FIN622 Official Handouts

Lesson 01

INTRODUCTION TO SUBJECT

Corporate finance is the study of planning, evaluating and drawing decisions in the course of business. Let’s take a simple example to determine the scope of our subject. This would cover around 85% to 90% of scheme of studies of corporate finance. Suppose you intend to kick start a business. Three up-front questions that hit our top of the head are: What type of investments do we need? In other words, what type of assets will be required to support the intended business? Where the money will come from? Sources of investments to be determined in black and white. How we will finance our day to day monetary matters like purchase of raw materials and payment of salaries etc? To answer these question let’s explore them individually for twin purpose: to know what is corporate finance and secondly, to determine the scope of the subject. Referring to question # 1 – Types of investment or assets needed in the business: The answer to this question can be found by defining Capital Budgeting process.

Capital Budgeting:

It involves planning, analyzing and acquiring capital assets like Plant and Machinery or Land or Building. These investments take ample amount of resources and therefore, these decisions are irreversible in nature. That in turn means that once the decision is implemented it would incur heavy losses if we want to un-do it subsequently. Therefore, making investment in capital assets is a very risky process and must be handled with care and skill.

SWOT analysis is also very helpful in capital budgeting process. SWOT stands for: Strengths Weaknesses Opportunities Threats Strengths are connected to Opportunities and in order to tap the lucrative opportunities you need to make capital investment, which must be handled with due care and skill ensuring effective decision making. This means that type of assets to be acquired depends on the nature, need and resources of business besides some other factors. For example, a large airline industry would acquire bigger plane than a smaller airline which may opt for a relatively cheaper plane. Taking up the second question in line, that is, “where the money will come from?” Broadly speaking there are two potential sources for making investments. The first sources emerge from the contributions of sponsors or directors who commence the business. This portion of investment is called Capital or Equity contribution. The other source of investment is from loans and various financial instruments and markets. Banks provide long term and short loans to the business world and this has been the most important source of business finance and is being used widely. Other source of external financing is issuance of bonds and securities in primary and secondary markets. This process is known as Capital Structure Decisions in which it is determined that how much of the total cost shall be financed by Equity contribution and Loans. Moving to third and last question: To finance day to day financial needs is in fact an issue that fall within the ambit of Working Capital policies. Following are the typical questions in this context: What would be our purchases level for raw materials? Do we need to import or are locally available? How much finances will be needed to procure raw materials? What are our customers or markets? How many days credit to be extended to customer and taken from creditor?

FINANCIAL STATEMENTS & CORPORATE FINANCE WITH SOME IMPORTANT CONCEPTS:

There are basically three financial statements that every business entity runs periodically. It includes:

Income Statement Cash Flow

This is a statement of resources controlled by and obligations to settle by an entity as on a specified date. The format of Financial Statements is governed by International Financial Reporting Standard in Pakistan. However, in US these are governed by the provisions of Generally Accepted Accounting Principles (GAAP). Balance Sheet Contents are: i) ii) Current Assets iii) Current Liabilities iv) Long Term Liabilities v) Capital & Reserves

Assets (both fixed and current) are placed in balance sheet in the order of less liquid or illiquid to liquid. This means that current assets are more liquid than fixed assets. Then question arises “what is liquidity?” or “what is a liquid asset?” An asset that can be converted to cash quickly and without loss of value is liquid asset. For example, prize bond is not a currency but you can get the face or par value of a prize bond when you sell the bond to any one. But this is not the case when you want to sell your motorcycle or car. Therefore, car or motor cycle is not a liquid asset but prize bond or gold are highly liquid. Current Assets and Current Liabilities when clubbed together, give birth to another concept known as working capital. Current assets are those that form part of the circulating capital of a business. They are replaced frequently or converted into cash during the course of trading. The most common current assets are stocks, trade debtors, and cash.

Current liabilities are those short-term liabilities which are intended to be constantly replaced in the normal course of trading activity. Current liabilities typically comprise: trade creditors, accruals and bank overdrafts. There is another concept of Cash Cycle associated with working capital. Take a compact example to understand. You acquire goods or raw materials from vendors on credit. It takes time (say in days) to process or transform raw materials to finished goods, which are sold to customers on credit. Customers or Debtors are allowed a time period (in days) to settle or pay their bills and money received from debtors is used to pay off creditor, who provided goods on credit. Let’s assume you allowed your customers 30 days to pay for goods you sold to them on credit. And on the other hand you sought 35 days cushion from creditors to pay off purchases of raw materials. In this simple example you were still able to use money for 5 days before paying to creditors. This means the operating cycle is positive. Other concepts from financial statements shall be taken up in the next hand out.

Lesson 02 COMPARISON OF FINANCIAL STATEMENTS

Often it becomes very difficult to compare financial statements of two or more business entities due to i) Size ii) Functional currency. However, we can overcome these problems by utilizing two effective tools of comparison. These tools can be used for comparing performance of single entity over period of time and to compare two or more entities.

1. COMMON SIZE STATEMENTS
2. RATIO ANALYSIS

1) COMMON SIZE STATEMENTS · RUPEES · RUPEES · age · %age

125,138,737 109,101,363 62.87 60.73

12,653,681 18,514,377 6.36 10.31

2,930,337 827,737 1.47 0.46 140,722,755 128,443,477

7,347,476 11,215,891 3.69 6.24

Stocks -do22,628,137 19,231,731 11.37 10.70

2,149,858 3,211,998 1.08 1.79

other receivables 26,089,950 17,450,008 13.11 9.71

107,524 110,421 0.05 0.06

58,322,945 51,220,049

100.00

100.00

(6,794,240) (2,821,322) 3.41 1.57

(8,004,000) 4.02

(6,760,139) (19,270,244) 3.40 10.73

(30,831,550) (44,786,359) 15.49 24.93

(52,389,929) (66,877,925) 5,933,016 (15,657,876)

TOTAL ASSETS LESS CURRENT

146,655,771 112,785,601