Principles of Finance

Definition of Finance Function
The finance function refers to the set of activities and processes within an organization that involve managing and controlling financial resources. It encompasses tasks such as budgeting, financial planning, investment decisions, risk management, and financial reporting to support the overall goals of the business.
The finance function refers to the management and oversight of financial aspects within an organization. It involves activities such as budgeting, financial planning, risk management, and monitoring financial performance to ensure effective use of resources and achievement of financial goals.
1. According to Eugene F. Brigham and Michael C. Ehrhardt, finance is "the study of how people and businesses evaluate investments and raise capital to fund them."
2. James C. Van Horne defines finance as "an applied branch of economics that studies the ways in which individuals, business entities, and other organizations allocate resources over time."
3. In the words of Franco Modigliani and Merton H. Miller, finance is "concerned with the process, institutions, markets, and instruments involved in the transfer of money among individuals, businesses, and governments."
These definitions highlight the multidimensional nature of finance, encompassing aspects of investment, capital allocation, and the transfer of funds within the economy.
Nature of finance function
Certainly, the nature of the finance function can be summarized in key points:
1. Resource Allocation Finance involves the efficient allocation of resources, both capital and financial, to maximize returns and achieve organizational goals.
2. Risk Management Finance addresses the identification, assessment, and management of financial risks to ensure stability and sustainability in the face of uncertainties.
3. Time Value of Money Recognizing the time value of money is crucial in finance, where the present and future value of cash flows are considered for decision-making.
4. Investment Decisions Finance plays a pivotal role in evaluating and selecting investment opportunities that align with the organization's objectives.
5. Capital Structure It involves decisions related to the composition of the organization's capital, striking a balance between debt and equity to optimize cost and risk.
6. Financial Markets Finance operates within the framework of financial markets, where instruments are traded, and capital is raised or invested.
7. Financial Planning Finance function includes the development of financial plans, budgets, and forecasts to guide the organization in achieving its financial objectives.
8. Liquidity Management Ensuring adequate liquidity to meet short-term obligations while optimizing the use of resources is a key aspect of financial management.
9. Profitability Maximization Finance aims to enhance shareholder wealth by making decisions that maximize profitability over the long term.
10. Regulatory Compliance Adherence to financial regulations and ethical standards is an integral part of the finance function to maintain transparency and trust.
These points collectively illustrate the multifaceted nature of finance, encompassing strategic decision-making, risk management, and the efficient use of financial resources.
Scope of Finance Function
1. Investment Decisions Finance involves evaluating and selecting investment opportunities to maximize returns while managing risk.
2. Capital Budgeting It includes decisions related to long-term investments in projects and assets, considering factors such as profitability and payback periods.
3. Capital Structure Finance function encompasses decisions about the composition of a firm's capital, balancing debt and equity to optimize cost and risk.
4. Working Capital Management Involves managing short-term assets and liabilities to ensure smooth day-to-day operations and liquidity.
5. Risk Management Finance addresses identifying, assessing, and mitigating financial risks, such as market fluctuations, interest rates, and currency exchange rates.
6. Financial Markets Understanding and navigating financial markets for efficient fund raising, trading, and investment activities.
7. Dividend Policy Deciding on the distribution of profits to shareholders, balancing the company's need for reinvestment and shareholder returns.
8. Financial Planning Developing comprehensive financial plans to achieve organizational goals and objectives.
9. Corporate Governance Finance plays a role in ensuring transparent and responsible management practices to protect the interests of shareholders and stakeholders.
10. International Finance Involves managing financial aspects in the context of global markets, currencies, and cross-border transactions.
The scope of finance is broad, covering various facets of managing funds and resources to optimize a firm's financial performance and value.
Meaning of Financial Management 
Financial management involves planning, organizing, directing, and controlling an organization's financial resources to achieve its objectives. It includes activities such as budgeting, financial forecasting, cash flow management, investment analysis, and strategic decision-making to optimize the use of funds. The primary goal of financial management is to maximize shareholder wealth by ensuring effective allocation of resources, managing risks, and maintaining financial stability. It plays a crucial role in facilitating sound business decisions that contribute to the long-term success and sustainability of the organization.
Traditional Approach towards Financial Management
The Traditional Approach to financial management emphasizes the following key principles:
1. Profit Maximization Traditional finance aimed primarily at maximizing profits as the ultimate goal of a business. The assumption is that higher profits lead to increased shareholder wealth.
2. Risk and Return Trade-off This approach acknowledges the trade-off between risk and return. It suggests that higher returns typically come with higher levels of risk. The goal is to find a balance that suits the risk tolerance of the business.
3. Time Value of Money The Traditional Approach recognizes the concept of time value of money, emphasizing that a sum of money today is worth more than the same amount in the future. This principle is fundamental in investment decisions and discounting future cash flows.
4. Separation of Ownership and Management The Traditional Approach assumes a clear distinction between ownership and management. Shareholders are considered the owners of the company, and managers act as agents responsible for running the business efficiently.
5. Use of Leverage Traditional financial management allows for the use of financial leverage (borrowing) to magnify returns, assuming that the cost of debt is lower than the return on investment.
6. Single Objective Profit maximization is often considered the single and primary objective of the firm in the Traditional Approach. Other goals, such as social responsibility, are secondary.
7. Short-Term Focus There's a tendency to focus on short-term financial goals and performance rather than considering long-term sustainability and growth.
It's important to note that while the Traditional Approach provides a foundation for financial decision-making, modern financial management often incorporates a more comprehensive set of principles, including considerations of shareholder value, stakeholder interests, and corporate social responsibility.
Modern Approach Towards Financial Management
The modern approach to financial management is characterized by several key principles and practices:
1. Value Maximization The primary goal is to maximize shareholder wealth by making decisions that increase the overall value of the firm. This aligns with the concept of shareholder wealth maximization.
2. Risk-Return Tradeoff Modern financial management recognizes the tradeoff between risk and return. Investments and financial decisions are evaluated based on their potential returns against the associated risks.
3. Time Value of Money Recognizes the importance of the time value of money in financial decision-making. Cash flows are discounted or compounded to reflect their present or future values, respectively.
4. Capital Market Efficiency Assumes that financial markets are generally efficient and that stock prices reflect all available information. This influences investment decisions and the reliance on market signals.
5. Dividend Relevance Acknowledges that dividend policy can affect a firm's value. The focus is not just on the amount of dividends but also on the impact of dividend decisions on the company's stock price.
6. Optimal Capital Structure Seeks to determine the mix of debt and equity that minimizes the cost of capital and maximizes the firm's value.
7. Real Options Recognizes that investment decisions may have embedded real options, allowing for flexibility in adapting to changing market conditions. This includes the flexibility to expand, defer, or abandon projects.
8. Behavioral Finance Integrates insights from psychology to understand how psychological factors influence financial decisions. It considers the impact of biases, emotions, and irrational behavior on financial markets.
9. Corporate Governance Emphasizes the importance of strong corporate governance practices to ensure transparency, accountability, and protection of shareholder interests.
10. Technological Integration Leverages technology for efficient financial management, including advanced analytics, automation, and financial modeling tools.
In essence, the modern approach to financial management is dynamic and incorporates contemporary theories, empirical evidence, and technological advancements to guide financial decision-making in a rapidly changing business environment.
The role of a finance manager involves several key responsibilities, which can be broken down into detailed steps: 1. Financial Planning and Analysis
- Develop financial forecasts and budgets.
- Analyze financial data and provide insights to support strategic decision-making.
- Conduct variance analysis to compare actual performance against budgeted or forecasted figures. 2. Risk Management - Identify financial risks facing the organization, such as market volatility, credit risk, or liquidity risk. - Develop and implement strategies to mitigate these risks, such as hedging strategies or insurance policies. - Monitor and evaluate risk management activities to ensure effectiveness. 3. Financial Reporting - Prepare financial statements in accordance with relevant accounting standards (e.g., GAAP or IFRS). - Ensure timely and accurate reporting of financial information to internal and external stakeholders. - Communicate financial results and analysis to management, investors, and regulatory bodies. 4. Capital Management - Manage the organization's capital structure, including debt and equity financing. - Evaluate investment opportunities and make recommendations on capital allocation. - Optimize the use of financial resources to maximize shareholder value. 5. Cash Management - Forecast cash flows to ensure sufficient liquidity for ongoing operations and strategic initiatives. - Monitor cash balances and manage cash flow processes, such as accounts receivable and accounts payable. - Implement strategies to optimize cash management, such as cash pooling or investment of excess funds. 6. Compliance and Governance - Ensure compliance with financial regulations and reporting requirements. - Establish and maintain internal controls to safeguard assets and mitigate risks of fraud or error. - Coordinate audits and reviews by external auditors and regulatory agencies. 7. Strategic Financial Planning - Collaborate with senior management to develop long-term financial strategies aligned with organizational goals. - Conduct financial analysis to evaluate the financial impact of strategic initiatives or business decisions. - Provide recommendations on capital investment, mergers and acquisitions, and other strategic opportunities. 8. Stakeholder Management - Build relationships with key stakeholders, including investors, lenders, and board members. - Provide financial analysis and guidance to support stakeholder decision-making and build trust in the organization's financial health. - Communicate effectively with stakeholders to address concerns, provide updates, and ensure alignment with financial objectives. These steps encompass the core responsibilities of a finance manager, which are essential for ensuring the financial health and success of an organization.
- Identify financial risks facing the organization, such as market volatility, credit risk, or liquidity risk.
- Develop and implement strategies to mitigate these risks, such as hedging strategies or insurance policies.
- Monitor and evaluate risk management activities to ensure effectiveness. 3. Financial Reporting
- Prepare financial statements in accordance with relevant accounting standards (e.g., GAAP or IFRS).
- Ensure timely and accurate reporting of financial information to internal and external stakeholders.
- Communicate financial results and analysis to management, investors, and regulatory bodies. 4. Capital Management
- Manage the organization's capital structure, including debt and equity financing.
- Evaluate investment opportunities and make recommendations on capital allocation.
- Optimize the use of financial resources to maximize shareholder value. 5. Cash Management
- Forecast cash flows to ensure sufficient liquidity for ongoing operations and strategic initiatives.
- Monitor cash balances and manage cash flow processes, such as accounts receivable and accounts payable.
- Implement strategies to optimize cash management, such as cash pooling or investment of excess funds. 6. Compliance and Governance
- Ensure compliance with financial regulations and reporting requirements.
- Establish and maintain internal controls to safeguard assets and mitigate risks of fraud or error.
- Coordinate audits and reviews by external auditors and regulatory agencies. 7. Strategic Financial Planning
- Collaborate with senior management to develop long-term financial strategies aligned with organizational goals.
- Conduct financial analysis to evaluate the financial impact of strategic initiatives or business decisions.
- Provide recommendations on capital investment, mergers and acquisitions, and other strategic opportunities. 8. Stakeholder Management
- Build relationships with key stakeholders, including investors, lenders, and board members.
- Provide financial analysis and guidance to support stakeholder decision-making and build trust in the organization's financial health.
- Communicate effectively with stakeholders to address concerns, provide updates, and ensure alignment with financial objectives. These steps encompass the core responsibilities of a finance manager, which are essential for ensuring the financial health and success of an organization.

Standard Costing

Standard Cost and Standard Costing are accounting concepts used by businesses to help manage and control costs. Here are their definitions and meanings:

1. Standard Cost:

Definition: Standard cost is the predetermined cost that a company expects to incur for producing a unit of a product or service under normal conditions, assuming efficient operations and optimal usage of resources.

Meaning: It represents an estimate of what each unit of production should cost, based on factors like material costs, labor costs, and overhead expenses. These predetermined costs serve as benchmarks against which actual costs are compared.

2. Standard Costing:

Definition: Standard costing is a cost accounting method that involves setting predetermined standard costs for various cost elements (e.g., materials, labor, and overhead) and then comparing these standards to actual costs incurred during production.

Meaning : It's a systematic approach to cost control and performance evaluation. By analyzing the variances between standard costs and actual costs, a company can identify areas where it may be underperforming or exceeding expectations. This information helps in making decisions to improve efficiency and cost-effectiveness.

In summary, standard cost represents the expected cost per unit, while standard costing is the process of comparing these expected costs to actual costs to assess performance and make necessary adjustments in business operations.

There are several types of standards used in business and accounting. These standards serve as benchmarks or reference points for measuring performance and controlling costs. Here are some common types of standards:

1. Ideal Standards: These are also known as "theoretical" or "perfect" standards. They assume the best possible conditions, with no inefficiencies or wastage. Ideal standards are used as long-term goals to motivate improvement.

2. Normal Standards: These standards are based on typical, reasonable conditions and assume a moderate level of efficiency. They are more practical than ideal standards and are used for day-to-day planning and performance evaluation.

3. Basic Standards: Basic standards are similar to normal standards but may be adjusted for longer time frames, considering fluctuations in market conditions, production methods, or resource availability.

4. Current Standards: Current standards are updated frequently to reflect the most recent data and conditions. They are used when the business environment is dynamic and subject to rapid changes.

5. Attainable Standards: These standards are set at a level that can be reasonably achieved by the workforce. They take into account the capabilities and limitations of the employees and resources.

6. Stretch Standards : Stretch standards are intentionally set at a challenging level, pushing employees and departments to exceed their usual performance levels. They are often used to encourage innovation and continuous improvement.

7. Fixed Standards: Fixed standards remain constant regardless of changes in production volume or external conditions. They are useful for comparing performance over time.

8. Flexible Standards: Flexible standards are adjusted for changes in production volume or other factors that can affect costs. They provide a more accurate measure of performance under varying conditions.

9. Cost Standards: These standards focus on cost elements such as material, labor, and overhead costs. They are essential for cost control and variance analysis.

10. Quality Standards: Quality standards define the expected quality level of products or services. They help ensure that the company meets customer expectations and maintains product integrity.

11. Time Standards: Time standards specify the amount of time required to complete specific tasks or processes. They are crucial for production scheduling and labor planning.

12. Safety Standards: Safety standards outline the necessary safety procedures and protocols to protect employees and assets. Compliance with safety standards is critical to prevent accidents and injuries.

13. Environmental Standards: Environmental standards address sustainability and environmental impact, ensuring that a company operates in an environmentally responsible manner.

These various types of standards serve different purposes within an organization, allowing for effective planning, performance measurement, and control in different areas of business operations.

Amalgamation, Absorption and External Reconstruction of Joint Stock Companies

 Amalgamation, Absorption & External Reonstruction

 Amalgamation : Amalgamation is a business combination. It means formation  of  a new company to take over the existing business of  two  or more  companies. Sections 391, 394, 394A, 395 & 396A of the Companies Act 1956 deal with amalgamation of the companies.

In  amalgamation,  old existing companies will close  down  their business  &  their  assets & liabilities are transferred  to  the  new company's account as per the agreement.

Absorption : When one company buys another and integrates its operations, assets, and liabilities with those of the acquired company, a limited company is absorbed. This can be achieved through a merger or acquisition procedure.

When two or more businesses merge, a new firm is created. The shareholders of the merging firms become shareholders in the new company, and the assets and liabilities of the merging companies are transferred to it.

A company buys the assets and liabilities of another company in an acquisition. The purchased company's shareholders may be compensated in cash, shares, or a combination of both.

A limited business may be absorbed for a number of reasons, which includes :

A bigger market share and more competition

Access to new markets or products

Integration of operations results in efficiency and cost savings.

Increased stability and financial strength

Risk diversification

However, there may be disadvantages to absorption, such as :

Integration costs and difficulties

Cultural distinctions between the two businesses

Employees and other stakeholders opposition

Regulation obstacles and authorization requirements

Possibility of decreasing shareholder value.

Before engaging in an absorption, businesses should do due diligence to evaluate the advantages and risks associated and prepare a thorough integration plan to guarantee a smooth transition.

PURCHASE CONSIDERATION :

1. Lump sum Method : If purchase consideration is more than  the  Net Assets,  the difference between the two is Goodwill & if the  purchase consideration is less than the Net Assets, the difference between  the two is Capital Reserve.

2.      Net Asset Method : Purchase consideration = Assets taken over  less Liabilities taken over.

3.      Net  Payment Method : Calculate the purchase consideration  &  the difference between the purchase consideration and the Net Assets  will be Goodwill or Capital Reserve.

ACCOUNTING TREATMENT

Journal Entries in the books of Vendor / Purchased Company

Journal Entries in the books of Purchasing Company

Ratio Analysis and Financial Statements

Introduction:

Ratio analysis is a potent tool used by financial analysts, investors, and companies to evaluate the performance and health of a company's finances. Analysts can compute and decipher many financial ratios by looking at financial documents, particularly the income statement, balance sheet, and cash flow statement. These ratios offer important information on the profitability, liquidity, solvency, and effectiveness of a company. The importance of ratio analysis, crucial financial statements, and key points to keep in mind when utilizing ratio analysis are all covered in this chapter.

Financial Statements:

1.1. Income Statement: The income statement summarizes the revenues, costs, and net income of a corporation.

Revenues, cost of goods sold (COGS), operational expenses, non-operating items, and taxes are important factors.

It displays the performance and profitability of a business over a specific time frame.

1.2 Balance Sheet

The balance sheet provides a moment in time view of a company's financial situation.

It consists of shareholders' equity, assets, and liabilities.

Liabilities show what a corporation owes, whereas assets show what it has, and shareholders' equity shows the ownership stake.

The liquidity and solvency of a corporation are disclosed on the balance sheet.

1.3 Cash Flow Statement

The cash inflows and outflows within a certain time period are tracked by the cash flow statement.

Operating activities, investing activities, and financing activities make up its three divisions.

The cash flow statement shows how well a business can produce and handle cash.

Liquidity Ratios:

2.1. Ratio Analysis:

Using liquidity measures, you may gauge a company's capacity to pay short-term debts.

The quick ratio and the current ratio are typical liquidity ratios.

These ratios aid in determining if a business has enough cash and assets to pay its short-term obligations.

Ratios of Profitability:

A company's capacity to make profits in relation to its revenue, assets, and equity is gauged by profitability ratios.

The gross profit margin, operating margin, and return on equity (ROE) are examples of common profitability ratios.

These ratios can be used to evaluate a company's productivity and profitability.

2.4 Efficiency Ratios:

Efficiency ratios assess how well a business uses its resources and assets.

Inventory turnover, accounts receivable turnover, and asset turnover are important efficiency ratios.

These statistics show how effectively a business operates and how well it can make money off its assets.

2.5 Market Ratios

Market ratios represent how the market views the worth and prospects of a company.

The price-to-earnings (P/E) ratio and earnings per share (EPS) are examples of common market ratios.

Investors can use these statistics to assess if the shares of a company is overvalued or undervalued.

3.1. Peer and Industry Comparison:

To acquire useful insights, it is essential to contrast a company's ratios with those of its competitors and the industry as a whole.

The success of a company should be assessed in the context of its particular industry because ratios differ throughout industries.

3.2 Historical Analysis

Comparing ratios from different time periods to conduct a trend analysis makes it easier to spot trends and assess a company's performance over time.

A more comprehensive viewpoint is provided by historical analysis, which also identifies any shifts or trends in financial performance.

3.3. Ratio analysis's drawbacks:

Ratio analysis has drawbacks, including its reliance on historical data and disregard for qualitative considerations.

Along with ratio analysis, it is crucial to take into account other elements including market trends, competitive dynamics, and management caliber.

Ratio analysis is an effective method that offers important insights into the health and performance of a company's finances. Analysts can evaluate a company's profitability, liquidity, solvency, and efficiency by scrutinizing financial statements and computing different ratios. 

Ratio analysis is a potent instrument that offers important insights into the financial performance and health of an organization. Analysts can determine a company's profitability, liquidity, solvency, and efficiency by examining financial documents and calculating various ratios. Making well-informed decisions based on ratio analysis requires taking into account historical patterns, industry benchmarks, and qualitative aspects.

DEPRECIATION

DEPRECIATION

Depreciation is assessed to represent the true worth of assets on the balance sheet and to appropriately determine profit or loss.

Depreciation, then, is the continuous, ongoing, and irreversible loss of value resulting from normal wear and tear or any other comparable cause in a fixed asset. Assets can be depreciated in six different ways. As only a few instances, consider the following techniques: fixed installment, straight line, beginning cost, decreasing or reducing balance, written-down value, annuity, revaluation, depreciation, sinking fund, and insurance policy processes. However, this year we will be studying the first two methods.

(i) Fixed Instalment / Straight Line / Original Cost Method: Under this method, depreciation is charged at a fixed rate at the end of every year during the lifetime of an asset. The formula for depreciation :

Depreciation =  Original Cost of asset + Installation Charges – Break-up Value / Scrap Value

Estimated Life Of An Asset

(ii) Diminishing Balance / Reducing Balance/ Written Down Value Method : Under this method, depreciation is charged on the opening balance of the asset each year at a given rate.

An amount received when an asset is sold after its useful life is called Scrap Value / Residual Value / Break up Value.

Charges incurred for the erection of the machinery are called Installation Charges / Erection Charges.

ACCOUNTING TREATMENT
1. When any asset is purchased
                    Asset A/c. Dr.
                        To Cash / Bank A/c.

2. When depreciation is charged
                    Depreciation A/c. Dr.
                        To Asset A/c.

3. When depreciation is transferred to Profit & Loss A/c.
                    Profit & Loss A/c. Dr.
                        To Depreciation A/c.

4. When any is sold
                    Cash / Bank A/c. Dr.
                        To Asset A/c.

5. When there is loss on sale of any asset
                    Profit & Loss A/c. Dr.
                        To Asset A/c.

When there is profit on sale of asset vice-versa

ISSUE OF SHARES

Issue of shares

Every company needs funds to start the business as well as to run the business. This funds a race from various modes. The funds can be raised in the form of loan from banks, money lenders or from investors. But there is an another way to raise funds from the public in the form of shares of the company.

The capital required for the company is divided in the form of shares of the company. Such capital is called as share capital of the company. Interested people invest their amount for purchasing these shares. The investors of such capital are called as shareholders of the company.

These shareholders are the owners of the company. They get a part of profit of the company at the end of the year in the form of dividend. If the company earns huge profits then these shareholders get a good amount of dividend. In case the company goes in heavy losses then these shareholders may not even get their invested amount of capital.

The shareholders being the owner of the company have the right to vote in the Annual General Meeting.

 BILL OF EXCHANGE

Under section 5 of Negotiable Instrument Act, 1981,”A bill of exchange is an instrument in writing containing an unconditional order, signed by the maker, directing a certain sum of money only to, or to the order of a certain person or the bearer of the instrument .”

Parties of the Bill : There are three original parties of a bill of exchange – the drawer, the drawee and the payee .

Drawer : A person who draws the bill is called drawer.

Drawee : A person to whom the bill is Drawn or the acceptor of the bill called a Drawee.

Payee : A person to whom the money is ordered to be paid is called the payee. He may be drawer also

Endorser : A person who endorse the bill (or transfer the bill) to the other party is called the endorser.

Endorsee : A person to whom the bill is endorsed or transferred is called the endorsee.

·        Write the word / term / phrase which can substitute each of the following statement.

1.      A person to whom bill is endorsed.

Ans : Endorsee

2.      A person who draws a bill.

Ans : Drawer

3.      A person to whom the bill is payable.

Ans : Payee.

4.      Encashment of bill with the bank at some rebate.

Ans : Discounting of the bill.

5.      A bill drawn in one country and payable in other country.

Ans : Foreign bill

6.      The date on which bill is payable.

Ans : Due Date

7.      Payment of bill before due date.

Ans : Retirement of bill.

8.      Non payment of bill on the due date.

Ans : Dishonour of bill.

9.      A person who notes the dishonour of the bill.

Ans : Notary Public

10.   Payment of bill on due date.

Ans : Honour of bill.

11.   A person who accepts the bill.

Ans : Acceptor / Drawee.

12.   A person who endorses the bill.

Ans : Endorser.