Reasons for Need of Financial Management - Essay Example

Topic: FM Order 163908 Deadline: 2007-04-15 22:24 Style: APA Language Style: English (U.K Pages: 16 Introduction: Financial management is that managerial activity which is concerned with the planning and controlling of the firm's financial resources. Though it was a branch of economics till 1890, as a separate activity or discipline it is of recent origin. Still it has no unique body of knowledge of its own, and draws heavily on economics for its theoretical concepts even today. The subject of financial management is of immense interest to both academicians and practicing managers. It is of great interest to academicians because the subject is still developing, and there are still certain areas where controversies exist for which no unanimous solutions have been reached as yet. Practicing managers are interested in this subject because among the most crucial decisions of the firm are those which relate to finance, and an understanding of the theory of financial management provides them with conceptual and analytical insights to make those decisions skillfully1. Requirement 1: Assessment of the financial goal and also of why financial management is needed at all: The financial goal at minimum level is 153000 for six months started from September 2007 to February 2008. If this financial goal is set up as 153000 for six months, the base's small store will not run at an operating loss. Reasons for need of financial management: Financial management, as an academic discipline, is concerned with decision-making in regard to the size and composition of assets and the level and structure of financing. To make wise decisions a clear understanding of the objectives, which are sought to be achieved, is necessary. The objective provides a framework for optimum financial, decision-making. In other words, they are concerned with designed a method of operating the internal investment and financing of a firm. These all are done in a systematic way if financial management is studied 2. In our problem, financial management is needed for some reasons. Such as: - Financial management is related to profit maximization as a decision criterion. According to profit maximization goal, actions that increase profits should be undertaken and those that decrease profits are to be avoided. In specific operational terms, as applicable financial management, the profit maximization criterion implies that the investment, financing and other decisions of the problem should be oriented to the maximization of profits. Though in our specific problem, financial goal is set up in such a way that of not operating at a loss, financial management is needed at all as the main objective of financial management is profit maximization. Workings for setting up financial goal: Fixed cost: Refurbishment cost 3: 8000 Building fixed overheads: 2000 per month 2000 6 months=12000 for 6 months So total fixed cost= 8000+12000 =20000 Fluctuation of Personnel Contingent 4 100 150 200 250 300 Cost of Goods sold 5 108000 162000 216000 270000 324000 Advanced stock Purchased for 2 weeks 3600 5400 7200 9000 10800 Total variable Cost 6 111600 167400 223200 279000 334800 Total revenue: Spend of customers/ Revenue of the store 7 150000 225000 300000 375000 450000 Total cash inflow Considering Fluctuations: 3000 8 153000 228000 303000 378000 453000 Total cash inflow Considering Fluctuations: 4000: 154000 229000 304000 379000 454000 Net cash inflow (Considering starting Cash as 3000) 9 21400 40600 59800 79000 98200 Remark 10 So to operate the store at not operating loss the minimum financial goal have to be 153000 for six months. Requirement 2: Tools to analyze a project: Ratios provide very useful tools for the manager to assess the organization by making two basic types of comparisons. First, the analyst can compare a present ratio with past (or expected) ratios for the organization to determine if there has been an improvement or deterioration or no change over time. Second, the ratios of one organization may be compared with similar organizations or with industry averages at the same point in time making sure that "apples are compared with apples and oranges with oranges." This is a type of "benchmarking" so that one may determine whether the organization is "average" in performance or doing better or worse than others. Ratios are simple measures or comparisons of one thing to another. These tools allow vital comparisons that are not possible when dealing with a single number. The insights gained by ratio analysis will assist in gaining vital understanding but ratios will never give answers, only clues. Ratios are found in all types of organizations from sports to education to business to the military to . . .. We analyses the project using ratio analysis by the following way: Ratio How Calculated What It Shows: Gross profit margin Sales - Cost of good sold Sales Total margin available to cover operating expenses and yield a profit. Operating profit margin (Return on Sales) Profits before taxes and before interest Sales Profitability without interest Net profit margin (Net Return on Sales) Profit after taxes Sales Sales prices may be too low or costs are too high! Return on total assets Profits after taxes Total assets Or Profit after taxes + interest Total Assets We show working about analysis in the appendix. Requirement 3: Selection of appropriate cash budgeting methods and preparation of an appropriate cash budget for the next 12 months: Cash budgeting methods is the method of determining how the monthly activities of ones parish or school impact the cash of the operation. Two most commonly used methods of cash budgeting are: The receipts and disbursements method The adjusted net income method The receipts and disbursements method is generally employed to forecast for limited periods. Such as a week or a month. The adjusted net income method, on the other hand, is preferred for longer durations ranging between a few months to a year. Both methods have their pros and cons. The cash flows can be compared with budgeted income and expense items if the receipts and disbursements approach is followed. On the other hand, the adjusted income approach is appropriate in showing a company's working capital and future financing needs. Therefore, in this problem adjusted net income method is appropriate because this method is used for a longer period as we prepare a cash budget for 12 months of the store. And also for on some assumptions given below: This method of cash forecasting involves the tracing of working capital flows. It is sometimes called the sources and uses approach. Two objectives of the adjusted net income approach are: To project the company's need for cash at a future date and To show whether the company can generate the required funds internally, and if not, how much will have to be borrowed or raised in the capital market. It is, in fact, a projected cash flow statement based on pro-forma financial statements. It generally has three sections: Sources of cash, Uses of cash and Adjusted cash balance. This procedure helps in adjusted estimated earnings on an accrual basis to a cash basis. It also helps in anticipating the working capital movements. Cash budget For the next 12 months started from March 2008 to February 2009 (Using the adjusted net income method) Descriptions a. Cash inflows: Spend of customers/ Revenue of the store (suppose fluctuated personnel contingent is 200) b. Cash outflows: Cost of Goods sold Advanced stock Purchased for two weeks Net increase in cash and cash equivalents (a-b) Started cash balance (suppose 4000) 11 Cash and cash equivalent as at 28th February 600000 (432000) (7200) 160800 4000 164800 Remark 12 Requirement 4: Discussion of the use of both cash and inventory management models: While it is true that financial managers need not necessarily follow cash management models exactly but a familiarity with them provides an insight into the normative framework as to how cash management should be conducted. There are 36 analytical models for cash management: Baumol Model Miller-orr Model and Baumol model: The purpose of this model is to determine the minimum cost amount of cash that a financial manager can obtain by converting securities to cash, considering the cost of conversion and the counter-balancing cost of keeping idle cash balances which otherwise could have been invested in marketable securities. The total cost associated with cash management, according to this model, has two elements (1) cost of converting marketable securities into cash and (2) the lost opportunity cost. The conversion costs are incurred each time marketable securities are converted into cash. Symbolically, total conversion cost per period =Tb/c Where, b=cost per conversion assumed to be independent of the size of the transaction T=total transaction cash needs for the period C=value of marketable securities sold at each conversion. The opportunity cost is derived from the lost/forfeited interest rate (I) that could have been earned on the investment of cash balance kept by the firm. The model assumes a constant, and a certain pattern of cash outflows. At the beginning of each period, the firm starts with a cash balance which it gradually spends until at the end of the period it has a zero cash balance and must replenish its each supply to the level of cash balance in the beginning. Symbolically, the average lost opportunity cost = i(C/2) Where, i = interest rate that could have been earned C/2=the average cash balance i.e. the beginning cash (c) plus the ending cash balance of the period (zero) divided by 2. The total cost associated with cash management comprising total conversion cost plus opportunity cost of not investing cash until needed in interest-bearing instruments can be symbolically expressed as: I (C/2) + (Tb/C) To minimize the cost, therefore, the model attempts to determine the optimal conversion amount i.e. the cash withdrawal that costs the least. The reason is that a firm should not keep the total beginning cash balance during the entire period, as it is not needed at the beginning of the period. For example, if the period were one thirty-day month, only one-thirtieth of the opening cash balance each day will be required. This means if only one-thirtieth of the entire amount is withdrawn, the rest could be left invested in interest-earning marketable securities. As a month, twenty-nine day do the firm and so on could earn interest. Symbolically, the optimal conversion (C) amount =2bt/i The model in terms of the above equation has important implications. First, as the total cash needs for transaction rises because of expansion/diversification etc. The optimal withdrawal increases less than proportionately. This is the result of economy of scale in cash management. Each project does not need its own additional cash balances. It only needs enough added to the general cash balance of the firm to facilitate expanded operations. Secondly, as the opportunity interest rate (i) increases, the optimal cash withdrawal decreases. This is so because as (i) increases it is more costly to forfeit the investment opportunity and financial managers want to keep as much cash invested in securities for as long as possible. They can afford to do this at the higher interest rates because at those higher rates any shortfall costs caused by a lower withdrawal are offset. In sum, the Baumol model of cash management is very simplistic. Further, its assumption of certainty and regularity of withdrawal of cash do not realistically reflect the actual situation in any firm. Also, the model is concerned only with transaction balances and not with precautionary balances. In addition, the assumed fixed nature of the cash withdrawals is also not realistic. Nevertheless, the model does clearly and concisely demonstrates the economics of scale and the counteracting nature of the conversion and opportunity costs, which are undoubtedly major considerations in any financial manager's cash management strategy. Miller-orr Model: The objective of cash management, according to Miller-orr (MO), is to determine the optimum cash balance level, which minimizes the cost of cash management. Symbolically, C= bE (N) /t + iE (M) Where, b=the fixed cost per conversion E (M) =the expected average daily cash balance E (N) =the expected number of conversions T=the number of days in the period I=the lost opportunity costs C=total cash management costs The MO model is, in fact, an attempt to make the Baumol model more realistic as regards the pattern of cash flows. As against the assumption of uniform and certain levels of cash balances in the Baumol model, the MO model assumes that cash balances randomly fluctuate between an upper bound (h) and a lower bound (o) When the cash balances hit the upper bound, the firm has too much cash and should buy enough marketable securities to bring the cash balances back to the optimal bound (z) When the cash balances hit zero, the financial manager must return them to the optimum bound (z) by selling/converting securities into cash. According to the MO model, as in Baumol model, the optimal cash balance (z*) can be expressed symbolically as Z*=33bQ2/4i Where Q=the variance of the daily changes in cash balances Thus, as in Baumol model, there are economics of scale in cash management and the two basic costs of conversion and lost interest that have to be minimized. MO model also specifics the optimum upper boundary (h*) as three times the optimal cash balance level such that h*=3z* Further the financial manager could consider the use of less liquid, potentially more profitable securities as investments for the cash balances in excess of h*. Reasons for choosing a particular model: Miller-orr (MO) model is preferable in cash management in this problem. There are some reasons for choosing this model is given below: The limitation of the Baumol model is that it does not allow the cash flows to fluctuate. Firms in practice do not use their cash balance uniformly nor are they able to predict daily cash inflows and outflows. The Miller-orr (MO) model overcomes this shortcoming and allows for daily cash flow variation.13 It assumes the net cash flows are normally distributed with zero value of mean and standard deviation. This assumption is relevant to the required problem as in this problem cash flow fluctuation is considered. . The MO model provides for two-control limits-upper control limit and the lower control limit as well as a return point. The MO model is more realistic since it allows variation in cash balance within upper limit and the lower limit. This assumption is also relevant and necessary for the required problem, as the project is needed to continue without at a financial loss. So the financial manager of this project can easily predict the upper and lower bound of cash flow to avoid financial loss. Inventory management model: The aim of inventory management should be to avoid excessive and inadequate levels of inventories and to maintain sufficient inventory for the smooth production and operations. An effective inventory management should Ensure a continuous supply of raw materials to facilitate uninterrupted production, Maintain sufficient stocks of raw materials in periods of short supply and anticipate price changes, Maintain sufficient finished goods inventory for smooth sales operation, and efficient customer service, Minimize the carrying cost and time, and Control investment in inventories and keep it at an optimum level. Models of inventory management are: 1. EOQ with Shortages and Lead Time 2. The ABC Classification 3. Just-in-time (JIT) model EOQ model: One main model of the inventory management is EOQ model. Description about it is given below: The economic order quantity (EOQ) model, as a technique to determine the economic quantity, is based on three restrictive assumptions, namely: 1) The firm knows with certainty, the annual usage (consumption) of a particular item of inventory. 2) The rate at which the firm uses inventory is steady over time. 3) The orders placed to replenish inventory stocks are received at exactly that point in time when inventories reach zero. It addition, it may also be assumed that ordering and carrying costs are constant over the range of possible inventory levels being considered. The model can, using a short-cut method, be calculated by the following equation: EOQ=2SO/ C Where S=usage unit for the inventory planning period (i.e. total inventory requirement in units) O= the ordering cost per unit C = the carrying cost per unit The ABC Classification: Large numbers of firms have to maintain several types of inventories .it are not desirable to keep the same degree of control on all the items. The firm should pay maximum attention to those items whose value is the highest .the firm should, therefore, classify inventories to identify which items should receive the most effort in controlling. The firm should be selective in its approach to control investment in various types of inventories. This analytical approach is called the ABC analysis and tends to measure the significance of each item of inventories in terms of its value. The high-value items are classified as "A items" and would be under the tightest control."C items" represent relatively least value and would be under simple control."B items" fall in between these two categories and require reasonable attention of management. The ABC analysis concentrates on important items and is also known as control by importance and exception (CIE).14As the items are classified in the importance of their relative value, this approach is also known as proportional value analysis (PVA). The following steps are involved in implementing the ABC analysis: Classify the items of inventories, determining the expected use in units and the price per units and the price per unit for each item. Determine the total value of each item by multiplying the expected units by its unit's price. Rank the items in accordance with the total value, giving first rank to the item with highest total value and so on. Compute the ratios (percentage) of number of units of each item to total value of all items. Combine items on the basis of their relative value to form three categories-A, B and C. The ABC classification system is to grouping items according to annual sales volume, in an attempt to identify the small number of items that will account for most of the sales volume and that are the most important ones to control for effective inventory management. Reorder Point: The inventory level R in which an order is placed where R = D.L, D = demand rate (demand rate period (day, week, etc), and L = lead time. Safety Stock: Remaining inventory between the times that an order is placed and when new stock is received. If there are not enough inventories then a shortage may occur. Safety stock is a hedge against running out of inventory. It is an extra inventory to take care on unexpected events. It is often called buffer stock. The absence of inventory is called a shortage. Just in time (JIT) model: Just in time (JIT) is defined in the APICS dictionary as "a philosophy of manufacturing based on planned elimination of all waste and on continuous improvement of productivity". It also has been described as an approach with the objective of producing the right part in the right place at the right time (in other words, "just in time"). Waste results from any activity that adds cost without adding value, such as the unnecessary moving of materials, the accumulation of excess inventory, or the use of faulty production methods that create products requiring subsequent rework. JIT (also known as lean production or stockless production) should improve profits and return on investment by reducing inventory levels (increasing the inventory turnover rate), reducing variability, improving product quality, reducing production and delivery lead times, and reducing other costs (such as those associated with machine setup and equipment breakdown). In a JIT system, underutilized (excess) capacity is used instead of buffer inventories to hedge against problems that may arise. Just-In-Time (JIT) inventory systems are important to financial managers because inventory is a necessary current asset that represents a significant investment. Gitman describes the JIT system as a tool to minimize inventory investment (Gitman 578). The ideology is that the materials arrive at the time they are needed for production and the company minimizes inventory investment by having only work-in-process (WIP) inventory. Inventory turnover can be increased which will result in a higher profit margin. This eliminates the need for safety stocks, and reduces inventory on hand. However there must be extensive coordination between the company, supplier and shipping company to meet schedules for the production line. If a supplier or shipping company cannot meet the schedule, the production will halt, as is the case with quality problems. Gitman summarizes JIT as a system for efficiency for production, materials and delivery. There are logistics, systems management, financial management, supply chain efficiency, inventory turnover, quality and a demand for the product to be considered as well as what outside forces can interfere with any of those aspects. Those requirements dictate the necessity of sound financial and business management. JIT is not possible without reliable delivery, short distances between the client and server or a speedy transportation and materials handling system, consistent quality so throughput is unaffected, and the ability to respond to outside fluctuations. Within all of that, every aspect needs to be leaned out to eliminate wasted resources in the simplest methods. The Just In Time Inventory Method (JIT) seeks to produce inventory so that its production is completed just as the inventory is needed (e.g., being sold or used). For inventory being purchased, inventory should arrive just as it is being sold or used. A perfect JIT model reduces carrying costs to zero. When purchasing inventory, firms implementing JIT try to develop relationships with their suppliers so that the inventory arrives when needed. For example, the supplier makes more Smith; Inc. is a Mom & Pop manufacturer of explosives. The annual demand for the explosives is estimated to be 5,000 units. The annual cost to hold one unit in inventory is $10 per year, and the cost to initiate a production run is $1,000. There are no explosives on hand, and Smith has scheduled four equal production runs of explosives for the upcoming year, the first of which is to be run immediately. Smith has 250 business days per year, sales occurred uniformly throughout the year, and production is completed within one day. Using the EOQ formula, we see that that the optimal run is 1,000 units: Reasons for choosing a particular model: From the discussion, we can conclude that just in time (JIT) model is appropriate for our required problem because of some benefits, which are arisen by following this model over the other models mentioned above: Better quality products Quality the responsibility of every worker, not just quality control inspectors Reduced scrap and rework Reduced cycle times Lower set-up times Smoother production flow Less inventory, of raw materials, work-in-progress and finished goods Cost savings Higher productivity Higher worker participation More skilled workforce, able and wiling to switch roles Reduced space requirements Improved relationships with suppliers Besides these benefits, the JIT model is relevant for the required problem as it discusses the just in time inventory supply so that stock is sufficient to maintain adequate supply of stock to the army forces (men and women who stayed in the Scottish base). Appendix:Top of Form Appendix: Break-even return: Fixed cost Contribution margin ratio Revenue - variable cost Contribution margin ratio= Revenue 300000 - 223200 = 300000 = 0.256 So, Break-even return per customer: 20000 0.256 = 78125 Therefore, starting cash required to provide a break-even return = (Fixed cost + variable cost) - break-even return = 20000 + (2.4 times 25 weeks 18 200) - 78125 =20000+ 216000 - 78125 =157875 15 Analysis of the project using appropriate tools: We can analyze the project using ratio analysis by the following way: Ratio How Calculated What It Shows: Gross profit margin 300000 - 216000 300000 28% margin available to cover operating expenses and yield a profit. Operating profit margin (Return on Sales) 300000 - 223200 Profitability without interestis 25.6% Net profit margin (Net Return on Sales) 300000 - 223200 300000 Sales prices may be25.6% too low or costs are too high! Return on total assets 16 300000 - 223200 4000 =19.2% Break Even Analysis: The break even point for a product is the point where total revenue received equals total costs associated with the sale of the product (TR=TC). A break even point is typically calculated in order for businesses to determine if it would be profitable to sell a proposed product, as opposed to attempting to modify an existing product instead so it can be made lucrative. Break-Even Analysis can also be used to analyze the potential profitability of an expenditure in a sales-based business. If the product can be sold in a larger quantity than occurs at the break even point, then the firm will make a profit; below this point, a loss. Break-even quantity is calculated by: Total fixed costs / (selling price - average variable costs). Explanation - in the denominator, "price minus average variable cost" is the variable profit per unit, or contribution margin of each unit that is sold. This relationship is derived from the profit equation: Profit = Revenues - Costs where Revenues = (selling price * quantity of product) and Costs = (average variable costs * quantity) + total fixed costs. Therefore, Profit=(selling price*quantity)-(average variable costs*quantity total fixed costs). Solving for Quantity of product at the breakeven point when Profit equals zero, the quantity of product at breakeven is Total fixed costs / (selling price - average variable costs). The calculation of break-even analysis is same as described in the starting point of the appendix. 17 Calculation Contribution Margin Analysis: Contribution margin analysis is a technique used in brand marketing and product management to help a company decide what product(s) to add to its product portfolio. The manager asks what will happen to profits if a new product is added or an existing product is discontinued.ns take into account additional revenues, additional costs, effects on other products in the portfolio (referred to as cannibalization), and competitors' reactions. Contribution margin is sales revenue less variable costs. It is the amount available to pay for fixed costs and provide any profit after variable costs have been paid. Contribution margin=sales revenue less variable costs = 300000 - 223200 = 76800 18 CVP analysis (cost-volume-profit analysis) CVP stands for Cost-Volume-Profit. CVP analysis examines the behavior of total revenue, cost, and profit as the output level (volume), selling price, variable costs, or fixed costs changes. CVP analysis helps managers to answer "what-if"-type questions: What if volume increases by 5,000 units - how will profit, revenues, and/or costs be affected What if we raise our price - what will be the effect of profit In effect, CVP analysis is a planning tool that utilizes information about cost behavior to provide managers with an overview of the effects of short-run financial changes. CVP analysis typically involves several assumptions that must be reasonably satisfied for the analysis to be valid. First, the behavior of total revenue and costs is linear (straight-line) with respect to output units within the relevant range. Second, total costs can be divided into fixed, variable, or semi variable with respect to output units within the relevant range. Third, the unit selling price, unit variable costs, and fixed costs are known. Finally, the analysis involves a single product, or in multi product firms, the sales mix remains constant over the relevant range. In more complex analyses, some of these assumptions may be relaxed. Simply solving the equation for quantity yields: Revenues - Variable Costs - Fixed Costs = Operating Income (Unit Sales Price * Quantity) - (Unit Variable Cost * Quantity) - Fixed Costs = Income Reasons for choosing a particular tool: In the required problem, ratio analysis is the appropriate tool. As the project is needed to continue without at a financial loss. So, to maintain the project without a financial loss, it is needed to know whether it is continuing at a financial loss or not and also compare the present situation with past situation such as comparison current week with previous week. This type of comparison helps the financial manager to know whether the present situation is better or not. If the financial manager finds any variance, he can easily take effective steps to remove the problem.therefore; it will help manager to operate the project without at a financial loss. References: (1) Pandey, I.M. (2001), Financial Management, Vikas publishing house pvt ltd, 8th ed., p. 3,885-904,911-933. (2) Khan, M.Y & P.K.jain. (1999), Financial Management Text and Problems. Tata McGraw-hill publishing company limited, 2nd Ed, p.11-12, 701-704, 734-737. (3) Pamela A. Braden (2006), "Ratio Analysis", West Virginia University Parkersburg Publication, Available at (4) Project Management, Ask the PowerPoint News Group, Available at: (5) Dr. Arsham H (1996),"Economic Order Quantity and Economic Production Quantity: Models for Inventory Management" Available at: < > (6) Chase, Jacobs, and Aquilano, 11th edition, Irwin/McGraw-Hill, referred to as "CJA") and often are based very closely on the associated chapter(s) in the textbook. (7) Richard J. Schonberger: "Just-In-Time Production Systems: Replacing Complexity With Simplicity in Manufacturing Management", Industrial Engineering, October 1984, pages 52-63; and Applications of Single-Card and Dual-Card Kanban, Interfaces, August 1983, pages 56-67. available at: < http://personal.ashland.edu/rjacobs/m503jit.html > (8) Cost-Volume-Profit (CVP) Analysis by Dr. Ed McIntyre at Florida State University, available at: < http://www.auburn.edu/jonesj6/ac610/sp6.pdf > (9) Cost-Volume-Profit Analysis, Copyright 2007 Advameg, Inc available at: < http://www.referenceforbusiness.com/management/Comp-De/Cost-Volume-Profit-Analysis.html > (10) Main tools, Wikimedia Foundation, Inc., available at: < http://en.wikipedia.org/wiki/CVP_analysis#Main_tools > (11) Joseph Damiano (2002), Just In Time Inventory: A Financial Perspective, available at: < http://josephdamiano.com/Articles/JIT.htm > (12) Dr. W. Blaker Bolling (1986), ratio analysis, available at Read More