Understanding financial concepts

Introduction

To direct a business towards maximum profitability, the businessmen have to make use of all the available financial tools in order to achieve their ultimate objective of the business. The factor of risk is always associated with the business. With the help of a large range of financial & statistical tools, the businessmen are able to take educated risk and can drive their businesses towards yellow bricks road.

Discussion

NPV &Payback concept & their application

As we know that the term NPV is an abbreviation for Net Present Value. It is the difference between the present value of the present cash inflows and the present value of the future cash outflows. NPV is one of the methods of projects or investments analysis, and we commonly use this tool in capital budgeting. The concept of NPV is a practical application of one of the fundamental concepts of Economics and Finance known as the Time Value of Money.

The Payback period is the one of the oldest and most commonly used capital budgeting tool we use for the evaluation of various projects and investment options. The Payback Period concept, acronym being “PP”, calculates the amount of time it takes for a project to recover its initial investment. PP concept postulates that projects with quick PP period should be preferable over the projects having a lengthy PP period.

From a business owner's point of view, both the capital budgeting tools are of outmost significance. A businessman can consider both the tools when he has different projects and investment options available to choose. Let's consider an example. A business owner can purchase a packaging machine for his small factory. He could avail a loan from a bank with an annual interest rate of 10% per annum. Over here, he will calculate the NPV of the project and Payback period. If the PP is short and NPV is greater than the cost of capital i.e. 10%, then this project is feasible according to NPV and PP criterion in this example.

Debt financing - Advantages and disadvantages

When a corporate entity needs funds, it often has two available sources of it. One source is the equity financing, and the other one is debt financing. When a company issues shares in order to generate funds for its operations, working capital, and/or capital budgeting, it is what we call as equity financing. When a company issues notes, bills, mortgages and/or bonds etc. in order to generate funds, it is what we call as debt financing. In order words, it is the borrowing of funds by the business in order to keep the business running. The debt financing has two aspects.

Long term debt financing

Short term debt financing

Long term debt financing is related with the financing needs associated with the larger assets (usually fixed assets) such as plants & machinery and land & building. The repayment of long term financing also spans more than a financial year.

Short term debt financing is related with the financing needs associated with assets (usually current assets) such as inventory ...