. Making instead of buying or buying instead of making may be one way of reducing the cost of producing the main product. Alternatively, choosing to make or buy may be a way of increasing the quality of the component and thus increasing the overall quality of product.
A company has to take make or buy decision when it has to face following choices:
i. Buy certain part or sub-assemblies from outside suppliers, or
ii. Use available capacity to produce the item within the factory.

Cost analysis for make or buy is necessary. The decision in such case will be made by comparing the price being paid to outsides and all additional costs that will have to incurred for manufacturing the product. This type of make or buy decision should be made only after a proper analysis that compares manufacturing costs with purchasing costs and assess the best used of the available facilities. Consideration of a 'Make' option automatically implies that the company has the available capacity for that purpose or has considered the cost of obtaining the necessary capacity in the decision analysis.

Relevant Information Regarding Make Or Buy Decisions Are As Follows:
- Incremental production cost for each unit
- Unit cost of purchasing from outside supplier
- Number of available suppliers
- Quantity of production capacity available to manufacture components
- Opportunity costs of using facilities for production rather than for other purposes
- Quality for space available for storage
- Costs associated with carrying inventory
- Increase in through put generated by buying components.