L.9 - Finance

Finance is for enterprise Like life giving air's presence Honest financial management, will ensure long existence."

UDYAM SHATRA-Chapter 9,verse 08

Key Objectives:

This module and its associated activities should help the student to:

1.Compare debt and equity financing.

2.Calculate debt-to-equity ratio and debt ratio

3.Evaluate the risks of heavy debt financing .

4.Evaluate the risks of excessive equity financing

Enterprise Concepts:

Financing.Finance is the use and manipulation of money. Raising money for business is one aspect of financing

Debt.The business borrows the money and pays it back over a set period of time at a set rate of interest. Companies sell debt in the form of bonds and debenture. They may also take loans from banks as part of debt.

Equity.The business gives up a Percentage of ownership for money. The investor receives a percentage of future profits from the business based upon the percentage of ownership. Companies sell equity in the form of shares

Grants.Some charity organisation or community groups may give grants to promising youths. A grant is sort of outright donation. The entrepreneur may show this as equity.

Subsidies.Subsidies are financial help given to aspiring entrepreneurs who want to start a new business under some government schemes.

Bonds.Bonds are deposits taken by the company from the public.Company indemnifies the holder of the bond for refund of value of the bond after stipulated period along with interest due. Bonds are not tradable on the stock exchange

Debentures.: If a loan to be raised by a company is divided into uniform parts(each part being serially numbered)and the loan is raised by enabling people to buy as many parts as they wish,then each part will be known as debenture. The debenture therefore is an acknowledgment under seal of a debt or loan. It is as good as loan taken from individual on certain terms and conditions and on payment of a fixed interest rate for a fixed period. A Company assures/guarantees to the holder to refund the value of the debenture on maturity. On liquidity of the company the debenture holder gets the preferential rights to the refund of the value of the debenture. Debentures can be traded on the stock exchange.

■ Ratios

1. Debt to Equity

The financial strategy of a company is expressed by its debt to equity ratio.

DEBT/ EQUITY = DEBT-TO- EQUITY RATIO

If a company has a debt-to-equity ratio of one to one (expressed as 1:1), this means that for every Rupee one of debt the company has Rupee one of equity.

Debt=1 Equity=1

2. Debt Ratio

Another ratio that gives a picture of financial strategy is the debt-ratio. This is the ratio of debt to asset. A debt ratio of 0.5 means that every Rupee One of asset is financed by 50 paise of debt and 50 paise of equity.

Amount of debt/amount of assets = debt ratio

e.g. 0.50/1.00= 0.50

■ Simple Accounting

Whatever be the nature of enterprise, some method of accounting is recommended. This helps to keep control over the cash that flows in and out of the business. A simple method of accounts is the Receipts & Payments Account, which is maintained in what is called Cash & Bank Book.

RECEIPTS AND PAYMENTS ACCOUNT

· Receipts: Money coming in

· Payments: Money paid out

· Balance: Difference between money coming in and paid out i.e. amount of funds.

· Cash & Bank book: It records daily each cash/bank transaction in respect of Receipt or Payment. It begins with opening balance of Cash and Bank on the left side. This side is also called RECEIPTS side or Debit side of account. The Cash & Bank book closes with Cash/Bank balances, at end of a particular period, recorded on the right side i.e. PAYMENT side. The latter is also called Credit side.

■ The Balance Sheet

Here we will try to understand:

- How to read a simple Balance Sheet

- Use ratios to analyse a Balance Sheet.

The Balance Sheet

A balance Sheet is a financial statement showing as of a particular date :

-The Assets

-The Liabilities (debts)

-Net worth of a business

Balance Sheet is typically prepared at the end of some accounting period, and is part of final accounts.

· NET WORTH:

Net Worth is the difference between assets and liabilities and is also called OWNER'S EQUITY.

· FINANCIAL YEAR (FY)

Financial Year is a one year (twelve months) of accounting period for a business. In India it is typically 1st April of this year to 31st March of next year. Balance Sheets are typically prepared at the end of every FY...

· ASSETS

Assets are all items of worth owned by a business, such as cash, inventory, furniture etc. M

1) Current Assets: Current Assets are assets that can be sold for cash in a fairly short time, usually within one year. Car closing stee M PAYMENT

3) Fixed Assets: Fixed assets are assets of permanent nature. For example Land, building, plant and machinery. Fixed assets are largely long term assets i.e. those that could take a long time, say more than a year to turn into cash.

· LIABILITIES

Liabilities are all debts owed by the business such as. ..

-bank loans

-loans from family or friends etc.

Ø Current liabilities: are those that must be paid in a fairly short period, usually within a year.

Ø Long term liabilities: are those that are to be paid over a period longer than one year.

· OWNER'S EQUITY

Also known as CAPITAL or NET WORTH Owner's Equity or net worth is what's left over after liabilities are subtracted from Assets. In other words, owner's equity is the value 'on the balance sheet' of the business to the owner.

Assets - Liabilities= Net Worth or owner's Equity or capital

Or

Assets Liabilities + Net worth

This is also referred to as

THE FINANCIAL EQUATION

■ Drawing up a simple Balance Sheet

The balance sheet is usually divided into two columns.

- On the left side are listed all the debts and equity referred to as Liability side.

- On the right side are listed all the assets referred to as Asset side

Enterprise Skills:

The student 'Activities' in each lesson are designed to clarify the ENTERPRISE CONCEPTS of the lesson and develop some ENTERPRISE SKILLS (E.SKILLS). The E.SKILLS included in a lesson may not be exhaustive, but are indicative.

E.SKILLS stated in a lesson elsewhere may also get addressed through the activities of a particular lesson.

Some useful E.SKILLS are dealt with below:

Numeracy skill.: The skill to calculate, estimate, use calculators and measuring instruments, analyse and respond to quantitative information, recognise and use numerical pattern & relationships is broadly referred to as NUMERACY SKILL.

Data interpretation: The ability to interpret numerical data, figures, charts,graphs and tables is referred to as Data Interpretation.

Activities:

Activity 1 - USING NEW WORDS IN FINANCE

Instruction To Students

• • • The students should fill in the blanks using the terms given.

    • Terms- Ownership, debt ratio, equity, bonds and debentures, loan agreement, debt-to-equity ratio

    • After completing the activity, each group should present and share its main discussion points with the rest of the class.

Work Sheet

1. If you raise money by selling shares, you are giving up _________.

2. Holders of ___________ receive dividends and annual corporate reports.

3. If you borrow money from a bank, you will have to sign a ___________ .

4. The ratio of debt to assets is called a ____________.

5. When a company issues __________________it is raising money through debt.

6. The financial strategy of a company is expressed by its ________________ .

Activity 2 - CASH BANK BOOK (RECORD OF RECEIPTS PAYMENT DAY WISE).

Instruction To Students

• • • • Students should fill the worksheet with entries from the information about ‘Lata’s Snacks Business for January’. First four entries are done in students Activity worksheet. Some cells are filled, some are blanks.

      • After completing the activity, each group should present and share its main discussion points with the rest of the class.

Method 1:

Cash & Bank Book (Record of Receipts and Payments Day wise)

Summary of Reciepts & Payments for the period 1Jan to 31 Jan

Instruction To Students

• • • • • Often professional accountants maintain Receipts on left side of Accounts books and Payments on right side in the same account books. The accounts are then periodically balanced off.

        • Students should complete the Worksheet below using this Method 2

        • After completing the activity, each group should present and share its main discussion points with the rest of the class.

Activity 3 - LATA'S INCOME EXPENDITURE ACCOUNTS (P & L ACCOUNTS).

Instruction To Students

• • • • • • Once more refer to the Record of RECEIPTS & PAYMENTS of Lata’s Snacks Business.

          • From the R & P Account , ask the students to identify the:

          • - SALES entries

          • - COST of Production entries.

          • Outgoes on ASSETS that have appeared in the ‘Balance sheet’ are not to be taken in the P & L Account.

          • Prepare a Income & Expenditure i.e. Profit and Loss Account using the Worksheet.

          • After completing the activity, each group should present and share its main discussion points with the rest of the class.

Work Sheet

Determine these ratios to understand the P&L Account.:

Costs-to-sales % = COSTS x 100 =

SALES

Profit-to-sales % = PROFITS x 100 =

SALES

What impression do you get about the profitability of LATA’S SNACKS BUSINESS

from these ratios? Is Lata’s Sales Income adequately covering her costs? Why?

Does Lata make adequate profits? What could happen if more competitors start similar snacks business around Lata’s centre?

Activity 4 - LATA'S BALANCE SHEET.

Instruction To Students

• • • • • • Students should once again study the Record of RECEIPTS & PAYMENTS (R&P) for Lata’s Business for the month of January.

          • After completing the activity, each group should present and share its main discussion points with the rest of the class.

Work Sheet

1. What items does Lata own on January 31 and what is its value? These are her assets. Fixed assets are her vessels and furniture. Current assets are her cash.

_______________________________________________________________________________________

2. What loan liability does Lata have on 31 January? This is her long term liablity. (Current liablities are creditors example suppliers to whom payments are due shortly. Does Lata have any current liabilities?)

_______________________________________________________________________________________

3. Prepare Lata’s Balance Sheet on 31st. Jan . And determine her NET WORTH (OWNER’S EQUITY) on that day.

_______________________________________________________________________________________

Always the

Total Liabilities = Total Assets

in the Balance Sheet

Determine these ratios to understand the Balance Sheet.:

Current Assets-to - Current Liabilities ratio = Current Assets (CA) =

Current Liabilities (CL)

Total Debt-to - Equity ratio = DEBT (D) =

EQUITY (E)

Total Debt-to -Assets ratio = DEBT (D) =

ASSETS (A)

Students should diagrammatically represent the Current Assets (CA) to Current Liabilities (CL) , Debt (D) to Equity (E) ratio and the Debt (D) to Assets (A) ratio in the following diagrams.

What impression do you get about the financial health of LATA’S SNACKS BUSINESS from these ratios? Is Lata financially strong enough to bear her debts? Why?

Do the current assets of Lata cover her current liabilities adequately?

Do Lata’s Total Assets cover for her debts (long term + current liabilities) adequately?

What would be the risks if LATA’S business had heavy debt financing, i.e. very large loans had been taken from Bank, in excess of her actual needs?

What was Lata’s Equity Financing when she started on 1 January?

What is her Equity Financing on 31 January? Could there be risks in excessive equity financing in future?

Activity 5 - START UP FINANCE PLAN.

Instruction To Students

• • • • Students should list resources they will need for starting up their enterprise. Try to assess whether:

You really need it

Can you get it as courtesy (free of cost)

Can you get it on loan (borrow)

Can you hire it

If you must buy, can you do as follows

Buy new ?

Buy second hand ?

Buy some in cheap way ?

Buy on credit ?

• • • • The resource list given here is only suggestive. You may draw up your own.

      • After completing the activity, each group should present and share its main discussion points with the rest of the class.

The Enterprise (You Choose) : ______________________________

List the resources you will need to starting this enterprise and complete the table given below :

Total amount of start-up cash needed Rs.__________

LESSON INDEX