Pillai Institute of Management Studies and

Research (PIMSR),
New Panvel

Master of Management Studies (MMS)

MMS Semester-2
Subject : Financial Management

Basic Concepts of Financial Management

by
Prof. K.G.S. MANI

(1) Basic concepts of Accounting :

(a)
(i)
(ii)
(iii)

Basics Accounting Principles :

Debit the Receiver and Credit the Giver,
Debit what comes in, and credit what goes out,
Debit all expenses and losses, and Credit all gains and
profits.

(b) Financial statements : (i) Trial Balance, (ii) Trading and

Profit & Loss Account (Income and Expenses Account),
and (iii) Balance Sheet.
(c) Remember : All items appearing in Trading, Profit &
Loss Account and Balance Sheet have already undergone
double entry booking effect. All items given below the
balance sheet as adjustments have not undergone
double entry booking. As such, respective accounts have
to be prepared for such items.
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(1) Current Assets : All items of assets which are

receivable or realisable within an accounting period of
one year are known as current assets. The following
items are current assets :
(1) Cash in hand
(2) Cash at bank
(3) Sundry Debtors
(4) Bills Receivables
(5) Inventories (raw-material, semi-finished goods, finished
goods and consumable stores)
(6) Short term loans, deposits and advances
(7) Marketable investments and short term securities, etc.
(8) Temporary investments
(9) Prepaid expenses,
(10)Accrued income (Income accrued but not received)
(11)Other assets (to be received within one year)
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(2)Current Liabilities : All items of liabilities which are payable

within an accounting period of one year are known as current
liabilities. These include the following items :
(1) Sundry Creditors
(2) Bills Payables (amount payable to suppliers of raw materials
etc
(3) Bank Loans and Overdraft (repayable within one year)
(4) Instalment on loan secured/unsecured payable within one year
(5) Outstanding expenses
(6) Proposed Dividends (dividends payable during current year)
(7) Unclaimed dividends
(8) Advances received from customers
(9) Provision for taxation
(10)Income received in advance
(11)Interest accrued but not due on secured and unsecured loans
(12)Other liabilities (if any payable within one year)

(3)Long Term Liabilities : This is also known as non-current

liabilities. These are liabilities payable after/beyond one year
(1) Equity share capital (permanent liabilities)(owners capital)
(2) Share Premium account
(3) Shares forfeited account
(4) Reserves and Surplus(all reserves including capital reserve)
(5) Sinking Fund, Compensation Fund, etc
(6) Preference share capital (redeemable preference shares)
(7) Debentures and Bonds (borrowed capital) (creditorship
securities)
(8) Long term loans (Bank loans, Mortgage Loans repayable
beyond one year)
(9) Other Long term loans (borrowed from Associate concern,
etc)
(10) Provision for depreciation on fixed assets
(11) Other Liabilities (payable after one year)

(4) Non-current Assets : These are fixed assets and other

assets which are maturing or receivable after/beyond one
year.
Fixed Assets : (1) Land & Buildings
(2) Plant & Machinery, (3) Furnitures and Fixtures,
Intangible Assets :
(4) Goodwill
(5) Trade Marks and Patent Rights
(6) Investments : Long Term Investments (more than one year)
(7) Loans and Advances extended to Associate Concerns
(maturing after one year)
Miscellaneous expenses :
(8) Preliminary expenses (portion not written-off)
(9) Discount on issue of shares and debentures
(10) Deferred expenses (advertisement suspense account, etc)
(11) Profit & Loss Debit balance (Loss) (to be adjusted against
capital funds)
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Long Term Borrowings : These are long term liabilities

repayable beyond/after one year and include the
following items :
(i) Debentures,
(ii) Bonds,
(iii) Term Loans from Banks (repayable after/beyond one
year)
(iv) Term Loans from Financial Institutions (-do-)
(v) Deferred payment liabilities
(vi) Fixed Deposits (repayable after/beyond one year)
(vii) Loans and Advances from related parties (Customers,
Associate companies, Friends & Relatives),
(viii)Long Term maturities of finance-lease obligations,
(ix) Other long term loans (specifying nature), if any.

Share-holders Funds (or) Proprietors funds

(i) Shareholders funds = Equity share capital (+)

Preference
share capital (+) Undistributed
profit
(+) Reserves & Surplus (-)
Accumulated Losses

(ii) Capital Employed = Equity share capital (+)

Preference
share capital (+) Undistributed profits
(+) Reserves & Surplus (+) Long
Term Borrowings (-) Fictitious Assets

Intangible Assets : These are not generally not visible

assets but have value in the books of account of the
company :
(i) Goodwill,
(ii) Trade Marks and Brands,
(iii) Patent Rights and Copy Rights,
(iv) Computer Software,
(v) Publishing Titles,
(vi) Mining Rights,
(vii)Intellectual property rights and operating rights,
(viii)Formulae (Coca Cola), Recipes (Maggie Ketchup),
Models, Designs, Proto-types,
(ix) Licences and Franchise,
(x) Others (specifying nature), if any.

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Contingent Liabilities : These items always appear outside

the Balance Sheet since they are not liabilities as on the
date of Balance Sheet (example : 31 st March 2014). The
following items are included under Contingent Liabilities :
(i) Claims against the Company not acknowledged as debt,
(ii) Guarantees (given by the Company on behalf of Associate
companies, Sister concerns, etc to banks and others),
(iii) Other monies for which the Company is contingently liable,
(iv) Uncalled liability on shares (subscribed by the company)
and other investments partly paid,
(v) Estimated amount of contracts remaining to be executed
on capital account and not provided for (in the accounts
during the year),
(vi) Other commitments (specifying nature), if any.

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Basic Concepts of Financial Management :

Cost of goods sold (COGS) :
(also known as Cost of Sales (COS)
Opening stock of finished goods + Raw-material
consumed + all manufacturing expenses - closing
stocks of finished goods
Raw material consumed = opening stock of RM +
Purchase of RM closing stock of RM;
Manufacturing expenses means all direct expenses
(other than administration, sales and financial expenses)
Short term provisions made by the Company :
This includes the following items :
(i) Provision for taxation, (ii) Provision for dividend,
(iii) Provision for employee benefits (for workmens
compensation fund), (iv) Provision for warranty.
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Working Capital :
(a) Gross Working Capital : This is the total of all items of
Current Assets
(b) Net Working Capital : This is the excess of current assets
over current liabilities (example : CA CL). This is also known
as Working Capital (WC). Net Working Capital (NWC) is
defined as excess of current assets over current liabilities. If
CA are more, then it is called NWC is positive(+) and if CL are
more, it is known as NWC is negative (-).
Example : CA = 100, CL=60, see the changes in WC below :
NWC or Working Capital (WC) = 100 60 = 40
Important points :
(a) If CA increases, WC increases = 140 60 = 80 (increased),
(b) If CA decreases, WC decreases = 80 60 = 20 (decreased),
(c) If CL increases, WC decreases = 100 50 = 50 (decreased),
(d) If CL decreases, WC increases = 100 30 = 70 (increased).

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(c ) Working Capital Gap : Current Assets (minus) current

liabilities (excluding short term bank borrowings). That is,
Current Assets (-) [(Current Liabilities minus Short Term
Bank Borrowings)]
Example : CA = 100, CL = 60, Short Term Bank Borrowings
or Loans = 10
Net Working Capital Gap = 100 (-) [(60-10)] = 50
(d) Source of Funds means inflow of funds or inflow of cash
(e) Application of funds means outflow of funds or outflow
of cash
(f) Remember : Increase in CA and decrease in CL both
increases working capital (see concept and example in
previous slide). This is known as application of funds.
Decrease in CA and increase in CL both increases Working
Capital. This is known as source of funds.

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(d) Basic Concepts :

(i) Financial Leverage :
A firm/company which finances
completely with shareholders equity is called an unlevered
firm/company. A levered company is one which has
financed its long-term capital with debt. Financial leverage
is used by the company to improve the returns to equity
shareholders by way of dividends. Financial Leverage can
bring in higher returns to equity shareholders only when
return on assets is higher than the cost of debt. Hence, the
cost of debt should be kept minimum. In other words, debt
component in capital structure should less. Higher debt will
retail more payment of interest from the profit and less
amount would be available for equity shareholders by ways
of dividends. This is also known as capital gearing. The
standard capital mix by debt and equity is 2 : 1 (example :
for Re 1 of equity (owned capital) ideal debt (borrowed
capital) should not be more than Rs 2 as a measure of
standard ratio)
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(ii) Capital Gearing :

(a) Capital gearing refers to the relationship between
capital (borrowed capital or debt) entitled to fixed rate
of return (interest) and owners capital (equity) which
has varying rate of return (dividend).
(b) It refers to the relationship between equity (owned
capital) and debt (borrowed capital).
(c) A company is said to be highly geared when its fixed
interest bearing securities (debts) are more than equity
share holders. This means equity is less and debt is
more in the capital structure of the company.
(example : equity is 1 or 1/3 and debt is 2 or 2/3).
(d) A company is said to be low-geared when equity
shareholders funds are greater than fixed interest
bearing securities (debts). In other words, equity is
more than debt. (example : equity is 2 or 2/3 and debt
is 1 or 1/3).
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(e) High gearing is also known s trading on equity. If

the company operates with less equity and more debts,
it is trading on equity (owners may get more dividend
due to less equity shares and payment of fixed interest
amounts for debts, if assets are more efficient and
generate more income).

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(viii)Overtrading : Overtrading the stage where the

company is doing more business than its normal
capacity. Overtrading is the result of excessive sales.
The decision of accepting excessive orders compels the
management to make more credit purchases and
engage more workers or make over-time payment to
workers engaged longer than usual hours in order to
fulfil the commitments. Overtrading can be indicated
from the following tests :
(a) Increasing tendency of total trade creditors,
(b) Piling of stock,
(c ) Reduction in turnover,
(d) comparison of credit period obtained with normal
credit period allowed in that trade. If the credit period
taken is more than normally allowed, it is definitely an
index of poor cash position and consequently overtrading.
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(ix)Undertrading : It is the reverse of overtrading.

Undertrading generally hints at inadequate volume of
business. This is due to under-employment of assets of the
business, leading to fall in sales and results in financial
crisis. This makes the business unable to meet the
commitments and ultimately leads to forced liquidation.
(x) Over-capitalisation : A company is said to be overcapitalised if its earnings are not sufficient to justify a fair
return on the amount of share capital and debentures that
have been issued. It is also said to be over-capitalised
when the total of owned-capital and borrowed capital
exceeds its fixed and current assets, i.e. when it shows
accumulated losses on the assets side of Balance Sheet.
Over capitalisation can be removed by reducing capital so
as to obtain a satisfactory relationship between proprietors
funds and net profits. In case over-capitalisation is the
result of over-valuation of assets then it can be remedied
by bringing down the value of assets to their proper value.
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(xi) Under-capitalisation : If the owned-capital of

business is much less than total borrowed capital, then it
is a sign of under-capitalisation. This means that the
owned capital of business is disproportionate to scale of
its operation and hence the business is dependent upon
borrowed money and trade creditors. Under-capitalisation
may be result of over-trading. It must be distinguished
from high gearing. In the case of high gearing there is
a comparison between equity capital and fixed interest
bearing capital (which includes preference share capital
also and excludes trade creditors) whereas in the case of
under-capitalisation, the comparison is between total
owned capital (both equity and preference share capital)
and total borrowed capital (which includes trade creditors
also).

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e) Concepts of various ratios :

(i) Current Ratio : Current Ratio is a measure of liquidity
calculated dividing the current assets by current liabilities.
(ii) Liquidity Ratio : Liquidity Ratio is the ability of a
business/firm to satisfy its short-term obligations as they
become due.
(iii) Acid Test Ratio (or) quick Ratio : It is a measure of liquidity
calculated divided current assets minus inventory and
prepaid expenses by current liabilities.
(iii) Net Working Capital : It is a measure of liquidity calculated
by subtracting current liabilities from current assets. It is
the excess of current assets over current liabilities.
(iv) Debt-Equity Ratio : This ratio measures the ratio of longterm debts or total debts to shareholders equity.
(a) D/E ratio = Total debt divided by Shareholders equity.
(b) D/E ratio = Long term debt divided by Shareholders
equity.
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(v) Proprietary Ratio : This indicates the extent to which

assets re financed by owners funds.
(vi) Interest Coverage Ratio : This ratio measures the
firms ability to meet all interest payments obligations.
(vii)Debt Service Coverage Ratio (DSCR) : DSCR is the
ability of a firm to make the contractual payments
(instalments and interest) required on a scheduled
basis over the life of the debt or loan.
(viii) Gross Profit Ratio : This ratio measures the
percentage of each sales rupee remaining after the firm
has paid for its goods.
(ix) Net Profit Ratio : It measures the percentage of each
sles rupee rupee remaining after all costs and expenses
including interest and taxes have been deducted.
(x) Return on Investments (ROI) : This ratio measures the
overall effectiveness of management in generating
profits with its available assets.
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(xi) Return on Shareholders Equity : This measures the return

on the owners (both preference and equity shareholders)
investment in the business/firm.
(xii)Return on Ordinary Shareholders Equity : This measures
the return on the total equity funds of ordinary shareholders.
Shareholders Ratio :
(xiii)Earnings Per Share (EPS) : Earning per share is calculated
to find out overall profitability of the organisation. Higher
ratio signifies higher overall profitability. The growth
Company is identified as one, where EPS increases year
after year.
(xiv)Price-Earning Ratio (P/E ) : This ratio is a multiple obtained
by dividing the market price of the share with the earnings
per share. This multiple changes as a result of changes in
the market price. Higher the ratio, better the investors
confidence in the Company. Low PE ratio indicates that
investors perception about the company for investment in
its shares is very low and risky.
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(xv)Dividend Pay-out Ratio : The purpose of this ratio is to

find out the proportion of earning used for payment of
dividend and the proportion of earnings retained in the
business. The ratio is a relationship between earning
per equity share and dividend per equity share. Higher
ratio signifies that the company has utilised larger
portion of its earning for payment of dividend to equity
shareholders. Lower ratio indicates that smaller portion
of earning has been utilised for payment of dividend.

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Turnover Ratios :
(xvi) Stock Turnover Ratio (or) Inventory Turnover Ratio :
This ratio is computed by dividing the cost of goods
sold by the average stocks (inventory). (Average stock
refers to simple average of opening and closing stocks).
The ratio indicates how fast stocks are sold. A high ratio
is good form the view-point of liquidity. A low ratio
would signify that stocks do not sell fast and stay on in
the shelf or in the warehouse of the company for a long
time.
(xvii)Debtors Turnover Ratio : It is determined by dividing
the net credit sales by average debtors (including bills
receivable) outstanding during the year. A high ratio
indicative of shorter time-lag between credit sales and
cash collection. A low ratio shows that debts are not
being
collected rapidly.

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(xviii) Creditors Turnover Ratio : It is a ratio between net

credit purchases and the average amount of creditors
(including bills payable) outstanding during the year. A
low turnover ratio reflects liberal credit terms granted by
suppliers, while a high ratio shows that accounts are to
be settled rapidly. The creditors turnover ratio is an
important tool of analysis as the company can reduce its
requirement of current assets by relying on suppliers
credit.
(xix)Fixed Assets Turnover Ratio : This ratio is a relationship
between Net Sales and Fixed Assets. It is calculated by
dividing Net Sales by Fixed Assets. Higher ratio is
favourable. It shows that the Company is able to
generate more sales in relation to the size of assets
invested. It indicates efficiency of the management in
utilisation of fixed assets.
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(xx) Working Capital Turnover Ratio : This ratio is

calculated by dividing Net Sales by working capital. The
ratio shows the extent of working capital required
turned over for achieving the sales. Higher ratio is
favourable. It shows that working capital has been
utilised effectively for achieving of sales.

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Funds Flow Statement (Statement of Sources and

Applications) :
(1) Steps in the preparation of Funds Flow Statement :
(i) Preparation of profit and loss account (to know funds
from operations or funds lost in operations);
(ii) Preparation of accounts for non-current items (to
ascertain the hidden information);
(iii) Preparation of statement of changes in Working Capital
(taking current assets and current liabilities only);
(iv) Preparation of Funds Flow Statement.
(2) Format (specimen/proforma) for Funds Flow Statement :
Funds Flow statement should be prepared in T shape
format or vertical format. But T shape format is
preferred. (Refer to slides for problems and solutions in
Funds Flow Statement for details)
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(i) General Rules for flow of funds :

(1) There will be flow of funds if a transaction involves :
(i) current assets and fixed assets i.e. purchase of
building for cash;
(ii) current assets and capital i.e. issue of shares for
cash;
(iii) current assets and fixed liabilities i.e. redemption of
debentures in cash;
(iv) current liabilities and fixed liabilities i.e. creditors
paid-off in debentures;
(v) current liabilities and capital e.g. creditors paid-off in
shares
(vi) current liabilities and fixed assets e.g. Building
transferred to creditors in satisfaction of their claims.
(Fixed Liabilities : share capital, reserves and surplus,
debentures , long term loans)
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(2) There will not be any flow of funds, if transaction involves :

(i) current assets and current liabilities e.g. payment made to
creditors;
(ii) fixed assets and fixed liabilities e.g. building purchased
and payment made in debentures;
(iii) fixed assets and capital e.g. building purchased and
payment made in shares.
(j)Rules for preparing Schedule of Changes in Working
Capital(WC):
(Note : WC is excess of current assets over current liabilities)
(i) Increase in current asset, results in increase (+) in
working capital
(ii) Decrease in current asset, results in decrease(-) in wc
(iii) Increase in current liability, results in decrease (-) in wc
(iv) Decrease in current liability, results in increase (+) in wc

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Concepts on Cash Flow Statement : (to be discussed later)

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THANK YOU

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