CAPITAL STRUCTURE

Capital structure of a company refers to the

composition of it’s capitalization and it
includes all long term capital sources viz.
loans, reserves, shares & bonds.
--Gerestenberg
The capital structure of business can be
measured by the ratio of various kinds of
permanent loan & equity capital to total
capital.
__ Schwarty
Capital structure is made of debt & equity
securities which comprise a firm’s financing
of it’s assets.
OBJECTIVES OF SUITABLE CAPITAL
STRUCTURE :
i) Minimize the cost of capital & maximize
the profit.
ii) To have a proper mix of debt & equity, to

attain an ‘Optimal Capital Structure’.

FACTORS AFFECTING
CAPITAL STUCTURE :
Internal Factors:
i) Financial Leverage – It measures the ability of
the firm to make the use of fixed charge bearing
securities in the capital structure. It enables the
firm to deploy debt funds in the capital structure
with an intention to enjoy reduction in the
incidence of tax. Such benefit will result in
improving shareholder’s value provided---
A) Cost of debt is usually lower than the ROI.
B) Interest paid on debt is permissible under
Tax laws.
C) The benefit of tax is passed on to the
equity holders.
ii) Risk :- Debt securities increase the
financial risk, while equity securities do
not carry risk element. However there is
a trade-off between the two in terms of
t returns to the shareholders. Thus there
needs to be a judicial mix between debt
& equity for optimum returns.
iii) Growth & Stability:- A company with
comfortable cash-flow position can raise
debt funds or plough back profits as capital.
A relatively new company with less revenue
must reduce it’s dependence on debt.
iv) Retaining Control:- The attitude of
management towards retaining control over
the company will have direct impact on the
capital structure.
v) Cost of Capital:- The cost of capital refers
to the expectation of suppliers of funds. In
order to earn sufficient profits the firm
should minimise the cost of capital &
maximise the returns.
vi) Flexibility:- Flexibility means the firm’s ability to
adopt it’s capital structure to the changing needs.
Redeemable preference shares & redeemable
debentures increase the flexibility of capital structure.
It can be redeemed at the discretion of company.
.
vii) Purpose of Finance:- Capital structure
depends on the purpose of financing –
expansion, diversification or new venture etc.
ix) Asset Structure:- Funds are required to make
investments in fixed assets, current assets.
Fixed assets could be financed through long
term sources & short term sources may be used
for working capital requirements. Hence asset
structure will influence capital structure.
External Factors : -
1. Size of the company :-
2. Nature of Industry :- Capital intensive industry
(e.g. Iron & steel, power generation) has to
depend upon equity financing & on debt to a
smaller extent. A trading firm may depend upon
debt financing or preference capital.
3. Investors :- Risk perception & expectation of
investors in terms of returns contributes to the
decisions regarding the capital structure.
4. Cost of Floatation :- It refers to the expenses
incurred in the process of issuing securities.
The finance manager has to evaluate the various
expenses like advertising, campaigning, printing

application forms, fees of merchant bankers,

underwriting commission, brokerage etc.
5. Legal Requirements :- SEBI guidelines in
respect of promoter’s contribution, debt-equity
ratio, current ratio, investor protection norms
influence the capital structure. Also monetary &
fiscal policies have a direct bearing on capital
structure.
6. Period of Finance :- Short – term (1-3 years),
Medium – term ( 8 - !0 years), Long – Term
periods will influence capital structure of the firm.
7. Interest Rates :- The general rates of interest
in the economy will have direct impact on
borrowed funds & indirect impact on all other
funds.
8. Level of Business Activity :- In the periods of
heavy demand requirements of funds is more &
leads to the changes in capital structure.
Composition of the same in the recessionary
trends is entirely different.
9. Availability of Funds :- Levels of liquidity in
the capital & money market influences the
capital structure.
10. Taxation Policy :- Corporate tax, taxes on
dividend & capital gains directly influence the
decision of capital structure.
11. General Price Level :- Stable price level of
resources encourages investment of more
long – term funds in the capital structure.
While under fluctuating trends short – term funds
will be preferred more than the long – term funds.
THEORIES OF CAPITAL STRUCTURE
The overall objective of wealth-maximisation is
not only attained by allocating the available
funds in the profitable proposals but also by
selecting the optimal capital structure which
reduces the overall cost of capital. However, this
premise has also been contradicted by thinkers
like Miller, Modigliani-Miller etc. Thus various
theories of capital structure are categorized as
Theories of Relevance & Irrelevance.
Following are some of the important theories
of capital structure.
Net Income Approach or Durand Approach
According to this approach there exists a direct
relationship between the capital structure, cost
of capital & valuation of the firm. The weighted
average cost of capital can be reduced by
increasing the debt component in the capital mix
& thus valuation of the firm can be increased. It
is based on the following assumptions.
• The cost of debt is cheaper than the cost of
equity.
• There are no taxes.
• The use of debt does not change the risk
perception of the investors.
NET OPERATING INCOME APPROACH
This approach is also proposed by Durand
advocating that there is no one optimal structure.
Thus valuation of the firm & it’s cost of capital are not
dependent on the capital structure. Any combination of
debt to equity mix in the capital structure does not affect
the value of the firm. It is just an opposite theory to NI
approach.
Basic assumptions of this theory are:-
• Overall capitalisation rate remain constant regardless of
debt in the capital structure. Market capitalises the value
of the firm.
• Increase in cost of debt financing in capital mix is offset
by increase in returns to equity shareholders.
• The debt capitalisation rate is constant.
• Corporate income-tax does not exist.
• The advantage of debt in capital mix is offset by the
increase in equity capitalisation rate.
TRADITIONAL APPROACH :-
It is the mean between two extreme approaches of Net
Income & Net Operating Income. It believes in the existence
of ‘Optimal Capital Structure’.
Accordingly it believes that upto a certain point additional
introduction of debt capital in the capital structure will
reduce the overall cost of capital & increase the total value
of the firm. Beyond the point, the overall cost of capital will
tend to rise & value of the firm will reduce. Thus by judicious
mix of debt & equity capital, it is possible to maximise the
total value of the firm.
MODIGLIANI-MILLER APPROACH :-
This approach closely operating income approach.
According to this approach, value of the firm & it’s cost of
capital are independent of it’s capital structure. Weighted
average cost of capital remains constant irrespective of
 debt to equity mix in the capital structure. The NOI approach is being
restated & a behavioral justification is on part of investors is added in this
model.
Assumptions:-
i) Corporate tax does not exist.
ii) Investors have the complete information of the capital market. This
implies that investors can borrow and lend funds at the same rate and
can move quickly from one security to another without incurring any
transaction cost.
iii) Securities are infinitely divisible.
iv) Investors are rational and well informed about the risk-return of all
securities.
v) All the investors have same probability distribution about the
expected future earnings.
vi) The personal leverage & the corporate leverage are perfect
substitute.
On the basis of these assumptions, MM model derived that-
A) The total value of the firmis equal to the capitalised value of the
operating earnings. The capitalisation rate is appropriate to the risk-
class of the firm.
B) The total value of the firm is independent of the financing mix.
C) The cut-off rate for the investment decision of the firm depends upon
the risk-class to which the firm belongs and thus is not affected by the
financing pattern of these investment.

The MM model argues that if two firms are alike in all respect except
that they differ in respect of their financing pattern and their market
value, then the investors will develop a tendency to sell the shares
of the over valued firm (creating selling pressure) and buy the
shares of the under-valued firm (creating the demand pressure).
This buying & selling will continue till the two firms have the same
market values.
 CAPITAL BUDGETTING DECISIONS
Capital budgeting decisions are often the most
important decisions of corporate financial
management as they affect the profitability of the
firm.
Any decision that requires the use of resources
is a capital budgetting decision. The relevance &
significance of capital budgetting may be stated
as follows.
A) Long term effects
B) Substantial Commitments
C) Irreversible decisions
D) Affect the capacity & strength to compete.
 IRR vs NPV METHOD
• IRR approach gives a rate which is unique to each
project. NPV approach gives a trade-off between the
cash-inflows & cash-outflows using a general required
rate of return.
• IRR gives % return while NPV gives absolute return.
• For IRR, the availability of required rate of return is not a
pre-requisite while for NPV it is necessary.
• NPV can be used as an indicator of expected increase
in the wealth of the shareholders, while IRR can’t be
used so.
• NPV can be more conclusive in accept-reject decisions.
IRR may give multiple results.
• NPV gives better ranking as compared to the IRR.
• NPV calculations are relatively easier compared to IRR
calculations which are based on Trial & Error method.
RISK & UNCERTAINTY IN CAPITAL BUDGETTING

The types of risks can be classified into different categories

1) Project –Specific Risk :- Risk specific to the project
under consideration & may be due to estimation error.
2) Competition Risk :- Risk due to the strategic-actions of
competitors leading to affect the cash-flows of the
project.
3) Industry-specific Risk :- This risk is specific to industry
& can be analysed in three ways.
a) Technology Risk – Reflecting the effects of
changing technology.
b) Legal Risk - Reflecting the effect of changing laws
& regulation affecting particular industry only.
c) Commodity Risk – Reflecting the effect of price
changes in goods & services used.
4) International Risk :- This risk is a risk associated with
the projects outside the domestic market. It arises due to
variation in the movement of various currencies.
5) Market-Risk :- This risk related changes in the market
factors like changes in interest-rates, inflation,
economic conditions etc.
Following are the important methods of risk analysis in capital
budgetting.
I) Risk adjusted Rate of Return
II) Certainty Equivalent coefficient
III) Probabilistic Method
IV) Sensitivity Analysis
V) Coefficient of Variation method or Std. deviation
VI) Decision Tree Analysis
RISK ADJUSTED RATE OF RETURN :
Risk free return is one at which the business firms
comfortably earn sufficient profits without assuming the
risk. In order to adjust the risk associated with the
business, a premium must be added to the discount rate.
This premium indicates the quantified version of risk of the
business. According to this method, certain % of discount
factor will be added to the risk-free return & such risk-
adjusted ROR will be used to find the PV of actual cash
inflows.
Risk Adjusted ROR = Rf + R
Rf =Risk free return
R = Risk Premium
CERTAINTY EQUIVALENT COEFFICIENT
Under this method, the risk in the project is quantified by
using the certainty equivalent coefficients. The given
cash-flows are reduced by using the certainty equivalent
coefficients. The expected future cash flows which are
risky & uncertain are converted into certainty cash-flows.
These adjusted cash-flows are then discounted at risk-
free discount rate to find out NPV of the proposal. The
certainty equivalent factors may be different for different
years.
PROBABLISTIC METHOD
In capital budgetting decisions outlay of investments are
known with certainty, however cash-flows are unknown &
thus are uncertain. Therefore probability values are used
to reduce the uncertain cash-flows to certain cash-flows.
Later the discount factor will be used to find NPV.
SENSITIVITY ANALYSIS
Cash-flows are very sensitive to business situations. Every
product sales are influenced by many factors like
seasons, prevailing economic situation in the country etc.
Seasonal products have very high cash-flows during a
particular period. Thus overall situation of the business
or economy will be grouped into three different
categories – Optimistic, Most likely & Pessimistic. These
cash-flows are discounted for different projects by using
the discounting factor, through which NPV is calculated.
COEFFICIENT OF VARIATION / STD. DEVIATION
According to this method, the risk in the project is
calculated by using standard deviation or variance. The
stability of cash-flows are measured by coefficient of
variation. Higher the CV or SD, higher is the risk in the
project.
 DECISION – TREE ANALYSIS
A decision-tree is the graphic display of the relationship
between a present decision & a possible future event,
future decisions and their consequences. It indicates
sequence of events, which is mapped out in a form
resembling the branches of a tree. It is possible for a firm
to look systematically at decisions and forecast their
outcomes with the help of a decision tree. A decision tree
approach may be described as a way of displaying the
anatomy of a business investment decision and of
showing the interplay of present decisions, chance events,
competitors’ moves & possible future decisions and their
consequences. A decision tree enables one to explore a
variety of problems.
CAPITAL - RATIONING

Capital Rationing may be defined as a situation where the

firm has limited funds available for fresh investments. Many
profitable and financially viable proposals may be available
but can’t be undertaken in view of limited funds.
Internal Capital Rationing:-
It is a situation where the firm has imposed limit on the funds
allocated for fresh investment though, funds might be
available or could be generated through capital markets.
Internal capital rationing is not in the best interest of the
shareholders in the long run, as it results foregoing the
profitable proposals.
External Capital Rationing :-
It is a situation when the firm is willing to undertake the
financially viable proposals but can’t do so either due to
lack of sufficient funds or depressed capital markets.
External Capital Rationing may occur due to following
reasons.
1. Lack of Credibility
2. High floatation cost
3. Higher marginal cost of capital
The projects subject to capital rationing can be classified as-
• Divisible Projects :- The projects which could be
undertaken completely or partially are divisible projects.
• Indivisible Projects :- Such projects can’t be undertaken
in parts rather they would be subject to investment either
full or not at all.
CAPITAL BUDGETTING UNDER INFLATION
Inflation indicates diminishing purchasing power of the
money. The inflation not only affects the cash flows but
also the discount-rates because of the irreversible
relationship between inflation, interest rates & discount
rates in capital budgetting. Thus finance manager has two
choices in dealing with inflation; first to incorporate the
expected inflation in the estimates of future cash flows &
second to discount the cash flows at a rate that
incorporates the expected inflation.
Discount-Rate/ Cut-off Rate & Inflation :-
Discount rate should take care of the inflation & the pure
required rate of return. Thus –
Nominal Discount Rate = ( 1+ Inflation Rate ) x ( 1+ Real
Rate of Discount ) – 1
PV = Cash Inflow
( 1+Inflation rate)( 1+ Real rate of Discount )
NPV = PV – Cash Outflow
Cash Flows & Inflation:-
Just like the two types of discount rates i.e. Real & Nominal,
there are two types of cash flows,
i) Money cash flows :- These cash flows include the effect
of inflation. They are known as the nominal cash flows.
The money cash flows occur in terms of the purchasing
power of the period in which they occur.
ii) Real Cash flows :- These cash flows which are
expressed in terms of constant prices. They are
expressed in terms of real values.
Real C/F = Money C/F
1+ Inflation Rate
 DIVIDEND DISTRIBUTION THEORIES
Dividend is that portion of earnings after tax which is
distributed among the shareholders.
Formulation of proper dividend policy is one of the major
financial decision to be taken by financial manager as it
may have a critical influence on the value of the firm.
FACTORS INFLUENCING DIVIDEND POLICY
1. Stability Of Earnings
2. Financing Policy of the Company
3. Liquidity position
4. Dividend policy of competitors
5. Past dividend Rates
6. Debt Obligations
7. Ability to borrow
8. Growth needs of the company.
9. Profit Rate
10. Legal Requirements
11. Policy of control
12. Effect of Taxation
13. Cyclical Variations
14. Attitude of the interested group
TYPES OF DIVIDEND
• Cash Dividend :- Here the shareholders receive the
cheques for the amounts out of earnings of the business.
• Scrip Dividend :- When earnings of the company justify
dividend, but the company’s cash position is temporarily
weak, it may declare dividend in the form of scrips. In this
method shareholders are issued
transferable promissory notes which may or may not be
interest bearing.
• Bond Dividend :- It is similar to scrip dividend except in
place of promissory notes bonds are issued.
• Property Dividend :- This involves a payment with assets
other than cash. This form of dividend is paid wherever
there are assets that are no longer necessary in the
operation of the business.
• Stock Dividend :- It is a dividend paid in kind. When
stock dividends are paid, a portion of the surplus is
transferred to the capital account and shareholders are
issued additional shares. Such shares are known as
bonus shares and the process is known as capitalisation
of profit. Stock-dividend does not alter the cash position
of the company.
PAYMENT OF DIVIDEND : Provisions of
Company Act :
• Dividend should be paid to the shareholders of the
company, if so authorised by it’s articles on paid-up value
of shares u/s93.
• The rate of the dividend to be paid will be recommended
by the board of directors and declared in the AGM of the
shareholders. However, shareholders can’t increase the
rate of dividend recommended by BOD.
• The dividend is payable out of the current year’s profit
after providing for necessary depreciation on assets for
the current year or for past years (if not already provided)
as per the provisions of Schedule XIV of the Company Act
1956.
• Before any dividend is paid in cash, the company is
required to transfer a certain minimum amount to reserves
from current year’s profit. The rates at which profits need
to be transferred to reserves for various rates of dividend are-
Dividend more than 10% but less than 12.5% - 2.5% trfr.
>12.5% - 15% --- 5%
>15% -- 20% --- 7.5%
> 20% ---- 10%
• The company can’t declare dividend out of capital
[Sec205(1)]. If the board of directors declare dividend out
of capital, they are personally liable to make good for the
loss to the company.
• Any amount of dividend declared including interim
dividend shall be deposited into a separate bank account
within five days from the date of declaration of such
dividend.
• If the dividend has been declared but has not been paid
or dividend warrents have not been posted within 30days
from the declaration of dividend to any shareholder
entitled to the payment of the dividend, every director of the
company who knowingly a party to the default, shall be
punishable.
• Dividend shall be paid only to the registered members of
the company i.e. to those members whose names are
found in the register of members.(sec206)
• The declared dividend should be paid within 42 days from
the date of declaration ( sec207). In case of default the
defaulting director shall be liable for punishment of seven
days simple imprisonment or a fine Rs.500 per day,
during the period when default continues or both.
• Any unclaimed dividends after 30 days from the
declaration of the same are required to be transferred to
a separate account opened with a scheduled bank. If any
amount remains pending in this account for a period of 7
years, such amount will be transferred by the company to
a fund established by the Central Government as
‘Investor Education & Protection Fund’.
Guidelines Regarding Issue of Bonus Shares

• Articles of Association of the company should permit the

issue of bonus shares. If there is no such provision in the
articles, they need to be amended first.
• The authorised share capital should be sufficient to absorb
the share capital of the company after the issue of bonus
shares. If the authorised share capital is not sufficient, the
same needs to be increased first
• Bonus shares can’t be issued in respect of partly-paid
shares.
• Issue of bonus shares needs to be approved by the BOD &
the company should issue the bonus shares within a period
of six months from the date of approval given by BOD.
• Bonus shares can be issued out of the free reserves
appearing on the balance sheet & the share premium a/c
collected in cash.
• Company can’t issue bonus shares if it has defaulted-
- In respect of payment of interest or repayment of principal
amount, either in case of debentures or in case of public
deposits.
- In respect of payment of employee dues, like provident
fund, gratuity, bonus etc.
- Pending conversion of fully convertible debentures or partly
convertible debentures into shares of the company, no
company can issue bonus shares unless the same benefit
is extended to holders of these FCDs or PCDs by by
reserving a part of shares for them. Such shares can be
actually issued when the conversion into shares takes
place.
- A listed company shall forward a certificate duly signed by
the company & countersigned by it’s statutory auditor or a
company secretary in practice certifying that the company
has complied with all the terms & conditions in respect of
issue of bonus shares.
THEORIES OF DIVIDEND
Relevance Of Dividend Policy :-
In these theories it is argued that dividend policy has an
effect on the market value of shares & the value of the firm.
A firm should pay a dividend to shareholders to fulfill the
expectations of shareholders in order to maintain or increase
the market price of the share.
1. Walter Model :-
This theory is based on following assumptions.
 All investment proposals of the firm are financed
through retained earnings only.
 The cost of capital ( K ), the rate of return ( r ) remain
constant even after fresh investment decisions are taken.
Firm has a long life.
This model considers that the investment decision &
 dividend decision are inter-related. A firm should or should not
pay dividends, depends upon whether it has suitable investment

opportunities to invest the retained earnings. If the firm pays

dividends to shareholders, they in turn, will invest this income
to get further returns. This expected return to shareholders is
the opportunity cost of the firm & hence cost of capital k to
the firm. If the firm doesn’t pay dividends, and retains the
earnings which will be reinvested to get returns. This rate of
return must be atleast equal to cost of capital k.
According to this model, a firm can maximise the market
value of it’s shares by adopting dividend policy as follows.
If r> k, payout zero & retain 100%.
r< k, payout 100% & retain nil.
r = k, dividend is irrelevant & the dividend is not expected
to affect market value of shares.
Walter’s mathematical model is
P = D/k + ( r/ k ) ( E – D )
k
where, P = Market price of equity share
D = Dividend per share paid by firm
k = Cost of equity share capital
r = Rate of return on investment
E = Earnings per share of the firm
2. Gordon Model :-
A model developed by Myron Gordon is also based on the
assumptions similar to that made in Walter’s model. However,
two additional assumptions made by this model are –
i) The growth rate of the firm ‘g’, is the product of it’s retention
ratio ‘b’, & it’s rate of return ‘r’. i.e. g = br.
ii) Cost of capital is more than growth rate i.e. k > g.
Gordon model is based on premise that investors are
basically risk averse & value current dividends more than future
capital gains which are seemingly uncertain. The
mathematical equation is –
P = E( 1- b)
k – br
where, b = Retention ratio ( 1- payout ratio )
Irrelevance of Dividend Theory:-
These theories argue that dividend policy has no effect on the
market price of shares. The shareholders do not differentiate
between the present dividend or future capital gains. They are
basically interested in higher returns either earned by the firm
by reinvesting profits in profitable
options or earned by themselves by making investment of
dividend income.
The irrelevance approach is based on two pre-conditions--
i) Investment & financing decisions have already been made
& these decisions will not be altered by the amount of
dividends payment.
ii) The capital markets are perfect, as such there are no
transaction costs for investors & no floatation costs
for the companies.
Residuals Theory of Dividends:- This theory is based on
following assumptions—
i) External financing is not available to the firm
ii) Even if external financing is available, due to it’s
excessive costs, firm will prefer to retain it’s earnings
for investments in the profitable opportunities.
iii) If the firm doesn’t have such opportunities, the profits
may be distributed among shareholders.
In this approach the firm doesn’t decide as to how
much dividends be paid rather it decides how much
profits be retained. The profits not required to be retained
may be distributed as dividends. Therefore dividend
decision is a passive decision.
The dividends are distribution of residual profits. The firm
would treat the dividend decision in three steps:
i) Determining the level of capital expenditures by taking
into consideration investment opportunities.
ii) Using the optimal financing mix, find out the amount of
equity financing needed to support the capital
expenditure in step i) above.
iii) As the cost of retained earnings ‘k’ is less than the
cost of new equity capital, the retained earnings would
be used to meet the equity portions financing in step ii)
above. If the available profits are more than this need,
then the surplus profits may be distributed as
dividends to shareholders. As far as required if equity
financing is in excess of the amount of profits available
no dividends would be paid to the shareholders.

Modigliani & Miller Approach:- According to this approach

market price of shares is affected by the earnings of the
firm & not by the pattern of income distribution.
Assumptions in M&M approach:-
i) The capital markets are perfect.
ii) All information is freely available to all the investors.
iii) The investors are rational.
iv) Securities are divisible & can be split into any fraction.
v) There are no taxes.
vi) Investment & dividend decisions are independent.
vii) Investment opportunities & future profits of firms are
known with certainty.
The argument in the model is, neither the firm paying
dividends nor the shareholders receiving the dividends
will be adversely affected by the proportion of dividends. It is an
arbitration mechanism that actually works. Given the investment
opportunities, a firm will finance these either by ploughing back
profits or if pays the dividends, then will raise an equal amount of
new share capital externally by selling new shares. The amount of
dividends paid to existing shareholders will be replaced by new
share capital raised externally. The benefit of increase in market
value will be offset completely by the decrease in terminal value of
the share. The shareholders will be indifferent between the
dividend payment or retaining the profits.
Po = 1/ ( 1+ k ) x ( D 1 +P1)

Where, Po = Present market price of the share

k = cost of equity capital
 D1 = Expected dividend at the end of year1
P1 = Expected market price of the share at the
end of year1
__________________________________________
MANAGEMENT OF CASH
Motives Of Holding Cash
i) Transaction Motive
ii) Precautionary Motive
iii) Speculative Motive
Estimating Cash Requirements
• Operating Cash flows :- These cash flows arise as the result
of regular operations of the business. E.g.cash sales,
collection from debtors, Interest/dividend received, payment
to creditors,purchases of raw material, wages
Non-operating cash flows: These are the items of cash flow

which arise as the result of other operations of the business.

E.g. Issue of shares/debentures, Receipt of loans, sale of
fixed assets, redemption of debentures, loan instalment,
purchase of fixed assets, interest, taxes, dividends.
Concept of Float :- Float is a time lag between issue & actual
receipt of the payment. This time gap arises due to
various reasons as—
i) Postal Float – Time required for receiving the cheque
from customer through post office.
ii) Deposit Float --Time required by the company to
process the received cheque & deposit the same into
bank.
iii) Bank Float – Time required by the banker of the
company to collect the payment from the customers’
bank.
PRINCIPLES OF CASH MANAGEMENT

• Accelerate Cash Collections: The customer could be

insisted upon to make payments through DD, LC, Hundies
/ Bills of Exchange to reduce bank float. Cash discounts,
de-centralising the collections, lock-box ( P.O box) help in
accelerating the collections.
• Delay Cash Payments :- Availing more credit period,
centralising disbursements will be helpful in delaying
payments.
• Maintenance of optimum cash balance :-By preparing the
cash-budget the optimum levels of cash requirements
could be worked out. Accordingly company can take the
decision of investment of excess cash on short-term basis
or to meet the short-fall.
• Investment of Excess Cash Balance :- Idle cash involves
opportunity cost. Thus avenues to invest excess cash
balance must be explored. Inter-corporate loans/deposits,

Stock-market options, commercial papers are some of the

avenues.
 WORKING CAPITAL MANAGEMENT
Factors Determining Working Capital Requirement:--
• Basic Nature of Business-Trading, Manufacturing etc.
• Business Cycle Fluctuations- Periods of boom, recession
or recovery
• Seasonal Operations- Cycles of high & low demand
• Market Competitiveness- Highly competitive,
monopolistic etc.
• Credit Policy –Towards suppliers & customers
• Supply Conditions- Lag period in stock replenishment
Gross Working Capital:- Total Current Assets
Net Working Capital:- Total C.A. – Total C.L.
OPERATING CYCLE- It is a time duration starting from
procurement of goods or raw materials & ending with
sales realisation.
Operating Cycle of a firm consists of the time required for the
completion of the sequence of following activities.
1. Procurement of raw materials & services.
2. Conversion of raw materials into W-I-P.
3. Conversion of W-I-P into finished goods.
4. Sale of finished goods ( cash or credit )
5. Conversion of receivables into cash.
Operating Cycle period is the sum of –
• Inventory Conversion Period ( ICP ) – Time required
for conversion of raw materials into finished goods.
• Receivables Conversion Period ( RCP ) – Time
required to convert the credit sales into cash
realisation.
NOC ( Net Operating Cycle ) = TOCP – DP
= ICP + RCP – DP ( Deferral Period )
 OVERTRADING & UNDERTRADING
The concepts of over-trading and under-trading are
intimately connected with the net working capital position
of the business. To be more precise, they are connected
with the cash position of the business.
OVER-TRADING : Over-trading means an attempt to
maintain or expand scale of operations of the business
without sufficient cash resources. The firms involved in
over-trading have a high turnover ratio & a low current
ratio. In such situation, it is not in a position to maintain
proper stocks of materials, finished goods, etc., & has to
depend entirely on the suppliers to supply them at the
right time.
Causes of Over-trading :-
• Depletion Of working capital – Results in depletion of
cash resources. Cash resources may get depleted by
premature repayment of long –term loans, excessive drawings,
dividend payments, purchase of fixed assets & excessive net
trading losses etc.
• Faulty Financial Policy :- Such policy can result in
shortage of cash & over-trading in several ways like—
Using working capital for purchase of fixed assets.
Attempting to expand the volume of business without
raising necessary resources.
• Over-Expansion :- In national emergencies like war,
natural calamities etc. a firm may require to produce goods
on a larger scale. The government may pressurise the
manufacturers to increase the volume of production
without providing for adequate finances.
• Inflation & Rising Prices:- inflationary trend in the economy
puts pressure on the prices of the resources. The
manufacturer needs more cash resources even to
maintain the existing level of activity.
• Excessive Taxation:- Heavy taxes result in depletion of
cash resources at a scale higher than what is justified. The
cash position is further strained on account of efforts to the
company to maintain reasonable dividend rates for their
shareholders.
CONSEQUENCES OF OVER-TRADING
• Difficulty in Paying Wages & Taxes – Leads to insecurity
& dissatisfaction among the labour & affects the reputation
of the company in the business.
• Costly Purchases-
• Reduction in Sales- Company may suffer in terms of
sales because cash needs may compel it to offer liberal
cash discounts to debtors & also resort to distress sale.
• Difficulties in making payments- Will force the company
to persuade creditors to extend credit facilities.
• Obsolete Plant & Machinery-
 SYMPTOMS & REMEDIES FOR OVERTRADING
Symptoms
• Considerable rise in amount of creditors as compared to debtors
• Increased bank borrowings & corresponding inventories
• Purchase of fixed assets from short term funds.
• Low current ratio & high turnover ratio.
• Fall in working capital turnover
Remedies
- Reduce the business or increase finance
- Sell or merge with healthy business entity, preferably under the same
management.
 UNDERTRADING
• It is reverse of Overtrading. It means improper & under-utilisation of
funds lying at the disposal of a firm. In such a situation the level of
trading is low as compared to the capital employed in the business.
It results in increase in the size of inventories, book debts and cash
balances. Basic cause of undertrading is under-utilisation of the
firm’s resources. This may be due to following causes.
• Conservative policies followed by the management.
• Non-availability or shortage of basic facilities necessary for
production such as, raw materials, labour, power etc.
• General depression in the market resulting in fall in the demand.
SYMPTOMS
• High current ratio.
• Low Turnover ratios.
 •Increase in working capital turnover(working capital/sales)

• CONSEQUENCES
• Profits showing declining trend resulting a lower ROI.
• Decline in market value of shares.
• Loss of reputation
• REMEDIES
• Dynamic & result oriented approach
• Diversification and attempt to improve utilisation factor of
the firm’s resources.s
 RBI Guidelines on W.C. finance
• Tandon Committee Recommendations
The recommendations are based on following points.
• Determination of working capital requirements of industry,
which the banks should finance.
• Supervision of credit for ensuring proper end-use of
funds.
• Methodology of sending periodical forecasts by borrowers
relating to: business of the company, production plans
and credit requirements
• Norms for build-up of current assets and for debt to equity
ratio to ensure minimal dependence on bank finance.
• Suggestions for improvement of manner & style of
lending.
The committee submitted it’s report in Aug 1975.This report
has been a major breakthrough in the improvement of bank
credit system. The recommendations relate to:
• Norms for holding inventory and receivables.
• Quantum of permissible bank loans.
• Style of credit.
• Follow-up & supervision of credit.
Norms For Inventory & Receivables :- These norms have been suggested
for 15 major industries. The committee has suggested the level of
current assets which each industrial unit is supposed to hold. Norms
are maximum level of current assets that a unit is to hold. The norms
are expressed as follows -
Raw Materials – so many months of cost of materials consumed
W-I-P – so many months of cost of production
Finished Goods – so many months of cost of sales
Receivables – so many months of cost of sales
Quantum of Permissible Bank Finance :- Three methods have been
suggested for determining the maximum permissible amount of bank
finance. The extent of bank finance will gradually reduce stepwise.
 Method 1:- MPBF = 0.75(CA-CL)
Method 2:- MPBF = 0.75(CA)-CL
Method 3:- MPBF = 0.75(CA-CCA)-CL CCA=Core Current Assets
Tandon Committee suggested that borrowings in excess of what is permissible
under the first method should be converted into a working capital term loan
and repaid over a period of time.
• Chore Committee Recommendations
One recommendation of Tandon Committee Report was to bifurcate cash credit
limits into a demand loan and a fluctuating cash credit component. Chore
committee(1979) made a deep study on this issue. The committee was to:
A) Review the operation of the cash credit system in recent years particularly
with reference to the gap between sanctioned credit limits and the extent of
their utilisation.
B) Suggest –
i) modifications to ensure rational management of funds by commercial
banks.
ii) Alternate type of credit facilities, which would ensure greater discipline and
enable banks to relate credit limits to increase in output or other productive
activities.
Implementation of Recommendations
• A) Working Capital Advances of Rs.10 lakhs and over per
borrower:- For this category, banks should review the accounts of the
borrower to verify the continued viability and also the need based
character of the advance.
• B) Working Capital Advances of Rs.50 lakhs and over per
borrower:- It was proposed that banks should sanction separate
limits for peak level requirements and non-peak level requirements.
The important criteria would be borrowers’ utilisation of bank credit in
the past.
• Withdrawals from accounts are to be regulated through quantity
statements. If the borrower does not submit the statement in time,
bank may charge 1% premium on the total outstanding till the
statement is submitted. In the event of default being persistent in
nature the account of the borrower may be frozen.
• Ad-hoc or temporary advances may be sanctioned for
predetermined period to meet unforeseen contingencies. For all these
advances banks are to charge 1% more than the normal rate except
in cases of natural calamity.
• Discounting bills should be encouraged in place of cash credit against
book debt for financing sales.
• Recent RBI Guidelines :-
Following recent changes have been made by RBI in the guidelines for
bank lending for working capital purposes and by way of term loans.
I) Lending Norms for Working Capital :-
a) Banks would henceforth decide the levels of holding of individual
items of inventory as also of receivables, which should be supported
by bank finance, after taking into account the production/processing
cycle of an industry. RBI would only advise about the overall levels of
inventory and receivables for various industries to serve as a broad
indicators for guidance of banks.
b) Banks would be free to sanction ad hoc credit limits to borrowers,
where considered necessary and charging of additional interest for
this purpose is no longer mandatory.
c) Other aspects like maintenance of minimum current ratio,
submission of quarterly data would continue with simplification of
presentation of information.