Management Consulting/Financial Management
Sir,need your help kindly guide for following questions
Q-1) What are the techniques of Capital Budgeting? Explain in brief.
Q-2) What are the approaches (models) of Dividend Policy.
Q-3) Write a note on Stock Markets in India.
Q-4) Explain Inventory Management, which is a part of Working Capital
Q-5) What are the techniques of analyzing financial statements.
Q-6) Explain the concept of budget. Describe any 5 types of budgets.
Q-7) What do you mean by leverages. Explain all three types of
Q-8) Explain the concept of break even analysis.
Q-1) What are the techniques of Capital Budgeting? Explain in brief.
Techniques of capital budgeting:
Capital budgeting is a mathematical concept in the sense that we have to use different
quantitative investments criteria to evaluate whether an opportunity is worth investing in or not.
Some of these techniques of capital budgeting are as under
1. Pay back period
2. Return on investment (ROI)
3. Net Present Value (NPV)
4. Profitability Index (PI)
5. Internal Rate of Return (IRR)
We will assume that the interest rate, or the discount rate, or the required of return, which we use In calculating the net present value is given, later on, when we will discuss the concept of risk, we would see how the discount rate is calculated .
For now, let us talk about the pay back period.
Pay back period:
In this technique, we try to figure out how long it would take to recover the invested capital through positive cash flows of the business.
Reverting back to the cafe example, an initial investment of Rs. 200,000 is required to start the business; Rs 10,000 per month are expected to be earned for the first year, and Rs 20,000 would be earned every month in the second year.
Now according to the aforementioned assumptions, in the first year, you earn Rs.10, 000 per month, which make Rs. 120,000 for the year (twelve months). Since you had invested Rs. 200,000 initially of which Rs. 120,000 have been recovered in the first year, you are still Rs.80, 000 short of
recovering your initial investment. In the second year, you would be earning Rs. 20,000 per month, so the remaining Rs. 80,000 can be recovered in the next four months. We can say that the initial invested
capital can be recovered in 16 months, or the payback period for this investment is 16 months. The shorter the payback period of a project, the more an investor would be willing to invest his money in the project.
While the payback period is a simple and straightforward method for analyzing a capital
budgeting proposal, it has certain limitations. First and the foremost problem is that it does not take into account the concept of time value of money. The cash flows are considered regardless of the time in
which they are occurring. You must have noticed that we have not used any interest rate while making calculation.
Now, let us talk about the next budgeting criteria called return on investment.
Return on Investments:
The concept of return on investment loosely defined, as there are a number of ratios that can be used to analyze return on investment. However, in capital budgeting it implies the annual average cash flow a business is making as a percentage of investment. In other words, it is an average percentage of
investment recovered in cash every year.
The formula for return on investment is as follows:
Dividing the average annual cash flow by the initial investment, we can calculate the return on investment.
Taking the same example of a café, the initial investment of Rs.200,000, Rs 10,000 per month profit in the 1st year in Rs 20,000 per month profit for the second year, we can easily calculate the ROI
ROI= ((120,000+240,000)/2)/200,000= 0.90 = 90%
Where, Rs 120,000=cash flow for 1st year at Rs 10,000 per month
Rs 240,000=cash flow for the 2nd year at Rs 20,000 per month.
Return on Investment is also very easy to calculate, but like payback period, it does not take into account the time value of money concept.
A high ROI ratio is considered better and 90% is a very good rate of return but before
deciding whether or not this project should be taken up, we should compare this project with the alternative opportunities on hand. It is also important to take into consideration the prevailing rate of inflation in the country so that the returns could be adjusted accordingly. However, we would talk about
the inflation rate and market interest rate in more detail later.
The next and the most important criteria for evaluating a capital budgeting proposal is net present value.
Net Present Value (NPV):
NPV is a mathematical tool which uses the discounting process, something that we have found
missing in the aforementioned capital budgeting techniques. Net Present Value is defined as the value
today of the Future Incremental After-tax Net Cash Flows less the initial investment.
The formula for calculating NPV is as follows:
NPV=-IO+∑CFt/ (1+i) t
Where,CFt=cash flows occurring in different time periods
-IO= Initial cash outflow
i=discount /interest rate
t=year in which the cash flow takes place
Initial cash outflow, being an outflow, is always expressed as a negative figure.
NPV is considered one of the most popular capital budgeting criteria. The disadvantage with the
NPV is that it is difficult to calculate since these calculations are based on too many estimates.
In order to calculate the NPV we need to forecast the future cash flows and sales; the discount factor is
also an estimate. If the NPV of a project is more than zero, it should be accepted. If two or more projects
under contemplation, then the one with the higher NPV, should be accepted. When a company invests in
projects with positive NPV, they raise the shareholders' wealth or company's value. This would also
increase the market value added and the economic value added for the firm.
Taking the same example of a café, an initial investment of Rs.200, 000, Rs 10,000 per month
profit in the 1st year in Rs 20,000 per month profit for the second year. However, for the calculation of
the NPV we would be requiring another important input--the discount rate. Assume the discount rate is
10 percent. Ten percent is what you at least expect to earn from the business. This is the rate of return,
which you can get by simply putting your money with a bank. If the business cannot yield more than 10
percent, then it is pointless to take unnecessary headache of setting up a business and running it, since
ten percent can be earned with a no-sweat-effort of placing the money with a bank.
Where,CFt=cash flows occurring in different time periods, i.e., Rs 120,000 in the first year and Rs
240,000 in the second year
-IO= Initial cash outflow = -200,000
i=discount /interest rate = 10 percent
t= 2 years
Putting in the values in the formula
= - 200,000 +
At the end of 2nd year, the NPV is +ve, you can also solve this example by monthly
compounding if you want to have a more precise answer.
The cash flows at the end of the first year and second year will have to be brought back to the present.
The present value of the cash flows occurring at the end of the first year can be calculated by dividing
the cash flows by 1 plus discount factor as under.
120000/(1+0.10) = 109,091
The cash flow occurring at the end of the second year can be calculated by dividing the cash
flow by one plus discount factor squared.
240,000/1+(0.10)2 = 198,347
=+Rs.107438 at the end of second year NPVis +ve
In other words, according to your cash flow forecast and required return, two years of running this
business is worth Rs 107,438 in cash to you today. The following diagram can explain the point further.
N.P.V (Café Example Cash Flow Diagram)
CF2 = Rs
NPV = Rs
i = 10%
i = 10%
Yr 0 (Today)
Io = Rs
The next criterion that we would talk about here is the profitability index, or the cost-benefit ratio.
It is quite similar to the NPV in terms of concept and calculation. Profitability index
may be defined as the ratio of the present value of future cash flows to the initial investment.
The profitability index can be calculated using the following formula.
PI = [Σ CFt / (1+ i) t ]/ IO
Those projects with a profitability index ratio of more than one (PI >= 1.0) are considered
acceptable. Here it is important to mention that those projects, which are ranked as acceptable using the
NPV method, would also be acceptable on the profitability index criteria.
Example: The profitability index for the café example can be calculated as under.
PI = [120,000]/ (1+ 0.1) + [240,000 / (1+ 0.1)2]/200,000
= (109,091 + 198,347) / 200,000 = 1. 54
PI = 1.54 > 1.0
Therefore, the project is acceptable. Notice that we have taken into consideration the annualized
return. The same can be calculated using the monthly returns with a slight adjustment in the formula as
we have studied in the previous lectures. If there were two or more projects that need ranking, the one
with the highest profitability index would be acceptable.
Let us now talk about the fifth and the final capital budgeting criteria of our course, known as Internal
Rate of Return (IRR).
Internal Rate of Return (IRR):
IRR is a widely used and an important measure, which is more common in practice than the
NPV. IRR, unlike NPV that is expressed in dollar amounts, is always quoted in terms of percentage,
which makes it comparable to the other market interest rates or the inflation rate.
RR calculation involves the same equation that we have earlier used for the calculation of NPV.
The only difference is that while calculating IRR we would set the value of NPV equal to zero and then
solve the equation for the value if `i'. In other words, the value of `i', at which the net present value of
the project equals zero would be considered as the internal rate of return of the project.
his is important to remember that unlike NPV calculation, the value of IRR is constant in every
year for the life of the project. While working out the NPV, we can change the discount rate for every
single, but for IRR you would come up with a rate that is constant and fixed for every single year in the
life of the project. Another simplistic explanation of IRR can be that it is the break-even rate of return.
In other words, at this rate of return, we would be able to recover the initial investment in project's
RR is calculated by a trial and error method or iteration. Finding the value of an unknown
variable may involve solving of higher degree polynomial equations and the easiest way to go about it is
to use trial and error method.
n a trial-and-error method, we tryout a value of `i', and see if the equation comes to the value of
zero; if it does not, try another value, even if the second value does not bring the equation down to zero
and so on. The higher the IRR, the better it is considered, however, which value of the IRR can be
considered as acceptable is difficult to measure. We would discuss more details of it in the coming
Another important distinction needs to clarification here is that the internal rate of return is
different from the discounting rate that we use in the calculation of the NPV. In the NPV formula, we
used the discount rate as the required rate of return that we expected the project to generate. In case of
IRR, we used the existing cash flows to find the forecasted return. These two different interpretations of
`i' should be kept in mind while calculating NPV and IRR.
We can calculate the IRR for the café project in the following manner. Using the same formula of NPV,
we can put the values in the formula
NPV= -IO +CF1/ (1+IRR) + CF2/ (1+IRR) 2
= 0= -200,000 + 120,000/ (1+0.1) + 240,000/ (1+0.1)2
Solving the equation assuming IRR to be 10 percent, we have obtained a figure of 107,483, which was
calculated as our NPV for the café project. However, in order to bring the NPV down to zero, we need
to apply a higher rate as an assumed IRR. If we assume IRR to be 50 percent the equation can be solved
NPV= -IO +CF1/ (1+IRR) + CF2/ (1+IRR) 2
= 0= -200,000 + 120,000/(1+0.5) + 240,000/(1+0.5)2
The calculation gives us a figure of -13,333, which is lesser than zero. In order to bring the value equal
to zero we would use a rate lesser than 50 percent.
Trying out various IRR rates, we can finally reach a rate of 43.6 percent at which the value of
NPV would come down to -48 which is close to zero. If we try out IRR with more decimal places, we
can bring the value of NPV equal to zero. However, with approximation, 43.6 percent is the actual IRR
of the project.
Q-2) What are the approaches (models) of Dividend Policy.
What are the approaches of Dividend Policy.
Dividends - Introduction To Dividends
When a company earns profits from operations, management can do one of two things with those profits. It can choose to retain them - essentially reinvesting them into the company with the hope of creating more profits and thus further stock appreciation. The alternative is to distribute a portion of the profits to shareholders in the form of dividends. Management can also opt to repurchase some of its own shares - a move that would also benefit shareholders.
A company must keep growing at an above-average pace to justify reinvesting in itself rather than paying a dividend. Generally speaking, when a company's growth slows, its stock won't climb as much, and dividends will be necessary to keep shareholders around. This growth slowdown happens to virtually all companies after they attain a large market capitalization. A company will simply reach a size at which it no longer has the potential to grow at annual rates of 30-40% like a small cap, regardless of how much money is plowed back into it. At a certain point, the law of large numbers makes a mega-cap company and growth rates that outperform the market an impossible combination. In this section, we'll take a deeper look at the different types of dividends and the mechanics of dividend payments; how companies establish dividend policy and the different types of dividend policies; the reasons why companies and investors might prefer higher, lower or no dividend payments; and share repurchases, stock splits and stock dividends as an alternative to cash dividends.
Dividends - Cash Dividends And Dividend Payment
A cash dividend is money paid to stockholders, normally out of the corporation's current earnings or accumulated profits. Not all companies pay a dividend. Usually, the board of directors determines if a dividend is desirable for their particular company based upon various financial and economic factors. Dividends are commonly paid in the form of cash distributions to the shareholders on a monthly, quarterly or yearly basis. All dividends are taxable as income to the recipients.
Dividends are normally paid on a per-share basis. If you own 100 shares of the ABC Corporation, the 100 shares is your basis for dividend distribution. Assume for the moment that ABC Corporation was purchased at $100/share, which implies a $10,000 total investment. Profits at the ABC Corporation were unusually high so the board of directors agrees to pay its shareholder $10 per share annually in the form of a cash dividend. So, as an owner of ABC Corporation for a year, your continued investment in ABC Corp should give us $1,000 in dividend dollars. The annual yield is the total dividend amount ($1,000) divided by the cost of the stock ($10,000) which gives us in percentage terms, 10%. If the 100 shares of ABC Corporation were purchased at $200 per share, the yield would drop to 5%, since 100 shares now cost $20,000, or your original $10,000 only gets you 50 shares instead of 100. If the price of the stock moves higher, then dividend yield drops and vice versa. The Mechanics of Dividends
Do dividend-paying stocks make a good overall investment? Dividends are derived from a company's profits, so it is fair to assume that dividends are generally a sign of financial health. From an investment strategy perspective, buying established companies with a history of good dividends adds stability to a portfolio. Your $10,000 investment in ABC Corporation, if held for one year, will be worth $11,000, assuming the stock price after one year is unchanged. Moreover, if ABC Corporation is trading at $90 share a year after you purchased for $100 a share, your total investment after receiving dividends still breaks even ($9,000 stock value + $1,000 in dividends).
Herein lies the appeal to buying stocks with dividends: they help cushion declines in actual stock prices, and they also present an opportunity for stock price appreciation coupled with the steady stream of income that dividends provide.
This is why many investing legends such as John Bogle, Warren Buffett and Benjamin Graham all espouse the virtues of buying stocks that pay a dividend as a critical part of the investment return of an asset. (Discover the issues that complicate these payouts for investors Dividend Facts You May Not Know.)
Risks to Dividends
During the financial meltdown in 2008-2009, all of the major banks either slashed or eliminated their dividend payouts. These companies were known for consistent, stable dividend payouts each quarter for hundreds of years, yet despite their storied history, the dividends were cut.
The lesson is that dividends are not guaranteed and are subject to macroeconomic as well as company-specific risks. Another potential downside to investing in dividend-paying stocks is that companies that pay dividends are not usually high growth leaders. There are a few exceptions, but high-growth companies usually do not pay dividends to shareholders even if they have significantly outperformed over the vast majority of all stocks over the last five years. Growth companies tend to spend more dollars on research and development, capital expansion, retaining talented employees and/or mergers and acquisitions, which leaves them with little to no money to spend on dividends.
For these companies, all earnings are considered retained earnings and are reinvested back into the company instead of rewarding loyal shareholders.
It is equally important to beware of companies with extraordinarily high yields. As we have learned, if a company's stock price continues to decline, its yield goes up. Many rookie investors get teased into purchasing a stock just on the basis of a potential juicy dividend. However, there is no specific rule of thumb in relation to how much is too much in terms of a dividend payout.
The average dividend yield on the S&P 500 companies that pay a dividend historically fluctuates somewhere between 2-5%, depending on market conditions. In general, it pays to do your homework on stocks yielding more than 8% to find out what is truly going on with the company. Doing this due diligence will help you decipher those companies that are truly in financial shambles from those that are temporarily out of favor and therefore present a good investment. (To read more on this subject, see Why Dividends Matter, How Dividends Work For Investors and 6 Common Misconceptions About Dividends.)
How Companies Pay Dividends
Dividend payouts follow a set procedure. To understand it, first we'll define the following terms:
1. Declaration Date
The declaration date is the day the company's board of directors announces approval of the dividend payment.
2. Ex-Dividend Date
The ex-dividend date is the date on which investors are cut off from receiving a dividend. If, for example, an investor purchases a stock on the ex-dividend date, that investor will not receive the dividend. This date is two business days before the holder-of-record date.
The ex-dividend date is important because from this date forward, new stockholders will not receive the dividend, and the stock price reflects this fact. For example, on and after the ex-dividend date, a stock usually trades at a lower price as the stock price adjusts for the dividend that the new holder will not receive.
3. Holder-of-Record Date
The holder-of-record (owner-of-record) date is the date on which the stockholders who are eligible to receive the dividend are recognized.
(Understanding the dates of the dividend payout process can be tricky. We clear up the confusion in Declaration, Ex-Dividend and Record Date Defined.)
4. Payment Date
Last is the payment date, the date on which the actual dividend is paid out to the stockholders of record.
Example: Dividend Payment
Suppose Newco would like to pay a dividend to its shareholders. The company would proceed as follows:
1. On Jan. 28, the company declares it will pay its regular dividend of $0.30 per share to holders of record as of Feb. 27, with payment on Mar. 17.
2. The ex-dividend date is Feb. 23 (usually four days before of the holder-of-record date). As of Feb. 23, new buyers do not have a right to the dividend.
3. At the close of business on Feb. 27, all holders of Newco's stock are recorded, and those holders will receive the dividend.
4. On Mar. 17, the payment date, Newco mails the dividend checks to the holders of record.
Dividends - Dividend Policy
Dividend policy is the set of guidelines a company uses to decide how much of its earnings it will pay out to shareholders. Some evidence suggests that investors are not concerned with a company's dividend policy since they can sell a portion of their portfolio of equities if they want cash. This evidence is called the "dividend irrelevance theory," and it essentially indicates that an issuance of dividends should have little to no impact on stock price. That being said, many companies do pay dividends, so let's look at how they do it.
There are three main approaches to dividends: residual, stability or a hybrid of the two.
Residual Dividend Policy
Companies using the residual dividend policy choose to rely on internally generated equity to finance any new projects. As a result, dividend payments can come out of the residual or leftover equity only after all project capital requirements are met. These companies usually attempt to maintain balance in their debt/equity ratios before making any dividend distributions, deciding on dividends only if there is enough money left over after all operating and expansion expenses are met.
For example, let's suppose that a company named CBC has recently earned $1,000 and has a strict policy to maintain a debt/equity ratio of 0.5 (one part debt to every two parts of equity). Now, suppose this company has a project with a capital requirement of $900. In order to maintain the debt/equity ratio of 0.5, CBC would have to pay for one-third of this project by using debt ($300) and two-thirds ($600) by using equity. In other words, the company would have to borrow $300 and use $600 of its equity to maintain the 0.5 ratio, leaving a residual amount of $400 ($1,000 - $600) for dividends. On the other hand, if the project had a capital requirement of $1,500, the debt requirement would be $500 and the equity requirement would be $1,000, leaving zero ($1,000 - $1,000) for dividends. If any project required an equity portion that was greater than the company's available levels, the company would issue new stock.
Typically, this method of dividend payment creates volatility in the dividend payments that some investors find undesirable.
The residual-dividend model is based on three key pieces: an investment opportunity schedule (IOS), a target capital structure and a cost of external capital.
1. The first step in the residual dividend model to set a target dividend payout ratio to determine the optimal capital budget.
2. Then, management must determine the equity amount needed to finance the optimal capital budget. This should be done primarily through retained earnings.
3. The dividends are then paid out with the leftover, or residual, earnings. Given the use of residual earnings, the model is known as the "residual-dividend model."
A primary advantage of the dividend-residual model is that with capital-projects budgeting, the residual-dividend model is useful in setting longer-term dividend policy. A significant disadvantage is that dividends may be unstable. Earnings from year to year can vary depending on business situations. As such, it is difficult to maintain stable earnings and thus a stable dividend. While the residual-dividend model is useful for longer-term planning, many firms do not use the model in calculating dividends each quarter.
Dividend Stability Policy
The fluctuation of dividends created by the residual policy significantly contrasts with the certainty of the dividend stability policy. With the stability policy, quarterly dividends are set at a fraction of yearly earnings. This policy reduces uncertainty for investors and provides them with income.
Suppose our imaginary company, CBC, earned $1,000 for the year (with quarterly earnings of $300, $200, $100 and $400). If CBC decided on a stable policy of 10% of yearly earnings ($1,000 x 10%), it would pay $25 ($100/4) to shareholders every quarter. Alternatively, if CBC decided on a cyclical policy, the dividend payments would adjust every quarter to be $30, $20, $10 and $40, respectively. In either instance, companies following this policy are always attempting to share earnings with shareholders rather than searching for projects in which to invest excess cash.
Hybrid Dividend Policy
The final approach is a combination between the residual and stable dividend policy. Using this approach, companies tend to view the debt/equity ratio as a long-term rather than a short-term goal. In today's markets, this approach is commonly used by companies that pay dividends. As these companies will generally experience business cycle fluctuations, they will generally have one set dividend, which is set as a relatively small portion of yearly income and can be easily maintained. On top of this set dividend, these companies will offer another extra dividend paid only when income exceeds general levels.
Q-3) Write a note on Stock Markets in India.
The stock market is a market for partial ownership of companies where buyers and sellers come together. Prices of stocks change based on whether they are in high demand or low demand, and the demand for a certain security is based on its rate of return and risk level.
o Stock markets exist to trade securities of companies. This is economically useful because financial capital should not be wasted on companies that are doomed to be unsuccessful. Capital is always flowing to companies that show themselves to be successful by ensuring high returns at low risk for their investors.
o Ideally, this means that when the stock market goes through its daily fluctuations, it is moving resources from areas of low yield to areas of high yield. As capital moves away from companies that cannot guarantee investors returns, it moves toward companies that can. Companies are thus rewarded for being profitable by the chance to increase profits.
o The stock market changes every day, as individual buyers and sellers come together to trade stocks in stock exchanges. Price is an indicator of the relative value of the company, according to investors. Remember that no one firm or individual can control the stock market--the stock market is the aggregation of many small actions and thus cannot be centrally controlled or predicted.
o Markets for other products fluctuate, and it is no surprise that stock markets do as well. The macro-fluctuations of the market, such as changes in indexes like the S&P 500, are indications of many micro-fluctuations as investors all over the world buy and sell stock. Fluctuations can be because of new information in the market and elsewhere, such as changes in legal structures and politics. Fluctuations are thus difficult to predict.
o The U.S. stock market has been growing for the past 75 years at roughly 10 percent to 11 percent annually, and has been one of the largest creators of wealth in the 20th and 21st centuries. Inflation rates, historically 3 percent to 4 percent, will wipe out the value of a regular bank deposit in mere decades. The stock market, even though it can vary wildly from year to year, is still the best long-term investment option for many investors.
What are Bear?
Bear : An operator who expects the share price to fall
Bear Market : A weak and falling market where buyers are absent
What are Bulls?
Bull : An operator who expects the share price to rise and takes position in the market to sell at a later date.
Bull Market : A rising market where buyers far outnumber the sellers
A bull market is one where prices are rising, whereas a bear market is one where prices are falling. The two terms are also used to describe types of investors.
A stock market bull is someone who has a very optimistic view of the market; they may be stock-holders or maybe investors who aggressively buy and sell stocks quickly. A bear investor, on the other hand, is pessimistic about the market and may make more conservative stock choices. Sometimes, the terms are used to refer to specific funds or stocks. Bear market funds, for example, are those that are falling and faring poorly. Investors sometimes refer to bull stocks to describe securities that are aggressively rising and making their investors money.
Knowing what is meant by the bear and bull market can help you understand whether the market is currently rising or falling. There is no need to get frightened by a bear market indicator; however, as experts agree that the market is cyclical. When prices start falling, they will eventually rise too.
What Drives Bear and Bull Markets?
The stock market is affected by many economic factors. High employment levels, strong economy, and stable social and economic conditions generally build investor confidence and encourage investors to put their money in the stock market. Often, this can bolster bull markets. Also, new technologies and companies that encourage investors to put their money in stocks can create bull markets. For example, in the 1990s, the dot com craze encouraged many investors to put their money in stocks that they felt would keep increasing. In some cases, a bullish market is simply self-perpetuating. Since the market is doing well, it only encourages investors to invest more money or to start investing.
On the other hand, discouraging economic or social political changes in a society can push the market down. Sudden instability or unemployment -- or even fears of unemployment caused by wars and other problems -- can start to make investors more conservative and therefore lead to bear markets. Of course, again this becomes a self-perpetuating trend. As the economy slows down, companies begin downsizing. Increased unemployment makes people far less willing to gamble on the stock market. Sometimes, a panic caused by dire predictions about the market can also create bearish conditions.
How To Predict Bear and Bull Markets?
The easiest way to predict both types of markets is to realize that what goes up must come down. That is, if the market is rising, then you know that at some point it will start to fall again. Similarly, if the market is currently falling, you can be certain that eventually it will pick up again. There are no precise ways to predict either bull or bear markets, although general social economic situations can help you to determine what will happen. A country which wages a war will experience bullish market conditions as government contracts create more jobs and boost investor confidence if their expectation is to win. Sudden international crises push the market downward and create bearish conditions. News is very often a good indicator of where investors are headed. The reports will inform about loss of investor confidence as well as sudden economic downturns that may affect the market. If you notice from stock market research that several indexes have changed by 15% to 20%, you can be sure that market direction is changing. When you notice such changes, it is time to sit up and take notice. You may be headed for a bullish or bearish market.
Market Conditions In Both Cases
While referring to markets is either bull or bear is very general, there are certain types of specific markets conditions that exist in both markets. For example, a bullish market is often accompanied by a sudden increase demand for securities and smaller supplies of the same securities. This is because more investors are willing to buy securities while fewer wish to sell. This, of course, only pushes prices higher. The very opposite is true in a bearish market.
The investor's behavior is another condition prevalent in both markets. In bullish markets, there's a sudden increase interest in the stock market. More people are hopeful about possible profits on the stock market and most people are optimistic about economic conditions. In a bearish market, investors are not very confident and therefore invest less.
Q-4) Explain Inventory Management, which is a part of Working Capital
The working capital management refers to the management of working capital, or precisely to the management of current assets. A firm’s working capital consists of its investments in current assets, which includes short-term assets—cash and bank balance, inventories, receivable and marketable securities. Therefore, the working capital management refers to the management of the levels of all these individual current assets. On the other hand, inventory, which is one of the important elements of current assets, reflects the investment of a firm’s fund. Hence, it is necessary to efficiently manage inventories in order to avoid unnecessary investments. A firm, which neglects the management of inventories, will have to face serious problems relating to long-term profitability and may fail to survive. With the help of better inventory management, a firm can reduce the levels of inventories to a considerable degree e.g., 10 to 20% without any adverse effect on production and sales. Thus, inventory is a vital factor in business operations. This paper tries to evaluate the effect of the size of inventory and the impact on working capital through inventory ratios, working capital ratios, trends, computation of inventory and working capital, and liquidity ranking. Finally, it was found that the size of inventory directly affects working capital and it's management.
Managing inventory is a juggling act. Excessive stocks can place a heavy burden on the cash resources of a business. Insufficient stocks can result in lost sales, delays for customers etc.
The key is to know how quickly your overall stock is moving or, put another way, how long each item of stock sit on shelves before being sold. Obviously, average stock-holding periods will be influenced by the nature of the business. For example, a fresh vegetable shop might turn over its entire stock every few days while a motor factor would be much slower as it may carry a wide range of rarely-used spare parts in case somebody needs them.
Nowadays, many large manufacturers operate on a just-in-time (JIT) basis whereby all the components to be assembled on a particular today, arrive at the factory early that morning, no earlier - no later. This helps to minimize manufacturing costs as JIT stocks take up little space, minimize stock-holding and virtually eliminate the risks of obsolete or damaged stock. Because JIT manufacturers hold stock for a very short time, they are able to conserve substantial cash. JIT is a good model to strive for as it embraces all the principles of prudent stock management.
The key issue for a business is to identify the fast and slow stock movers with the objectives of establishing optimum stock levels for each category and, thereby, minimize the cash tied up in stocks. Factors to be considered when determining optimum stock levels include:
What are the projected sales of each product?
How widely available are raw materials, components etc.?
How long does it take for delivery by suppliers?
Can you remove slow movers from your product range without compromising best sellers?
Remember that stock sitting on shelves for long periods of time ties up money which is not working for you. For better stock control, try the following:
Review the effectiveness of existing purchasing and inventory systems.
Know the stock turn for all major items of inventory.
Apply tight controls to the significant few items and simplify controls for the trivial many.
Sell off outdated or slow moving merchandise - it gets more difficult to sell the longer you keep it.
Consider having part of your product outsourced to another manufacturer rather than make it yourself.
Review your security procedures to ensure that no stock "is going out the back door !"
Higher than necessary stock levels tie up cash and cost more in insurance, accommodation costs and interest charges
Q-5) What are the techniques of analyzing financial statements.
Evaluating the performance of a business can be challenging, and requires a systematic collection and review of financial information. Financial statements provide this summary of collected data. The three primary statements include income, balance sheet and statement of cash flows. Public companies also have a statement of equity. Reviewing and analyzing financial statements provide the user with trends and indicators to compare operations and management.
Analyzing a single period financial statement works well with vertical analysis. On the income statement, percentages represent the correlation of each separate account to net sales. Express all accounts other than net sales as a percentage of net sales. Net income represents the percentage of net sales not used on expenses. For example, if expenses total 69 percent of net sales, net income represents the remaining 31 percent. Vertical analysis performed on balance sheets uses total assets and total liabilities for comparison of individual balance sheet accounts.
Horizontal analysis is the comparison of data sets for two periods. Financial statements users review the change in data much like an indicator. Optimistic analysts look for growth in revenue, net income and assets in addition to reductions in expenses and liabilities. Calculating absolute dollar changes requires the user to subtract the base figure from the current figure. Expressing changes with percentages requires the user to divide the base figure by the current figure, and multiply by 100.
Review of three or more financial statement periods typically represents trend analysis, a continuation of horizontal analysis. The base year represents the earliest year in the data set. Although dollars can represent subsequent periods, analysts commonly use percentages for comparability purposes. Users review statements for patterns of incremental change representing changes in the business in questions. Financial statement improvements include increased income and decreased expenses.
Ratios express a relationship between two more financial statement totals, and compare to budgets and industry benchmarks. Five common categories of ratios exist: liquidity, asset turnover, leverage, profitability and solvency. Reviewing ratios for performance compared with prior periods or industry specific benchmarks provides financial statements users with recognition of strengths and weaknesses. Risk Management Association, or RMA, publishes data on industry specific benchmarks for more in-depth analysis.
Analyzing financial statements presents an opportunity for reviewing past data and possibly budgets. However, the data used is historical in nature, indicating it may not be a good representation of the future due to unforeseeable circumstances. Market value of assets and liabilities can be under or overstated significantly leaving statement users unaware of the real value of a balance sheet. Pro forma statements, or forward-looking financial statements, provide estimates at best resulting in speculation.
Q-6) Explain the concept of budget. Describe any 5 types of budgets.
Budgets are statements of estimated resources set apart for execution of planned works or activities over a specified period of time. A budget is the blue print of the outcome of the organization’s operations in a financial year. Budget indicates the quantitative parameters of an organization’s performance. Terry has defined budgetary control “as a process of finding out what is being done and comparing the result with corresponding budget data to verify accomplishments, or to remedy differences.”
A Comprehensive budget reflects the national sources of income and heads of expenditure and also the surplus or deficit in a period under consideration. Dimock says “A budget is a financial plan summarizing the financial experience of the past, stating the current plan and projecting it over a specified period of time in future.” Thus a budget is the keystone of financial administration and the various operations in the field of public finance are correlated through the instrument of budget. A budget is a financial report of statement and proposals which are periodically placed before the legislature for its approval and sanction. It is the report of the entire financial operations of the government and gives us a glimpse of future fiscal policy. Willoughby states “The real significance of the budget lies in providing for an orderly administration of the financial affairs of a government.”
Budget System in India:
Budget in India is called ‘Annual Financial Statement.’ This statement is prepared separately for railways and other than railways or what is called a general budget. The states have their own budgets but the Parliament prepares budget for the country as a whole.
Another significant feature of the budget in India is its division into two categories, namely ‘Voteable Budget’ and ‘Non-voteable Budget.’ The non-voteable budget includes the salaries and allowances of such high dignitaries as the President of India, Chairman and Members of U.P.S.C., Chief Justice of India and such other dignitaries.
Formulation of Budget:
Heads of the offices are required to prepare preliminary estimates giving the developmental plans of their departments and approximate income and expenditure under each head. In case a department is interested in including a new item, it will have to give a detailed explanatory not for the purpose. The budget proposals thus prepared are scrutinized by the controlling officers, and finally passed on to the finance ministry. The Finance Ministry is empowered to cut down any proposal forwarded by any department. The main idea of loading the Ministry of Finance with such responsibility is that it is not a spending ministry. Being overall in charge of all the proposals made by different departments, it has a very comprehensive picture of the situation and the finance limitations. In case a department feels that its proposals have unreasonably been turned down, the matter may be referred to the cabinet which is the final authority.
Format of the Budget:
All the budget estimates are prepared under three heads:
Part I: Indicates establishment charges.
Part II (a): Deals with such items of expenditure in which there is considerable fluctuation.
Part II (b): Deals with such expenditure which is more or less not fluctuating in nature.
Part III: Deals with the new items of expenditure on which the sanction of government is yet to be taken.
In India budget is prepared for the financial year which commences on 1st April and ends on 31st March of the succeeding year. A final shape is given only when the representative of departments, Accountant General and Ministry of Finance have come to the same conclusion.
Managerial accounting approaches a company's financial situation in an operational way, giving information in a manner that supports managers in planning and control procedures. Various budget formats in managerial accounting influence how a manager forecasts department activity and how he addresses progress or shortfall to meet goals. Companies may use several types of managerial budgets concurrently.
A master budget is a comprehensive projection of how management expects to conduct all aspects of business over the budget period, usually a fiscal year. The master budget summarizes projected activity by way of a cash budget, budgeted income statement and budgeted balance sheet. Most master budgets include interrelated budgets from the various departments. Managers typically use these subset budgets to plan and set performance objectives. Master budgets are generally used in larger businesses to keep many managers on the same page.
The operational budget covers revenues and expenses surrounding the day-to-day core business of a company. Revenues represent sales of products and services; expenses define the costs of goods sold as well as overhead and administrative costs directly related to producing goods and services. While budgeted annually, operating budgets are usually broken down into smaller reporting periods, such as weekly or monthly. Managers compare ongoing results to budget throughout the year, planning and adjusting for variations in revenue.
Cash Flow Budget
A cash flow budget examines the inflows and outflows of cash in a business on a day-to-day basis. It predicts a company's ability to take in more money than it pays out. Managers monitor cash flow budgets to pinpoint shortfalls between expenses and sales -- times when financing may be needed to cover overheads. Cash flow budgets also suggest production cycles and inventory levels so that a company's resources are available for activity, not sitting idle on warehouse shelves.
A financial budget outlines how a business receives and spends money on a corporate scale, including revenues from core business plus income and costs from capital expenditures. Managing assets such as property, buildings, investments and major equipment may have a significant effect on the financial health of a company, particularly through the peaks and troughs of daily business. Executive managers use financial budgets to leverage financing and value the company for mergers and public offerings of stock.
A static budget contains elements where expenditures remain unchanged with variations to sales levels. Overhead costs represent one type of static budget, but these budgets aren't confined to traditional overhead expenses. Some departments may have a fixed amount of money set in budget to spend, and it is up to managers to make sure such amounts are spent without going over-budget. This condition occurs routinely in public and nonprofit sectors, where organizations or departments are funded largely by grants
Q-7) What do you mean by leverages. Explain all three types of
1. The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.
2. The amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged.
Leverage is most commonly used in real estate transactions through the use of mortgages to purchase a home
1. Leverage can be created through options, futures, margin and other financial instruments. For example, say you have $1,000 to invest. This amount could be invested in 10 shares of Microsoft stock, but to increase leverage, you could invest the $1,000 in five options contracts. You would then control 500 shares instead of just 10.
2. Most companies use debt to finance operations. By doing so, a company increases its leverage because it can invest in business operations without increasing its equity. For example, if a company formed with an investment of $5 million from investors, the equity in the company is $5 million - this is the money the company uses to operate. If the company uses debt financing by borrowing $20 million, the company now has $25 million to invest in business operations and more opportunity to increase value for shareholders.
Leverage helps both the investor and the firm to invest or operate. However, it comes with greater risk. If an investor uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater than it would've been if the investment had not been leveraged - leverage magnifies both gains and losses. In the business world, a company can use leverage to try to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroys shareholder value.
Leverage, as a business term, refers to debt or to the borrowing of funds to finance the purchase of a company's assets. Business owners can use either debt or equity to finance or buy the company's assets. Using debt, or leverage, increases the company's risk of bankruptcy. It also increases the company's returns; specifically its return on equity. This is true because, if debt financing is used rather than equity financing, then the owner's equity is not diluted by issuing more shares of stock.
Investors in a business like for the business to use debt financing but only up to a point. Beyond a certain point, investors get nervous about too much debt financing as it drives up the company's default risk.
There are three types of leverage:
What is Operating Leverage?
Breakeven analysis shows us that there are essentially two types of costs in a company's cost structure -- fixed costs and variable costs. Operating leverage refers to the percentage of fixed costs that a company has. Stated another way, operating leverage is the ratio of fixed costs to variable costs. If a business firm has a lot of fixed costs as compared to variable costs, then the firm is said to have high operating leverage. These firms use a lot of fixed costs in their business and are capital intensive firms.
A good example of capital intensive business firm are the automobile manufacturing companies. They have a huge amount of equipment that is required to manufacture their product - automobiles. When the economy slows down and fewer people are buying new cars, the auto companies still have to pay their fixed costs such as overhead on the plants that house the equipment, depreciation on the equipment, and other fixed costs associated with a capital intensive firm. An economic slowdown will hurt a capital intensive firm much more than a company not quite so capital intensive.
You can compare the operating leverage for a capital intensive firm, which would be high, to the operating leverage for a labor intensive firm, which would be lower. A labor intensive firm is one in which more human capital is required in the production process. Mining is considered labor intensive because much of the money involved in mining goes to paying the workers. Service companies that make up much of our economy, such as restaurants or hotels, are labor intensive as well. They all require more labor in the production process than capital costs.
In difficult economic times, firms that are labor intensive typically have an easier time surviving than capital intensive firms.
What does operating leverage really mean? It means that if a firm has high operating leverage, a small change in sales volume results in a large change in EBIT and ROIC, return on invested capital. In other words, firms with high operating leverage are very sensitive to changes in sales and it affects their bottom line quickly.
Business risk is just one portion of the risk that determines a business firm's future return on equity. Business risk is the risk that a firm's shareholders face if the firm has no debt. It is the risk inherent in the firm's operations. It rises from economic uncertainty which leads to uncertainty about future profits and capital requirements.
One component of business risk is variability in product demand. Customers always have to have food so in difficult economic times, the Publix grocery store chain will have less product variability than Ford Motor Company. Customers don't have to buy new cars during periods of economic uncertainty. Most business firms also have variability in product sales prices and input costs. Firms that are slower to bring new products to market expose themselves to more business risk. Think of the American automobile companies. Foreign car companies brought fuel efficient cars to market faster than American car companies, exposing them to more business risk.
If a business firm has high fixed costs and their costs do not decline as demand declines, then the firm has high operating leverage which means high business risk.
What is Financial Leverage?
Financial leverage refers to the amount of debt in the capital structure of the business firm. If you can envision a balance sheet, financial leverage refers to the right-hand side of the balance sheet. Operating leverage refers to the left-hand side of the balance sheet - the plant and equipment side. Operating leverage determines the mix of fixed assets or plant and equipment used by the business firm. Financial leverage refers to how the firm will pay for it or how the operation will be financed.
As discussed earlier in this article, the use of financial leverage, or debt, in financing a firm's operations, can really improve the firm's return on equity and earnings per share. This is because the firm is not diluting the owner's earnings by using equity financing. Too much financial leverage, however, can lead to the risk of default and bankruptcy.
One of the financial ratios we use in determining the amount of financial leverage we have in a business firm is the debt/equity ratio. The debt/equity ratio shows the proportion of debt in a business firm to equity.
What is Combined, or Total, Leverage
Combined, or total, leverage is the total amount of risk facing a business firm. It can also be looked at in another way. It is the total amount of leverage that we can use to magnify the returns from our business. Operating leverage magnifies the returns from our plant and equipment or fixed assets. Financial leverage magnifies the returns from our debt financing. Combined leverage is the total of these two types of leverage or the total magnification of returns. This is looking at leverage from a balance sheet perspective.
It is also helpful and important to look at leverage from an income statement perspective. Operating leverage influences the top half of the income statement and operating income, determining return from operations. Financial leverage influences the bottom half of the income statement and the earnings per share to the stockholders.
The concept of leverage, in general, is used in breakeven analysis and in the development of the capital structure of a business firm.
Q-8) Explain the concept of break even analysis.
The BREAK EVEN POINT is , in general ,the point at which the gains equal
the losses. A break even point defines when an investment
will generate a positive return. The point where sales or revenues equal expenses. Or also the point where total costs equal total revenues. There is no profit made or loss incurred at the break-even point. This is important for anyone that manages a business, since the break¬even point is the lower limit of profit when prices are set and margins are determined.
Achieving Break-even today does not return the losses occurred in the past. Also it does not build up a reserve for future losses. And finally it does not provide a return on your investment (the reward for exposure to risk).
The Break-even method can be applied to a product, an investment, or the entire company's operations and is also used in the options world. In options, the Break-even Point is the market price that a stock must reach for option buyers to avoid a loss if they exercise. For a Call, it is the strike price plus the premium paid. For a Put, it is the strike price minus the premium paid.
THE RELATIONSHIP BETWEEN FIXED COSTS, VARIABLE COSTS AND RETURNS
Break-even analysis is a useful tool to study the relationship between fixed costs, variable costs and returns. The Break-even Point defines when an investment will generate a positive return. It can be viewed graphically or with simple mathematics. Break-even analysis calculates the volume of-production at a given price necessary to cover all costs. Break-even price analysis calculates the price necessary at a given level of production to cover all costs. To explain how break-even analysis works, it is necessary to define the cost items.
Fixed costs, which are incurred after the decision to enter into a business activity is made, are not directly related to the level of production. Fixed costs include, but are not limited to, depreciation on equipment, interest costs, taxes and general overhead expenses. Total fixed costs are the sum of the fixed costs.
Variable costs change in direct relation to volume of output. They may include cost of goods sold or production expenses, such as labor and electricity costs, feed, fuel, veterinary, irrigation and other expenses directly related to the production of a commodity or investment in a capital asset. Total variable costs (TVC) are the sum of the variable costs for the specified level of production or output. Average variable costs are the variable costs per unit of output or of TVC divided by units of output.
The Break-even Point analysis must not be mistaken for the Payback Period, the time it takes to recover an investment.
In Value Based Management terms, a break-even point should be defined as the Operating Profit margin level at which the business / investment is earning exactly the minimum acceptable Rate of Return, that is, its total cost of capital.
BREAK-EVEN POINT CALCULATION
Calculation of the BEP can be done using the following formula:
BEP = TFC / (SUP - VCUP)
• BEP = break-even point (units of production)
• TFC = total fixed costs,
• VCUP = variable costs per unit of production,
• SUP = selling price per unit of production.
BENEFITS OF BREAK-EVEN ANALYSIS
The main advantage of break-even analysis is that it explains the relationship between cost, production volume and returns. It can be extended to show how changes in fixed cost-variable cost relationships, in commodity prices, or in revenues, will affect profit levels and break-even points. Break-even analysis is most useful when used with partial budgeting or capital budgeting techniques. The major benefit to using break-even analysis is that it indicates the lowest amount of business activity necessary to prevent losses.
LIMITATIONS OF BREAK-EVEN ANALYSIS
• It is best suited to the analysis of one product at a time;
• It may be difficult to classify a cost as all variable or all fixed; and
• There may be a tendency to continue to use a break-even analysis after the cost and income functions have changed.