Financial Management CBCFB5T08

Syllabus topics (RTMNU)

• Financial Decisions: Investment Decision, Financing Decision, Dividend Decision
• Time Value of Money: Present Value and Future Value
• Annuity and Perpetuity
• Risk–Return Relationship

Financial Decisions: Investment, Financing and Dividend

Financial management is the planning, organising, directing and controlling of the financial activities of a firm — getting funds and using them well. Its main goal is wealth maximisation (maximising the market value of shares), which is better than mere profit maximisation because it considers time value and risk.

1. Investment decision (capital budgeting): where to invest funds — in which long-term assets/projects (new plant, new branch), and also how much in current assets (working capital). It is judged by return and risk.
2. Financing decision: from where to raise funds — the mix of equity and debt (capital structure). Debt is cheaper (interest is tax-deductible) but adds risk; equity is safer but costlier.
3. Dividend decision: how much of the profit to pay as dividend and how much to retain for growth. Depends on earnings, growth plans, shareholders' preference, liquidity and taxation.

The three decisions are inter-related: a big investment plan needs finance, and retained profits (dividend decision) are a source of finance. Some books also add the liquidity (working capital) decision.

Time Value of Money

Meaning: Time value of money means that ₹1 received today is worth more than ₹1 received in the future, because money today can be invested to earn interest. Reasons: (1) investment opportunity (interest), (2) inflation reduces purchasing power, (3) risk/uncertainty of future receipts, (4) preference for present consumption.

Two techniques: compounding (finding future value) and discounting (finding present value).

Future Value and Present Value

Illustration 1 (FV): ₹10,000 deposited for 3 years at 10% compounded annually. FV = 10,000 × (1.10)³ = 10,000 × 1.331 = ₹13,310.

Illustration 2 (PV): What is the present value of ₹50,000 to be received after 4 years if the discount rate is 8%? PV factor = 1/(1.08)⁴ = 0.735. PV = 50,000 × 0.735 = ₹36,750 (₹36,751 by exact calculation).

Annuity and Perpetuity

An annuity is a series of equal payments or receipts at regular intervals for a fixed period (e.g. EMIs, SIPs, pension). In an ordinary annuity payments come at the end of each period; in an annuity due, at the beginning. A perpetuity is an annuity that continues for ever (e.g. preference dividend on irredeemable shares, endowment scholarships).

Illustration 3 (FV of annuity): Rahul invests ₹5,000 at the end of every year for 5 years at 10%. FV = 5,000 × [(1.10)⁵ − 1] ÷ 0.10 = 5,000 × 6.1051 = ₹30,525.50.

Illustration 4 (PV of annuity): A machine gives ₹20,000 a year for 4 years; discount rate 10%. PV = 20,000 × 3.170 (annuity factor) = ₹63,400 (₹63,397 exact).

Illustration 5 (Perpetuity): A scholarship of ₹6,000 a year for ever, interest 12%. Amount needed now = 6,000 ÷ 0.12 = ₹50,000.

Risk–Return Relationship

Return is the gain from an investment (income + change in value), usually as a percentage. Risk is the chance that the actual return will differ from the expected return; it is measured by standard deviation (σ) or variance, and for shares also by beta. There is a positive trade-off: higher expected return comes with higher risk (FD/government bonds — low risk, low return; equity shares — high risk, high return). A rational investor wants maximum return for a given risk.

Types of risk: systematic (market) risk — interest rate, inflation, market risk; cannot be diversified; unsystematic (specific) risk — business and financial risk of one company; can be reduced by diversification.

Illustration 6 (Expected return and risk): A share may give 10%, 15% or 20% with probabilities 0.3, 0.4 and 0.3.

Standard deviation σ = √15 = 3.87%. Expected return is 15% with a risk of 3.87%.

Likely exam questions

1. (Long, 8/16 marks) Explain the investment, financing and dividend decisions of financial management and their inter-relationship.
2. (Long, 8/16 marks) What is time value of money? Calculate (a) the future value of ₹10,000 at 10% for 3 years, (b) the present value of ₹50,000 receivable after 4 years at 8%, and (c) the present value of an annuity of ₹20,000 for 4 years at 10%.
3. (Short, 4 marks) Explain the risk–return relationship.
4. (Short, 4 marks) What is a perpetuity? Find the present value of ₹6,000 a year for ever at 12%.
5. (Short, 4 marks) Distinguish between compounding and discounting.

Syllabus topics (RTMNU)

• Meaning and Importance of Capital Budgeting
• Types of Capital Investment Decisions
• Capital Budgeting Techniques: Payback Period
• Accounting Rate of Return (ARR)
• Net Present Value (NPV)
• Profitability Index (PI)
• Internal Rate of Return (IRR)

Meaning and Importance of Capital Budgeting

Definition: Capital budgeting is the process of evaluating and selecting long-term investment proposals (in fixed assets) whose benefits are expected over several years. Examples: buying new machinery, setting up a new plant, replacing old equipment, launching a new product line.

Importance: (1) large funds are involved; (2) long-term effect on profitability and growth; (3) decisions are irreversible or costly to reverse; (4) involve risk because future is uncertain; (5) affect the firm's competitive position; (6) wrong decisions lead to over- or under-capacity.

Process: identify proposals → screen → evaluate (techniques below) → select → implement → review (post-audit).

Types of Capital Investment Decisions

• Expansion of existing business (more capacity).
• Diversification into new products/markets.
• Replacement and modernisation of old assets.
• Mutually exclusive projects — accepting one means rejecting the other.
• Independent projects — can be accepted together.
• Contingent projects — one depends on another.
• Capital rationing decisions — choosing among projects when funds are limited.

Capital Budgeting Techniques

Techniques are traditional (non-discounted) — Payback Period and ARR; and modern (discounted cash flow, DCF) — NPV, PI and IRR. DCF methods use cash flows after tax (CFAT) = Profit after tax + Depreciation.

Common data for all illustrations: Satpuda Industries Ltd is considering a machine costing ₹5,00,000 with a life of 5 years and no scrap value (depreciation on straight-line = ₹1,00,000 a year). Expected CFAT: Year 1 ₹1,50,000; Year 2 ₹1,60,000; Year 3 ₹1,40,000; Year 4 ₹1,20,000; Year 5 ₹1,00,000. Cost of capital 10%.

1. Payback Period

Meaning: the number of years needed to recover the initial investment from cash inflows. Rule: accept if payback is less than the target; among projects, shorter is better.

₹4,50,000 is recovered in 3 years; ₹50,000 remains, recovered from Year 4's ₹1,20,000. Payback = 3 + 50,000/1,20,000 = 3.4167 years = 3 years 5 months.

Merits: simple, stresses liquidity, reduces risk. Demerits: ignores time value of money and cash flows after payback.

2. Accounting Rate of Return (ARR)

Profit after tax = CFAT − Depreciation: 50,000; 60,000; 40,000; 20,000; 0 → total ₹1,70,000; average = ₹34,000. Average investment = 5,00,000 ÷ 2 = ₹2,50,000. ARR = 34,000 ÷ 2,50,000 × 100 = 13.6% (on initial investment: 34,000 ÷ 5,00,000 = 6.8%). Merits: simple, uses accounting data, considers whole life. Demerits: ignores time value; uses profit not cash.

3. Net Present Value (NPV)

At 10% cost of capital, NPV = +₹17,710, so the project is acceptable. Merits: considers time value and all cash flows; consistent with wealth maximisation. Demerits: needs cost of capital; difficult for projects of different sizes.

4. Profitability Index (PI)

PI = 5,17,710 ÷ 5,00,000 = 1.035 > 1 → accept. PI is useful for ranking projects under capital rationing.

5. Internal Rate of Return (IRR)

Meaning: IRR is the discount rate at which NPV = 0 (PV of inflows = PV of outflows). Rule: accept if IRR > cost of capital. Find it by trial and error and interpolation.

From the table: NPV at 10% = +17,710; at 12% = −5,830. IRR = 10 + [17,710 ÷ (17,710 + 5,830)] × 2 = 10 + 0.752 × 2 = 11.50%. Since IRR (11.50%) > cost of capital (10%), accept.

Likely exam questions

1. (Long, 8/16 marks) What is capital budgeting? Explain its importance and the types of capital investment decisions.
2. (Long, 8/16 marks) A machine costs ₹5,00,000 with a life of 5 years and no scrap value. CFAT: ₹1,50,000; ₹1,60,000; ₹1,40,000; ₹1,20,000; ₹1,00,000. Cost of capital 10%. Calculate payback period, ARR, NPV, PI and IRR (PV factors at 10%: 0.909, 0.826, 0.751, 0.683, 0.621; at 12%: 0.893, 0.797, 0.712, 0.636, 0.567).
3. (Short, 4 marks) Distinguish between NPV and IRR.
4. (Short, 4 marks) What are the merits and demerits of the payback period method?
5. (Short, 4 marks) A project costs ₹2,00,000 and gives ₹50,000 a year. Find its payback period.

Syllabus topics (RTMNU)

• Meaning and Objectives of Financial Analysis
• Tools of Analysis: Meaning, Importance, Advantages, Limitations and Uses of Comparative Financial Statements and Common Size Statements
• Practical Problems on Intra and Inter Company Comparison

Meaning and Objectives of Financial Analysis

Financial statement analysis is the process of studying the relationships among items of the financial statements (Balance Sheet and Statement of Profit and Loss) to judge the profitability, liquidity, solvency and efficiency of a business. Analysis means breaking the data into simple groups; interpretation means explaining what they mean.

Objectives: (1) judge profitability (earning capacity); (2) judge short-term liquidity; (3) judge long-term solvency; (4) measure operating efficiency; (5) compare with past years and with other firms; (6) help forecasting and planning; (7) help investors, lenders and management take decisions.

Types: external (by outsiders) and internal (by management); horizontal (over years — comparative and trend) and vertical (one year — common size, ratios). Tools: comparative statements, common size statements, trend analysis, ratio analysis, cash flow and funds flow analysis.

Comparative Financial Statements

Meaning: statements that show figures of two or more years side by side, along with the absolute change (increase/decrease in ₹) and the percentage change, so that the direction of change can be seen. They may be a comparative Balance Sheet or a comparative Income Statement.

Importance and uses: shows trends and direction of change; easy comparison between years; helps forecast; shows the strong and weak points; useful for management, investors and lenders. Advantages: simple to prepare and understand; shows both ₹ and % change. Limitations: different accounting policies over years distort comparison; inflation is ignored; only shows change, not reasons; too many years make it complicated.

Illustration 1 (Intra-company comparison): Prepare a Comparative Income Statement of Wardha Foods Ltd from the following (₹):

Interpretation: Sales rose by 20% but cost of goods sold rose faster (25%), so gross profit grew only 12.5%. Operating expenses were controlled (8% rise), so operating profit grew 15.2%. Other income fell 40%. Net profit rose 11.11%. The company should control its cost of goods sold.

Common Size Statements

Meaning: statements in which each item is shown as a percentage of a common base. In a common size Income Statement the base is revenue from operations = 100; in a common size Balance Sheet the base is total assets (or total equity and liabilities) = 100. It is a tool of vertical analysis.

Importance and uses: shows the structure (composition) of assets, liabilities and costs; makes comparison between firms of different sizes possible (inter-company comparison); shows the share of each item. Advantages: easy comparison, removes the size effect, simple to read. Limitations: no fixed standard percentage to judge; changes in the base hide changes in items; ignores qualitative factors; inter-firm comparison is misleading if accounting policies differ.

Illustration 2 (Inter-company comparison): Prepare Common Size Balance Sheets of A Ltd and B Ltd as on 31 March 2026:

Interpretation: A Ltd depends more on owners' funds (60% equity and reserves) than B Ltd (45%); B Ltd uses more debt (30% long-term borrowings against 20%) and more current liabilities, so it is riskier. B Ltd keeps more inventory (25% against 15%). A Ltd has more fixed assets in proportion (60% against 50%). A Ltd looks financially safer.

Intra-company vs Inter-company Comparison

Likely exam questions

1. (Long, 8/16 marks) What is financial statement analysis? Explain its objectives and the tools of analysis.
2. (Long, 8/16 marks) Prepare a Comparative Income Statement from: Revenue ₹10,00,000 (2024-25) and ₹12,00,000 (2025-26); COGS ₹6,00,000 and ₹7,50,000; Operating expenses ₹1,50,000 and ₹1,62,000; Other income ₹20,000 and ₹12,000; Tax rate 25%. Interpret the results.
3. (Short, 4 marks) What are common size statements?
4. (Short, 4 marks) State the limitations of comparative statements.
5. (Short, 4 marks) Distinguish between intra-company and inter-company comparison.

Syllabus topics (RTMNU)

• Meaning, Importance, Advantages, Limitations and Uses of Ratio Analysis and Trend Analysis
• Practical Problems on Liquidity, Profitability, Activity and Solvency Ratios
• Practical Problems on Trend Analysis

Ratio Analysis — Meaning

A ratio is the numerical relationship between two related figures. Ratio analysis is the technique of calculating and interpreting accounting ratios to judge the financial position and performance of a firm. Ratios may be shown as a pure ratio (2:1), as times (5 times) or as a percentage (8%).

Importance and uses: simplifies data; shows liquidity, solvency, profitability and efficiency; helps inter-firm and intra-firm comparison; helps forecasting, planning and control; useful to management, investors, creditors, banks and Government. Advantages: pinpoints weak areas, helps decision-making, basis for credit decisions. Limitations: based on past historical data; ignores price changes (inflation); different accounting policies reduce comparability; window dressing can mislead; no universal standard ratios; ignores qualitative factors; a single ratio alone means little.

Classification of Ratios and Formulas

Illustration 1 (Ratios): From the following data of Gondia Traders Ltd for 2025-26, calculate key ratios. Inventory ₹2,00,000 (opening ₹1,80,000); debtors ₹1,50,000; cash ₹50,000; prepaid expenses ₹20,000; creditors ₹1,40,000; bills payable ₹40,000; outstanding expenses ₹30,000; equity share capital ₹5,00,000; reserves ₹2,00,000; 10% debentures ₹3,00,000; sales (all credit) ₹15,00,000; cost of goods sold ₹10,00,000; interest ₹30,000; profit after tax ₹1,20,000 (tax rate 25%).

Working: Current assets = 2,00,000 + 1,50,000 + 50,000 + 20,000 = ₹4,20,000. Current liabilities = 1,40,000 + 40,000 + 30,000 = ₹2,10,000. Quick assets = 4,20,000 − 2,00,000 − 20,000 = ₹2,00,000. Shareholders' funds = ₹7,00,000. PBT = 1,20,000 ÷ 0.75 = ₹1,60,000; EBIT = 1,60,000 + 30,000 = ₹1,90,000. Capital employed = 7,00,000 + 3,00,000 = ₹10,00,000. Average inventory = (1,80,000 + 2,00,000) ÷ 2 = ₹1,90,000.

Interpretation: liquidity is satisfactory (current ratio at the ideal 2:1, quick ratio close to 1:1); the firm is solvent with low debt (0.43:1) and covers interest 6.33 times; ROCE of 19% is good if the cost of capital is lower.

Trend Analysis — Meaning, Importance, Advantages, Limitations and Uses

Meaning: trend analysis studies the direction of change of financial items over several years by converting them into trend percentages with one year as the base year = 100. It is a tool of horizontal analysis.

Importance and uses: shows growth or decline over many years; helps forecasting and budgeting; compares growth of related items (sales vs profit, sales vs debtors). Advantages: simple, shows long-term direction, easy to present as graphs. Limitations: choice of base year affects results (an abnormal base year misleads); ignores inflation; accounting policies must be consistent; shows only change, not the reason.

Illustration 2 (Trend analysis): Calculate trend percentages taking 2021-22 as base year.

Interpretation: sales grew steadily by 55% in four years. Profit grew 50%, a little slower than sales; in 2023-24 profit fell even though sales rose, which suggests costs rose that year. Overall the trend is healthy.

Likely exam questions

1. (Long, 8/16 marks) What is ratio analysis? Explain its importance and limitations, and classify ratios with formulas.
2. (Long, 8/16 marks) From the following calculate current ratio, quick ratio, debt–equity ratio and inventory turnover: Inventory ₹2,00,000 (opening ₹1,80,000); Debtors ₹1,50,000; Cash ₹50,000; Prepaid expenses ₹20,000; Current liabilities ₹2,10,000; Equity ₹7,00,000; Debentures ₹3,00,000; Cost of goods sold ₹10,00,000.
3. (Short, 4 marks) What is trend analysis?
4. (Short, 4 marks) Calculate trend percentages of sales: ₹10,00,000; ₹11,50,000; ₹12,40,000 (first year as base).
5. (Short, 4 marks) Explain the current ratio and quick ratio.