IHM Solved Paper 2013-2014 | Financial Management 5th sem

IHM Solved Paper 2013-2014 | Financial Management 5th Semester | Ihm notes | Hmhelp

Q.1. Financial Planning is key to success. What are the basic fundamentals of financial planning? Explain the goals of financial management.

Goals of financial management

There are three major goals of the financial management Maximize Profit, Minimise Cost & Maximise Market Share.

Maximize Profits

A company’s most important goal is to make money and keep it. Profit-margin ratios are one way to measure how much money a company squeezes from its total revenue or total sales.

There are three key profit-margin ratios: gross profit margin, operating profit margin and net profit margin.

1. Gross Profit Margin 

The gross profit margin tells us the profit a company makes on its cost of sales or cost of goods sold. In other words, it indicates how efficiently management uses labour and supplies in the production process.

Suppose that a company has $1 million in sales and the cost of its labour and materials amounts to $600,000. Its gross margin rate would be 40% ($1 million – $600,000/$1 million).

The gross profit margin is used to analyze how efficiently a company is using its raw materials, labour and manufacturing-related fixed assets to generate profits. A higher margin percentage is a favourable profit indicator.

Gross profit margins can vary drastically from business to business and from industry to industry. For instance, the airline industry has a gross margin of about 5%, while the software industry has a gross margin of about 90%.

2. Operating Profit Margin
By comparing earnings before interest and taxes (EBIT) to sales, operating profit margins show how successful a company’s management has been at generating income from the operation of the business:

If EBIT amounted to $200,000 and sales equalled $1 million, the operating profit margin would be 20%.

This ratio is a rough measure of the operating leverage a company can achieve in the conduct of the operational part of its business. It indicates how much EBIT is generated per dollar of sales. High operating profits can mean the company has effective control of costs, or that sales are increasing faster than operating costs. Positive and negative trends in this ratio are, for the most part, directly attributable to management decisions.

Because the operating profit margin accounts for not only costs of materials and labour, but also administration and selling costs, it should be a much smaller figure than the gross margin.

3. Net Profit Margin
Net profit margins are those generated from all phases of a business, including taxes. In other words, this ratio compares net income with sales. It comes as close as possible, to sum up in a single figure how effectively managers run the business:

If a company generates after-tax earnings of $100,000 on its $1 million of sales, then its net margin amounts to 10%.

Often referred to simply as a company’s profit margin, the so-called bottom line is the most often mentioned when discussing a company’s profitability.

Again, just like gross and operating profit margins, net margins vary between industries. By comparing a company’s gross and net margins, we can get a good sense of its non-production and non-direct costs like administration, finance and marketing costs.

For example, the international airline industry has a gross margin of just 5%. Its net margin is just a tad lower, at about 4%. On the other hand, discount airline companies have much higher gross and net margin numbers. These differences provide some insight into these industries’ distinct cost structures: compared to its bigger, international cousins, the discount airline industry spends proportionately more on things like finance, administration and marketing, and proportionately less on items such as fuel and flight crew salaries.

When a company has a high-profit margin, it usually means that it also has one or more advantages over its competition. Companies with high net profit margins have a bigger cushion to protect themselves during the hard times. Companies with low-profit margins can get wiped out in a downturn. And companies with profit margins reflecting a competitive advantage are able to improve their market share during the hard times, leaving them even better positioned when things improve again.

Like all ratios, margin ratios never offer perfect information. They are only as good as the timeliness and accuracy of the financial data that gets fed into them, and analyzing them also depends on a consideration of the company’s industry and its position in the business cycle. Margins tell us a lot about a company’s prospects, but not the whole story.

Minimize Costs

Companies use cost controls to manage and/or reduce their business expenses. By identifying and evaluating all of the business’s expenses, management can determine whether those costs are reasonable and affordable. Then, if necessary, they can look for ways to reduce costs through methods such as cutting back, moving to a less expensive plan or changing service providers. The cost-control process seeks to manage expenses ranging from phone, internet and utility bills to employee payroll and outside professional services.

To be profitable, companies must not only earn revenues but also control costs. If costs are too high, profit margins will be too low, making it difficult for a company to succeed against its competitors. In the case of a public company, if costs are too high, the company may find that its share price is depressed and that it is difficult to attract investors.

When examining whether costs are reasonable or unreasonable, it’s important to consider industry standards. Many firms examine their costs during the drafting of their annual budgets.

Maximize Market Share

Market share is calculated by taking a company’s sales over a given period and dividing it by the total sales of its industry over the same period. This metric provides a general idea of a company’s size relative to its market and its competitors. Companies are always looking to expand their share of the market, in addition to trying to grow the size of the total market by appealing to larger demographics, lowering prices or through advertising. Market share increases can allow a company to achieve greater scale in its operations and improve profitability.

The size of a market is always in flux, but the rate of change depends on whether the market is growing or mature. Market share increases and decreases can be a sign of the relative competitiveness of the company’s products or services. As the total market for a product or service grows, a company that is maintaining its market share is growing revenues at the same rate as the total market. A company that is growing its market share will be growing its revenues faster than its competitors. Technology companies often operate in a growth market, while consumer goods companies generally operate in a mature market.

OR

Q.2. 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 to meet the day-to-day transaction of the business concern. It may cross working capital and net working capital. Normally working capital consists of various compositions of current assets such as inventories, bills, receivable, debtors, cash, and bank balance and prepaid expenses.

According to the definition of Bonneville, “any acquisition of funds which increases the current assets increase the Working Capital also for they are one and the same”.

Working capital is needed to meet the following purpose:
● Purchase of raw material
● Payment of wages to workers
● Payment of day-to-day expenses
● Maintenance expenditure etc.

Factors affecting the working capital need 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.

OR

What do you understand by the term “over capitalisation”? State the factors responsible for such a state of affairs.

Overcapitalization refers to the company which possesses an excess of capital in relation to its activity level and requirements. In simple means, overcapitalization is more capital than actually required and the funds are not properly used.

According to Bonneville, Dewey and Kelly, overcapitalization means, “when a business is unable to earn fair rate on its outstanding securities”.

Example
A company is earning a sum of Rs. 50,000 and the rate of return expected is 10%. This company will be said to be properly capitalized. Suppose the capital investment of the company is Rs. 60,000, it will be over capitalization to the extent of Rs. 1,00,000.

The new rate of earning would be:
50,000/60,000×100=8.33%
When the company has overcapitalization, the rate of earnings will be reduced from
10% to 8.33%.

Causes of Over Capitalization
Overcapitalization arises due to the following important causes:
• Over-issue of capital by the company.
• Borrowing large-amount of capital at a higher rate of interest.
• Providing inadequate depreciation to the fixed assets.
• Excessive payment for the acquisition of goodwill.
• High rate of taxation.
• Underestimation of capitalization rate.

Effects of Over Capitalization
Overcapitalization leads to the following important effects:
• Reduce the rate of earning capacity of the shares.
• Difficulties in obtaining the necessary capital to the business concern.
• It leads to falling in the market price of the shares.
• It creates problems on re-organization.
• It leads under or mis-utilisation of available resources.

Remedies for Over Capitalization
Overcapitalization can be reduced with the help of effective management and systematic
design of the capital structure. The following are the major steps to reduce overcapitalization.
• Efficient management can reduce overcapitalization.
• Redemption of preference share capital which consists of a high rate of dividend.
• Reorganization of equity share capital.
• Reduction of debt capital.

Q.3.  Write short notes on:

(a)Debt-equity Ratio

The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders‘ equity and debt used to finance a company’s assets. Closely related to leveraging, the ratio is also known as risk, gearing or leverage.

Debt to Equity Ratio =    Total Liabilities/Total Stockholders’ Equity

It measures how much of total assets is financed by the debt.

(b)Over-Trading

Over-trading arises only when the capital employed is inadequate in comparison with the volume of business.

In other words, it is an expansion of sales without adequate support from the capital. That is to say, the company with limited resources tries to increase the volume of business which, ultimately, suffers from acute shortage of liquid funds.

This results in a Low Proprietary Ratio, Low Current Ratio and Liquid Ratio with inadequate working capital. Under this condition, the company does not maintain the adequate level of inventories and, as a result, it has to depend on regular supplies. On the other hand, payments of expenses (Wages, Salaries etc..) and Creditors including taxes cannot be made in the time since there is a serious shortage of cash.

Whether or not the company is over-trading can easily be known after analysing certain ratios, viz., Current Ratio, Liquid Ratio, Debtor’s Turnover Ratio, and

Inventory Turnover Ratio etc.. In the case of over-trading, however, the Current Ratio and Liquid Ratio will be lower than their standard of normal ratios but the turnover ratios will be higher than their standard of normal ratios.

(c) Any two financial statements

An income statement is also called for profit and loss account, which reflects the operational position of the firm during a particular period. Normally it consists of one accounting year. It determines the entire operational performance of the concern like total revenue generated and expenses incurred for earning that revenue.
Income statement helps to ascertain the gross profit and net profit of the concern. Gross profit is determined by preparation of trading or manufacturing a/c and net profit is determined by preparation of profit and loss account.

Position statement is also called a balance sheet, which reflects the financial position of the firm at the end of the financial year.

Position statement helps to ascertain and understand the total assets, liabilities and capital of the firm. One can understand the strength and weakness of the concern with the help of the position statement.

OR

Evaluate the following as a form of financing:

(a)Equity shares

Equity Shares also are known as ordinary shares, which means, other than preference shares.

Equity shareholders are the real owners of the company. They have a control over the management of the company. Equity shareholders are eligible to get the dividend if the company earns a profit. Equity share capital cannot be redeemed during the lifetime of the company.

The liability of the equity shareholders is the value of the unpaid value of shares.

Features of Equity Shares
Equity shares consist of the following important features:

1. Maturity of the shares: Equity shares have permanent nature of capital, which has no maturity period. It cannot be redeemed during the lifetime of the company.

2. Residual claim on income: Equity shareholders have the right to get income left after paying fixed rate of dividend to preference shareholder. The earnings or the income available to the shareholders is equal to the profit after tax minus preference dividend.

3. Residual claims on assets: If the company wound up, the ordinary or equity shareholders have the right to get the claims on assets. These rights are only available to the equity shareholders.

4. Right to control: Equity shareholders are the real owners of the company. Hence, they have power to control the management of the company and they have power to take any decision regarding the business operation.

5. Voting rights: Equity shareholders have voting rights in the meeting of the company with the help of voting right power; they can change or remove any decision of the business concern. Equity shareholders only have voting rights in the company meeting and also they can nominate a proxy to participate and vote in the meeting instead of the shareholder.

6. Pre-emptive right: Equity shareholder pre-emptive rights. The pre-emptive right is the legal right of the existing shareholders. It is attested by the company in the first opportunity to purchase additional equity shares in proportion to their
current holding capacity.

7. Limited liability: Equity shareholders are having only limited liability to the value of shares they have purchased. If the shareholders are having fully paid up shares, they have no liability. For example: If the shareholder purchased 100 shares with the face value of Rs. 10 each. He paid only Rs. 900. His liability is only Rs. 100.
Total number of shares 100
Face value of shares Rs. 10
Total value of shares 100 × 10 = 1,000
Paid up value of shares 900
Unpaid value/liability 100
Liability of the shareholders is only unpaid value of the share (that is Rs. 100).

(b)Preference share

The parts of corporate securities are called as preference shares. It is the shares, which have preferential right to get a dividend and get back the initial investment at the time of winding up of the company. Preference shareholders are eligible to get fixed rate of dividend and they do not have voting rights.

Features of Preference Shares
The following are the important features of the preference shares:

1. Maturity period: Normally preference shares have no fixed maturity period except in the case of redeemable preference shares. Preference shares can be redeemable only at the time of the company liquidation.

2. Residual claims on income: Preferential shareholders have a residual claim on income. Fixed rate of dividend is payable to the preference shareholders.

3. Residual claims on assets: The first preference is given to the preference shareholders at the time of liquidation. If any extra Assets are available that should be distributed to equity shareholder.

4. Control of Management: Preference shareholder does not have any voting rights. Hence, they cannot have control over the management of the company.

(c)Debenture

A Debenture is a document issued by the company. It is a certificate issued by the company under its seal acknowledging a debt.
According to the Companies Act 1956, “debenture includes debenture stock, bonds and any other securities of a company whether constituting a charge of the assets of the company or not.”

Features of Debentures

1. Maturity period: Debentures consist of the long-term fixed maturity period. Normally, debentures consist of 10–20 years maturity period and are repayable with the principal investment at the end of the maturity period.

2. Residual claims in income: Debenture holders are eligible to get a fixed rate of interest at every end of the accounting period. Debenture holders have priority of claim in income of the company over equity and preference shareholders.

3. Residual claims on asset: Debenture holders have priority of claims on Assets of the company over equity and preference shareholders. The Debenture holders may have either specific change on the Assets or floating change of the assets of the company. Specific change of Debenture holders are treated as secured creditors and floating change of Debenture holders are treated as unsecured creditors.

4. No voting rights: Debenture holders are considered as creditors of the company.
Hence they have no voting rights. Debenture holders cannot have the control over the performance of the business concern.

5. Fixed rate of interest: Debentures yield a fixed rate of interest till the maturity period. Hence the business will not affect the yield of the debenture.

A debenture is a type of debt instrument that is not secured by physical assets or collateral. Debentures are backed only by the general creditworthiness and reputation of the issuer. Both corporations and governments frequently issue this type of bond to secure capital.

Q.4.  Write short notes on:

(a)Deferred Revenue Expenditure

It will be easier to understand the meaning of deferred revenue expenditure if you know the word deferred, which means “Holding something back for a later time”.

Deferred Revenue Expenditure is an expenditure which is revenue in nature and incurred during an accounting period, but its benefits are to be derived over a number of following accounting periods. These expenses are unusually large in amount and, essentially, the benefits are not consumed within the same accounting period.

The part of the amount which is charged to the profit and loss account in the current accounting period is reduced from the total expenditure and the rest is shown in the balance sheet as an asset (fictitious asset, i.e. it is not really an asset).

Example

Let’s suppose that a company is introducing a new product to the market and decides to spend a large amount on its advertising in the current accounting period. This marketing spend is supposed to draw benefits beyond the current accounting period, hence, it is a better idea not to charge the entire amount in the current year’s P&L Account and spread it over multiple periods.

(b)Pay Back Period Method

The payback period (PBP) is the amount of time that is expected before an investment will be returned in the form of income. When comparing two or more investments, business managers and investors will typically compare the projects to see which one has the shorter PBP. Projects with longer PBP are usually associated with higher risk.

For example, if a company invests $300,000 in a new production line, and the production line then produces positive cash flow of $100,000 per year, then the payback period is 3.0 years ($300,000 initial investment ÷ $100,000 annual payback).

The formula for the payback method is simplistic: Divide the cash outlay (which is assumed to occur entirely at the beginning of the project) by the amount of net cash inflow generated by the project per year (which is assumed to be the same in every year).

(c)Net Working Capital

Net-working capital is the aggregate amount of all current assets and current liabilities. It is used to measure the short-term liquidity of a business, and can also be used to obtain a general impression of the ability of company management to utilise assets in an efficient manner.

To calculate net working capital, use the following formula:

+ Cash and cash equivalents
+ Marketable investments
+ Trade accounts receivable
+ Inventory
– Trade accounts payable

= Net working capital

(d)Net Present Value Method

Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyse the profitability of a projected investment or project.

The following is the formula for calculating NPV:

where

Ct = net cash inflow during the period t

Co = total initial investment costs

r = discount rate, and

t = number of time periods

Q.5. From the following Balance Sheets of Arora Co. Ltd. for the period 31st March 2009 and 31st March 2010, prepare a schedule of changes in Working Capital and Funds Flow Statement:

BALANCE SHEET AS ON 31ST MARCH

Notes:-

• Plant amount is decreased it means a part of it is sold.
• Furniture amount is increased it means furniture is purchased.
• Equipment amount is increased it means equipment is purchased.

Working Notes:

1.  Computation of the Cash Received and Cash Spent

Q.6. There are two projects A & B. Each project requires an investment of ₹2,00,000/-. Rank these projects according to the ‘Pay Back Period’ method on the basis of the following information:

PROFIT/ INFLOWS OF CASH

Pay Back Period = Initial Investment/ Annual Cash Inflow    

Project A= Initial Investment is ₹2,00,000  i.e, Paid back after 5 years.

Project B= Initial Investment is ₹2,00,000  i.e, Paid back after 4 years.

Therefore, Project B is considered 1^st  and Project A as 2^nd.

Q.7. State True or False:

(a) Gross profit is sales minus cost of goods sold. True

(b) Working capital is the difference between current assets minus current liabilities. True

(c) Average Stock is calculated: Opening Stock plus closing stock /2. True

(d) Equity share capital is also known as risk capital. True

(e) Retaining of huge cash balances is a sound policy. False

Q.8. Following are the Balance Sheets of a concern for the years 2000 and 2001. Prepare a comparative balance sheet and study/report on the financial position of the concern:

OR

Rank the following projects in the order of their desirability according to the Net Present Value Method:

Initial investment:
Project A – ₹20000
Project B – ₹30000
Discount rate 10%
Present value ₹1/- @10% (discount factor) using present value tables:

For Project A

Initial Investment = Rs 20,000/-

Present Value of Return= 23,606/-

Return on Investment = (23,606 – 20,000) / 20,000

= 3,606 / 20,000 = 0.18

= 18%

For Project B

Initial Investment = Rs. 30,000/-

Present Value of Return = 33,486/-

Return on Investment = (33,486 – 30,000) / 30,000

= 0.11

= 18%

In the order of their desirability

1st – Project B (As its giving 18% ROI)

2nd – Project A (As its giving 11% ROI)

Q.9. Distinguish between Fund Flow Statement and Cash Flow Statement.

Q.10. Following is the Profit & Loss Account of M/s. Arbaz Hotel Ltd. for the period ending 31.03.2010. Calculate:

(a)  Gross profit ratio (b)  Net profit ratio (c)  Operating ratio (d)  Administrative expenses ratio

From the given Profit and Loss account

Administrative Expenses= 20,000/-

Gross Profit= 201,000/-

Net Profit= 80,000/-

Operating Expenses= Administrative expenses + Sales & Marketing Expenses = 20,000 + 89,000 = 109,000/-

Operating Profit i.e EBIT = Gross Profit – Operating Expenses = 201,000 – 109,000 = 92,000/-

Total Sales= 5,60,000/-

Now As we know,

Gross Profit Ratio = Gross Profit / Net Sales = 201,000 / 5,60,000

= 201/560   = 0.358 = 35.8%

Net Profit Ratio = Net Profit / Total Sales = 80,000 / 5,60,000

= 8/56 = 1:7 = 0.14 = 14%

Operating Ratio = Operating Profit / Net Sale = 92,000 / 560,000

= 23:190 = 0.1642 = 16.42%

Administrative Expense Ratio = Administrative Expense / Net Sales = 20,000 / 560,000

= 1:28 = 0.03 = 3%