nd

BBS 2
Fundamentals year
of Financial NOTE
[All
Management Important
Theory+
Formulas]

Based on New syllabus [2081]

BY SUJAN KANDEL

BATCH: 2076-2080

JAYA BAGESWOREE MULTIPLE CAMPUS

BENIGHAT RORANG-03, MALEKHU, DHADING

[0]
NOTE CONTENTS:

Page no.

1. Introduction to Financial Management 2

2. Financial Statement Analysis 3

3. Time Value of Money 5

4. Fundamentals of Risk & Return 7

5. Financial Assets Valuation 9

6. Cost of Capital 11

7. Capital Structure & Leverage 13

8. Basics of Capital Budgeting Decision 15

9. Working Capital Management 17

10. Distribution to Shareholders 20

[1]
 UNIT 1

Introduction to Financial Management

What is financial management? [ 2 Marks ]

 Financial management is defined as the set of activities that deals with collection &
proper use of funds so as to maximize the business profitability & return of investment.

Nature/ characteristics/ Importance of Financial Management: [ 2 Marks ]

 Focus on fund collection
 Proper utilization of funds
 Trying to increase the firm’s value
 Goal oriented

Functions of Financial management: [ 10 Marks ]

A. Executive finance function B. Routine function (Day to day

function)
 Investment decision  Monitoring of fixed & current assets
 Financing decision  Supervision & controlling of cash
 Dividend decision payments & receipts
 Working capital management decision  Protecting papers such as contracts,
policies, certificates
 Maintain the companies records
 Reporting to make financial
management easier.

Those function that requires strong Those functions which can be

managerial skills & competence. So, it performed without the involvement of
involves higher level management of a managerial skills & expertise. So, it
company. includes lower level staff.

Profit maximizing goal Vs. Value/wealth Maximizing goal: [10 marks]

Profit Max. goal Wealth Max. goal

 Its goal is not clear.  Its goal is clear.
 It ignores time value of money.  It considers time value of money.
 It ignores quality aspect of future  It considers quality & quantity aspect
activity. of future activity.

[2]
 UNIT 2

Financial Statement Analysis

Meaning of Ratio analysis / Financial statement analysis: [ 2 Marks ]
 It is a tool used for evaluating & understanding the financial health of an organization.

Uses / Needs of ratio analysis / Financial statement analysis: [ 2 Marks ]

 Helps in business decision making
 Helps in financial planning & forecasting
 Helps to measure the strength & weakness of the organization

Limitation of financial ratio analysis: [ 2 Marks ]

 Based on historical information
 Requires basis of comparison
 Difference in interpretation
 Ignores qualitative aspect

Types of Financial ratios: [ 10 Marks ]

Types Standard
A. Liquidity ratios 2:1
1. Current ratio =
1:1
2. Quick ratio =

3. Cash ratio = -

B. Assets Higher
1. Total Assets turnover ratio =
Management
ratios
2. Fixed assets turnover ratio = Higher

Higher
3. Inventory turnover ratio
=

Or, =

4. Account receivable turnover ratio Higher

5. Days sales outstanding (DSO) Lower

=

[3]
C. Debt Management Less than 1
1. Debt to assets ratio (DA) =
ratios
Between 0 to
2. Debt to equity ratio (DE) = 1

Higher
3. Times interest earned ratio(TIE) or,
Interest coverage ratio =

4. Cash coverage ratio = Higher

D. Profitability ratios Higher

1. Net profit margin =

2. ROA =
Higher

3. ROE =
Higher
E. Market value 1. Earnings per share (EPS) Higher
ratios =

2. Dividend per share (DPS) Higher

=

3. Price earnings ratio (PE) Lower

=

Higher
4. Book value per share (BVPS)
=

Where, Book value = Total stockholders’

equity – Preference share capital
Higher
5. Market to book ratio =
Under DuPont equation: [ 2 Marks ]
ROA = Net profit margin * Total assets turnover ratio
ROE = Net profit margin * Total assets turnover ratio * Equity multiplier
Or, ROE = ROA * Equity multiplier

[4]
 UNIT 3

Time Value of Money

Meaning of Time Value of Money: [ 2 Marks ]

 It refers to an idea that the sum of money received in the present date is worth more than
the same sum of money received in some future date.

Reasons for Time Value of Money: [ 2 Marks ]

 Future is uncertain.
 Inflation level ( rise in the price of goods & fall in the value of money)
 Reinvestment opportunity (earning capacity of money)
 Individual preference for current consumption than future consumption.

Significance / Importance of Time Value of Money: [ 2 Marks ]

 Financing decision
 Investment decision
 Security & other assets valuation
 Evaluating investment opportunities.

LIST OF FORMULAS: [ 10/15 Marks ]

A. Present Value (PV) PV= FV
Or,
PV= FV (

B. Future Value (FV)

FV=
Or,
FV= PV ( )
C. Present Value of Annuity  When Payment is made at the
beginning of the year:

PVA (due)= PMT⌊ ⌋ (1+i)

Or,
PVA (due)= PMT [ (1+i)
 When payment is made at the end of
each year:

PVA = PMT⌊ ⌋
Or, PVA = PMT [

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D. Future Value of Annuity  When payment is made at the
beginning of each year:

FVA (due)= (1+i)

Or,

FVA (due)= PMT [ (1+i)

 When payment is made at the end of

the year:

FVA =
Or,

FVA = PMT [

E. Annual payments (PMT)

 PMT=

F. Present Value of Perpetuity



G. Equal monthly installment (EMI)

 EMI =

H. PV of Uneven cash flow

 PV= + +…. +

I. FV of Uneven cash flow

 FV= +
+……. +

J. Effective annual rate (EAR)

 EAR = –1

[6]
 UNIT 4

Fundamentals of Risk & Return

Meaning of Risk, Return & Portfolio: [ 2 Marks each ]

 Risk may be defined as the chances of happening an unfavorable event. In other words,
it is the deviation between expected return & actual return.

 Return is the rate of benefits that yields from investment due to appreciate in its value.
It comes in the form of dividend, interest income & capital gain.

 Portfolio is the set of investment having more than two alternatives. It must be
diversified that helps to minimize risk & maximize return.

Meaning of Diversification: [ 2 Marks ]

 It is the process of adding two or more securities in a portfolio with the aim of reducing
total risk.
 Types of Risk:
 Systematic risk/ Non-diversifiable risk ----(that cannot be controlled &
affect entire sector of the economy)
 Unsystematic risk/ Diversifiable risk -----( that can be controlled & affect
the specific industries or companies only)

LIST OF FORMULAS: [ 10/15 Marks ]

 = (when price & dividend are given)

1. Rate of Return, E

 E( )= ∑ (when probability is given)

∑
 ̅̅̅ = (when probability is not given)

2. Standard Deviation  = √∑[ ( )]

(

∑ ̅̅̅
 =√

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3. Coefficient of
 =
Variation (CV)
 =(
4. Variance
 COV( =∑ -E( -E( *
5. Covariance
∑
 COV( =

 COV( = * *

6. Correlation
 =

7. Return on portfolio  = * E( + * E(

( If Covariance is available)
8. Standard deviation on
portfolio  =√

( If Correlation is available)

 =√

9. Required rate of  E( )= + [E( - ]

return under CAPM

10. Assets risk premium  ARP = [E( - ]

11. Beta Coefficient for

individual assets  =
 = * + * ………+ *
12. Beta portfolio ( )

( )
13. Slope of SML  Slope =

[8]
 UNIT 5

Financial Assets Valuation

Meaning of Financial assets: [ 2 Marks ]

Real Assets that can be exist physically such as

assets Land , Vehicle, and Equipment etc.
ASSETS

Financial  Those assets which do not have

assets physical existence are called
financial assets.
 Includes Shares, Bond,
Debenture, Treasury bill etc.
 Characteristics such as; No
physical existence,
Productiveness, Non-
depreciable, Transferability,
Marketability, Convertibility.

Types of Financial assets: [ 2 Marks ]

Meaning Characteristics
A. Bond It is a long term debt capital, a  Par value (Rs.1000)
promissory note where the  Fixed Coupon rate
issuer promises to pay fixed  Fixed Maturity date
interest for a specific period of  Indenture
time.  Conversion feature

B. Common stock It is a security issued by a  Par value (Rs.100)

company to raise equity  Infinite maturity date
capital. It is a major source of  Voting right
long term financing.  Residual claim on
income & assets

C. Preferred stock It is also called preference  Par value (Rs.100)

share that represents the long  Fixed dividend
term source of financing. It  Maturity
involves both feature of bond  Cumulative features
& common stock, so it is also  Conversion features
called hybrid security.  No voting rights

[9]
 LIST OF FORMULAS: [ 10/15 Marks ]

1. Valuation of the bond & stock

Bond Stock
 Perpetual bond  Zero growth model

 Zero coupon bond  Constant/ Normal growth model

 Coupon bond with finite maturity  Non-constant/ Supernormal growth model

( )

Or,

[ ] Or,

2. Calculation of YTM & YTC

YTM YTC
Step 1. Calculation of approximate YTM: Step 1. Calculation of approximate YTC:

Approx. YTM = Approx. YTC =

Step 2. Calculation of PV at Various rates in Step 2. Calculation of PV at Various rates in bond

bond equation equation

Step 3. Calculation of Actual YTM Step 3. Calculation of Actual YTC:

Actual YTM = Actual YTC =
3. Total rate of Return
Total return on Bond = Total return on Stock
=

4. others
Required rate of return on stock Annual yield on Bond
 Under dividend discount model(DDM):  Nominal annual yield:
= m * Periodic yield

 Under CAPM:  Effective annual yield:

=

[10]
 UNIT 6

Cost of Capital

Meaning of Cost of Capital: [ 2 Marks ]

 It is the minimum required rate of return that must be earned on investment. It is used as
a major tool in financial decision making.

Application /Uses /Significance of Cost of capital in financial decision making:

[ 5 Marks ]
1. Investment decision
 Cost of capital is required to calculate the net present value of the projects.

2. Capital structure decision

 Capital structure is designed in such a way that the combination of long term source of
financing that minimizes the overall cost of capital.

3. Dividend policy decision

 If the reinvestment rate is higher than the cost of equity, the company should not pay the
dividends & vice versa.

Factor affecting Weighted average cost of capital (WACC): [ 5 Marks ]

A. Level of interest rate
 If the rate of interest increases, the cost of debt also increases as a result WACC also
increases & vice versa.
B. Investment policy
 If a firm declares to invest in new projects, the investors expected return also increases,
as a result WACC also increases.
C. Operating & financing decision
 The risk involved in operating & financial decisions increase WACC & vice versa.
D. Tax rate
 If increase in tax rate reduces cost of debt as a result, WACC also declines & vice versa.
E. Capital structure
 In a certain limit, the use of debt helps to reduce the WACC.
F. Dividend policy
 Higher DPR increases the chances of raising external equity, which increases cost of
equity as a result, WACC also increases.

[11]
LIST OF FORMULAS: [ 10 Marks ]

1. Calculation of Cost of debt:

Before tax cost of debt ( for Perpetual debt only)

( for redeemable debt only)

Where,

After tax cost of debt

2. Calculation of Cost of Preferred stock:

Cost of Preferred stock
( if stock is selling at Face value)

( If stock is selling at other price than face value)

Approximate cost of Preferred stock

( )

3. Calculation of Cost of Equity/ Common stock:

A. Cost of Retained earnings/  Under Dividend discount model(DDM):
Internal equity (

 Under CAPM:

 Under Bond yield-plus-Risk premium

approach:

B. Cost of External equity

4. Others:
Weighted average cost of capital (WACC)

Retained earnings Break point

[12]
 UNIT 7

Capital Structure & Leverage

Concept of Capital structure: [ 2 Marks ]

 The composition of long term source of financing such as long term debt & equity is
called Capital structure. In other hand, it is the mix of specific ratio of debt & equity that
a firm uses for its operation & growth.

Factors affecting Business risk: [ 2 Marks ]

Those risk that arises due to operation of the business rather than the uses of debt is called
Business risk.

 Fixed cost
 Demand of product
 Selling price
 Variability in cost of factor of production.

Definition of leverage: [ 2 Marks each]

 Operating leverage may be defined as the % change in operating income (EBIT) due to
the given change in sales.
 Financial leverage may be defined as the % change in EPS due to the given changes in
EBIT.
 Total (combined) leverage may be defined as the % change in EPS due to the given
changes in sales.

Break-even Analysis: [ 2 /5 Marks ]

 Break-even analysis may be defined as the process of determining a company’s break-
even point through a financial calculation. Break-even point is the volume of sales, where
revenue equals to operational costs. It can be classified into 3 types such as,

1) Operating BEP: The level of sales where revenue equals to total cost. So, there is
neither profit nor loss.

2) Cash BEP: The level of sales that should be needed to cover cash operating costs.

3) Financial BEP: The level of operating income that should be needed just to cover
the fixed financial costs & produces EPS equal to zero.

[13]
LIST OF FORMULAS: [ 10 Marks ]

1. Degree of Operating
Leverage (DOL)
Or,

2. Degree of Financial  When there is no use of preference share

Leverage (DFL)

Or,

 When there is use of preference share

3. Degree of Total
(Combined) Leverage Or,
(DTL)

4. Break-even point (in

units)
5. Break-even point (in
rupees)

6. Contribution margin
ratio

7. Operating profit
(EBIT)
8. Cash break-even point
(in units)

9. Cash break-even point

(in rupees)

10. Financial BEP (in Rs.)

11. Financial BEP ( in

units)

[14]
 UNIT 8

Basics of Capital Budgeting Decision

Meaning of Capital Budgeting: [ 2 Marks ]

 It is the process of acquiring fixed assets or the process of investment made in capital
projects which have a longer time horizon. It may be 5, 10 years or even more than 20
years. It depends upon nature of assets the company acquires in the near future.

Characteristics of Capital Budgeting: [ 2Marks ]

 Huge investment
 Long time period
 Risk & uncertainty

Definitions: [ 2 Marks each ]

Payback Period (PBP): It is the length of time required for investment net cash inflows to
cover its cost or initial investment.

Discounted Payback Period (DPBP): It is the length of time required to cover its initial
investment with considering the time value of money.

Net Present Value (NPV): It is the difference between the present value of future cash
inflow and Initial investment.

Internal Rate of Return (IRR): Those discount factor which equates the present value of
future cash inflow to the initial investment is called IRR.

Modified Internal Rate of Return (MIRR): Those discount factor which equates
terminal value to initial investment is called MIRR.

Profitability Index (PI): It is the ratio between total present value of cash flow and initial
investment.

IRR vs. NPV: [ 2 marks ]

 As compared to NPV with IRR, we should choose the NPV method because positive
NPV helps to maximize the shareholders’ wealth.
 The NPV method assumes that the firm can reinvest at cost of capital, whereas IRR
method assumes that the firm can reinvest at IRR.

[15]
LIST OF FORMULAS: [ 15 Marks ]
1. Payback Period
( for equal cash flow)
(PBP)

( for Unequal cash flow)

2. Discounted Payback period

(DPBP)

3. Net present value

(NPV) ∑

Or,
( )

4. Internal rate of return

(IRR) Step 1. Calculation of Fake annuity

Step 2. Calculation of Fake payback

Step 3. Looking PVIFA table as the value

computed in step 2.

Step 4. Calculation of NPV at various rates

Step 5. Calculation of IRR:

5. Modified internal rate of return

(MIRR)

6. Profitability Index
(PI)

[16]
 UNIT 9

Working Capital Management

Concept of working Capital: In net concept, Working capital is the difference between
current assets & current liabilities. i.e. WC= CA-CL [ 2 Marks ]

Types of Working Capital: [ 2 Marks ]

a) Permanent working capital: It refers to minimum level of current assets that must be
maintained all the time.
b) Seasonal working capital: It refers to the requirement of additional working capital due to
seasonal variations in production & sales levels.

Factor affecting size of Working Capital: [ 5 Marks ]

 Nature & size of the business
 Cash conversion cycle
 Seasonal fluctuation
 Growth & expansion

Significance of Working Capital: [ 5 Marks ]

 A direct connection to sales & profitability
 Important for both little & big businesses
 Grab an opportunity for business
 To handle crisis
 To improve organization reputation & goodwill
 For business survival

Cash Conversion Cycle: It is the length of time between paying for purchases & receiving
cash from the sales of finished goods. [ 2 Marks ]

Meaning of Inventory Management: [ 2 Marks ]

 Inventory management is the process of maintaining appropriate level of investment
made in inventory with aim of reducing the overall cost of inventory. The main motives
of holding inventory are Transaction motive, Precautionary motive, & speculative
motive.

Purpose of Inventory management: [ 2 or 5 Marks ]

 To provide materials continuously
 To prevent from excessive investment in inventory
 To prevent the misappropriation of materials
 To purchase materials at reasonable price

[17]
Determinants of Inventories: [ 2 Marks ]
 Nature of business
 Seasonal effect
 Production cycle
 Delivery period
 Nature of goods

Meaning of Cash Management: [ 2 Marks ]

 It refers to the monitoring & maintaining of cash flow to ensure that a business has
enough funds for its various functions.

Significance of Cash management: [ 2/ 5 Marks ]

 Prevention from insolvency
 Advantage of business opportunities
 Strong credit rating
 Helpful in emergency

Motives of Holding Cash: [ 2/ 5 Marks ]

a) Primary motive
 Transaction motive
 To meet compensating balance
b) Secondary motive
 Precautionary motive
 Speculative motive

Meaning of Receivable Management: [ 2 Marks ]

 It is the entire process of keeping track of what customers buy from companies on credit.
It involves developing credit policy, sending follow-up correspondences to customers, &
collecting due payments.

Elements of credit policy: [ 2 Marks ]

 Credit standard
 Credit terms
 Collection policy
 Monitoring of credit policy

[18]
LIST OF FORMULAS: [ 5/ 10 Marks ]
1. Inventory Conversion Period
(ICP)

2. Receivable Conversion Period

(RCP)

3. Payable Deferral period

(PDP)

4. Operating Cycle

5. Cash Conversion Cycle

Or,

6. Working Capital

Or,

7. Economic order quantity

(EOQ) √

8. Optimal number of orders (N)

9. Total cost of EOQ

( )

10. Total inventory cost (TIC)

11. Average inventory level

12. Maximum inventory level

13. Reorder level

Where,

[19]
 UNIT 10

Distributions to shareholders

Meaning of dividend: [ 2 Marks ]

 Dividend is the percentage of company’s earnings that is paid to its shareholders as their
share of the profits. It may be paid in the the form of cash or additional shares(Stock)
dividend.

Types of dividend: [ 2 Marks ]

1) Cash dividend: Dividends are distributed to its shareholders in the form of cash.
2) Stock dividend: Dividends are distributed to its shareholders in the form of additional
number of shares.

Factors affecting dividend policy: [ 2 Marks ]

 Legal requirements
 Firms liquidity position
 Investment opportunities
 Stability in earnings
 Restrictions imposed by bondholders & preferred shareholders
 Shareholders individual tax situation

Stock split: It is the corporate action in which a company increases the number of shares
outstanding by issuing more shares to current shareholders. [ 2 Marks ]

Reverse stock split: It is the corporate action in which a company reduces the number of
share outstanding , thereby raising the market price of each share. [ 2 Marks ]

Amount of dividend

Adjusted stock price after

stock dividend

Equilibrium repurchase
price ( )

Where, N= No. of share o/s prior to distribution

The End

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