NCHM Solved Paper 2014-2015 | Financial Management 5th Semester | Ihm notes | Hmhelp

IHM NOTES 5TH SEM NCHM SOLVED PAPER

IHM Solved Paper 2014-2015 | Financial Management 5th Sem | Ihm notes | Hmhelp

Q.1. A Balance Sheet of a company is given below:

Note: Sales for the year was₹2,50,000/-

Calculate:
(a) Current ratio

(b) Fixed assets to current assets ratio

(c) Debt equity ratio

(d) Liquidity ratio

(e) Fixed assets turnover ratio

Q.2. What is Working Capital? Discuss the factors which determine working capital needs of a firm.Discuss the features of Financial Management.

Working capital is a measure of both a company’s efficiency and its short-term financial health. Working capital is calculated as:

Working Capital = Current Assets – Current Liabilities

The working capital ratio (Current Assets/Current Liabilities) indicates whether a company has enough short-term assets to cover its short-term debt. Anything below 1 indicates negative W/C (working capital). While anything over 2 means that the company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is sufficient.  Also known as “net working capital”.

Main 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.

Features of Financial Management:

Financial Management: Feature # 1: Estimating Financial Requirements:

The first task of a financial manager is to estimate short-term and long-term financial requirements of his business. For this purpose, he will prepare a financial plan for the present as well as for future. The amount required for purchasing fixed assets as well as needs of funds for working capital will have to be ascertained.

The estimations should be based on sound financial principles so that neither there are inadequate nor excess funds with the concern. The inadequacy of funds will adversely affect the day-to-day working of the concern whereas excess funds may tempt a management to indulge in extravagant spending or speculative activities.

Financial Management: Feature # 2: Deciding Capital Structure:

 The capital structure refers to the kind and proportion of different securities for raising funds. After deciding about the quantum of funds required it should be decided which type of securities should be raised. It may be wise to finance fixed assets through long-term debts. Even here if gestation period is longer, then share capital may be most suitable.

Long-term funds should be employed to finance working capital also, if not wholly then partially. Entirely depending upon overdrafts and cash credits for meeting working capital needs may not be suitable. A decision about various sources for funds should be linked to the cost of raising funds.

If cost of raising funds is very high then such sources may not be useful for long. A decision about the kind of securities to be employed and the proportion in which these should be used is an important decision which influences the short-term and long-term financial planning of an enterprise.

Financial Management: Feature # 3: Selecting a Source of Finance:

 After preparing a capital structure, an appropriate source of finance is selected. Various sources, from which finance may be raised, include share capital, debentures, financial institutions, commercial banks, public deposits, etc.

If finances are needed for short periods then banks, public deposits and financial institutions may be appropriate; on the other hand, if long-term finances arc required then share capital and debentures may be useful.

If the concern does not want to tie down assets as securities then public deposits may be a suitable source. If management does not want to dilute ownership then debentures should be issued in preference to shares. The need, purpose, object and cost involved may be the factors influencing the selection of a suitable source of financing.

Financial Management: Feature # 4: Selecting a Pattern of Investment:

When funds have been procured then a decision about investment pattern is to be taken. The selection of an investment pattern is related to the use of funds. A decision will have to be taken as to which assets are to be purchased? The funds will have to be spent first on fixed assets and then an appropriate portion will be retained for working capital.

Even in various categories of assets, a decision about the type of fixed or other assets will be essential. While selecting a plant and machinery, even different categories of them may be available. The decision-making techniques such as Capital Budgeting, Opportunity Cost Analysis etc. may be applied in making decisions about capital expenditures.

While spending on various assets, the principles of safety, profitability and liquidity should not be ignored. A balance should be struck even in these principles. One may not like to invest in a project which may be risky even though there may be more profits.

Financial Management: Feature # 5: Proper Cash Management:

Cash management is also an important task of finance manager. He has to assess various cash needs at different times and then make arrangements for arranging cash.

Cash may be required to:

• (a) Purchase raw materials,
• (b) Make payments to creditors,
• (c) Meet wage bills;
• (d) Meet day-to-day expenses.

The usual sources of cash may be:

• (a) Cash sales,
• (b) Collection of debts,
• (c) Short-term arrangements with banks etc.

The cash management should be such that neither there is a shortage of it and nor it is idle. Any shortage of cash will damage the creditworthiness of the enterprise. The idle cash with the business will mean that it is not properly used.

It will be better if Cash Flow Statement is regularly prepared so that one is able to find out various sources and applications. If cash is spent on avoidable expenses then such spending may be curtailed. A proper idea on sources of cash inflow may also enable to assess the utility of various sources.

Some sources may not be providing that much cash which we should have thought. All this information will help in efficient management of cash.

Financial Management: Feature # 6: Implementing Financial Controls:

An efficient system of financial management necessitates the use of various control devices.

Financial control devices generally used are:

• (a) Return on investment,
• (b) Budgetary Control,
• (c) Break Even Analysis,
• (d) Cost Control,
• (e) Ratio Analysis
• (f) Cost and Internal Audit.

Return on investment is the best control device to evaluate the performance of various financial policies. The higher this percentage better may be the financial performance. The use of various control techniques by the finance manager will help him in evaluating the performance in various areas and take corrective measures whenever needed.

Financial Management: Feature # 7: Proper Use of Surpluses:

The utilisation of profits or surpluses is also an important factor in financial management. A judicious use of surpluses is essential for expansion and diversification plans and also in protecting the interests of shareholders. The ploughing back of profits is the best policy of further financing but it clashes with the interests of shareholders.

A balance should be struck in using funds for paying a dividend and retaining earnings for financing expansion plans, etc. The market value of shares will also be influenced by the declaration of dividend and expected profitability in future.

OR Write the difference between Fund Flow Statement and Cash Flow Statement.

Q.3. What do you understand by Financial Analysis and what are its objectives?

Financial analysis is the process of evaluating businesses, projects, budgets and other finance-related entities to determine their performance and suitability. Typically, financial analysis is used to analyze whether an entity is stable, solvent, liquid or profitable enough to warrant a monetary investment. When looking at a specific company, a financial analyst conducts analysis by focusing on the income statement, balance sheet and cash flow statement

Objectives of financial analysis are as follows

1.Assessment Of Past Performance: Past performance is a good indicator of future performance. Investors or creditors are interested in the trend of past sales, cost of goods sold, operating expenses, net income, cash flows and return on investment. These trends offer a means for judging management’s past performance and are possible indicators of future performance.2.Assessment of current position: Financial statement analysis shows the current position of the firm in terms of the types of assets owned by a business firm and the different liabilities due to the enterprise.3.Prediction of profitability and growth prospects: Financial statement analysis helps in assessing and predicting the earning prospects and growth rates in earning which are used by investors while comparing investment alternatives and other users in judging earning potential of the business enterprise.4.Prediction of bankruptcy and failure: Financial statement analysis is an important tool in assessing and predicting bankruptcy and probability of business failure.5. Assessment of the operational efficiency: Financial statement analysis helps to assess the operational efficiency of the management of a company. The actual performance of the firm which is revealed in the financial statements can be compared with some standards set earlier and the deviation of any between standards and actual performance can be used as the indicator of the efficiency of the management.

OR

Q.4. Define the following terms in not  more than five lines each (any five):

a. Net Profit Ratio

Net profit ratio (NP ratio) expresses the relationship between net profit after taxes and sales. This ratio is a measure of the overall profitability net profit is arrived at after taking into account both the operating and non-operating items of incomes and expenses. The ratio indicates what portion of the net sales is left for the owners after all expenses have been met.

Example:

From the following information calculate net profit ratio (NP ratio)

Total sales = $520,000; Sales returns = $ 20,000;  Net profit $40,000

Net sales = (520,000 – 20,000) = 500,000

Net Profit Ratio = [(40,000 / 500,000) × 100]

= 8%

Significance: Net profit ratio is used to measure the overall profitability and hence it is very useful to proprietors. The ratio is very useful as if the net profit is not sufficient, the firm shall not be able to achieve a satisfactory return on its investment

b. Trend Analysis

The financial statements may be analysed by computing trends of series of information. It may be upward or downward directions which involve the percentage relationship of each and every item of the statement with the common value of 100%. Trend analysis helps to understand the trend relationship with various items, which appear in the financial statements. These percentages may also be taken as index number showing relative changes in the financial information resulting with the various period of time. In this analysis, only major items are considered for calculating the trend percentage.

c. 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 a 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).

d. Cash Budget

A cash budget is an estimation of the cash inflows and outflows for a business over a specific period of time, and this budget is used to assess whether the entity has sufficient cash to operate. Companies use sales and production forecasts to create a cash budget, along with assumptions about necessary spending and accounts receivable. If a company does not have enough liquidity to operate, it must raise more capital by issuing stock or by taking on debt.

e. Stock Turnover

Stock Turnover Ratio= Cost of Sales / Average Inventory

Stock turnover is a ratio showing how many times a company’s inventory is sold and replaced over a period of time.

The days in the period can then be divided by the stock turnover formula to calculate the days it takes to sell the inventory on hand. It is calculated as sales divided by average stock.

Stock turnover measures how fast a company is selling inventory and is generally compared to industry averages. A low turnover implies weak sales and, therefore, excess inventory. A high ratio implies either strong sales and/or large discounts.

f. Working Capital

Working capital is a measure of both a company’s efficiency and its short-term financial health. Working capital is calculated as:

Working Capital = Current Assets – Current Liabilities

The working capital ratio (Current Assets/Current Liabilities) indicates whether a company has enough short-term assets to cover its short-term debt. Anything below 1 indicates negative W/C (working capital). While anything over 2 means that the company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is sufficient.  Also known as “net working capital”.

Q.5. Prepare a Funds Flow Statement for the year 2013 from the following Balance Sheets:

Balance Sheets as on 31st March 2013

* Provision for Tax may or may not be treated as current liability.

Funds flow statement

Working Notes:

1.  Computation of the Cash Received and Cash Spent

Q.6.  Write short notes on any two:

(a)DU Pont Control Chart

In ratio analysis, Du-Pont Control Chart shows the relationship of net profit margin ratio and total investment turnover ratio for calculating return on total investment ratio (ROI). If the company wants to increase return on investment (ROI), it has to concentrate to increase net profit margin and total investment turnover ratio.

The Du Pont Chart helps management to identify the areas of problems, which affect profit, In other words, management can easily visualize the different forces affecting profits, and profits could be improved either by putting capital into effective use, which will result in higher turnover ratio, or by better sales efforts, which will result in higher profit ratio.

(b)Common size income statement

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.

(c)Financial Planning

Financial planning and decision play a major role in the field of financial management which consists of the major area of financial management such as, capitalization, financial structure, capital structure, leverage and financial forecasting.

Financial planning includes the following important parts:

●  Estimating the amount of capital to be raised.

●  Determining the form and proportionate amount of securities.

●  Formulating policies to manage the financial plan.

Q.7.  Differentiate between the following (any two):

(a)Over Trading and Under Trading

Overtrading: It means doing trading more than your requirements and more than your understanding levels.
Under trading: It means when you do not do trading because of fear and that is also harmful because if you do not do trading then how your trading skills will be developed.

Over-trading and under-trading are facets of over and under-capitalization. Overtrading is a curse to the business.

OVERTRADING:

A company which is under-capitalized will try to do too much with the limited amount of capital which it has. For example, it may not maintain a proper stock of stock. Also, it may not extend much credit to customers and may insist only on cash basis sales. It may also not pay the creditors on time. One can detect cases of overtrading by computing the current ratio and the various turnover ratios. The current ratio is likely to be very low and turnover ratios are likely to be very higher than normal in the industry concerned.

UNDER TRADING:

Under-trading is the reverse of over-trading. It means keeping funds idle and not using them properly. This is due to the underemployment of assets of the business, leading to the fall in sales and results in financial crises. This makes the business unable to meet its commitments and ultimately leads to forced liquidation. The symptoms, in this case, would be a very high current ratio and very low turnover ratio. Under-trading is an aspect of over-capitalization and leads to low profit.

Factors responsible for over trading

• Overconfidence.
• Over-excitement.
• Excess balance in the trading account.
• Greed.
• Working on some kind of news which turns out to be a rumour.

Factors responsible for under trading

• Lack of confidence.
• Series of lost trades in past.
• Falling account balance.
• Taking too much advises and getting confused
• Comparison of your trading styles with trading styles of other traders.

(b)Under Capitalisation and Over Capitalisation.

Over Capitalization:

A company is said to be overcapitalized when the aggregate of the par value of its shares and debentures exceeds the true value of its fixed assets.In other words, over capitalisation takes place when the stock is watered or diluted.

It is wrong to identify over capitalisation with an excess of capital, for there is every possibility that an over capitalised concern may be confronted with problems of liquidity. The current indicator of over capitalisation is the earnings of the company.

If the earnings are lower than the expected returns, it is overcapitalized. Overcapitalisation does not mean a surplus of funds. It is quite possible that a company may have more funds and yet to have low earnings. Often, funds may be inadequate, and the earnings may also be relatively low. In both the situations, there is over capitalisation.

Over capitalisation may take place due to – exorbitant promotion expenses, inflation, shortage of capital, inadequate provision of depreciation, high corporation tax, liberalised dividend policy etc. Over capitalisation shows the negative impact on the company, owners, consumers and society.

Undercapitalization:

Under capitalisation is just the reverse of over capitalisation, a company is said to be under capitalised when its actual capitalisation is lower than its proper capitalisation as warranted by its earning capacity. This happens in case of well-established companies, which have insufficient capital but, large secret reserves in the form of considerable appreciation in the values of fixed assets not brought into books.

In case of such companies, the dividend rate will be high and the market value of their shares will be higher than the value of shares of other similar companies. The state of under capitalisation of a company can easily be ascertained by comparing of a book value of equity shares of the company with their real value. In case the real value is more than the book value, the company is said to be under capitalised.

Under capitalisation may take place due to – underestimation of initial earnings, underestimation of funds, conservative dividend policy, windfall gains etc. Under-capitalisation has some evil consequences like a creation of power competition, labour unrest, consumer dissatisfaction, the possibility of manipulating share value etc..

(c)Profit Maximisation and Wealth Maximisation

 or

The essential difference between the maximization of profits and the maximization of wealth is that the profits focus is on short-term earnings, while the wealth focus is on increasing the overall value of the business entity over time. These differences are substantial, as noted below:

• Planning duration. Under profit maximization, the immediate increase in profits is paramount, so management may elect not to spend on discretionary expenses, such as advertising, research, or maintenance. Under wealth maximization, management always makes the discretionary expenditures.
• Risk management. Under profit maximization, management minimizes expenditures, so it is less likely to pay for hedges that could reduce the organization’s risk profile. A wealth-focused company would work on risk mitigation, so its risk of loss is reduced.
• Pricing strategy. When management wants to maximize profits, it prices products as high as possible in order to increase margins. A wealth-oriented company could do the reverse, electing to reduce prices in order to build market share over the long term.
• Capacity planning. A profit-oriented business will spend just enough on its productive capacity to handle the existing sales level and perhaps the short-term sales forecast. A wealth-oriented business will spend more heavily on capacity in order to meet its long-term sales projections.

Q.8. Prepare a Statement of changes in Working Capital from the following Balance Sheets of ABC Ltd.

Q.9. XYZ Ltd. is considering to purchase a machine. Two machines are available A

and B costing ₹2,50,000/-.

Evaluate the two alternatives according to Net Present Value method (Cost of Capital @ 10%).
State the importance of financial statement analysis. Explain any one technique of financial statement analysis.

Q.10. What do you mean by Financial Planning? Explain the causes of Under- capitalisation.

Financial Planning is the process of estimating the capital required and determining its competition. It is the process of framing financial policies in relation to procurement, investment and administration of funds of an enterprise.

Objectives of Financial Planning

Financial Planning has got many objectives to look forward to:

1. Determining capital requirements- This will depend upon factors like cost of current and fixed assets, promotional expenses and long-range planning. Capital requirements have to be looked at both aspects: short- term and long- term requirements.
2. Determining capital structure- The capital structure is the composition of capital, i.e., the relative kind and proportion of capital required in the business. This includes decisions of debt-equity ratio- both short-term and long-term.
3. Framing financial policies with regards to cash control, lending, borrowings, etc.
4. A finance manager ensures that the scarce financial resources are maximally utilized in the best possible manner at least cost in order to get maximum returns on investment.

Under-capitalisation may be caused by the following factors:

(i) Acquisition of Assets during Recession:

Assets might have been acquired at low costs during necessary conditions in the market. And now higher incomes are being earned by their use.

(ii) Under-estimation of Requirements:

There may be under-estimation of capital requirements of the company by the promoters. This may lead to capitalisation which is insufficient to conduct its operations.

(iii) Conservative Dividend Policy:

The management may follow a conservative dividend policy leading to higher rate of ploughing back of profits. This would increase the earning capacity of the company.

(iv) Efficient Management:

The management of a company may be highly efficient. It may issue the minimum share capital and may meet the additional financial requirements through borrowings at lower rates of interest.

(v) Creation of Secret Reserves:

A company may have large secret reserves due to which its profitability is higher.