Ch-8: Introduction to Financial Management

Financial management means how a business manages its money—how it earns,

spends, saves, and plans.
👉 In simple words:
“Financial management = handling money wisely in a business.”

Why Financial Management is Important

A business idea may be very good, but without money, it cannot survive.
👉 A business needs money for:
 Buying raw materials
 Paying salaries
 Paying rent and bills
 Marketing products
If money is not managed properly → business may fail.

Sources of Money
Money in a business comes from two main sources:
1. External Sources
Money from outside:
 Investors
 Bank loans
📌 Example:
A startup gets funding from an investor to start operations.

2. Internal Sources
Money is generated from business profit.
📌 Example:
A shop reinvests its earnings to expand.

Common Mistakes by New Businesses

Many new businesses:
❌ Ignore financial management
❌ Do not track money properly
👉 This leads to:
 Cash shortage
 Business failure

Understanding Cash vs Profit

A business may be profitable but still face problems due to a lack of cash.
Example:
A small company sells products to big companies like:
 Apple
 General Electric
 The Home Depot
👉 These companies often pay after:
 30 days
 60 days
 90 days

Problem:
The small business must:
 Buy materials
 Pay workers
  Pay bills
But the payment comes late.
👉 Result:
Even if sales are high → business may run out of cash.

Growth Creates More Financial Pressure

As a business grows:
 More customers → more orders
 More orders → more expenses
📌 Example:
A clothing brand grows quickly:
 Needs more fabric
 Needs more workers
👉 If cash is not available → growth becomes a problem instead of success.

Key Financial Management Questions

A business must regularly ask these important questions:

1. Are We Making Profit or Loss?

👉 This tells if the business is successful.
📌 Example:
If income = 100,000
Expenses = 80,000
✔ Profit = 20,000

2. How Much Cash Do We Have?

👉 Cash is needed for daily operations.
📌 Example:
Even if profit exists, no cash = cannot pay salaries.

3. Can We Pay Short-Term Obligations?

Short-term obligations include:
 Salaries
 Bills
 Supplier payments
📌 Example:
If a business cannot pay suppliers on time → trust is damaged.

4. Are We Using Our Resources Efficiently?

👉 Resources = machines, employees, inventory
📌 Example:
If machines are idle → waste of money.

5. How Do We Compare with Competitors?

👉 Compare growth and profit with similar businesses.
📌 Example:
If competitors grow faster → your strategy may be weak.

6. Where Will Future Funds Come From?

Businesses need money for:
 Expansion
 New equipment
 Technology
📌 Example:
A company may:
 Take a loan
 Bring investors

7. Can We Partner to Reduce Risk?

👉 Partnership helps share cost and risk.
📌 Example:
Two companies collaborate:
 Share investment
 Share profits

8. Are We Financially Healthy Overall?

👉 Final question:
Is the business stable and strong financially?

Final Simple Idea

Financial management helps a business:
 Stay alive
 Grow smoothly
 Avoid financial problems
👉 Without proper money management:
Even a good business idea can fail.

Financial Objectives of a Firm

Every business has some main financial goals. These goals help the business:
  Stay successful
 Manage money properly
 Grow in the future
👉 There are four main financial objectives:
1. Profitability
2. Liquidity
3. Efficiency
4. Stability

1. Profitability (Earning Profit)

Explanation:
Profitability means how much profit a business earns.
👉 Profit = Income – Expenses
A business must earn profit to survive in the long run.

Important Point:
New businesses may not earn profit in the beginning because they:
 Train employees
 Build their brand
 Spend on marketing
But eventually, they must become profitable.

Example:
A new clothing brand spends a lot on advertising in the first year → no profit
After 2–3 years, customers increase → business starts earning profit
2. Liquidity (Availability of Cash)
Explanation:
Liquidity means having enough cash to pay short-term expenses.
👉 Even profitable businesses can fail if they don’t have cash on time.

Key Terms:
Accounts Receivable
Money that customers owe to the business
📌 Example:
You sold goods on credit → customer will pay later

Inventory
Products or materials waiting to be sold
📌 Example:
Clothes in a shop or raw materials in a factory

Problem:
If:
 Too much money is stuck in receivables
 Too much stock is unsold
👉 Then, the business may not have cash to pay bills

Example:
A shop sells goods on credit worth 100,000
But customers haven’t paid yet
👉 Shop cannot pay rent → liquidity problem
3. Efficiency (Using Resources Properly)
Explanation:
Efficiency means how well a business uses its resources (money, machines,
time) to earn profit.
👉 Less waste + better use of resources = higher efficiency

Example:
 Southwest Airlines
This company:
 Keeps planes on ground for very short time
 Quickly reloads passengers
👉 Result:
Planes fly more → earn more money

Example:
A factory uses machines continuously instead of letting them sit idle → more
production → more profit

4. Stability (Financial Strength)

Explanation:
Stability means how strong and secure a business is financially.
👉 A stable business:
 Earns profit
 Has enough cash
 Does not have too much debt

Important Concept:
Debt-to-Equity Ratio
It shows how much loan (debt) a company has compared to its own money
(equity).
👉 If debt is too high → risky situation

Example:
A business keeps taking loans repeatedly
👉 Eventually:
 Cannot repay loans
 Faces a financial crisis

Example:
Two businesses:
 Business A: Low debt → stable
 Business B: High debt → risky

Buying Groups / Co-ops

Explanation:
Small businesses join to buy products in bulk.
👉 This helps them:
 Get discounts
 Reduce costs
 Compete with big companies

Example:
5 small grocery shops join:
 Buy goods in bulk
  Get lower prices
👉 Result:
They can compete with large supermarkets

Final Simple Summary

A successful business must balance all four objectives:
 Profitability → Earn profit
 Liquidity → Have enough cash
 Efficiency → Use resources wisely
 Stability → Stay financially strong
👉 If any one of these is weak, the business may face problems.

The Process of Financial Management

Financial management is a step-by-step process that helps a business:
 Understand its financial position
 Plan for the future
 Make better decisions
👉 “It is the process of tracking, planning, and improving a business’s financial
performance.”

Financial Statements (Understanding Past Performance)

Explanation:
A financial statement is a written report that shows:
 How much money a business earned
 What it owns
  What it owes
👉 It tells the financial health of a company.

Main Types of Financial Statements:

1. Income Statement
Shows:
 Profit or loss
📌 Example:
Sales = 100,000
Expenses = 80,000
👉 Profit = 20,000

2. Balance Sheet
Shows:
 Assets (what business owns)
 Liabilities (what business owes)
📌 Example:
Assets = Cash, machines
Liabilities = loans, bills

3. Statement of Cash Flows

Shows:
 Where cash is coming from
 Where cash is going
📌 Example:
Cash received from sales
Cash paid for salaries
👉 These statements help answer:
 Are we making money?
 Do we have enough resources?

Forecasts (Planning the Future)

Explanation:
Forecasts are future estimates of:
 Sales
 Expenses
 Profits
👉 Based on:
 Past performance
 Current situation
 Future plans

Example:
A bakery expects:
 Sales next year = 500,000
 Expenses = 350,000
👉 Forecast helps in planning growth.

👉 New businesses often:

 Estimate sales first
 Then calculate expenses based on industry standards

Budgets (Detailed Financial Plan)

Explanation:
A budget is a detailed plan of:
 Income
 Expenses
 Investment needs
👉 It helps control spending.

Example:
Monthly budget:
 Rent = 20,000
 Salaries = 50,000
 Marketing = 10,000
👉 Helps ensure money is used properly.

Steps in Financial Management Process

Step 1: Analyze Past Financial Performance

Businesses study previous financial statements to understand:
 Profit trends
 Expenses
 Financial position
👉 Usually, last 2–3 years are analyzed.

Example:
If sales increased every year → good sign
If expenses increased faster → problem

Step 2: Prepare Forecasts

Based on past data, businesses predict:
 Future sales
 Future costs

Example:
If sales grew by 10% yearly → expected to grow again

Step 3: Prepare Pro Forma Statements & Budgets

Explanation:
Pro forma statements are future financial statements.
👉 They show:
 Expected profit
 Expected financial position
Budgets are used to:
 Control spending
 Manage resources

Example:
A company prepares next year’s expected income statement → helps in planning.

Step 4: Ongoing Financial Analysis

Businesses regularly check performance using financial ratios.
Explanation:
Financial ratios compare numbers to evaluate performance.

Example:
Profit ratio = Profit / Sales
👉 Helps answer:
 Are we improving?
 Are we meeting goals?

Special Case: New Ventures

New businesses:
 Don’t have past data
👉 So they start from:
Forecasting → then analysis later
After first few months:
 They begin creating financial statements
 Use them for future planning

Comparing with the Industry

It is not enough to look at your own numbers.
👉 You must compare with competitors.

Example:
Your business growth = 15%
Industry growth = 30%
👉 Conclusion:
You are falling behind, not improving.
Importance of Financial Analysis
Businesses must make decisions based on data, not guesswork.
👉 As emphasized by
 Bill Gates
👉 His idea:
 Always rely on numbers
 Avoid decisions based on “gut feeling”

Example:
A manager thinks sales are good (gut feeling)
But data shows profits are decreasing
👉 Without analysis → wrong decisions

Final Simple Summary

The financial management process includes:
1. Study past performance
2. Predict the future
3. Plan to use budgets
4. Continuously analyze results
👉 This helps a business:
 Make smart decisions
 Avoid financial problems
 Grow successfully
 Financial Statements
Financial statements are reports that show the financial condition of a business.
👉 They help answer:
 Are we making profit?
 Do we have enough money?
 Are we financially strong?

Types of Financial Statements

There are two main types:
1. Historical Financial Statements
Explanation:
These show the past performance of a business.
👉 Usually prepared:
 Quarterly
 Half-yearly
 Annually
Public companies must submit these reports to
 Securities and Exchange Commission

Important:
A detailed annual report of a company.
👉 It includes:
 Financial data
 Business details
 Risks

Example:
A public company publishes its yearly report → investors can check its
performance.

2. Pro Forma Financial Statements

Explanation:
These are future projections.
👉 They show:
 Expected sales
 Expected profit
 Future financial condition
Example:
A startup predicts:
 Sales next year = 1 million
 Profit = 200,000
👉 These are planning estimates, not actual results.

Historical Financial Statements

There are three main statements:

1. Income Statement (Profit & Loss Statement)

Explanation:
Shows:
👉 Profit or loss over a period

Key Elements:
Net Sales
Total sales after discounts and returns
Suppose:
 You sold burgers worth = Rs. 50,000
 You gave discounts = Rs. 5,000
 Some refunds/returns = Rs. 2,000
👉 Net Sales = 50,000 − 5,000 − 2,000 = Rs. 43,000

Cost of Sales
Cost of producing goods
This is the direct cost of making the burgers.
Includes:
 Bread, meat, sauces
 Cooking oil
 Packaging
Suppose:
 Total cost of ingredients and preparation = Rs. 20,000
👉 Cost of Sales = Rs. 20,000

Operating Expenses
Other expenses like marketing, salaries
Includes:
 Worker salaries
 Stall rent
 Electricity
 Marketing (flyers, ads)
Suppose:
 Salaries = Rs. 8,000
 Rent = Rs. 5,000
 Electricity = Rs. 2,000
 Marketing = Rs. 1,000
👉 Operating Expenses = Rs. 16,000

Important Concept:
Profit Margin
Percentage of profit from sales
👉 Formula:
Net Income
Profit Margin=
Net Sales

Example:
Profit = 20,000
Sales = 100,000
👉 Profit Margin = 20%
✔ Increasing profit margin = good sign
❌ Decreasing = cost problem

Special Ratio:
P/E Ratio (Price-to-Earnings)
Used for public companies
👉 Shows how much investors pay for earnings
📌 Example:
Stock price = $20
Earnings per share = $2
👉 P/E = 10

2. Balance Sheet
Explanation:
A balance sheet shows the financial position at one point in time.

Structure:
👉 Assets = Liabilities + Owners’ Equity
Assets (What business owns):
Current Assets
Cash, inventory, receivables
Fixed Assets
Buildings, machines
Other Assets
Goodwill, etc.

Liabilities (What business owes):

Current Liabilities
Short-term debts
Long-Term Liabilities
Loans

Owners’ Equity
Owner’s investment + retained earnings (the portion of a company’s profit that is
kept in the business instead of being distributed to owners or shareholders)

Example:
Assets = 500,000
Liabilities = 200,000
Equity = 300,000

Important Concepts:
Working Capital
Current Assets – Current Liabilities
📌 Example:
Assets = 100,000
Liabilities = 60,000
👉 Working Capital = 40,000

Current Ratio
Ability to pay short-term debts
👉 Formula:
Current Assets
Current Ratio=
Current Liabilities

📌 Example:
Assets = 90,000
Liabilities = 30,000
👉 Ratio = 3
✔ Good liquidity (how easily a company can convert its assets into cash to meet
short-term obligations)

Debt Ratio
Shows financial risk
👉 Formula:
Total Debt
Debt Ratio=
Total Assets

📌 Example:
Debt = 200,000
Assets = 500,000
👉 Ratio = 40%
✔ Lower ratio = safer
Important Note:
Balance sheets may not show real value because:
 Assets shown at old cost
 Brand value not included
 Intellectual property may not appear

3. Statement of Cash Flows

Explanation:
Shows:
👉 How cash is coming in and going out

Three Activities:
1. Operating Activities
Daily business operations
📌 Example: Sales, salaries

2. Investing Activities
Buying/selling assets
📌 Example: Buying machines

3. Financing Activities
Loans and investments
📌 Example: Taking a loan
☕ Small Example: A Coffee Shop Business
1. Operating Activities (Daily Work)
These are the regular day-to-day activities of the business.
In your coffee shop:
 You sell coffee and snacks → cash coming in
 You pay salaries to staff → cash going out
 You pay for milk, coffee beans → expenses
👉 Example:
You earn Rs. 30,000 from sales and pay Rs. 10,000 in salaries

2. Investing Activities (Long-term Assets)

These involve buying or selling long-term assets for business growth.
In your coffee shop:
 You buy a new coffee machine
 You upgrade furniture or interior
👉 Example:
You buy an espresso machine for Rs. 50,000

3. Financing Activities (Money Sources)

These are activities where you get or return money from external sources.
In your coffee shop:
 You take a loan from a bank
 You get investment from a friend
 You repay loan installments
👉 Example:
You take a Rs. 100,000 loan from a bank
 Ratio Analysis
Explanation:
Ratios help understand financial data better.
👉 Types:
 Profitability ratios
 Liquidity ratios
 Stability ratios

Profit ratio helps check profitability

The current ratio helps check liquidity

Comparing with Industry Norms

Explanation:
A business should compare its performance with competitors.
👉 Helps identify:
 Strengths
 Weaknesses

Example:
Your growth = 15%
Industry growth = 30%
👉 You are behind competitors

Final Simple Summary

Financial statements help a business:
 Understand past performance
  Plan future growth
 Make smart decisions
👉 The three key statements:
 Income Statement → Profit
 Balance Sheet → Position
 Cash Flow → Cash movement

Forecasts
Explanation:
Forecasts are predictions about the future financial performance of a business.
👉 They estimate:
 Sales
 Expenses
 Profit
 Investment needs

Why Forecasts are Important:

Forecasts help a business:
 Plan ahead
 Avoid surprises
 Make better decisions
👉 They are used to prepare:
 Pro forma financial statements
 Budgets
  Financial plans

Example:
A startup predicts:
 Sales next year = 500,000
 Expenses = 300,000
👉 This helps them plan hiring, production, and investment.

Assumptions Sheet
Explanation:
An assumptions sheet explains:
👉 Where the forecast numbers come from
It includes:
 Expected sales units
 Pricing
 Growth rate
 Cost percentages

Example:
A business assumes:
 Year 1: 500 units sold
 Year 2: 1000 units
 Year 3: 1500 units
👉 Investors check if these numbers are realistic.

Important Point:
If assumptions are unrealistic →
❌ Entire business plan loses credibility

Sales Forecast
Explanation:
A sales forecast predicts how much a business will sell in the future.
👉 It is the first and most important forecast.

Based On:
1. Past sales
2. Current demand
3. Future factors

Example:
A company’s sales:
 2022: 100,000
 2023: 130,000
 2024: 160,000
👉 It may forecast growth of 25% next year.

Example Factors:
A fitness drink company may consider:
 Health trends increasing
 More sports activities
 Opening new branches
 Economic conditions
Important Insight:
 Overestimate → excess stock, waste
 Underestimate → lost customers

Regression Analysis (Advanced Tool)

Explanation:
Regression analysis is a mathematical method to predict future sales using past
data.
👉 It finds relationships between variables.

Example:
Sales depend on:
 Advertising
 Price
 Number of customers
👉 Using regression → more accurate prediction

Forecast of Costs of Sales and Other Items

After sales forecast, businesses estimate expenses.

Percent-of-Sales Method
Explanation:
Each expense is calculated as a percentage of sales.

Example:
Past data:
  Sales = 100,000
 Cost = 50,000 → 50%
Future forecast:
 Sales = 200,000
👉 Expected cost = 100,000

Advantage:
Simple and easy to use

Limitation:
Not all expenses depend on sales

Example:
Salary of manager = fixed
👉 Cannot be calculated using percentage

Constant Ratio Method

Explanation:
All expenses grow at the same rate as sales.

Example:
Sales increase by 20%
👉 Expenses also increase by 20%

Using Common Sense in Forecasting

Businesses must adjust forecasts based on reality.
Example 1:
The company plans cost-cutting
👉 Expenses may grow more slowly than sales

Example 2:
Hiring a manager with a salary of 100,000
👉 Expenses increase suddenly

Break-Even Analysis
Explanation:
The break-even point is where:
👉 Total revenue = Total cost
👉 No profit, no loss

Formula:
Fixed Costs
Break-even point=
Price−Variable Cost

Example:
 Fixed cost = 101,000 (---)
 Price per unit = 2.75
 Variable cost = 1.10
👉 Break-even = 61,212 units

Meaning:
Business must sell 61,212 units to cover all costs

Daily Example:
61,212 units/year ≈ 170 units/day

Decision Making:
 If selling 170 units/day is realistic → start business
 If not → reconsider plan

Ways to Improve:
 Increase price
 Reduce cost
 Improve sales

Final Simple Summary

Forecasting helps a business:
 Predict the future
 Plan finances
 Avoid risks
👉 Key steps:
1. Estimate sales
2. Estimate costs
3. Prepare a financial plan
4. Check feasibility using break-even

What Does “Pro Forma” Mean?

Explanation:
Pro forma means:
👉 “expected or predicted financial statements of the future.”
In simple words:
👉 “What we think will happen in the future financially.”

Example:
A business says:
 Next year sales = 1 million
 Profit = 200,000
👉 This is pro forma, not actual.

Why Entrepreneurs Use It:

 To plan growth
 To convince investors
 To avoid future problems