MGT201 Midterm Handouts by Tasha Khanam

NOTE = If you go through the VU PPT slides of mgt201 once before

studying this handout, it will help you understand the topics more effectively and develop clearer concepts.

Module 1: Scope of Financial · Management: · I. Functions of Financial Management

The functions of financial management represent the primary pillars upon which a firm’s value is built. These functions are categorized into four main areas: Financing, Investing, Asset Management, and Financial Analysis.

1. Financing Activities

Financing activities focus on how a company raises the capital necessary to fund its operations and growth. This involves deciding between Internal Financing (retained earnings/profits) and External Financing (funds from outside investors or lenders).

Equity vs. Debt: A critical decision is the mix of equity (ownership) and debt (borrowed funds). Equity Financing involves issuing common or preferred shares, which grants certain rights and dividends to shareholders but does not require mandatory repayment. Debt Financing involves public issues or private loans that carry interest obligations. Financial Leverage: This refers to the use of debt to potentially increase the return on equity. While it can magnify profits, it also increases the risk of the firm due to fixed interest obligations.

2. Investing Activities

Investing involves the strategic allocation of the capital raised through financing into assets that will generate future returns.

Terms of Investment: Investments can be Long-Term (fixed assets, infrastructure) or Short-Term (marketable securities). Capital Budgeting: This is the process of evaluating long-term investment projects using Discounted Cash Flow (DCF) methods to determine their viability based on the required Rate of Return. External Markets: Companies can also invest outside their core business in Stock Markets (like the PSX) or through Indirect Investment such as Mutual Funds.

3. Asset Management (Working Capital Management)

Asset management ensures that the firm's daily operations run smoothly by managing its short-term resources.

Components: The primary components are Inventories, Receivables, and Cash. Goal: The objective is to maintain an optimal level of Net Working Capital and monitor performance through Working Capital Ratios (Current and Acid Test Ratios) and the Cash/Credit Cycle.

4. Financial Analysis

Financial analysis is the process of evaluating a company’s performance to support decision-making.

Types of Analysis: This includes Comparative Analysis (comparing performance over time), Index Analysis, and Risk Analysis. Ratio Analysis: This is a vital tool used to assess Liquidity (ability to meet short-term debts), Leverage (debt levels), Turnover (efficiency of asset use), and Profitability.

II. Detailed Breakdown of Financing Activities

1. Sources and Types of Financing

Financing is generally categorized by its source and time period. Long-term financing typically involves equity or long-term debt used for major assets, while short-term financing handles operational needs.

Equity Financing (Common vs. Preferred): Common shares represent ownership and usually come with voting rights. Preferred shares often have a fixed dividend rate and priority over common shares during liquidation. Internal Financing: This is the use of the company’s own Profit to reinvest in the business, which avoids the cost of issuing new securities.

2. Debt Financing and Interest Rates

Debt involves borrowing funds that must be repaid with interest.

Interest Structures: Loans can have Fixed Rates (staying the same) or Floating Rates (changing based on benchmarks like KIBOR or the Prime Rate). (KIBOR)=KARACHI INTER BANK OFFERED RATE. Public vs. Private: Companies can raise debt through Public Issues (bonds) or Private Loans from financial institutions.

III. Detailed Breakdown of Asset Management

1. Inventory Management

Inventory represents a significant portion of current assets. It is categorized into Raw Materials, Work in Process (WIP), and Finished Goods, alongside stores and spares.

Inventory Costs: Managers must balance Ordering Costs (the cost of placing an order) and Carrying Costs (the cost of holding stock in the warehouse) to find the most efficient stock level.

3. Receivables Management

Receivables are the amounts owed to a firm by its customers.

Credit Policy: A firm must define its Credit Period (how long customers have to pay) and Cash Discounts (incentives for early payment). Risks: Managers must account for Bad Debts (uncollectible accounts) and the Collection Cost associated with recovering money. Factoring: This is a specialized strategy where a firm sells its receivables to a third party (a factor) to get immediate cash.

4. Cash Management

Cash is the most liquid asset and is essential for solvency.

Cash Budget: This tool tracks Cash Inflows and Outflows to predict Surplus or Deficits. Technical Insolvency: This occurs when a firm cannot meet its immediate financial obligations despite having assets, highlighting the importance of liquidity over simple profitability.

IV. Detailed Breakdown of Financial Analysis

1. Ratio Analysis Categories

To truly understand a firm's health, financial managers look at several ratio categories:

Liquidity Analysis: Measures the ability to pay short-term debts. Turnover/Activity Analysis: Measures how efficiently a firm uses its assets to generate sales. Leverage/Gearing Analysis: Examines the proportion of debt in the capital structure. Profitability and Market Analysis: Assesses the firm’s ability to generate earnings relative to sales or share price.