Author: indiafreenotes

The Financing Decision is yet another crucial decision made by the financial manager relating to the financing-mix of an organization. It is concerned with the borrowing and allocation of funds required for the investment decisions.

The financing decision involves two sources from where the funds can be raised: using a company’s own money, such as share capital, retained earnings or borrowing funds from the outside in the form debenture, loan, bond, etc. The objective of financial decision is to maintain an optimum capital structure, i.e. a proper mix of debt and equity, to ensure the trade-off between the risk and return to the shareholders.

The Debt-Equity Ratio helps in determining the effectiveness of the financing decision made by the company. While taking the financial decisions, the finance manager has to take the following points into consideration:

• The Risk involved in raising the funds. The risk is higher in the case of debt as compared to the equity.
• The Cost involved in raising the funds. The manager chose the source with minimum cost.
• The Level of Control, the shareholders, want in the organization also determines the composition of capital structure. They usually prefer the borrowed funds since it does not dilute the ownership.
• The Cash Flow from the operations of the business also determines the source from where the funds shall be raised. High cash flow enables to borrow debt as interest can be easily paid.
• The Floatation Cost such as broker’s commission, underwriters fee, involved in raising the securities also determines the source of fund. Thus, securities with minimum cost must be chosen.

Thus, a company should make a judicious decision regarding from where, when, how the funds shall be raised, since, more use of equity will result in the dilution of ownership and whereas, higher debt results in higher risk, as fixed cost in the form of interest is to be paid on the borrowed funds.

Types of Financial Decisions

1. Investment Decision

A financial decision which is concerned with how the firm’s funds are invested in different assets is known as investment decision. Investment decision can be long-term or short-term.

A long term investment decision is called capital budgeting decisions which involve huge amounts of long term investments and are irreversible except at a huge cost. Short-term investment decisions are called working capital decisions, which affect day to day working of a business. It includes the decisions about the levels of cash, inventory and receivables.

A bad capital budgeting decision normally has the capacity to severely damage the financial fortune of a business.

A bad working capital decision affects the liquidity and profitability of a business.

Factors Affecting Investment Decisions / Capital Budgeting Decisions

(i) Cash flows of the project: The series of cash receipts and payments over the life of an investment proposal should be considered and analyzed for selecting the best proposal.

(ii) Rate of return: The expected returns from each proposal and risk involved in them should be taken into account to select the best proposal.

(iii) Investment criteria involved: The various investment proposals are evaluated on the basis of capital budgeting techniques. Which involve calculation regarding investment amount, interest rate, cash flows, rate of return etc. It is to be considered which technique to use for evaluation of projects.

2. Financing Decision

A financial decision which is concerned with the amount of finance to be raised from various long term sources of funds like, equity shares, preference shares, debentures, bank loans etc. Is called financing decision. In other words, it is a decision on the ‘capital structure’ of the company.

Capital Structure Owner’s Fund + Borrowed Fund

Financial Risk: The risk of default on payment of periodical interest and repayment of capital on ‘borrowed funds’ is called financial risk.

Factors Affecting Financing Decision

(i) Cost: The cost of raising funds from different sources is different. The cost of equity is more than the cost of debts. The cheapest source should be selected prudently.

(ii) Risk: The risk associated with different sources is different. More risk is associated with borrowed funds as compared to owner’s fund as interest is paid on it and it is also repaid after a fixed period of time or on expiry of its tenure.

(iii) Flotation cost: The cost involved in issuing securities such as broker’s commission, underwriter’s fees, expenses on prospectus etc. Is called flotation cost. Higher the flotation cost, less attractive is the source of finance.

(iv) Cash flow position of the business: In case the cash flow position of a company is good enough then it can easily use borrowed funds.

(v) Control considerations: In case the existing shareholders want to retain the complete control of business then finance can be raised through borrowed funds but when they are ready for dilution of control over business, equity shares can be used for raising finance.

(vi) State of capital markets: During boom period, finance can easily be raised by issuing shares but during depression period, raising finance by means of debt is easy.

3. Dividend Decision

A financial decision which is concerned with deciding how much of the profit earned by the company should be distributed among shareholders (dividend) and how much should be retained for the future contingencies (retained earnings) is called dividend decision.

Dividend refers to that part of the profit which is distributed to shareholders. The decision regarding dividend should be taken keeping in view the overall objective of maximizing shareholder s wealth.

Factors affecting Dividend Decision

(i) Earnings: Company having high and stable earning could declare high rate of dividends as dividends are paid out of current and past earnings.

(ii) Stability of dividends: Companies generally follow the policy of stable dividend. The dividend per share is not altered in case earning changes by small proportion or increase in earnings is temporary in nature.

(iii) Growth prospects: In case there are growth prospects for the company in the near future then, it will retain its earnings and thus, no or less dividend will be declared.

(iv) Cash flow positions: Dividends involve an outflow of cash and thus, availability of adequate cash is foremost requirement for declaration of dividends.

(v) Preference of shareholders: While deciding about dividend the preference of shareholders is also taken into account. In case shareholders desire for dividend then company may go for declaring the same. In such case the amount of dividend depends upon the degree of expectations of shareholders.

(vi) Taxation policy: A company is required to pay tax on dividend declared by it. If tax on dividend is higher, company will prefer to pay less by way of dividends whereas if tax rates are lower, then more dividends can be declared by the company.

A chief financial officer (CFO) is the senior executive responsible for managing the financial actions of a company. The CFO’s duties include tracking cash flow and financial planning as well as analyzing the company’s financial strengths and weaknesses and proposing corrective actions.

The CFO is similar to a treasurer or controller because they are responsible for managing the finance and accounting divisions and for ensuring that the company’s financial reports are accurate and completed in a timely manner. Many have a CMA designation.

The CFO reports to the chief executive officer (CEO) but has significant input in the company’s investments, capital structure and how the company manages its income and expenses. The CFO works with other senior managers and plays a key role in a company’s overall success, especially in the long run.

For example, when the marketing department wants to launch a new campaign, the CFO may help to ensure the campaign is feasible or give input on the funds available for the campaign.

 In the financial industry, a CFO is the highest-ranking financial position within a company.

The CFO may assist the CEO with forecasting, cost-benefit analysis and obtaining funding for various initiatives. In the financial industry, a CFO is the highest-ranking position, and in other industries, it is usually the third-highest position in a company. A CFO can become a CEO, chief operating officer or president of a company.

The Benefits of Being a CFO

The CFO role has emerged from focusing on compliance and quality control to business planning and process changes, and they are a strategic partner to the CEO. The CFO plays a vital role in influencing company strategy.

The United States is an international financial hub and global economic growth increases employment growth in the U.S. financial industry. Companies continue to increase profits leading to a demand for CFOs. The U.S. Bureau of Labor Statistics predicts the job outlook for financial managers to grow 7% between 2014 and 2024.

Role of Chief Financial Officer (CFO)

1. The Strategist CFO

The first role of the CFO is to be a strategist to the CEO. The traditional definition of success for a chief financial officer was reporting the numbers, managing the financial function, and being reactive to events as they unfold. But in today’s fast paced business environment, producing financial reports and information is no longer enough.

CFO’s in the twenty-first century must be able to “peak around corners”. Therefore, they must be able to apply critical thinking skills, along with financial acumen, to the long term goals of the organization.

2. The CFO as a Leader

The second role of the CFO hand in hand with the first one. That is one of a leader implementing the strategies of the company. As a result, it is no longer sufficient for a CFO to sit back and analyze the effort of others. The chief financial officer (CFO) of today must take ownership of the financial results of both the organization and senior management team.

The chief financial officer of today must be responsible for providing leadership to other senior management team members, including the CEO. The CFO’s role can sometimes force them to make the tough calls that others in the organization don’t or can’t make. Occasionally, this can mean the difference between success and failure.

3. The CFO as a Team Leader

The third role of the CFO is that of a team leader to other employees both inside and outside of the financial function. Not only will a coach call plays for a team, but they are also responsible for getting the highest results out of the talent on their team.

An aspiring and successful coach will produce superior results by finding the strengths of their team members and obtaining a higher level of performance than the individuals might achieve on their own. The role of the CFO (Chief Financial Officer) is to bring together a diverse group of talented individuals to achieve superior financial performance.

4. The CFO with Third Parties

Last, but not least, the role of the CFO is that of a diplomat to third parties. People outside of the company look to senior management team for inspiration and confidence in the company’s ability to perform. In almost every case the financial viability of the company is vouched for by the CFO.

The CFO’s role becomes that of the “face” of the company’s sustainability to customers, vendors and bankers. Often these third parties look to the CFO for the unvarnished truth regarding the financial viability of the company to deliver on it’s brand promise.

5. Today’s Role of the CFO

In today’s fast paced environment the role of the CFO is extremely fluid. One day the CFO might be developing a compensation plan for employees. Then the next day taking their bankers on a tour of the facilities. Consequently, to be a successful CFO in the future you must be a more multi-functional executive with financial skills.

Financial management functions are vital for managing financial resources. Finance is referred to as the provision of funds at the time when it is needed for the business. Finance function involves the procurement of funds from a number of sources and their proper utilization in business concerns. The basic concept of finance comprises capital, funds, and amount. The core finance function is the process of acquiring and utilizing funds for a business. Finance functions are connected to the overall fund management of a business organization. The finance function is also concerned with the decisions such as business nature, size of the firm, type of machinery used, use of debt capital, liquidity position and so on. A brief discussion of major financial management functions is stated below:

1. Estimates the capital requirements of business

A financial manager firstly has to make the estimation with regards to overall capital requirements of the business. This will depend on several determinants like probable costs and expected profits and upcoming programs and policies of the company. Predictions have to be made in an adequate and concern manner which increases the earning capacity of business and which ensures proper use of financial resources. Thus financial management functions guide a financial manager to estimate organizational capital requirements.

2. Ascertains capital composition

Once the estimation of capital requirement has been made with the best effort, the capital structure of the enterprise has to be decided. This involves the analysis of short- term and long- term debt equity. This will depend on the proportion of possessed equity capital a company and other additional funds which have to be raised from outside parties through borrowing.

3. Makes the Choice of sources of funds

A financial manager needs to evaluate different sources of funds. A company has many choices for raising additional funds to be procured in the business like loans to be taken from banks and other financial institutions, issue of company shares and debentures, public deposits to be drawn like in form of bonds. Choice of a factor depends on the relative advantages and disadvantages of each source and financing period.

4. Investment of total funds

The finance manager has to decide how to allocate the total amount of funds into profitable ventures. He has to make sure that there is safety on investment and positive regular returns are possible. The capital should be invested in a wisely manner so that there is less possibility of losing funds or experience loses. For that, the manager can use different investment tools like portfolio analysis, net present value, internal rate of return, an average rate of return and so on.

5. Disposal of surplus

Financial manager calculates profits of business at the end of an accounting period. Then the net profits decision has to be taken by the finance manager of the company. This decision can be made in two ways. He can declare a dividend to the shareholders of a company where the ordinary shareholders will get the profits in the form of money or share or retain profits for some purposes like expansion, diversification or innovation of the business.

6. Manages of cash flow

Finance manager of a company has to make decisions regarding cash management. Cash is required for several purposes like payment of wages and salaries to the workers, payment to the creditors, payment of electricity and water bills, meeting current liabilities of the business, cost of maintenance of having enough stock, purchase of raw materials for daily production etc.

7. Controls Finances

The functions of a finance manager are not only to do a financial plan, procure fund and utilize the funds but he also has to control the finances involving in the business. This function can be done by many techniques like ratio analysis, forecasting of financials, cost analysis and control and profit distribution techniques etc.

8. Decisions regarding acquisitions and mergers

A business organization can either be expanded through acquiring other business or by entering into the business by mergers with other firms. While acquisition decision denotes a process of purchasing new or existing companies, the merger is a process where two or more companies join together in the formation of a new business. During such decision, a financial manager has to deal with many complex valuations of securities of each company.

9. Tax Planning and protection of Assets

It is the duty of a financial manager to lessen the tax liability of the business. This task should be performed wisely. It is very important that a finance executive properly examines various schemes and invest accordingly. He should also protect the assets engaged in the business to ensure the best use of the resources.

10. Decision on Capital Budgeting

Long-term decisions involve investing in share or bond, purchasing new equipment, building new plant etc. These decisions are called capital budgeting. In this decision making of the company financial managers faces many complicated situations. As the process requires a huge amount of capital, it is necessary that a financial manager identifies the investment opportunities and involved challenges.

The efficient use of financial management functions helps a company to maximize wealth. Financial management is a continuous and interrelated process which involves identifying the required amount of capital that is needed for running the business promptly, evaluating and selecting best alternative sources of funds, allocating the funds according to the need of business area and distributing earned profits.

1. Simplicity

A financial plan should be so simple that it may be easily understood even by a layman. A complicated financial structure creates complications and confusion.

2. Based on Clear-cut Objectives

Financial planning should be done by keeping in view the overall objectives of the company. It should aim to procure funds at the lowest cost so that profitability of the business is improved.

3. Less Dependence on Outside Sources

A long-term financial planning should aim to reduce dependence on outside sources. This can be possible by retaining a part of profits for ploughing back. The generation of own funds is the way of financial operations. In the beginning, outside funds may be a necessity but financial planning should be such that dependence on such funds may be reduced in due course of time.

4. Flexibility

The financial plan should not be rigid. It should allow a scope for adjustments as and when new situations emerge. There may be a scope for raising additional funds if fresh opportunities occur. Similarly, idle funds, if any, may be invested in short-term and low-risk bearing securities. Flexibility in a plan will be helpful in coping with the demands of the future.

5. Solvency and Liquidity

Financial planning should ensure solvency and liquidity of the enterprise. Solvency requires that short-term and long-term payments should be made on dates when these are due. This will ensure credit worthiness and goodwill to the concern.

Solvency will be possible when liquidity of assets is maintained. There should be sufficient funds whenever payments are to be made. Proper forecasting of future payments will be helpful in planning liquidity.

6. Cost

The cost of raising capital is an important consideration in selecting a financial plan. The selection of various sources should be such that the cost burden should be mimimum. As and when possible interest bearing securities should be returned so that this burden is reduced.

7. Profitability

A financial plan should adjust various securities in such a way that profitability of the enterprise is not adversely affected. The interest bearing securities and other liabilities should be so adjusted that business is able to improve its profitability.

Considerations in Formulating Financial Plan

A financial plan should be carefully determined. It has long-term impact on the working of the enterprise.

The following variables should be kept in mind while selecting a financial plan:

1. Nature of the Industry

The needs for funds are different for various industries. The asset structure, element of seasonality, stability of earnings is not common factors for all industries. These variables will influence determining the size and structure of financial requirements.

2. Standing of the Concern

The standing of a concern will influence a decision about financial plan. The goodwill of the concern, credit rating in the market, past performance, attitude of the management is some of the factors which will be considered in formulating a financial plan.

3. Future Plans

The future plan of a concern should be considered while formulating a financial plan. The plans for expansion and diversification in near future will require a flexible financial plan. The sources of funds should be such which will facilitate required funds without any difficulty.

4. Availability of Sources

There are a number of sources from which funds can be raised. The pros and cons of all available sources should be properly discussed for taking a final decision on the sources. The sources should be able to provide sufficient and regular funds to meet needs at various periods. A financial plan should be selected by keeping in view the reliability of various sources.

5. General Economic Conditions

The prevailing economic conditions at the national level and international level will influence a decision about financial plan. These conditions should be considered before taking any decision about sources of funds. A favourable economic environment will help in raising funds without any difficulty. On the other hand, uncertain economic conditions may make it difficult for even a good concern to raise sufficient funds.

6. Government Control

The government policies regarding issue of shares and debentures, payment of dividend and interest rate, entering into foreign collaborations, etc. will influence a financial plan. The legislative restrictions on using certain sources, limiting dividend and interest rates, etc.; will make it difficult to raise funds. So, government controls should be properly considered while selecting a financial plan.

‘Forecast’ means to form an opinion beforehand i.e. to make a prediction. Thus financial forecasting means a systematic projection of the expected action of finance through financial statements.

Financial forecasting is the processing, estimating, or predicting how a business will perform in the future. The most common type of financial forecast is an income statement, however, in a complete financial model, all three statements are forecasted. In this guide on how to build a financial forecast, we will complete the income statement model from revenue to operating profit or EBIT.

It is needless to mention that such forecasting needs past records, cash flow and fund-flow behaviour, the applications of financial ratios etc. along with the industrial economic condition. It is a kind of plan which will be formulated at a future date for a specified period.

The merits of the financial forecasting are noted below:

(i) It can be used as a control device in order to fix the standard of performances and evaluating the results thereof

(ii) It helps to explain the requirement of funds for the firm together with the funds of the suppliers

(iii) It also helps to explain the proper requirements of cash and their optimum utilization is possible and so surplus/excess cash, if any, invested otherwise.

Financial planning, on the other hand, is nothing but one part of a larger planning process within an organization.

“A complete planning system begins at the highest level of policy with the firm’s basic goals or purpose, usually stated in qualitative, mission-oriented, terms. From this it is derived the firm’s commercial strategy, defining the product or services it will produce and the markets it will serve. Supporting policies are developed in production, marketing, research and development, accounting and finance. The extent to which the system formalized with detailed planning and budgeting system in each area depends in part on the firm’s size and the complexity of its operation.” — E. Solomon and J. S. Pringle

Thus, in a broader sense, financial planning can be viewed as the representation of an overall plan for the firms in terms of finance and, similarly, in a narrower sense, it may refer to the process of determining the financial requirements which is needed in order to support a given set of plans in other areas.

Financial Forecasting Vs. Budgeting

When you create a budget for your business, you plan to set aside money for certain costs, taking into account your income and expenses. The budget you make may be based on info from your financial forecast, but it’s distinct from the forecast itself.

Think of financial forecasting as a prediction, and budgeting as a plan. When you make a financial forecast, you see what direction your business is headed in, based on past performance and other factors, and use that to anticipate the future.

When you make a budget, you plan how you’re going to spend money based on what you expect your finances to look like in the future (your forecast).

For instance, if your financial forecast for next year says you’ll have an extra $5,000 in revenue, you might create a budget to decide how it will be spent—$2,000 for a new website, $1,000 for Facebook ads, and so on.

Three steps to creating your financial forecast

Ready to peer into the crystal ball and see the future of your business? There are three steps you need to follow:

Step 1: Gather your records

If you’re not looking into the past to see how your business has grown, you’re not really forecasting—you’re just guessing.

You’ll need to gather past financial statements so you can see how your business has developed over time, and then project that development into the future.

Your bookkeeper or bookkeeping software should generate financial statements for you. If you don’t have either, and you don’t have financial statements, you’ll need to take care of that before you can start forecasting. You need complete bookkeeping in order to get the transaction history you base your financial statements on.

Put aside the task for financial forecasting for the moment, and learn How to Catch Up on Your Bookkeeping.

Once your books and financial statements are up to date, you’ll have everything you need to start planning for the future.

Step 2: Decide how you’ll make your forecast

Depending what resources you choose to use, the type of forecast you create will fall between two poles—historical and researched-based.

Almost every financial forecast includes a little bit of historical forecasting, and a little bit that’s research-based. The blend you choose will depend on your needs and the resources at your disposal.

Remember, the goal is to create a realistic, useful forecast—without breaking the bank or eating up all your time.

(i) Historical forecasting

When you use your financial history to plot the future, it’s historical forecasting. You’re looking at your last few annual Income Statements, Cash Flow Statements, and Balance Sheets to see how fast you’ve grown in the past. From there, you can make a guess about how fast you’ll grow this year.

The benefit of this is that it’s relatively easy to do and doesn’t take a lot of time, money, or expertise. The drawback is that you’re only using info about your own business, and not looking at broader market trends—like what your competition has been up to.

Historical forecasting is a good bet if you’re forecasting for modest growth, or else creating a quick-and-dirty forecast for your own use not putting together a presentation for potential investors.

(ii) Research-based forecasting

When you do research about broader market trends, you’re using research-based forecasting. You may look at how your industry has performed over the past ten years, investigate new technologies and consumer trends, or try to measure the progress of your competitors. You might look at how companies similar to yours have planned their own growth.

The benefit of research-based forecasting is that you get a detailed, nuanced view of how your business could grow, taking into account a lot of different factors. And it’s the kind of forecast that investors and lenders want to see.

The drawback is that researched-based forecasting can be expensive. You may find you need to hire outside consultants and researchers to handle the heavy lifting.

Research-based forecasting is a good choice if you’re courting investors, or planning on rapid, aggressive growth. It’s also good if your company is brand new, and doesn’t have a lot of financial history to draw on for making projections.

Step 3: Create pro forma statements

Once you’ve collected the information you need to build your forecast, you can create pro forma statements.

We’ll cover the three key financial statements here. Whether you use all of them is up to you.

If you’re creating a quick forecast for your own planning, you may only need to create pro forma Income Statements. If you’re presenting to lenders or investors, you’ll want to use all three.

Rule of thumb: Any form you’d use in the month-to-month operation of your business should be created pro forma. For instance, if you move a lot of cash around every month, and you rely on Cash Flow Statements to make sure you’ve got enough money on hand to pay your vendors, then it’s wise to create pro forma Cash Flow Statements as part of your forecast.

(i) Creating the pro forma Income Statement

First, set a goal—a projection—for sales in the period you’re looking at.

Let’s say you made $30,000 in sales this year. Next year, you want to make $60,000. So, your total sales will increase by $30,000.

Set a production schedule that will let you reach that goal, and map it out over the time period you’re covering. In our example, there will be 12 Income Statements in the year to come (one each month). Map out that $30,000 increase in sales over the 12 statements.

You could do this by increasing sales a fixed amount every month, or gradually increasing the amount of sales you make per month. It’s up to your instincts and experience as a business owner.

Then, it’s time for the “loss” part of “Profit and Loss.” Calculate the cost of goods sold for each month, and deduct it from your sales. Deduct any other operating expenses you have, as well.

It’s important to take every expense into account so you get an accurate projection. If part of your plan is quadrupling your online advertising, be sure to include an expense that reflects that.

Once you’re done, your pro Forma Income Statements show you how much you can expect to earn and how much you can expect to spend in the time ahead.

(ii) Creating the pro forma Cash Flow Statement

You create a pro forma Cash Flow Statement a lot like the way you’d create a regular Cash Flow Statement. That means taking info from the Income Statement, and using the Cash Flow Statement format to plot out where your money is going, and how much you’ll have on hand at any one time.

Your projected cash flow can tell you a few things. If it’s in the negative, it means you’re not going to have enough cash on-hand to run your business, according to your current trajectory. You’ll need to make plans to borrow money and pay it off.

If your net cash flow is positive, you can plan on having enough surplus cash on hand to pay off loans, or save for a big investment.

(iii) Creating the pro forma Balance Sheet

Drawing on info from the Income Statement and the Cash Flow Statement lets you create pro forma Balance Sheets. But you’ll also need previous Balance Sheets to make this useful so you can follow the story of how your business got from “Balance A” to “Balance B.”

As a business owner, there may be nothing more important to to get a handle on your company’s future cash at hand, several tools are available to help you analyze projected income and expenses. They range from rudimentary spreadsheets to slick visualization apps. Here are five tools that can help you forecast your figures.

1. Templates

For some, there’s nothing like rolling up their sleeves and getting their hands dirty with an Excel spreadsheet. If this is you, here are some templates you can use to get you started. Futurpreneur Canada provides a cash flow template that will cover everything from outlining startup costs through to projecting cash flow month by month for two years.

SCORE, a network of business mentors created by the U.S. Small Business Administration (SBA), has its own cash flow and financial projection

Templates to help project cash flow over a 12- month or three-year period.

2. QuickBooks cash flow projector

The desktop version of QuickBooks offers short-term cash flow predictions via two features. The first, cash flow forecasting, uses outstanding invoices and bills in the accounting system to tell you what your cash at hand will look like over the next month or so.

Alternatively, you can use the cash flow projector tool included in some desktop versions of QuickBooks. This lets you analyze your historical accounting data and tweak it with your own manual adjustments, while also taking in accounts payable data.

QuickBooks cash flow projector will only project out for the next six weeks. If you want a longer-term view with extra goodies, you’ll need something with more power.

3. Float

While some accounting packages might give you basic cash flow forecasting, there’s a lot to be said for a best-of-breed solution that does one thing well. Float is a dedicated cash flow forecasting system that integrates with QuickBooks and with two other popular online accounting packages, Xero and FreeAgent.

Float imports accounting data directly from those packages, using them to generate cash flow forecasts on a daily or monthly basis. Its “what if” analysis tools show you what happens to your cash on hand over time as you play with parameters, and also lets you create multiple scenario layers showing what would happen in different events, such as taking on a new employee.

The online tool includes budgeting options that let you describe how your business will spend its cash, and then tracks those budgets throughout the month.

4. Dryrun

Dryrun also takes input from Xero and QuickBooks to let you track your forward cash flow. It lets you track partial payments, and allows you to collaborate with employees and business advisors so that they know your position.

This system includes another feature: sales forecasting. It draws data directly from web-based CRM tool Pipedrive, so that you can factor potential deals into your cash flow forecast, making it more accurate.

Sales is just one part of the cash flow puzzle. What are you spending on? Dryrun’s budget system offers the ability to define your own categories and create auto-repeating budget items that you can view in varying levels of detail.

DryRun’s what-if modelling system lets you compare multiple scenarios together at once, using multiple data points in each forecast.

5. Pulse

Pulse lets you monitor existing cash flow on a weekly or monthly basis, and project future cash flow using tools to estimate the effect of a new project or expense on your cash at hand.

Input data from QuickBooks automatically to cut down your workload, and then use it to visualize cash flow in a series of reports. This tool also does cash flow tracking in multiple currencies for those doing business internationally.

With Pulse, you can set user accounts at multiple levels, ranging from Owner down to Read Only, with varying levels of access.

Whichever tool you use, the secret to accurate forecasting lies in accounting for costs and income as accurately as possible. Being honest about your financial expectations is a key requirement in cash flow planning. If you can pull data from your accounting system, then you’re already off to a great start.

Cost of Capital is the required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. When analysts and investors discuss the cost of capital, they typically mean the weighted average of a firm’s cost of debt and cost of equity blended together.

As it is evident from the name, cost of capital refers to the weighted average cost of various capital components, i.e. sources of finance, employed by the firm such as equity, preference or debt. In finer terms, it is the rate of return, that must be received by the firm on its investment projects, to attract investors for investing capital in the firm and to maintain its market value.

The factors which determine the cost of capital are:

• Source of finance
• Corresponding payment for using finance

On raising funds from the market, from various sources, the firm has to pay some additional amount, apart from the principal itself. The additional amount is nothing but the cost of using the capital, i.e. cost of capital which is either paid in lump sum or at periodic intervals.

The cost of capital metric is used by companies internally to judge whether a capital project is worth the expenditure of resources, and by investors who use it to determine whether an investment is worth the risk compared to the return. The cost of capital depends on the mode of financing used. It refers to the cost of equity if the business is financed solely through equity, or to the cost of debt if it is financed solely through debt.

Many companies use a combination of debt and equity to finance their businesses and, for such companies, the overall cost of capital is derived from the weighted average cost of all capital sources, widely known as the weighted average cost of capital (WACC).

Classification of Cost of Capital

1. Explicit cost of capital

It is the cost of capital in which firm’s cash outflow is oriented towards utilization of capital which is evident, such as payment of dividend to the shareholders, interest to the debenture holders, etc.

2. Implicit cost of capital

It does not involve any cash outflow, but it denotes the opportunity foregone while opting for another alternative opportunity.

To cover the cost of raising funds from the market, cost of capital must be obtained. It helps in assessing firm’s new projects because it is the minimum return expected by the shareholders, lenders and debtholders for supplying capital to the business, as a consideration for their share in the total capital. Hence, it establishes a benchmark, which must be met out by the project.

However, if a firm is incapable of reaping the expected rate of return, the value of shares in the market will tend to decline, which will lead to the reduction in the wealth of the shareholders as a whole.

Importance of Cost of Capital

• It helps in evaluating the investment options, by converting the future cash flows of the investment avenues into present value by discounting it.
• It is helpful in capital budgeting decisions regarding the sources of finance used by the company.
• It is vital in designing the optimal capital structure of the firm, wherein the firm’s value is maximum, and the cost of capital is minimum.
• It can also be used to appraise the performance of specific projects by comparing the performance against the cost of capital.
• It is useful in framing optimum credit policy, i.e. at the time of deciding credit period to be allowed to the customers or debtors, it should be compared with the cost of allowing credit period.

Cost of capital is also termed as cut-off rate, the minimum rate of return, or hurdle rate.

Cost of capital represents a hurdle rate that a company must overcome before it can generate value, and it is used extensively in the capital budgeting process to determine whether a company should proceed with a project.

The cost of capital concept is also widely used in economics and accounting. Another way to describe the cost of capital is the opportunity cost of making an investment in a business. Wise company management will only invest in initiatives and projects that will provide returns that exceed the cost of their capital.

Cost of capital, from the perspective on an investor, is the return expected by whoever is providing the capital for a business. In other words, it is an assessment of the risk of a company’s equity. In doing this an investor may look at the volatility (beta) of a company’s financial results to determine whether a certain stock is too risky or would make a good investment.

• Cost of capital represents the return a company needs in order to take on a capital project, such as purchasing new equipment or constructing a new building.
• Cost of capital typically encompasses the cost of both equity and debt, weighted according to the company’s preferred or existing capital structure, known as the weighted-average cost of capital (WACC).
• A company’s investment decisions for new projects should always generate a return that exceeds the firm’s cost of the capital used to finance the project—otherwise, the project will not generate a return for investors.

Significance of Cost of Capital

1. Capital Allocation and Project Evaluation:

The cost of capital is paramount in capital allocation decisions. Companies must decide where to invest their limited resources, and the cost of capital serves as a benchmark for evaluating potential projects. By comparing the expected returns of a project with the cost of capital, firms can make informed investment decisions that align with shareholder value maximization.

2. Financial Performance Measurement:

It serves as a yardstick for assessing financial performance. A company’s ability to generate returns above its cost of capital indicates operational efficiency and effective resource utilization. Shareholders and investors often scrutinize this metric as it reflects the company’s capacity to create value and generate sustainable profits.

3. Cost of Debt and Equity Balancing:

The cost of capital guides the balance between debt and equity in a firm’s capital structure. As companies strive to minimize their overall cost of capital, they navigate the trade-off between the lower cost of debt and the potential risks associated with increased leverage. Striking the right balance ensures an optimal capital structure that minimizes costs while maintaining financial flexibility.

4. Investor Expectations and Market Perception:

It influences investor expectations and market perception. A company’s cost of capital is indicative of the returns investors require for providing funds. If a company consistently exceeds or falls short of this benchmark, it can impact investor confidence and influence stock prices. Managing and meeting these expectations are crucial for maintaining a positive market perception.

5. Risk Management:

The cost of capital integrates risk considerations. The cost of equity, for instance, incorporates the risk premium investors demand for investing in a particular stock. Understanding these risk components aids in strategic decision-making and risk management. Companies can adjust their capital structure and investment strategies to mitigate risk and align with their cost of capital.

6. Capital Structure Optimization:

It facilitates capital structure optimization. Achieving the right mix of debt and equity is essential for minimizing the cost of capital. Firms aim to find the optimal capital structure that maximizes shareholder value. This involves assessing the impact of various financing options on the overall cost of capital and choosing the combination that minimizes this metric.

7. Market Competitiveness:

The cost of capital impacts a company’s competitiveness. In industries where access to capital is a critical factor, having a lower cost of capital can provide a competitive advantage. This advantage enables companies to undertake projects and investments that might be financially unfeasible for competitors with higher capital costs.

8. Dividend Policy and Shareholder Returns:

It guides dividend policy. Companies consider the cost of capital when determining whether to distribute profits as dividends or reinvest in the business. This decision affects shareholder returns and influences the overall attractiveness of the company’s stock to investors.

9. Economic Value Added (EVA) and Shareholder Wealth:

The cost of capital is integral to Economic Value Added (EVA), a measure of a company’s ability to generate wealth for shareholders. By deducting the cost of capital from the Net Operating Profit After Taxes (NOPAT), EVA provides a clear picture of whether a company is creating or eroding shareholder value.

10. Strategic Planning and Long-Term Viability:

It informs strategic planning and ensures long-term viability. By aligning investment decisions with the cost of capital, companies can focus on projects that contribute most significantly to shareholder value over the long term. This strategic alignment is crucial for sustainable growth and maintaining a competitive edge in the dynamic business environment.

Capital budgeting is a method of analyzing and comparing substantial future investments and expenditures to determine which ones are most worthwhile. In other words, it’s a process that company management uses to identify what capital projects will create the biggest return compared with the funds invested in the project. Each project is ranked by its potential future return, so the company management can choose which one to invest in first.

Most business’ future goals include expanding their operations. This is difficult to do if the company doesn’t have enough capital or fixed assets. That is where capital budgeting comes into play.

Capital budgets or capital expenditure budgets are a way for a company’s management to plan fixed asset sales and purchases. Usually these budgets help management analyze different long-term strategies that the company can take to achieve its expansion goals. In other words, the management can decide what assets it might need to sell or buy in order to expand the company. To make this decision, management typically uses these three main analyzes in the budgeting process: throughput analysis, discounted cash flows analysis, and payback analysis.

Example

Obviously, capital budgeting involves difficult decisions. In most cases buying fixed assets is expensive and cannot be easily undone. The management has to decide to spend cash in the bank, take out a loan, or sell existing assets to pay for the new ones. Each one of these decisions comes with the eternal question: will they receive the proper return on investment? Because when you think about it, buying new fixed assets is no different than putting money any other investment. The company is buying equipment hoping that is will pay off in the future.

That is why many managers used the present value of future cash flows when deciding what to buy. Present value dollars will help them analyze the current and future cash inflows and outflows equally to come up with the best plan for the future.

Need and Importance of Capital Budgeting

Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the goal of the firm. The need and importance of capital budgeting has been explained as follows:

1. Long-term Implication

Capital expenditure decision affects the company’s future cost structure over a long time span. The investment in fixed assets increases the fixed cost of the firm which must be recovered from the benefit of the same project. If the investment turns out to be unsuccessful in future or give less profit than expected, the company will have to bear the extra burden of fixed cost. Such risk can be minimized through the systematic analysis of projects which is the integral part of investment decision.

2. Irreversible Decision

Capital investment decision are not easily reversible without much financial loss to the firm because there may be no market for second-hand plant and equipment and their conversion to other uses may not be financially viable. Hence, capital investment decisions are to be carried out and performed carefully and effectively in order to save the company from such financial loss. The investment decision which is undertaken carefully and effectively can save the firm from huge financial loss aroused due to the selection of unfavorable projects.

3. Long-term Commitments of Funds

Capital budgeting decision involves the funds for the long-term. So, it is long-term investment decision. The long-term commitment of funds leads to the financial risk. Hence, careful and effective planning is must to reduce the financial risk as much as possible.

Capital Budgeting Processes

The extent to which the capital budgeting process needs to be formalized and systematic procedures established depends on the size of the organization, number of projects to be considered, direct financial benefit of each project considered by itself, the composition of the firm’s existing assets and management’s desire to change that composition, timing of expenditures associated with the that are finally accepted.

1. Planning

The capital budgeting process begins with the identification of potential investment opportunities. The opportunity then enters the planning phase when the potential effect on the firm’s fortunes is assessed and the ability of the management of the firm to exploit the opportunity is determined. Opportunities having little merit are rejected and promising opportunities are advanced in the form of a proposal to enter the evaluation phase.

2. Evaluation

This phase involves the determination of proposal and its investments, inflows and outflows. Investment appraisal techniques, ranging from the simple pay back method and accounting rate of return to the more sophisticated discounted cash flow techniques, are used to appraise the proposals. The technique selected should be the one that enables the manager to make the best decision in the light of prevailing circumstances.

3. Selection

Considering the returns and risk associated with the individual project as well as the cost of capital to the organization, the organization will choose among projects so as to maximize shareholders wealth.

4. Implementation

When the final selection has been made, the firm must acquire the necessary funds, purchase the assets, and begin the implementation of the project.

5. Control

The progress of the project is monitored with the aid of feedback reports. These reports will include capital expenditure progress reports, performance reports comparing actual performance against plans set and post completion audits.

6. Review

When a project terminates, or even before, the organization should review the entire project to explain its success or failure. This phase may have implication for forms planning and evaluation procedures. Further, the review may produce ideas for new proposal to be undertaken in the future.

Capital budgeting processes include:

• Estimation of initial investment
• Estimation of cash inflows
• Evaluation of projects
• Selection of projects

Working Capital Management implies the management of current assets and current liabilities. Considering the importance of working capital, we can very well, say that the management of wording capital is very significant and should be efficient to keep the business going smoothly.

To be more explicit, working capital management includes proper handling of inventories, accounts receivable, cash and bank and liabilities such as accounts payable, outstanding expenses etc. In a big manufacturing organization, working capital occupies a preeminent position. Over half the total assets consists of working, capital. So its management deserves careful consideration.

The financial management today, because of various complexities in the market and competitive business environment, finds it necessary to deal with working capital in two parts overall manage­ment and management of each item separately.

Overall management of working capital requires proper estimation of working capital needed for the business, ratios of investments on different items of current assets and proper policy as to the rate of profit earning, possibility of loan procurement, advances etc.

One point is worth noting regarding management of working capital. Since working capital consists of varieties of items, management of one in the desirable way may affect another. For instance, making prompt and regular payments of bills receivable may affect cash bal­ance and the company may face difficulties in liquid cash.

Liquidity, flexibility is to be balanced in working capital management in such a wise and prudent way that the over-all management of the working capital contributes to the general welfare of the company.

Profitability, liquidity, flexibility all is important in managerial exercises but a happy compromise of these factors is no easy task. Financial astuteness is absolutely necessary to ensure a brilliant bright-forward management of working capital.

A deep study of the trend of business is absolutely essential to keep the business on right track. It is all the more important to plan the ratio of different items of working capital in the best interest of the company.

It may be that the outside creditors are to be satisfied in the interest of the company but at the same time requisite amount of cash balance must always be kept ready for day-to-day compliance of various obligations. Working capital management formulates policy that is based on experience.

If the policy of the top management is to ensure more profit, then more money is blocked in inventories and cash becomes depleted. It may create problem. Income of the company may suffer if more money is kept always ready to meet any current obligation. Obviously, idle cash does not earn any income.

In regard to cash in hand, working capital management is rather difficult and needs very careful consideration. A company is likely to face an adverse situation if the principles of liquidity and profit­ability are rigorously followed. Small cash in hand cripples a company to meet the obligation of creditors on demand.

In such a situation small suppliers will be naturally reluctant to supply raw materials to such a company and as a consequence the company will have pro­duction difficulty. This will lead to fewer sales and less profit. Therefore, a very balanced ratio profitability and liquidity will have to be maintained through sound management.

It emerges from the above discussion that it is rather impracticable to draw up any invariable standard for the management of work­ing capital. And it also transpires that cash is the major and very sen­sitive component of working capital, so the working capital manage­ment is, as a matter of fact, the management of cash (liquidity) with reference to profitability.

To conclude, working capital management is the planning and controlling of current assets (assets convertible into cash). Working capital indicates circular flow of cash (cash flow cycle). From cash to inventories to receivables and back to cash.

The two concepts of working capital are net working capital and gross working capital. Net working capital is a qualitative concept; the management will also get an idea about the ease and cost of raising working capital. Net working capital is measured by the current ratio viz. current as­sets/current liabilities.

Normally the current ratio should be 2: 1. A larger ratio indicates greater solvency and vice versa. Of course, ex­cessive current ratio would point out poor financial planning and it would reduce income.

The concept of gross capital is a financial concept whereas that of net concept is an accounting concept. For the management more interest is in the amount of current assets with which it has to oper­ate. “However, in an ever changing economy it is very difficult to secure perfect equilibrium between inflow and outflow of cash”.

So, enough supply of working capital is the objective of sound financial management. While aiming at sound working capital management, certain factors must always be kept in mind.

They are:-

• Nature of business
• Size of business
• Terms of purchase and sale
• Turnover of inventories
• Process of manufacture
• Importance of labour
• Proportion of raw material to total costs
• Cash re­quirements
• Seasonal variations
• Banking connections
• Growth and expansion

In gross sense working capital means the total of current assets and in net sense it is the difference between current assets and current liabilities.

Through working capital management, the finance manager tries to manage the current assets, current liabilities and to evaluate the interrelationship that exists between them, i.e. it involves the relationship between a firm’s short-term assets and short-term liabilities.

The aim of working capital management is to deploy such amount of current assets and current liabilities so as to maximize short-term liquidity. The management of working capital involves managing inventories, accounts receivable and payable as also cash.

The two steps involved in the working capital management are as follows:

(i) Forecasting the amount of working capital

(ii) Determining the sources of working capital

Apart from the two mentioned above the following two additional important aspects should be kept in mind while managing working capital:

(a) Inclusion of Profit

There is a lot of controversy regarding inclusion of profit in working capital requirement forecast. There are two views. The first view suggests that profit should be included in the working capital. The second view suggests that it should not be included. Inclusion or exclusion of profit depends primarily on the managerial policy adopted by the firm.

From the first view, if working capital is calculated on the basis of actual cash outflow then profit should not be included in calculating working capital because financing of profit is not required.

From the second view, where balance sheet approach is adopted for calculating working capital, profit element is not ignored as this should be included in the amount of debtors.

(b) Exclusion of Depreciation

Depreciation does not involve any actual cash outflow, so it should not be included in the estimation of working capital.