IHM Previous year Solved Paper 2016-2017 | Financial Management | 5th semester

IHM Previous year Solved Paper 2016-2017 | Financial Management | 5th semester |NCHM JEE

Q.1. Explain the objectives and functions of financial management.

The financial management is generally concerned with procurement, allocation and control of financial resources of a concern.

The objectives are :

1. To ensure regular and adequate supply of funds to the concern.
2. To ensure adequate returns to the shareholders this will depend upon the earning capacity, the market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in a maximum possible way at least cost.
4. To ensure the safety of investment, i.e, funds should be invested in safe ventures so that adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be the sound and fair composition of capital so that a balance is maintained between debt and equity capital.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to makeestimation with regards to capital requirements of the company. This will depend upon expected costs and profits and future programmes and policies of a concern. Estimations have to be made in an adequate manner which increases earning capacity of the enterprise.

2. Determination of capital composition: Once the estimation has beenmade, the capital structure has to be decided. This involves short- term and long- term debt equity analysis. This will depend upon the proportion of equity capital a company is possessing and additional funds which have to be raised from outside parties.

3.Choice of sources of funds: For additional funds to be procured, a companyhas many choices like-

1. Issue of shares and debentures
2. Loans to be taken from banks and financial institutions
3. Public deposits to be drawn like in form of bonds.
4. Choice of the factor will depend on relative merits and demerits of each source and period of financing.

4. Investment of funds: The finance manager has to decide to allocate fundsinto profitable ventures so that there is safety on investment and regular returns are possible.

5.Disposal of surplus: The net profits decision have to be made by the financemanager. This can be done in two ways:

1. Dividend declaration – It includes identifying the rate of dividends and other benefits as a bonus.
2. Retained profits – The volume has to be decided which will depend upon expansion, innovation, diversification plans of the company.

6.Management of cash: Finance manager has to make decisions with regardsto cash management. Cash is required for many purposes like payment of wages and salaries, payment of electricity and water bills, payment to creditors, meeting current liabilities, maintenance of enough stock, purchase of raw materials, etc..

7.Financial controls: The finance manager has not only to plan, procure andutilize the funds but he also has to exercise control over finances. This can be done through many techniques like ratio analysis, financial forecasting, cost and profit control, etc.

OR

How is the finance function organised? What are the functions that finance department performs in a large organisation?

Functions that finance department performs in a large organisation:-

1. Bookkeeping and Payables/Receivables

Bookkeeping is the most basic financial activity in a company. Before a business owner ever considers hiring a CFO, they bring in a bookkeeper, who tracks all of the transactions in the organization, covering both sales and expenses. As the organization grows, they might hire more specialized payables and receivables clerks, to take over functions such as corresponding with vendors and suppliers, above and beyond recording transactions.

2. Financial Reporting and Control

Financial Reporting and Control is the function that takes raw accounting entries and transforms them into usable and comparable financial statements. Requiring far more judgment than the bookkeeper’s role, this function involves everything from ruling on how to implement accounting principles to designing financial processes of the organization, selecting accounting systems, liaising with external auditors, and ensuring that there are no gaps or oversights in existing processes.

3. Tax and Compliance

Running a business involves paying tax, and paying tax means doing a lot of calculations and filling out a lot of forms. Often using the financial statements as a basis, along with various other configurations of the information produced by Bookkeeping and Payables/Receivables, the Tax and Compliance function will make sure all of the government forms and filings are sent complete and on-time to the taxman. A strong Tax and Compliance function will go one step beyond simple compliance, and will find ways to minimize tax, so as to maximize the company’s net income.

4. Strategic Planning and Financial Planning & Analysis

This function, “FP&A” for short, is the true bridge between the Past and the Future. FP&A regularly creates strategic and financial plans that forecast what financial results (sales and expenses) will look like in future periods. Then, they compare actual results—prepared with the assistance of the Financial Reporting and Control function—to determine areas where the business can improve. With this “variance analysis” complete, they can then prepare more accurate forecasts for the future. A strong FP&A function will not only generate annual forecasts but will be able to update them even over the course of a day or two, and to run many scenarios that examine the effects of, say, losing a big customer or an economic contraction.

5. Treasury & Working Capital Management

The key role of Treasury is to make sure that the company doesn’t run out of cash. This means, among other things, forecasting the upcoming working capital (receivables, payables and inventory) needs of the company, investing surplus cash in short-term instruments to generate modest interest income, and managing currency risk.

6. Capital Budgeting

Capital Budgeting is the function responsible for selecting between the various uses of capital, or capital projects. After all, most organizations will have money available to invest in the business, with the hopes of either growing sales or reducing expenses. But the opportunities for spending typically exceed the amount available to spend, so Capital Budgeting develops business cases to evaluate and identify the most effective projects. A strong Capital Budgeting function will not only forecast project benefits, but will also track these benefits over time to determine whether the use of capital was as effective as originally anticipated.

7. Risk Management

Risk Management is a function that is rapidly developing after the financial scandals of the early 2000s (Enron, WorldCom, the Great Recession and Lehman/Bear Stearns collapse, etc.). In the financial services industry, the function is particularly central as most institutions run with a high amount of debt (leverage), though leaders in other industries are also bulking up this function. Risk Management takes a hard look at some of the key risks faced by the company—currency, interest rate, market, operational, legal, etc.—and tries to quantify the possible impacts so that they can be mitigated as much as possible. If FP&A looks at the base case scenario for the company’s financial results, Risk Management takes a wrecking ball to it.

8. Corporate Development & Corporate Strategy

Corporate Development and Corporate Strategy can be widely defined, but it is the area of Finance most heavily populated by former investment bankers and management consultants. As such, common tasks that fall to this function include sourcing and analyzing mergers & acquisitions deals, raising debt and equity financing, making capital structure decisions and providing insight into high level strategic decisions such as entering a new market.

Q.2. Define capital structure. Explain the principles, while forming the capital structure of the organisation.

Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as long-term finance.

Capital structure is the mix of the long-term sources of funds used by a firm. It is made up of debt and equity securities and refers to permanent financing of a firm. It is composed of long-term debt, preference share capital and shareholders’ funds. “Capital structure is essentially concerned with how the firm decides to divide its cash flows into two broad components, a fixed component that is earmarked to meet the obligations toward debt capital and a residual component that belongs to equity shareholders”

Factors Determining Capital Structure

1. Trading on Equity- The word “equity” denotes the ownership of thecompany. Trading on equity means taking advantage of equity share capital to borrowed funds on a reasonable basis. It refers to additional profits that equity shareholders earn because of issuance of debentures and preference shares. It is based on the thought that if the rate of dividend on preference capital and the rate of interest on borrowed capital is lower than the general rate of company’s earnings, equity shareholders are at an advantage which means a company should go for a judicious blend of preference shares, equity shares as well as debentures. Trading on equity becomes more important when expectations of shareholders are high.

2.The degree of control- In a company, it is the directors who are so-called electedrepresentatives of equity shareholders. These members have got maximum voting rights in a concern as compared to the preference shareholders and debenture holders. Preference shareholders have reasonably less voting rights while debenture holders have no voting rights. If the company’s management policies are such that they want to retain their voting rights in their hands, the capital structure consists of debenture holders and loans rather than equity shares.

3.The flexibility of financial plan- In an enterprise, the capital structure should besuch that there is both contractions as well as relaxation in plans. Debentures and loans can be refunded back as the time requires. While equity capital cannot be refunded at any point which provides rigidity to plans. Therefore, in order to make the capital structure possible, the company should go for the issue of debentures and other loans.

4. Choice of investors- The company’s policy generally is to have differentcategories of investors for securities. Therefore, a capital structure should give enough choice to all kind of investors to invest. Bold and adventurous investors generally go for equity shares and loans and debentures are generally raised keeping in mind conscious investors.

5. Capital market condition- In the lifetime of the company, the market price ofthe shares has got an important influence. During the depression period, the company’s capital structure generally consists of debentures and loans. While in the period of boons and inflation, the company’s capital should consist of share capital generally equity shares.

6. Period of financing- When the company wants to raise finance for short period,it goes for loans from banks and other institutions; while for long period it goes for an issue of shares and debentures.

7. Cost of financing- In a capital structure, the company has to look at thefactor of cost when securities are raised. It is seen that debentures at the time of profit earning of company prove to be a cheaper source of finance as compared to equity shares where equity shareholders demand an extra share in profits.

8. Stability of sales- An established business which has a growing market andhigh sales turnover, the company is in position to meet fixed commitments. Interest on debentures has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are high and the company is in the better position to meet such fixed commitments like interest on debentures and dividends on preference shares. If a company is having unstable sales, then the company is not in a position to meet fixed obligations. So, equity capital proves to be safe in such cases.

9. Sizes of a company- Small size business firms capital structure generallyconsists of loans from banks and retained profits. While on the other hand, big companies having goodwill, stability and an established profit can easily go for the issuance of shares and debentures as well as loans and borrowings from financial institutions. The bigger the size, the wider is total capitalization.

OR

Define working capital. What factors would you take into consideration in estimating the working capital needs of a budget hotel?

Working Capital is the capital which is needed for meeting day to day requirement of the business concern. For example, payment to creditors, salary paid to workers, purchase of raw materials etc., normally it consists of recurring in nature. It can be easily converted into cash. Hence, it is also known as short-term capital.

Main factors affecting the working capital are as follows:

(1) Nature of Business:

The requirement of working capital depends on the nature of the business. The nature of the business is usually of two types: Manufacturing Business and Trading Business.

In the case of the manufacturing business, it takes a lot of time in converting raw material into finished goods. Therefore, capital remains invested for a long time in a raw material, semi-finished goods and the stocking of the finished goods.

(2) The scale of Operations:

There is a direct link between the working capital and the scale of operations. In other words, more working capital is required in case of big organisations while less working capital is needed in case of small organisations.

(3) Business Cycle:

The need for the working capital is affected by various stages of the business cycle. During the boom period, the demand for product increases and sales also increase. Therefore, more working capital is needed. On the contrary, during the period of depression, the demand declines and it affects both the production and sales of goods. Therefore, in such a situation less working capital is required.

(4) Seasonal Factors:

Some goods are demanded throughout the year while others have seasonal demand. Goods which have uniform demand the whole year their production and sale are continuous. Consequently, such enterprises need little working capital.

On the other hand, some goods have seasonal demand but the same are produced almost the whole year so that their supply is available readily when demanded.

Such enterprises have to maintain large stocks of raw material and finished products and so they need a large amount of working capital for this purpose. Woolen mills are a good example of it.

(5) Production Cycle:

Production cycle means the time involved in converting raw material into finished product. The longer this period, the more will be the time for which the capital remains blocked in raw material and semi-manufactured products.

Thus, more working capital will be needed. On the contrary, where the period of production cycle is little, less working capital will be needed.

(6) Credit Allowed:

Those enterprises which sell goods on cash payment basis need little working capital but those who provide credit facilities to the customers need more working capital.

(7) Credit Availed:

If the raw material and other inputs are easily available on credit, less working capital is needed. On the contrary, if these things are not available on credit then to make a cash payment quickly large amount of working capital will be needed.

(8) Operating Efficiency:

Operating efficiency means efficiently completing the various business operations. Operating efficiency of every organisation happens to be different.

Some such examples are: (i) converting raw material into finished goods at the earliest, (ii) selling the finished goods quickly, and (iii) quickly getting payments from the debtors. A company which has a better operating efficiency has to invest less in stock and the debtors.

Therefore, it requires less working capital, while the case is different in respect of companies with less operating efficiency.

(9) Availability of Raw Material:

Availability of raw material also influences the amount of working capital. If the enterprise makes use of such raw material which is available easily throughout the year, then less working capital will be required, because there will be no need to stock it in large quantity.

On the contrary, if the enterprise makes use of such raw material which is available only in some particular months of the year whereas for continuous production it is needed all the year round, then a large quantity of it will be stocked. Under the circumstances, more working capital will be required.

(10) Growth Prospects:

Growth means the development of the scale of business operations (production, sales, etc.). The organisations which have sufficient possibilities for growth require more working capital, while the case is different in respect of companies with fewer growth prospects.

(11) Level of Competition:

High level of competition increases the need for more working capital. In order to face competition, more stock is required for quick delivery and credit facility for a long period has to be made available.

(12) Inflation:

Inflation means a rise in prices. In such a situation more capital is required than before in order to maintain the previous scale of production and sales. Therefore, with the increasing rate of inflation, there is a corresponding increase in the working capital.

Q.3.  Explain ratio analysis types with the help of a chart and its importance.

Ratio analysis is a commonly used tool for financial statement analysis. A ratio is a  mathematical relationship between one number to another number. The ratio is used as an index for evaluating the financial performance of the business concern. An accounting ratio shows the mathematical relationship between two figures, which have a meaningful relationship with each other.

A ratio can be classified into various types. Classification from the point of view of financial management is as follows:
● Liquidity Ratio
● Activity Ratio
● Solvency Ratio
● Profitability Ratio

Liquidity Ratio
It is also called as the short-term ratio. This ratio helps to understand the liquidity in a business
which is the potential ability to meet current obligations. This ratio expresses the relationship
between current assets and current assets of the business concern during a particular
period. The following are the major liquidity ratio:

Activity Ratio
It is also called as the turnover ratio. This ratio measures the efficiency of the current assets
and liabilities in the business concern during a particular period. This ratio is helpful to
understand the performance of the business concern. Some of the activity ratios are given
below:

Solvency Ratio
It is also called as the leverage ratio, which measures the long-term obligation of the business
concern. This ratio helps to understand, how the long-term funds are used in the business
concern. Some of the solvency ratios are given below:

Profitability Ratio
Profitability ratio helps to measure the profitability position of the business concern. Some
of the major profitability ratios are given below.

OR

Write short notes on:

(i) Over capitalisation

Overcapitalization is a situation in which actual profits of a company are not sufficient enough to pay interest on debentures, on loans and pay dividends on shares over a period of time. This situation arises when the company raises more capital than required. A part of capital always remains idle. With a result, the rate of return shows a declining trend.

The causes can be-

1. High promotion cost- When a company goes for high promotional expenditure, i.e., making contracts, canvassing, underwriting commission, drafting of documents, etc. and the actual returns are not adequate in proportion to high expenses, the company is over-capitalized in such cases.
2. Purchase of assets at higher prices- When a company purchases assets at an inflated rate, the result is that the book value of assets is more than the actual returns. This situation gives rise to over-capitalization of the company.
3. A company’s floatation n boom period- At times company has to secure it’s solvency and thereby float in boom periods. That is the time when the rate of returns is less as compared to capital employed. This results in actual earnings lowering down and earnings per share declining.
4. Inadequate provision for depreciation- If the finance manager is unable to provide an adequate rate of depreciation, the result is that inadequate funds are available when the assets have to be replaced or when they become obsolete. New assets have to be purchased at high prices which prove to be expensive.
5. Liberal dividend policy- When the directors of a company liberally divide the dividends into the shareholders, the result is inadequate retained profits which are essential for high earnings of the company. The result is deficiency in company. To fill up the deficiency, fresh capital is raised which proves to be a costlier affair and leaves the company to be overcapitalized.
6. Over-estimation of earnings- When the promoters of the company overestimate the earnings due to inadequate financial planning, the result is that company goes for borrowings which cannot be easily met and capital is not profitably invested. This results in consequent decrease in earnings per share.

Effects of Overcapitalization

1. On Shareholders- The over-capitalized companies have following disadvantages to shareholders:
   1. Since the profitability decreases, the rate of earning of shareholders also decreases.
   2. The market price of shares goes down because of low profitability.
   3. The profitability going down has an effect on the shareholders. Their earnings become uncertain.
   4. With the decline in goodwill of the company, share prices decline. As a result, shares cannot be marketed in the capital market.
2. On Company-
   1. Because of low profitability, the reputation of a company is lowered.
   2. The company’s shares cannot be easily marketed.
   3. With the decline of earnings of the company, goodwill of the company declines and the result is fresh borrowings are difficult to be made because of loss of credibility.
   4. In order to retain the company’s image, the company indulges in malpractices like manipulation of accounts to show high earnings.
   5. The company cuts down it’s expenditure on maintenance, replacement of assets, adequate depreciation, etc.
3. On Public- An overcapitalized company has got many adverse effects on the public:
   1. In order to cover up their earning capacity, the management indulges in tactics like an increase in prices or decrease in quality.
   2. Return on capital employed is low. This gives an impression to the public that their financial resources are not utilized properly.
   3. Low earnings of the company affect the credibility of the company as the company is not able to pay it’s creditors on time.
   4. It also has an effect on working conditions and payment of wages and salaries also lessen.

(ii) Indifference point

An important tool that managers use to help them choose between alternative cost struc­tures is the indifference point. The indifference point is the level of volume at which total costs, and hence profits, are the same under both cost structures. If the company operated at that level of volume, the alternative used would not matter because income would be the same either way. At the cost indifference point, total costs (fixed cost and variable cost) associated with the two alterna­tives are equal.

There may be two methods or two alternatives to doing a thing, say two methods of production. It is also possible at a particular level of activity; one production method is superior to another, and vice versa. There is a need to know at which level of production, it will be desirable to shift from one production method to another production method. This level or point is known as cost indifference point and at this point total cost of two production methods is same.

(iii) Comparative and common size Income statements

A comparative Income statement is a document that compares an income statement with prior period statements or with the income statement generated by another company.

Analysts like comparative statements because the reports show the effect of business decisions on a company’s bottom line. Analysts can identify trends and evaluate the performance of managers, new lines of business and new products on one report, instead of having to flip through individual financial statements. When comparing different companies, a comparative statement shows how a business reacts to market conditions affecting an entire industry.

Common size income statement is an income statement in which each account is expressed as a percentage of the value of sales. This type of financial statement can be used to allow for easy analysis between companies or between time periods of a company. Common size income statement analysis allows an analyst to determine how the various components of the income statement affect a company’s profit.

Q.4.  Write short notes on:

(i) Payback period

Pay-back period is the time required to recover the initial investment in a project.

(It is one of the non-discounted cash flow methods of capital budgeting).
Pay-back period = Initial investment/Annual cash inflows

Merits of Pay-back method
The following are the important merits of the pay-back method:
1. It is easy to calculate and simple to understand.
2. Pay-back method provides further improvement over the accounting rate return.
3. Pay-back method reduces the possibility of loss on account of obsolescence.

Demerits
1. It ignores the time value of money.
2. It ignores all cash inflows after the pay-back period.
3. It is one of the misleading evaluations of capital budgeting

The payback period is the length of time required to recover the cost of an investment. The payback period of a given investment or project is an important determinant of whether to undertake the position or project, as longer payback periods are typically not desirable for investment positions.

The payback period ignores the time value of money, unlike other methods of capital budgeting, such as net present value, internal rate of return or discounted cash flow.

(ii)Cash flow statements

Cash flow statement is a statement which discloses the changes in cash position between the two periods.Along with changes in the cash position, the cash flow statement also outlines the reasons for such inflows or outflows of cash which in  turn helps to analyse the functioning of a business.Cash flow statement is a statement which shows the sources of cash inflow and uses of cash outflow of the business concern during a particular period of time.

It is the statement, which involves the only short-term financial position of the business concern. Cash flow
statement provides a summary of operating, investment and financing cash flows and
reconciles them with changes in its cash and cash equivalents such as marketable securities.

(iii)Average rate of return

The average rate of return means the average rate of return or profit taken for considering
the project evaluation. This method is one of the traditional methods for evaluating
the project proposals:

Merits
1. It is easy to calculate and simple to understand.
2. It is based on the accounting information rather than cash inflow.
3. It is not based on the time value of money.
4. It considers the total benefits associated with the project.

Demerits
1. It ignores the time value of money.
2. It ignores the reinvestment potential of a project.
3. Different methods are used for accounting profit. So, it leads to some difficulties
in the calculation of the project.

(iv)Profit maximisation

Profit maximization is a traditional and narrow approach, which aims at, maximizes the profit of the concern. The main aim of any kind of economic activity is earning a profit. A business concern is also functioning mainly for the purpose of earning profit. Profit is the measuring techniques to understand the business efficiency of the concernProfit maximization consists of the following important features.
1. Profit maximization is also called as cashing per share maximization. It leads to maximize the business operation for profit maximization.
2. The ultimate aim of the business concern is earning the profit, hence, it considers all the possible ways to increase the profitability of the concern.
3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the entire position of the business concern.
4. Profit maximization objectives help to reduce the risk of the business.

Q.5. Balance Sheet of a company as on 31.12.2010 is as follows:

Additional information:

(i)  Net income for the year Rs.1,40,000/-

(ii)  Fixed assets purchases were made during the year at a cost of
Rs.1,65,000/- and fully depreciated machinery costing Rs.40,000/-

(iii)  Depreciation for the year Rs.20,000/-

(iv)  Income tax paid was Rs.40,000/-

You are required to prepare:
(a) A statement of schedule of changes in working capital

(b) Sources and application of funds

Preparing the schedule/statement of changes in working capital requires us to present the information relating to the current area of the balance sheets pertaining to the two periods in the format given below and deriving and presenting the changes within them.

Q.6. A project cost Rs.25,000/-. The net profits before depreciation and tax, and tax rate 20% for the five years. Following are the expected cash flows to be:

You are required to calculate payback period.

Q.7. From the following information, prepare a comparative balance sheet and give your interpretations:

Q.8. A company has to choose one of the following two mutually exclusive projects A&B. Project A requires Rs.20,000/- and Project B requires Rs.15,000/- as initial investment. The firms cost of capital is 10%. Suggest which project should be accepted under NPV method. Following are the net cash flows:

Calculate: net present value
Present value Rs.1/- @ 10% (discount factor) using present value tables

For Project A

Initial Investment = Rs 20,000/-

Present Value of Return= 20,987.6/-

Return on Investment = (20,987.6 – 20,000) / 20,000

= 0.04938

= 4%

For Project B

Initial Investment = Rs. 15,000/-

Present Value of Return = 16,437.8/-

Return on Investment = (16,437.8 – 15,000) / 15,000

= 0.0958

= 9.58%

So, project should be accepted under NPV method will be

1st – Project B (As its giving 9.58% ROI)

Q.9. Tyre manufacturing company has drawn up the following profit and loss account for the year ended:

Calculate:
(a) Gross Profit Ratio

(b) Net Profit Ratio

(c) Operating Ratio

(d)Operating Profit Ratio

Operating Ratio Operating Profit Ratio

From the Question, we have
Net Profit = 28,000/-

Gross Profit = 52,000/-

Net Sales = 160,000/-

Operating Expense = 4,000 + 22,800 + 800 + 1,200 = 28,800/-

Operating Profit aka EBIT  = Gross Profit – Operating Expense = 52,000 – 28,800 = 23,200/-

Now,

Gross Profit Ratio = Gross Profit / Net Sales

= 52,000 / 160,000 = 13:80 = 0.1625 = 16.25%

Net Profit Ratio = Net Profit after tax / Net Sale

= 28,000 / 160,000 = 0.175 = 17.5%

Operating Ratio = Operating Expenses / Net Sales

= 28,800 / 160,000 = 0.18 = 18%

Operating Profit Ratio = Operating Profit / Net Sale

= 23,200 / 160,000 = 0.145 = 14.5%

Q.10. Fill in the blanks:

(a) Expenditure incurred on research is an example of Deferred revenue expenditure. (Deferred revenue expenditure/partly capital expenditure).

(b) Capital structure means the pattern of capital employed in the firm (capital employed/dividend).

(c) Capital budgeting is related to capital expenditure  (sales/capital expenditure).

(d) Quick assets = current assets (minus) stock.    (debtors/stock).

(e) Depreciation means a reduction in the value of fixed assets due to usage and efflux of time (current assets/fixed assets).