Finance Function & Planning

Cheatsheet Content

What is Finance Function? Practices and activities managing business finances. Oriented towards acquiring and managing financial resources to generate profit. Optimizes financial resources and information for productivity, planning, and decision-making. Key Finance Functions Financial Planning and Analysis Budgeting, forecasting, and analyzing financial performance for strategic decision-making. Revenue Forecasting: Estimating future revenue based on historical data. Formula: $\text{Projected Revenue} = \text{Historical Sales} \times (1 + \text{Growth Rate})^n$ Where $n$ is the number of periods. Break-Even Analysis: Determines the point where revenue equals costs. Formula: $\text{Break-even point (units)} = \frac{\text{Fixed Costs}}{\text{Selling Price per Unit} - \text{Variable Cost per Unit}}$ Helps understand minimum sales volume for profit. Investment Decision-Making Allocating company funds to generate highest returns. Deciding whether to invest in new projects or equipment. Net Present Value (NPV): Difference between PV of cash inflows and outflows. For single cash flow: $\text{NPV} = \frac{\text{Cash flow}}{(1 + i)^t} - \text{initial investment}$ For multiple cash flows: $\text{NPV} = \sum_{t=0}^{n} \frac{R_t}{(1 + i)^t}$ Positive NPV projects are generally undertaken. Internal Rate of Return (IRR): Discount rate that makes NPV zero. $0 = \sum_{t=1}^{T} \frac{C_t}{(1 + IRR)^t} - C_0$ Used to estimate profitability; compare to cost of capital. Modified Internal Rate of Return (MIRR): Assumes positive cash flows are reinvested at the firm's cost of capital. More accurately reflects cost and profitability than IRR. Financing Decision-Making Decisions on how to fund operations and growth (equity, debt, internal financing). Cost of Debt (after tax): Effective rate paid on borrowed funds, considering tax deductions. $\text{Cost of Debt (After Tax)} = R_d \times (1 - T_c)$ Where $R_d$ is pre-tax interest rate and $T_c$ is corporate tax rate. Cost of Equity (using CAPM): Return investors require for investing in equity. $R_e = R_f + \beta(R_m - R_f)$ Where $R_e$ is cost of equity, $R_f$ is risk-free rate, $\beta$ is beta, $R_m$ is expected market return. Liquidity Management Ensuring sufficient cash flow for short-term obligations and operating expenses. Maintains optimal balance between liquid assets and investing surplus cash. Current Ratio: Financial metric to evaluate ability to pay due debts within a year. $\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$ Ratio of 1.2 or higher is generally good. Quick Ratio: Liquidity metric using most liquid assets (excludes inventory). $\text{Quick Ratio} = \frac{\text{Cash & Cash Equivalents + Marketable Securities + Receivables + Other Current Assets}}{\text{Total Current Liabilities}}$ Provides a rigid measure of short-term liquidity. Risk Management Identifying, analyzing, and mitigating financial risks. Deciding whether to accept risks or mitigate them. Value at Risk (VaR): Predicts greatest possible losses over a specific time frame. $\text{VaR} = Z_{\alpha} \times \sigma \times \sqrt{t}$ Where $Z_{\alpha}$ is Z-score for confidence level, $\sigma$ is standard deviation, $t$ is time period. Capital Structure Management Optimizing mix of debt and equity financing to minimize cost of capital. Adjusting debt-equity ratio to reduce cost of capital while maintaining stability. Debt-to-Equity Ratio (D/E): Compares total liabilities to shareholders' equity. $\text{Debt-to-Equity Ratio} = \frac{\text{Total Liabilities}}{\text{Shareholders' Equity}}$ Higher ratio suggests more leverage and financial risk. Weighted Average Cost of Capital (WACC): Average rate of return a company expects to pay its investors. $\text{WACC} = (E/V) \times R_e + (D/V) \times R_d \times (1 - T_c)$ Where $E$ is market value of equity, $D$ is market value of debt, $V$ is total market value, $R_e$ is cost of equity, $R_d$ is cost of debt, $T_c$ is corporate tax rate. Importance of Finance Function Crucial for smooth operation and growth. Helps in making informed decisions, ensuring financial stability, and achieving long-term goals. Actual Investment Horizon: Understanding how long you plan to invest. Risk of equity reduces substantially over longer periods. Helps manage emotions during volatile markets. Financial Goals: Planning for future expenses and wealth accumulation. Mitigates impact of inflation on compounding costs. Ensures funds for major expenses like education or retirement. Scope of Financial Management Investment Decisions: Deciding how to allocate capital. Long-term (Capital Budgeting) and short-term decisions. Example: Stellar Manufacturing Co. evaluating robotic arm project using NPV, IRR, Payback Period, PI. Financing Decisions: Determining how to raise capital. Mix of debt and equity, types of debt instruments. Example: GreenTech Solutions Inc. deciding between equity, debt, or a combination. Liquidity Decisions: Managing liquid assets to meet short-term obligations. Ensures immediate liabilities are covered without financial distress. Example: Retail Dynamics Ltd. adopting a Moderate Liquidity Strategy. Dividend Policy Decisions: Determining distribution of profits to shareholders. Rewarding shareholders vs. retaining earnings for growth. Example: Tech Innovators Inc. choosing a Moderate Dividend Payout Policy. Financial Goals: Profit versus Value Maximization Profit Maximization Goal: Maximize company profit by decreasing costs or increasing revenue. Time Horizon: Short-term strategy. Time Value of Money: Does not consider it. Sustainability: May not always make sustainable decisions. Flexibility: Less flexible to adapt to short-term market changes. Risk: Can be risky to earn immediate profits. ESG: May not prioritize environmental, social, and governance factors. Financial Ratios Used: Net Profit Margin, ROI, turnover ratios. Maximisation Procedure: Increases earning capacity. Value Maximization Goal: Maximize the value of all shareholders (long-term). Time Horizon: Focuses on the long term. Time Value of Money: Considers it. Sustainability: Uses sustainable practices. Flexibility: Allows easy readjustments to strategies. Risk: Strategies tend to be less risky as company seeks long-term sustainability. ESG: Prioritizes ESG factors to improve reputation and compliance. Financial Ratios Used: EPS, P/E ratio, P/B ratio. Maximisation Procedure: Increases company's stock value for shareholders. Relationship between Finance Function and Other Functional Areas Economics: Provides theoretical foundation for financial decision-making (resource allocation, supply/demand). Accounting: Records financial transactions and provides data for analysis, financial statements, and budgeting. Mathematics: Foundation for financial concepts (interest, present/future value) and risk assessment models. Production Management: FM provides budgets for optimal resource allocation and assists in cost control. Marketing: FM allocates budgets for campaigns and assesses ROI, helps set pricing strategies. Human Resources: FM ensures allocation of funds for salaries, benefits, and budgeting for training/development. Role of Finance Manager Oversees financial planning, analysis, and management. Creates and maintains financial reports. Manages budgets and analyzes financial data. Ensures compliance with financial regulations. Develops and implements financial strategies aligned with business objectives. Forecasts financial trends and assesses risks. Manages relationships with external parties (auditors, banks, investors). Oversees financial transactions and monitors performance. Manages a finance team. Meaning of Financial Planning Practice of managing finances and preparing for potential costs/issues. Evaluates current financial situation, identifies goals, develops recommendations. Not the same as asset management. Different Types of Financial Planning Cash Flow Planning: Managing inflow and outflow of money for income and expenses. Investment Planning: Identifying life goals and investing in financial instruments (equities, debt, mutual funds). Insurance Planning: Securing oneself from unpredictable risks (life, health, auto, home). Tax Planning: Minimizing tax liability through tax-saving instruments and deductions. Real Estate Planning: Investing in real estate for long-term returns and as a safety net. Children's Future Planning: Planning for education and other expenses. Retirement Planning: Saving for a peaceful retirement. Budgeting: Cornerstone of financial planning, ensuring responsible spending and avoiding debt. Steps in Financial Planning Set Clear Goals: Define short-term and long-term financial goals. Assess Your Current Finances: Review financial documents, calculate net worth. Determine Your Income and Expenses: Track income and categorize expenditures. Analyze Risk Tolerance: Determine comfort level with investment volatility. Build an Emergency Fund: Establish savings for 3-6 months of living expenses. Create a Debt Repayment Strategy: Identify and pay off high-interest debts. Develop an Investment Strategy: Create a diversified portfolio based on goals and risk tolerance. Consider Tax Planning: Reduce tax liability through efficient investments and deductions. Review Insurance Coverage: Identify and protect against life, health, disability, and other risks. Regularly Review and Adjust: Keep plan updated, adjust budget and strategy as life changes. Key Elements in Finance Functions Future Value (FV) Value of a current asset at a future date based on assumed growth. Formula: $\text{FV} = \text{PV} \times (1 + r)^n$ Where PV is Present Value, $r$ is Interest Rate (%), $n$ is Number of Compounding Periods. Present Value (PV) Current value of a future sum of money or cash flow given a specified rate of return. Formula: $\text{PV} = \frac{\text{FV}}{(1 + i)^n}$ Where FV is Future Value, $i$ is Interest (discount) rate, $n$ is Period number. NOMINAL Interest Rate vs. Real Interest Rate Nominal Interest Rate ($\mathbf{i_{nom}}$): Advertised interest rate without accounting for inflation. Formula: $i_{nom} = i_{real} + \pi$ Where $i_{real}$ is Real interest rate, $\pi$ is Inflation rate. Real Interest Rate ($\mathbf{i_{real}}$): Reflects the true cost of funds after accounting for inflation. Formula: $i_{real} = i_{nom} - \pi$ (Projected Rate of Inflation) Provides insight into the actual return received by a lender or investor.