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Ans we r :
M e aning o f Fin anc ial M anag e me nt :
The pri mar y task of a C harte re d Ac c o un tant i s to de al w i th
fu nds, ' Man age me nt of Funds ' i s an i mpo rtan t aspe c t of fi na nc i al
ma na ge me nt i n a busi ne ss u nde rtak i n g or an y othe r i nsti tu ti on l i ke
hos pi tal , art soc i e ty, and so on. The te rm 'Fi na nc i al Mana ge me nt ' has
be e n de fi ne d di ffe re ntl y by di ffe re nt au thors.
Ac c o rdi n g to Sol o mon "Fi nanc i al Ma nage me nt i s c onc e rne d
w i th the e ffi ci e nt use of an i mport ant e c ono mi c re sourc e , name l y
c a pi tal fun ds. " Phi l l i pp atus has gi ve n a more el ab orate de fi ni ti on of
the te rm, as , "Fi nanc i al Ma na ge me n t, is c onc e rne d wi th the mana ge ri al
de c i si ons th at re sul ts i n the ac q ui si ti on an d fi na nc i ng of short and
l on g te rm c re di ts for the fi rm. " Thu s, i t de al s w i th the si tuati o ns th at
re qui re se le c ti on of spe c i fi c pro bl e m of si ze a nd grow t h of an
e nte rpri se . The an al ysi s of the se de c i si ons i s base d o n the expe c te d
i nfl ow s an d out fl ow s of fun ds an d the i r effe c t on ma na ge ri al obj e c ti ve s.
The most ac ce p tabl e de fi ni ti on of fi n anc i al ma nage me nt is th at gi ve n
by S. C .Kuc h hal as, "Fi na nc i al mana ge me nt de al s w i th proc ure me nt of
fu nds and thei r e ffe c ti ve uti l i sati on i n the b usi ne ss. " Thus, the re are 2
b asi c aspe c ts of fi na nc i al mana ge me nt :
1 ) p ro cure me nt o f f unds :
As fu nds c an be obtai ne d from di ffe re nt sourc e s th us, the i r
proc ure me nt i s alw ays c onsi de re d as a c ompl ex pro bl e m by b usi ne ss
c onc e rns. The se fu nds proc ure d from di f fere nt so urce s ha ve di ffe re nt
c ha rac te ri sti c s i n te rms of ri sk , c ost and c ontrol tha t a ma nage r mu st
c onsi de r w hi l e proc uri n g fun ds. The fun ds sho ul d be proc ure d at
mi ni mum c ost, at a bal a nc e d ri sk a nd c on trol fac tors.
Funds rai se d by issue of e qui ty share s are the be st from ri sk
poi nt of vi ew for the c om pan y, as i t h as no re pay me nt li a bi li ty exce p t
on wi n di ng u p of the c om pan y, but fro m c ost poi n t of vie w , i t i s most
expe nsi ve , as di vi de nd expe c ta ti ons of sh are hol de rs are hi g he r tha n
pre vai l i ng i nte re st rate s an d di vi de nds are ap prop ri ati on of profi ts an d
no t al l owe d as expe nse un de r the i nc ome tax ac t. The i ssue of ne w
e qui ty share s may di l ute the c ontrol of the exi sti n g share hol de rs.
De be nture s are c om para ti vel y c he ape r si nc e the i nte re st i s
p ai d out of profi ts be fore tax. B ut, the y e ntai l a hi gh de gre e of ri sk
si nc e the y have to be re p ai d as pe r the te rms of a gre e me nt; al so, the
i nte re st pay me nt has to be m ade w he t he r or n ot the c om pany make s
pro fi ts.
Funds c an al so be proc ure d from b ank s a nd fi na nc i al
i nsti t uti ons, t he y provi de fun ds su bje c t to c e rtai n re stri c ti ve c ove na nts.
The se c ove n ants re stri c t free do m of the bo rrowe r to rai se l oans from
ot he r so urc e s. The re form proc e ss i s al so movi n g i n di re c ti o n of a
c l ose r moni tori ng of 'e n d use ' of re sourc e s mobi l i se d thro ugh c api tal
ma rke ts. Suc h re stri c ti on s are e sse n ti al for the safe ty of fun ds provi de d
by i nsti tuti o ns an d i nve stors. The re are othe r fi nanc i al i nstr ume nts
use d for rai si ng fi na nc e e. g. c omme rc i al pape r, de e p di sc ou nt bo nds,
e tc . The fi na nc e mana ge r has to b al anc e the avai l abi l i ty of fu nds a nd
the re stri c ti ve provi si o ns tie d wi th suc h fu nds re sul ti n g i n l ac k of
fl exi bi l i ty.
I n the gl obal i se d c om pe ti ti ve sc e nari o, i t is no t e noug h to
de pe n d on avai l a ble w ays of fi na nc e but re sourc e mobi l i sati on i s to be
u nde rta ke n throu gh i nnovati ve w ays or fi na nc i al prod uc ts th at may
me e t the nee ds of i nve stors. M ul ti pl e o pti on c on ve rti ble bo nds c an be
si g hte d as an exa mpl e , fu nds c an be rai se d i ndi ge no usl y as al so from
a broad. Fore i gn Di re c t I nve stme nt (F DI ) a nd Fore i gn I nsti tu ti onal
I nve stors (FI I ) are tw o maj or sourc e s of fi na nc e from abro ad al on g w i th
A me ri c a n De p osi tory Re ce i pts (ADR 's) an d Gl obal De posi tor y Re c e i pts
(GD R's). The me c ha ni sm of proc uri ng fun ds i s to be modi fi e d i n the
l i ght of re q ui re me nts of forei g n i nve stors. Proc ure me n t of fun ds i nte r
al i a i nc l ude s :
Ans we r :
Ob je ct ive s of fin anci al ma nag e me nt :
Effi c i e nt fi nanc i al m ana ge me nt re qui re s exi ste nc e of some
obj e c ti ve s or goal s be c ause j ud gme nt as to w he the r or not a fi na nc i al
de c i si on i s effi c i e nt i s to be made i n li g ht of so me obj e c ti ve . The tw o
mai n obj e c ti ve s of fi na nc i al man age me nt are :
1 ) Pro f it M ax imis at io n :
I t i s tra di ti on al l y be i n g arg ue d, tha t the obj e c ti ve of a c om pan y i s to
e arn profi t, he nc e t he obj e c ti ve of fi nanc i al ma na ge me n t i s profi t
ma xi mi sati on. Th us, e ac h al te rnati ve , i s to be see n by the fi nanc e
ma na ge r fro m the vie w poi nt of profi t maxi mi sati on. B ut, i t c ann ot be
the onl y o bje c ti ve of a c omp any, i t i s at be st a li mi te d obj e c ti ve el se a
n um be r of probl e ms w oul d ari se . Some of the m are :
a) The te rm profi t i s vague an d doe s not cl ari fy w hat exac tl y i t me ans.
I t c onve ys di ffe re nt me ani n g to di ffe re nt pe opl e .
2 ) We alt h m ax imis at io n :
The c omp ani e s havi n g profi t m axi mi sati o n as i ts obj e c ti ve ,
ma y ado pt pol i c i e s yi e l di ng exor bi tan t profi ts i n t he sho rt run w hi c h are
u nhe al thy for the grow th, survi v al and ove ral l i nte re sts of the b usi ne ss.
A c o mpa ny may not u nde rta ke pl a nne d a nd pre sc ri be d sh ut- dow ns of
the pl a nt for mai nte nanc e , an d so on for m axi mi si ng profi ts i n the shor t
ru n. Thus, the obj e c ti ve of a fi rm sho ul d be to maxi mi se i ts val ue or
w e al th.
Ac c o rdi n g to Van Ho rne , " Val ue of a fi rm i s re pre se nte d by the
ma rke t pri c e of the c o mpa ny's c ommo n stoc k . . .. . . . the marke t pri c e of a
fi rm 's stoc k re pre se n ts the foc al j ud gme nt of al l mar ke t parti c i pa nts as
to w ha t the val ue of the parti c ul ar fi rm i s. I t take s i nto ac c o unt pre se nt
as al so pro spe c ti ve f uture e arni n gs pe r share , t he ti mi n g an d ri sk of
the se e arni ng, t he di vi de nd pol i c y of t he fi rm and many othe r fac tors
ha vi ng a be ari ng on the marke t pri c e of stoc k . The m arke t pri c e se rve s
as a pe rfo rma nc e i n dex or re por t c ard of the fi rm' s progre ss. I t
i ndi c a te s how we ll ma nage me n t i s d oi ng o n be hal f of stoc k hol de rs. "
S hare pri ce s i n the share mar ke t, at a gi ve n poi nt of ti me, are t he
re sul t of a mi xt ure of ma ny fac t ors, as ge ne ral ec ono mi c outl ook ,
p arti c ul ar ou tl ook of the c om pani e s un de r c o nsi de rati on, te c hni c al
fac t ors an d e ve n ma ss psyc hol ogy, b ut, take n o n a l ong te rm basi s,
the y re fle c t the val ue , w hi c h vari ous p arti e s, p ut on the c ompa ny.
N ormal l y thi s val ue i s a fu nc ti on, of :
Ans we r :
Fun ct io ns o f a Fin ance M anag e r :
The tw i n aspe c ts, proc ure me nt and effe c ti ve uti l i sati o n of
fu nds are c ruc i al task s fac e d by a fi nanc e ma na ger. The fi nanc i al
ma na ge r i s re qui re d to l ook i nto the fi nanc i al i m pl i c ati ons of a ny
de c i si on i n the fi rm. Th us al l de c i si ons i nvol ve ma nage me n t of fun ds
u nde r the pur vie w of the fi nanc e ma nage r. A l arge nu mbe r of de c i si ons
i nvol ve sub stan ti al or mate ri al c han ge s i n val ue of f und s proc ure d or
e mpl oye d. The fi na nc e ma na ge r, has to man age fun ds i n suc h a w ay so
as to make the i r opti m um uti l i sati o n and to e nsure t hei r proc ure me nt i n
a w ay th at the ri sk , c ost and c ontrol are pro pe rl y bal anc e d unde r a
gi ve n si tu ati on. He may no t, be c onc e rne d wi t h the de ci si ons, t hat d o
no t affe c t the basi c fi na nc i al man age me nt a nd str uc ture .
The nat ure of j ob of an ac c ou nta nt an d fi na nc e m ana ge r is
di ffe re nt, an ac c o unt ant 's j ob i s pri mari l y to re c ord the busi ne ss
tra nsac ti o ns, pre pare fi nanc i al state me n ts show i ng re sul ts of the
organi s ati on for a gi ve n pe ri o d an d i ts fi nanc i al c on di ti on at a gi ve n
poi nt of ti me . He i s to re c ord vari ous hap pe ni ngs i n mone tary te rms to
e nsure tha t asse ts, li abi l i ti e s, i nc ome s an d expe nse s are pro pe rl y
gro upe d, c l assi fi e d an d di sc l ose d i n the fi nanc i al sta te me n ts.
Ac c oun tan t i s n ot c onc e rne d wi th mana ge me nt of fu nds that is a
spe c i al i se d task an d i n mode rn ti me s a c ompl ex one . The fi n anc e
ma na ge r or c o ntrol le r has a task e nti re l y di ffe re n t from th at of an
ac c o unt ant, he i s to mana ge fun ds. Some of the i mpo rtan t de c i si ons as
re gards fi na nc e are as fol l ow s :
2 ) De cis io n re g ard ing cap it a l s t ruct ure : O nce the re qui re me nts of
fu nds is e sti mate d, a de c i si on re gardi ng vari ous sourc e s from w he re
the fu nds woul d be rai se d is to be take n. A prope r mi x of the vari ous
sourc e s i s to be w orke d out, e ac h sourc e of fun ds i nvol ve s di ffe re nt
i ssue s for c onsi de rati on. The fi nanc e ma nage r has to c are f ul l y l ook i nto
the exi sti ng c api tal struc ture and se e how the vari ous pro posal s of
rai si n g fun ds w il l affe c t i t. He i s to mai nt ai n a pro pe r b al anc e be twe e n
l on g an d short te rm fun ds an d to e nsure that suffi c i e nt l ong- te rm fu nds
are rai se d i n orde r to fi na nc e fi xe d asse ts an d othe r l ong -te rm
i nve stme n ts an d to provi de for pe rmane nt nee ds of work i n g c api tal . I n
the ove ral l vol ume of l ong- te rm fu nds, he i s to mai ntai n a prope r
b al anc e be twe e n ow n an d l oan fu nds and to se e t hat t he ove ral l
c a pi tal i sati on of the c o mpa ny i s suc h, th at the c om pany is abl e to
proc ure f und s at mi ni m um c ost and is abl e to tol e rate shoc k s of l e an
pe ri ods. Al l the se de ci si ons are k now n as ' fi nanc i ng de c i si ons '.
BOARD OF DIRECTORS
P RESI DEN T
i ) I nte re st rate s have bee n fre e d from re gul ati o n, tre as ury ope rati o ns
th us, have to be more sophi sti c a te d due to fl uc t uati n g i nte re st rate s.
Mi ni m um c ost of c api tal ne c e ssi tate s anti c i pa ti ng i nte re st rate
mo ve me n ts.
v) Mai n tai ni n g share pri c e s is c ruc i al . I n the l i be ral i se d sce nari o the
c a pi tal marke ts i s the i mpor tan t ave nue of fun ds for b usi ne ss. Di vi de n d
an d bo nus pol i ci e s frame d b y fi nanc e ma nage rs h ave a di re c t be ari n g
on the share p ri ce s.
1 ) Ris k :
The re i s unc e rtai nty a bout the re ce i pt of mone y i n fut ure .
3 ) Inve s t me nt op po rt un it ies :
Mos t of the pe rsons a nd c om pa nie s have pre fe re nc e for pre se nt mone y
be c au se of av ai l abi l i tie s of op port uni ti e s of i nve st me nt for e arni n g
a ddi ti on al c ash fl ow s.
FV = PV (1 + r)n
FVAn = Fu t u r e v a l u e o f a n a n n u i t y w h i c h h a s d u r a t i o n o f n y e a r s .
Thus, future value of an annuity is dependent on 3 variables, they being, the annual amount, rate of interest
a n d t h e t i m e p e r i o d , i f a n y o f t h e s e v a r i a b l e c h a n g e s i t w i l l c h a n g e t h e f u t u r e v a l u e o f t h e a n n u i t y. A
published table is available for various combination of the rate of interest 'r' and the time period 'n'.
PV = FVn ( 1 )n
1 + r
Where,
FVn = F u t u r e value n years hence
Fr o m a b o v e , i t i s c l e a r t h a t p r e s e n t v a l u e o f a f u t u r e m o n e y d e p e n d s u p o n 3 v a r i a b l e s i . e . F V , t h e r a t e o f
interest and time period. The published tables for various combinations of ( 1 )n
1 + r
are available.
PVAn = A/(1 + r)1 + A/(1 + r)2 + ................ + A/(1 + r)n-1 + A/(1 + r)n
= A [ (1 + r)n - 1]
r(1 + r)n
Where,
PVAn = Present value of annuity which has duration of n years
A = Constant periodic flow
r = Discount rate.
CH A PTER TH RE E
Cl ass if ic at io n of Rat io s :
Ans we r :
1 ) L iq uid it y rat io s :
'L i qui di ty' and 'shor t-te rm sol ve nc y ' are use d as synon yms,
me ani ng a bi li ty of the b usi ne ss to pa y i ts short- te rm l i abi l i tie s.
I nabi l i ty to pay- off short te rm li a bi li ti e s affe c ts the c onc e rn 's c re di bi li ty
an d c re di t rati n g; c onti nu ous de fa ul t i n pay me nts l e ads to c om me rci al
b ank ru ptc y that e ve ntual l y l e ads to si c k ne ss an d di ssol uti o n. Shor t-
te rm le nde rs an d c re di t ors of a b usi ne ss are i nte re ste d i n k now i n g the
c onc e rn's st ate of li q ui di ty for t hei r fi na nc i al stake . Tradi ti o nal l y
c u rre n t an d qui c k rati os are use d to hi g hl i gh t the busi ne ss 'l i q ui di ty ',
ot he rs may be c ash rati o, i nte rval me asure rati o a nd ne t w ork i ng
c a pi tal rati o.
i) Cu rre nt r at io :
W he re,
C urre nt asse ts = I nve ntori e s + S un dry de bt ors + C as h and B ank
b al anc e s + Re ce i vabl e s/ Ac c r ual s +
Loans and adva nc e s + Di sposa bl e I nve stme nts.
C urre nt li abi l i ti e s = C re di to rs for goo ds an d se rvi ce s + Short -te rm
Loa ns + B ank O ve rdra ft + C ash
c re di t + O utst an di ng expe nse s + Provi si on for
tax ati on + Pro pose d di vi de n d +
Unc l ai me d di vi de nd.
ii) Quick r at io :
W he re,
Q ui c k asse ts = S un dry de bt ors + C ash an d B ank bal anc e s +
Re ce i vabl e s/ Ac c r ual s +
Loans and adva nc e s + Di sposa bl e I nve stme nts i. e.
= C urre nt asse ts - I nve n tori e s.
C urre nt li abi l i ti e s = C re di to rs for goo ds an d se rvi ce s + Short -te rm
Loa ns + B ank O ve rdra ft + C ash
c re di t + O utst an di ng expe nse s + Provi si on for
tax ati on + Pro pose d di vi de n d +
Unc l ai me d di vi de nd.
Q ui c k li a bi li ti e s = C re di t ors for go ods a nd se rvi ce s + Shor t-te rm Loa ns
+ O utsta ndi n g expe nse s
ii i) Cas h r at io :
The c ash rati o me asure s absol u te l i qui di ty of the busi ne ss avai l abl e
w i th the c onc e rn.
W he re,
Ave rage dai l y ope rati n g expe nse s = (C ost of g oods + Se l li n g,
a dmi ni str ati ve a nd ge ne ral expe nse s -
De pre c i ati o n and othe r non- c ash
expe n di ture )/ no. of day s i n a ye ar.
I t i ndi c ate s prop orti on of ow ne rs ' fun d to tot al fun d i nve ste d
i n b usi ne ss. Tradi ti o nal be li e f says, hi ghe r the pro porti o n of ow ne r's
fu nd low e r is the de gree of ri sk .
b ) De b t Eq uit y Rat io :
a) De b t s e rvice co ve r ag e r at io :
Le nde rs are i nte re ste d i n j udgi n g the fi rm 's abi l i ty to p ay off
c u rre n t i nte re st an d i nstal me nts an d th us the de bt se rvi ce c ove rage
rati o.
W he re,
Ea rni n g avai l abl e for de bt se rvi c e = Ne t profi t + N on- c ash ope rati ng
expe nse s l i ke de pre c i ati on
an d othe r amo rti sati on s + N on-
ope ra ti ng a dj ust me nts as l oss on
sal e of fi xe d asse ts + I nte re st on
de b t fun d.
W he re,
EB I T = Earni ngs Be fore I nte re st an d Ta x
EBI T i s use d i n the nu me rator as the abi l i ty to p ay i nte re st is
no t affe c te d by ta x bu rde n as i nte re st on de bt fun ds i s a de d uc ti bl e
expe nse . Thi s rati o i ndi c ate s the exte nt to w hi c h earni ngs may fal l
w i tho ut c ausi n g an y di ffi c ul t to t he fi rm re ga rdi n g the pa yme nt of
i nte re st c harge s. A hi gh i nte re st c ove rage rati o me ans th at an
e nte rpri se c an e asil y me e t i ts i ntere st obl i ga ti ons e ve n i f EB I T su ffe r a
c onsi de rabl e de cl i ne , w hi l e a l ow e r rati o i ndi c ate s exc e ssi ve use of
de b t or i ne ffi c i e nt ope rati o ns.
b ) Pro p rie t a ry r at io :
Pro pri e tary rati o = Pro pri e tary fu nd/ Total asse ts
W he re,
Pro pri e tary fu nd = Eq ui ty share c api tal + Pre fe re nc e share c api tal +
Re se rve s & surpl u s - Fi ci ti ti ou s
asse ts
Tot al asse ts = Al l asse ts, b ut exc l u de s fi c ti ti o us asse ts an d l osse s.
I t is possi ble to re duc e e qui ty sta ke b y l owe ri ng li qui di ty rati o
i .e c urre nt rati o,
Ex amp le : W he n c u rre nt an d de bt- e qui ty rati os are bot h 2 : 1 e ac h,
an d the pro porti o n of fi xe d and c urre nt asse ts i s
5 : 1 E qui ty/ tot al asse ts = 3 1. 67 % but i f t he c u rre n t rati o i s re d uc e d to
1 .5 : 1 e qui ty/ total asse ts = 31 .1 1 %.
I t i s fu rthe r di vi de d as bel ow :
a) Inve nt o ry t urno ve r rat io :
W he re,
Ave rage i nve n tory = (O pe ni ng S toc k + C l osi ng stoc k )/2
I t may al so be c al c ul ate d wi th re fere nc e to c ost of sal e s i nste ad of
sal e s, as :
I nve ntory turnove r rati o = Raw mate ri al c onsu me d/ Ave rage raw
ma te ri al stoc k .
b ) De b to rs t urno ve r r at io :
W he n a fi rm se l l s g oods on c re di t, the re ali sati o n of sal e s
re ve n ue i s de l aye d an d re c e i vabl e are c re ate d. C ash is re ali se d from
the se re c ei va bl e s l ate r on, the spe e d wi t h w hi c h i t is re ali se d affe c ts
the fi rm 's l i qui di t y posi ti on. De btors turnove r rati o throw s l i gh t on the
c ol le c ti o n and c re di t p ol i ci e s of the fi rm.
Ave rage c oll e c ti on pe ri od = Ave rage ac c o unts re ce i va ble s/ ave rage dai l y
c re di t sal e s
W he re,
ave ra ge d ai l y c re di t sal e s = C re di t sale s/3 6 5
The above rati os provi de a uni q ue g ui de for de te rmi ni n g the
fi rm 's c re di t pol i c y.
c) C red it o rs t urno ve r r at io :
I t is c al c ul ate d on same li ne as de bt ors turnove r rati o an d
show s the ve l oc i ty of de bt payme n t by the fi rm,
Ave rage payme n t pe ri od = Ave rage ac c ou nts p ayabl e / ave rage dai l y
c re di t p urc ha se s
W he re,
ave ra ge d ai l y c re di t p urc hase s = cre di t p urc hase s/ 36 5
The fi rm c an c ompare w hat cre di t pe ri od i t re ce i ve s fro m the
su ppl i e rs and w hat i t offe rs to the c usto me rs. I t c an al so c om pare the
ave ra ge c re di t pe ri od offe re d to the c usto me rs i n the i ndust ry to w hi c h
i t be l ongs.
4 ) Pro f it ab il it y rat io :
The profi ta bi l i ty rati os me asure profi ta bi l i ty or the ope rati on al
e ffi c ie nc y of the fi rm re fl e c ti ng t he fi nal re sul ts of b usi ne ss ope rati ons.
The re sul ts of the fi rm ma y be eval ua te d i n te rms of i ts e arni n gs w i th
re fe re nc e to a gi ve n le vel of asse ts or sal e s or ow ne rs i nte re st, etc .
Th us, the profi ta bi li ty rati os are bro adl y c l assi fi e d i n fol l owi n g
c ate go rie s :
i) Pro f it ab il it y rat io s are re q uire d f o r a nalys is f ro m o wne rs p o int
o f vie w :
a) Re t urn o n e q uit y (ROE) : I t me asure s the profi ta bi li ty of e qui ty
fu nds i nve ste d i n t he fi rm and re ve al s how profi ta bl y the ow ne r's fu nds
are uti l i se d b y the busi ne ss.
EPS = N e t pro fi t avai l abl e to e qui ty hol de rs/ n o. of ordi nary sh are s
ou tsta ndi n g
W he re,
Re turn = N e t profi t + / - N on-tra di ng adj ust me nts exc l u di ng ac c r ual
a dj ustme n ts for amo rti sati on of
pre li mi nary expe nse s, goo dw il l , etc . + I nte re st on l ong te rm
de b ts + Provi si on for tax -
I nte re st/ Di vi de nd fro m non- tra de i nve stme n ts.
C api t al e mpl oye d = E qui ty sh are c a pi tal + Re se rve s & Sur pl us +
Pre fe re nc e share c api tal + De be n ture s
an d othe r l ong te rm l oan - Mi sc el l ane ou s
expe n di ture and l osse s - N on-tra de
i nve stme nts.
c) Re t urn o n as se t s (ROA) :
The profi t abi l i ty rati o i s me asure d i n te rms of re l ati onshi p be twe e n ne t
pro fi ts an d asse ts e mpl oye d to e arn t hat pro fi t. It me asure s the fi rm 's
pro fi tabi l i ty i n te rms of asse ts empl o ye d i n the fi rm.
v) Selling &
Distribution
expenses/Sales
* 100
a) Gro ss p rof it r at io :
I t i s use d to c omp are de p artme nt al or prod uc t profi t abi l i ty. If c osts are
c l assi fi e d sui ta bl y i nto fi xe d an d vari abl e el e me n ts, the n i nste ad of
gros s profi t rati o one m ay fi nd P/ V rati o.
Fixe d c ost re mai ni n g same , hi ghe r the P/ V rati o low e r is the bre ak e ve n
poi nt (B. E. P. ) O pe rati ng pro fi t rati o i s c al c ul ate d to e val uate ope rati ng
pe rfo rma nc e of b usi ne ss.
W he re,
O pe rati n g profi t = Sal e s - C ost of sale s
• Int e r- f irm co mp aris o n : Rati o anal ysi s not onl y throw s l i ght on
the fi rm 's fi na nc i al posi ti on but al so se rve s as a ste ppi n g stone
to re me di al me asure s. I t i s made possi ble by i nte r-fi rm
c om pari so n/ c omp ari son w i th i nd ustry ave rage . It sho ul d be
re asona bl y expe c te d tha t the fi rm' s pe rform anc e i s i n bro ad
c on formi t y wi t h that of the i ndus try to w hi c h i t be l ong s. An i nte r-
fi rm c omp ari son de mo nstra te s the re l ati ve po si ti on vi s-à-vi s i ts
c om pe ti tors. I f t he re sul ts are at vari anc e ei the r w i th the i nd ustry
ave ra ge or w i th th at of the c om pe ti tors, the fi rm c an se e k to
i de nti fy the prob abl e re asons and i n i ts l i gh t, take re me di al
me asure s. Rati os not onl y pe rfo rm po st-mo rte m of ope rati o ns,
b ut al so se rve s as b arome te r for fut ure, the y ha ve pre di c tor y
val ue an d are he l pf ul i n fore c asti ng a nd pl a nni n g fut ure b usi ne ss
ac ti vi ti e s and hel ps i n bu dge ti ng.
I t i ndi c ate s the pay bac k pe ri od to i nve stors or pros pe c ti ve i nve stors.
ii) Yie ld :
of e qui ty sh are s
i i i ) di vi de n d %
vi i i ) PE rati o = p ri ce /e a rni n gs
1 ) c as h ge ne rat i ng e ff ic ie ncy :
i t i s t he a bi li ty of a c ompa ny to ge ne rate c ash from i ts
c u rre n t or c onti n ui ng ope rati ons. Fol l ow i ng rati os are use d for t he
p urpo se.
i) c as h flo w yie ld :
c as h fl ow yi e l d = ne t c ash fl ow from ope rati n g ac ti vi ti e s/ ne t i nc ome
ii i) cas h f lo ws t o ass e ts :
c as h fl ow to asse ts = ne t c ash fl ow from o pe rati ng ac ti vi tie s/ ave rage
tot al asse ts
2 ) Fre e cas h f lo w :
stri c tl y c ash fl ow i s the amou nt of c as h tha t re mai ns afte r
de d uc ti n g fun ds th at the c om pany has to c om mi t to c on ti nue ope rati n g
at i ts pl a nne d l e ve l . Suc h c ommi t me nt has to c ove r c u rre nt or
c on ti nui n g ope rati o ns, i nte re st, i nc ome tax, di vi de n d, ne t c api tal
expe n di ture s and so on. If the c ash fl ow i s posi ti ve , i t me ans the
c om pa ny has me t al l i ts pl an ne d c ommi t me nt an d has c ash avai l abl e to
re duc e de bt or exp and. A ne gati ve fre e c ash fl ow me ans the c om pany
w i ll have to se ll i nve stme nts, b orrow mo ne y or i ssue stoc k i n shor t-
te rm to c onti n ue at i ts pl a nne d le ve l .
3 ) o t he rs :
be si de s me asuri n g c ash e ffi c ie nc y and fre e c as h fl ow, w i th
the he l p of c ash fl ow sta te me nt, the fi nanc i al an al ysts al so c al c ul ate s a
n um be r of ra ti os base d on c ash fi g ure s rat he r than on e arni n g fi gure s.
So me of w hi c h are as be l ow:
i i i ) se lf-fi na nc i n g i nve stme nt rati o = i nte rnal f undi ng/ ne t i nve stme nt
ac ti vi ti e s
i t i ndi c ate s how m uc h of t he fu nds ge ne rate d by t he b usi ne ss are re -
i nve ste d i n asse ts.
CAPITAL BUDGETING
1) substantial expenditure :
capital budgeting decision involves the investment of
substantial amount of funds and is thus it is necessary for a
firm to make such decision after a thoughtful consideration,
so as to result in profitable use of scarce resources. Hasty
and incorrect decisions would not only result in huge losses
but would also account for failure of the firm.
3) irreversibility :
most of such decisions are irreversible, once taken, the firm
may not been in a position to reverse its impact. This may be
due to the reason, that it is difficult to find a buyer for
second-hand capital items.
4) complex decision :
capital investment decision involves an assessment of future
events, which in fact are difficult to predict, further, it is
difficult to estimate in quantitative terms all benefits or
costs relating to a particular investment decision.
1) payback period :
it is one of the simplest method to calculate period
within which entire cost of project would be completely
recovered. It is the period within which total cash inflows
from project would be equal to total cash outflow of project,
cash inflow means profit after tax but before depreciation.
merits :
2) payback reciprocal :
it is reciprocal of the payback period. A major
drawback of the payback period method of capital budgeting
is that it does not indicate any cut off period for the purpose
of investment decision. It is, argued that reciprocal of
payback would be a close approximation of the internal rate
of return if the life of the project is at least twice the
payback period and project generates equal amount of final
cash inflows. In practice, payback reciprocal is a helpful tool
for quickly estimating rate of return of a project provided its
life is at least twice the payback period.
Merits :
It is a simple and popular method as it is easy to
understand and includes income from the project throughout
its life.
Limitations :
it is based upon crude average profits of the future
years. It ignores the effect of fluctuations in profits from year
to year. And thus ignores time value of money which is very
important in capital budgeting decisions.
= Σ(t=0 to n) CF t /(1+K) t
Where,
NPV = Net present value of a project
CF 0 = Cash outflows at the time 0(zero).
CF t = Cash flows at the end of year t(t = 0 to n) i.e. the
difference between cash inflow and outflow).
K = Discount rate
n = Life of the project
Merits :
Limitations :
Merits :
Where,
PV C FAT = Present value of cash inflows (DF r * annuity)
PV C 0 = Present value of cash outlay
r = Either of 2 interest rates used in theformula
r = Difference ininterest rates
PV = Difference in present values ofinflows
Acceptance Rule :
The use of IRR, as a criterion to accept capital
investmentdecision involves a comparison of IRR with
required rate of return called as Cutoff rate. The project
should the accepted if IRR is greater than cut off rate.If IRR
is equal to cut off rate the firm is indifferent. If IRR less than
cutoff rate, the project is rejected.
Merits :
Demerits :
Answer :
Risk :The term risk with reference to investment decision
isdefined as the variability in actual return emanating from a
project in futureover its working life in relation to the
estimated return as forecasted at thetime of initial capital
budgeting decisions. Risk is differentiated withuncertainty
and is defined as a situation where the facts and figures are
notavailable or probabilities cannot be assigned.
CHAPTER FIVE
LEVERAGE
1) Operating Leverage :
It is defined as the "firm's ability to use fixed operating costs
to magnify effects of changes in sales on its EBIT ". When
there is an increase or decrease in sales level the EBIT also
changes. The effect of changes in sales on the level EBIT is
measured by operating leverage.
2) Financial Leverage :
It is defined as the ability of a firm to use fixed financial
charges to magnify the effects of changes in EBIT/Operating
profits, on the firm's earnings per share. The financial
leverage occurs when a firm's capital structure contains
obligation of fixed charges e.g. interest on debentures,
dividend on preference shares, etc. along with owner's equity
to enhance earnings of equity shareholders. The fixed
financial charges do not vary with the operating profits or
EBIT. They are fixed and are to be repaid irrespective of
level of operating profits or EBIT. The ordinary shareholders
of a firm are entitled to residual income i.e. earnings after
fixed financial charges. Thus, the effect of changes in
operating profit or EBIT on the level of EPS is measured by
financial leverage.
3) Combined leverage :
Operating leverage explains operating risk and financial
leverage explains the financial risk of a firm. However, a firm
has to look into overall risk or total risk of the firm i.e.
operating risk as also financial risk. Hence, the combined
leverage is the result of a combination of operating and
financial leverage. The combined leverage measures the
effect of a % change in sales on % change in EPS.
CHAPTER SIX
1) Risk :
Risks are of 2 kinds viz. financial and business risk.
Financial risk is of 2 kinds as below :
2) Cost of capital :
Cost is an important consideration in capital
structure decisions and it is obvious that a business should
be atleast capable of earning enough revenue to meet its
cost of capital and also finance its growth. Thus, along with
risk, the finance manager has to consider the cost of capital
factor for determination of the capital structure.
3) Control :
Along with cost and risk factors, the control aspect
is also an important factor for capital structure planning.
When a company issues equity shares, it automatically
dilutes the controlling interest of present owners. In the
same manner, preference shareholders can have voting
rights and thereby affect the composition of Board of
directors, if dividends are not paid on such shares for 2
consecutive years. Financial institutions normally stipulate
that they shall have one or more directors on the board.
Thus, when management agrees to raise loans from financial
institutions, by implication it agrees to forego a part of its
control over the company. It is thus, obvious that decisions
concerning capital structure are taken after keeping the
control factor in view.
4) Trading on equity :
A company may raise funds by issue of shares or
by borrowings, carrying a fixed rate of interest that is
payable irrespective of the fact whether or not there is a
profit. Preference shareholders are also entitled to a fixed
rate of dividend, but dividend payment is subject to the
company's profitability. In case of ROI the total capital
employed i.e. shareholders' funds plus long term borrowings,
is more than the rate of interest on borrowed funds or rate of
dividend on preference shares, the company is said to trade
on equity. It is the finance manager's main objective to see
that the return and overall wealth of the company both are
maximised, and it is to be kept in view while deciding on the
sources of finance. Thus, the effect of each proposed method
of new finance on EPS is to be carefully analysed. This, thus,
helps in deciding whether funds should be raised by internal
equity or by borrowings.
5) Corporate taxation :
Under the Income tax laws, dividend on shares is
not deductible while interest paid on borrowed capital is
allowed as deduction. Cost of raising finance through
borrowings is deductible in the year in which it is incurred. If
it is incurred during the pre-commencement period, it is to
be capitalised. Cost of share issue is allowed as deduction.
Owing to such provisions, corporate taxation, plays an
important role in determination of the choice between
different sources of financing.
6) Government Policies :
Government policies is a major factor in
determining capital structure. For instance, a change in the
lending policies of financial institutions would mean a
complete change in the financial pattern followed by
companies. Also, rules and regulations framed by SEBI
considerably affect the capital issue policy of various
companies. Monetary and fiscal policies of government also
affect the capital structure decisions.
7) Legal requirements :
The finance manager has to keep in view the legal
requirements at the time of deciding as regards the capital
structure of the company.
8) Marketability :
To obtain a balanced capital structure, it is
necessary to consider the company's ability to market
corporate securities.
9) Maneuverability :
Maneuverability is required to have as many
alternatives as possible at the time of expanding or
contracting the requirement of funds. It enables use of
proper type of funds available at a given time and also
enhances the bargaining power when dealing with the
prospective suppliers of funds.
10) Flexibility :
It refers to the capacity of the business and its
management to adjust to expected and unexpected changes
in circumstances. In other words, the management would like
to have a capital structure providing maximum freedom to
changes at all times.
11) Timing :
Closely related to flexibility is the timing for issue of
securities. Proper timing of a security issue often brings
substantial savings due to the dynamic nature of the capital
market. Intelligent management tries to anticipate the
climate in capital market with a view to minimise cost of
raising funds and the dilution resulting from an issue of new
ordinary shares.
2) The total assets of the firm are given and the degree of
leverage can be altered by selling debt to repurchase shares
or selling shares to retire debt.
iii) The use of debt content does not change the risk
perception of investors as a result of both the K d (Debt
capitalisation rate) and K e (equity capitalisation rate)
remains constant.
V = S + D
Where,
V = Value of the firm
S = Market value of equity
D = Market value of debt
S = NI/K e
Where,
S = Market value of equity
NI = Earnings available for equity shareholders
K e = Equity Capitalisation rate
Under, NI approach, the value of a firm will be maximum at a
point where weighted average cost of capital is minimum.
Thus, the theory suggests total or maximum possible debt
financing for minimising cost of capital.
Overall cost of capital = EBIT/Value of the firm
Where,
S = Value of equity
D = Market value of debt
V = Market value of firm
Cost of equity = EBIT/(V - D)
Where,
V = Market value of the firm
EBIT = Earnings before interest and tax
D = Market value of debt
iii) The use of less costly debt funds increases the risk of
shareholders. This causes the equity capialisation rate to
increase. Thus, the advantage of debt is set off exactly by
increase in equity capitalisation rate.
3) Traditional Approach :
The traditional approach, also called an
intermediate approach as it takes a midway between NI
approach, that the value of the firm can be increased by
increasing financial leverage and NOI approach, that the
value of the firm is constant irrespective of the degree of
financial leverage. According to this approach the firm should
strive to reach the optimal capital structure and its total
valuation through a judicious use of debt and equity in
capital structure. At the optimal capital structure, the overall
cost of capital will be minimum and the value of the firm is
maximum. It further states, that the value of the firm
increases with financial leverage upto a certain point.
Beyond this, the increase in financial leverage will increase
cost of equity, the overall cost of capital may still reduce.
However, if financial leverage increases beyond an
acceptable limit, the risk of debt investor may also increase,
consequently cost of debt also starts increasing. The
increasing cost of equity owing to increased financial risk
and increasing cost of debt makes the overall cost of capital
to increase. Thus, as per the traditional approach the cost of
capital is a function of financial leverage and the value of
firm can be affected by the judicious mix of debt and equity
in capital structure. The increase of financial leverage upto a
point favourably affect the value of the firm. At this point,
the capital structure is optimal & the overall cost of capital
will be the least.
i) The total market value of a firm and its cost of capital are
independent of its capital structure. The total market value
of the firm is given by capitalising the expected stream of
operating earnings at a discount rate considered appropriate
for its risk class.
Assumptions :
Criticism :
These propositions have been criticised by numerous
authorities. Mostly criticism is as regards, perfect market and
arbitrage assumption. MM hypothesis argue that through
personnel arbitrage investors would quickly eliminate any
inequalities between the value of leveraged firms and that of
unleveraged firms in the same risk class. The basic argument
here, is that individual arbitrageurs, through the use of
personal leverage can alter corporate leverage, which is not
a valid argument in the practical world, as it is extremely
doubtful that personal investors would substitute personal
leverage for corporate leverage, as they do not have the
same risk characteristics. The MM approach assumes
availability of free and upto date information, this also is not
normally valid.
V u = [EBIT ( 1 - t )]/K 0
V l = V u + Debt (t)
1) Cost of debt :
The explicit cost of debt is the interest rate as per contract
adjusted for tax and the cost of raising debt.
- Cost of irredeemable debentures :
Cost of debentures not redeemable during the life
time of the company,
K d = (I/NP) * (I - T)
Where,
K d = Cost of debt after tax
I = Annual interest rate
NP = Net proceeds of debentures
T = Tax rate
Where,
I = Annual interest payment
NP = Net proceeds of debentures
RV = Redemption value of debentures
t = tax rate
N = Life of debentures
Where,
PD = Annual preference dividend
PO = Net proceeds of an issue of preference shares
K p = PD + [(RV - NP)]/N
[(RV + NP)/2]
Where,
PD = Annual preference dividend
NP = Net proceeds of debentures
RV = Redemption value of debentures
N = Life of debentures
K e = [D 1 /P 0 ] + g
Where,
K e = Cost of capital
D 1 = Dividend for the period 1
P 0 = Price for the period 0
g = Growth rate
D/P + g approach seems to answer the problem of
expectations of investor satisfactorily, however, it poses one
problem that is how to quantify expectation of investor
relating to dividend and growth in dividend.
K 0 = K 1 W 1 + K 2 W 2 +.............
Where,
K 1 , K 2 are component costs and W 1 , W 2 are weights.
[X - B]/S 1 = X/S 2
Where,
X = Indifference point (EBIT)
S 1 = Number of equity shares outstanding
S 2 = Number of equity shares outstanding when only equity
capital is used.
B = Interest on debt capital in rupees.
CHAPTER SEVEN
SOURCES OF FINANCE
1) Long term :
i) Share capital or Equity share capital
ii) Preference shares
iii) Retained earnings
iv) Debentures/Bonds of different types
v) Loans from financial institutions
vi) Loans from State Financial Corporation
vii) Loans from commercial banks
viii) Venture capital funding
ix) Asset securitisation
x) International financing like Euro-issues, Foreign currency
loans.
2) Medium term :
i) Preference shares
ii) Debentures/Bonds
iii) Public deposits /fixed deposits for a duration of 3 years
iv) Commercial banks
v) Financial institutions
vi) State financial corporations
vii) Lease financing/Hire-purchase financing
viii) External commercial borrowings
ix) Euro -issues
x) Foreign currency bonds.
3) Short-term :
i) Trade credit
ii) Commercial banks
iii) Fixed deposits for a period of 1 year or less
iv) Advances received from customers
v) Various short-term provisions
1) According to period :
i) Long term sources
ii) Medium term sources
iii) Short term sources
2) According to ownership :
i) Owners capital or equity capital, retained earnings, etc.
ii) Borrowed capital such as, debentures, public deposits,
loans, etc.
3) Retained Earnings :
Long term funds may also be provided by
accumulation of company's profits and on ploughing them
back into business. Such funds belong to the ordinary
shareholders and increases the company's net worth. A
public limited company must plough back a reasonable
amount of profit every year, keeping in view the legal
requirements in this regard, and its own expansion plans.
Such funds entail almost no risk and the present owner's
control is maintained as there is no dilution of control.
4) Debentures or bonds :
Loans can be raised from public on issue of
debentures or bonds by public limited companies.
Debentures are normally issued in different denominations
ranging from Rs. 100 to 1000 and carry different rates of
interest. On issue of debentures, a company can raise long
term loans from public. Usually, debentures are issued on the
basis of a debenture trust deed which lists terms and
conditions on which debentures are floated. They are
normally secured against the company's assets. As compared
with preference shares, debentures provide a more
convenient mode of long term funds. Cost of capital raised
through debentures is low as the interest can be charged as
an expense before tax. From the investors' view point,
debentures offer a more attractive prospect than preference
shares as interest on debentures is payable whether or not
the company makes profits. Debentures are thus,
instruments for raising long term debt capital. Secured
debentures are protected by a charge on the company's
assets. While the secured debentures of a well-established
company may be attractive to investors, secured debentures
of a new company do not normally evoke same interest in the
investing public.
Advantages :
7) Bridge finance :
It refers to loans taken by a company from
commercial banks for a short period, pending disbursement
of loans sanctioned by financial institutions. Normally, it
takes time for financial institutions to disburse loans to
companies. However, loans once approved by the term
lending institutions pending the signing of regular term loan
agreement, that may be delayed due to non-compliance of
conditions stipulated by the institutions while sanctioning
the loan. The bridge loans are repaid/adjusted out of term
loans as and when disbursed by the concerned institutions.
They are secured by hypothecating movable assets, personal
guarantees and demand promissory notes. Generally, the
interest rate on them is higher than on term loans.
1) The assets are shifted off the balance sheet, thus, giving
the originator recourse to off balance sheet funding.
3) Bank advances :
Banks receive deposits from public for different
periods at varying rates of interest there are funds invested
and lent in such a manner that when required, they may be
called back. Lending results in gross revenues out of which
costs, such as interest on deposits, administrative costs, etc.
are met and a reasonable profit is made. A bank's lending
policy is not merely profit motivated but has to keep in mind
the socio-economic development of the country. As a prudent
policy, banks normally spread out their funds as under :
i) About 9 - 10 % in cash.
Documents required :
- In case of partnership firms, banks usually require the
following documents :
• Joint and several demand pronote signed on behalf of
the firm as also by partners individually;
• Letter of continuity, signed on behalf of the firm and
partners individually;
• Letter of pledge to secure demand cash credit against
stock, in case of pledge or agreement of
hypothecation to secure demand cash credit, in case of
hypothecation.
• Letter of authority to operate the account;
• Declaration of Partnership, in case of sole traders, sole
proprietorship declaration;
• Agreement to utilise the monies drawn in terms of
contract;
• Letter of hypothecation for bills.
- Following documents are required by banks, in case of
limited companies :
• Demand pro -note;
• Letter of continuity;
• Agreement of hypothecation of letter of pledge, signed
on behalf of the company;
• General guarantee of the directors' resolution;
• Agreement to utilise the monies drawn in terms of
contract should bear the company's seal;
• Letter of hypothecation for bills
b) Post shipment finance : It takes the below mentioned
forms :
Answer :
1) Deep Discount Bonds :
It is a form of a zero interest bond, sold at a
discounted value and on maturity face value is paid to the
investors. In such bonds, there is no interest paid during lock
in period. IDBI was the first to issue a deep discount bond in
India in January, 1992. It had a face value of Rs. 1lakh and
was sold for Rs. 2700 with a maturity period of 25 years. The
investor could hold the bond for 25 years or seek redemption
at the end of every 5 years with maturity value as below :
Holding period
5 10 15 20 25
(years)
Maturity value
5700 12000 25000 50000 100000
(Rs.)
Annual rate of
16.12 16.09 15.99 15.71 15.54
interest (%)
6) Option bonds :
These are cumulative and non-cumulative bonds
where interest is payable on maturity or periodically.
Redemption premium is also offered to attract investors.
These were recently issued by IDBI, ICICI, etc.
7) Inflation bonds :
They are bonds in which interest rate is adjusted for
inflation. The investor, thus, gets an interest free from the
effects of inflation. For instance, if interest rate is 12 % and
inflation rate is 5 %, the investor will earn 17 %, meaning
that the investor is protected against inflation.