Financial Management Notes

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Financial Management
FINANCIAL MANAGEMENT Unit 1. Introduction. A business is an activity which is carried on with the intention of earning profits. If the operations of a typical manufacturing organization are considered, it involves the purchasing of raw material, processing the same with the help of various factors of production like labour and machinery, manufacturing the final product and marketing and selling the finished product in the market to earn the profits. Thus production, marketing and business financing are the key operational areas in case of any business organization, out of which finance is the most crucial one. This is so as the functions of production and marketing are related with the function of finance. If the decisions relating to money and funds fail, it may result into the failure of the business organization as a whole. Hence, it is utmost important to take the proper financial decisions and that too at a proper point of time. Finance is the life-blood of modern business economy. We cannot imagine a business without finance in the modern world. It is the basis of all economic activities, no matter; the business is big or small. The problem of finance and that of financial management is to be dealt within every organisation. The problem of finance is equally important to government, semigovernments and private bodies, and to profit and nonprofit organisations. Definition. Financial management is that managerial activity which is concerned with planning and controlling of firms financial resources. According to Paul. G. Hasings, 'Finance' is the management of the monetary affairs of a company. It includes determining what has to be paid for raising the money on the best terms available and devoting the available resources to best uses." Kenneth Midgley and Ronald Burns state. "Financing is the process of organizing the flow of funds so that a business can carry out its objectives in the most efficient manner and meet its obligations as they fall due." Financial Management is an area of financial decision making harmonizing individual motives and enterprise goals.-Weston and Brigam.
Financial Management is the application of the planning and control functions to the finance function.Howard and Upton. Financial Management is the operational activity of a business that is responsible for obtaining and effectively, utilizing the funds necessary for efficient operations.Joseph and Massie. From the above definitions of the term finance given above, it can be concluded that the term business finance mainly involves rising of funds and their effective utilization keeping in view the over all objectives of the firm. The management makes use of the various financial techniques, devices etc for administering the financial affairs of the firm in the most effective and efficient way.
FINANCE AND RELATED DISCIPLINES.
Financial management -an integral part of over all management is not a totally independent area. It draws heavily on related disciplines and fields of study, such as Economics, Accounting, Marketing, Production, and Quantitative Methods.
FINANCIAL MANAGEMENT AND ECONOMICS.
The relevance of economics to Financial Management can be described in the lights of the two broad areas of economics, -macro economics, and micro economics. Macro economics is concerned with the over all institutional environment in which the Company operates. It looks at the Economy as a whole. It is concerned with the institutional structure of the banking system, money and capital markets, financial intermediaries, monetary credit, and fiscal policies. Since the business operates in the macro economic environment, it is important for financial managers to understand the broad economic environment. Micro economics deals with the economic decisions of individuals and organizations. It concerns itself with the determination of optimal operating strategies. A financial manger uses these to run the firm efficiently and effectively.
FINANCIAL MANAGEMENT AND ACCOUNTING.
Accounting function is a necessary input in to the finance function. ie. accounting is a sub function of finance. Accounting generates information about a firm. The end products of accounting constitute financial statements such as Balance Sheet, P&L Account and the statement of changes in financial position. The information contained in this reports and statements assist financial managers in assessing the past performance and taking future decisions of the firm and in meeting the legal obligations such as payment of
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Taxes and so on. Thus accounting and finance are functionally closely related.
FINANCE AND OTHER RELATED DISCIPLINES.
2. The focus was on financing problems of Corporate enterprises (i.e. Companies). Non corporate organizations lay outside its scope. 3. The approach laid over emphasis on the problems of long term financing. Hence day to day financial problems and working capital management of a business did not receive any attention. MODERN APPROACH. The modern approach views the term 'Financial management' in a broad sense and provides a conceptual and analytical frame work for financial decision making. According to it Finance function covers both acquisitions of funds as well as their allocations. Thus the Financial Management, in the modern sense of the term, can be broken down in to 3 major decisions as functions of Finance. 1. The investment Decision 2. The Financing Decision 3. The Dividend Policy Decision. FINANCE FUNCTIONS.
1. INVESTMENT DECISION.
Apart from economics and accounting, finance also draws considerably for its key day today decisionson supportive disciplines such as Marketing, Production, and Quantitative methods. For instance financial managers should consider the impact of new product development and promotion plans made in the marketing area since their plans will require Capital or Fund out flows and have an impact on the projected cash flows. Similarly changes in the production process may necessitate capital expenditure which the financial managers must evaluate and finance. And finally the tools of analysis developed in the quantitative techniques are helpful in analyzing complex financial management problems. Thus the marketing, production and quantitative techniques are only indirectly related to day to day decision making by financial managers and are supportive in nature , while Economics and Accounting are primary disciplines on which the financial managers draws substantially.
SCOPE OF FINANCIAL MANAGEMENT.
The approach to the scope and functions of financial management is divided in to two broad categories. Traditional Approach and Modem Approach.
TRADITIONAL APPROACH.
The investment decision relates to the selection of Assets in which funds will be invested by a firm. The Assets which can be acquired fall in to two broad categories. A. Long Term or Fixed Assets, which yield a return over a period of time in future. B. Short term or Current Assets which in the normal course of business are convertible in to cash usually within a year. The aspects of financial decision making with reference to long term assets is popularly known as Capital Budgeting and financial decision making with reference to current assets is popularly termed as Working Capital Management.
CAPITAL BUDGETING.
The traditional approach to the scope of financial management refers to the subject matter, in academic literature in the initial stages of its development, as a separate branch of academic study. The term 'Corporation Finance' was used to describe what is known as Financial management. As the name suggests, the concern of 'Corporation Finance' was with the financing of Corporate enterprises. In other words the scope of finance function was treated by the traditional approach in the narrow sense of procurement of fund by corporate enterprises to meet their financing needs. So the field of study included, 1. Institutional arrangements in the form of financial institutions which comprise the organization of Capital Market. 2. Financial instruments through which Funds are raised from the capital market. & 3. The Legal and Accounting relationship between a firm and its sources of funds. The traditional approach was criticized in the following grounds. 1. The approach equated finance function with raising and administering of funds only. The limitation was that internal decision-making was completely ignored.
Capital Budgeting is probably the most crucial financial decisions for a firm. It relates to the selection of an asset or investment proposal or course of action whose benefits are likely to be available in future over the life time of the project. The first aspect of capital budgeting decision relates to the choice of the new asset out of the alternatives available or the reallocation of capital, when an existing asset fails to justify the funds committed. Whether an asset will be accepted or rejected will depend upon the relative benefits and returns associated
with it. The measurement of worth of the investment proposal is, there for, a major element in Capital budgeting decisions. The second element of Capital Budgeting decision is the analysis of risk and uncertainty. Since the benefits from the investment proposals extend in to the future, there accrual is uncertain. They have to be estimated under various assumptions of the physical volume of sales and the level of prices. An element of risk in the sense of 'uncertainty of future benefits' is thus involved in the capital budgeting. The returns from capital budgeting decisions should, there fore, be evaluated in relation to the risk associated with it.
WORKING CAPITAL MANAGEMENT.
pay cash dividend regularly. Periodically additional shares, called Bonus shares, are also issued to the existing share holders in addition to the cash dividend. OBJECTIVES OF FINANCIAL MANAGEMENT. Financial management is concerned with the efficient use of capital funds. It evaluates how funds are procured and used. Financial management covers decision making in three inter related areas namely Investment, Financing and Dividend policy. The financial manager has to take these decisions with reference to the objectives of the firm. The objectives provide a frame work for optimal financial decision making. There are two widely discussed approaches in this regard. 1. 2. Profit Maximization Approach Wealth Maximization Approach.
Working capital management is concerned with the management of current asset. One aspect of working capital management is the trade off between profitability and risk. There is a conflict between profitability and liquidity. If a firm does not have adequate working capital, it may become illiquid and consequently may not have the ability to meet its current obligations. If current assets are too large, profitability is adversely affected. The key strategies and considerations in ensuring a trade oil' between profitability and liquidity is one of the major dimensions of working capital management. In addition, the individual current asset should be efficiently managed so that neither in adequate nor unnecessary funds are locked up.
2. FINANCING DECISIONS.
PROFIT MAXIMISATION APPROACH.
According to this approach, actions that increase profits should be undertaken and that decrease profits should be avoided. Profits maximization approach implies that the functions of financial management/ Decisions taken by financial mangers (i.e. the investment, financing, and dividend policy decisions) should be oriented towards maximization of profits or Rupee income of the firm. Or the Company should select those assets, projects, and decisions which are profitable and reject those which are not. In the Economic theory, the behaviour of a Company is analyzed in terms of profit maximization. While maximizing profits, a firm either produces maximum output for a minimum input, or uses minimum input for a given out put. So the underlying logic of profit maximization is efficiency. Profit is a test of economic efficiency and it provides a yard stick by which economic performance can be judged. The profit maximization criterion has however been criticized on several grounds. The main technical flaws are ambiguity, timing of benefits and quality of benefits. 1. AMBIGUITY.
The second major decision involved in financial management is the financing decision. The concern of the financing decision is with the Financing Mix or Capital Structure or Leverage. The term capital structure refers to the proportion of debt (i.e., fixed interest source of financing) and equity capital (or variable dividend security). The financing decision of a firm relates to the choice of the proportion of these sources to finance the investment requirements. A capital structure with a reasonable proportion of debt and equity capital is called optimum capital structure.
3. DIVIDEND POLICY DECISION.
The third major decision of financial management is the decision relating to dividend policy. Two alternatives are available in dealing with the profits of the firm. They can be distributed to the share holders in the form of dividends or they can be retained in the business itself. The final decision will depend upon the preference of the share holders and the investment opportunities available within the firm. The optimum dividend policy is one which maximizes the market value of the Co's shares. Most profitable Co's
One practical difficulty with profit maximization criterion for financial decision making is that, the term profit is a vague and ambiguous concept. It is amenable to different interpretations by different people. It is not clear in what sense the term profit has been used. It may be total profit before tax or after tax or profitability rate. Rate of profitability may again be in relation to Share capital; owner's funds, total capital employed or sales. Furthermore, the word profit does
not speak anything about the short-term and long-term profits. Profits in the short-run may not be the same as those in the long run. A firm can maximise its shortterm profit by avoiding current expenditures on maintenance of a machine. But owing to this neglect, the machine being put to use may no longer be capable of operation after sometime with the result that the firm will have to make huge investment outlay to replace the machine. Thus, profit maximisation suffers in the long run for the sake of maximizing short-term profit. Obviously a loose expression like profit can't form the basis of operational criterion for financial management. 2. TIMING OF BENEFIT
mutually exclusive projects, the one with the highest NPV should be adopted. The objective of wealth maximisation takes care of the questions of the timing and risk of expected benefits. These problems are handled by selecting an appropriate rate for discounting the expected flow of future benefits. It should be remembered that the benefits are measured in terms of cash flows. In investment and financing decisions it is flow of cash which is important, not the accounting profits. The Wealth created by a Company through its actions is reflected in the market value of companies' shares. The value of the companies share is represented by the market price, which in turn, is a reflection of the firm's financial decisions. The market price of the share serves as the performance indicator.
A more important technical objection to profit maximization is that it ignores the differences in the time pattern of the benefits received. The profit maximization criterion does not consider the distinction between returns received in different time periods and treats all benefits irrespective of the timings, as equally valuable. This is not true in actual practice as benefits in early years should be valued more highly than equivalent benefits in later years. The assumption of equal value is in consistent with the real world situation. 3. QUALITY OF BENEFITS.
Profit maximization ignores the quality aspect of benefits associated with a financial course of action. The term quality refers to the degree of certainty with which benefits can be expected. As a rule, the more certain the expected return, the higher is the quality of the benefits. An uncertain and fluctuating return implies risk to the investors. To conclude the profit maximization criterion is unsuitable and in appropriate as an operational objective of investment, financing and dividend decision of a firm. It is not only vague and ambiguous, but it also ignores risk and time value of money.
WEALTH MAXIMIZATION APPROACH.
This is also known as value maximization or Net Present Worth maximization. It removes the technical limitations of profit maximization criterion. (i.e. ambiguity, timing of benefit and quality of benefit.) Wealth maximization means maximizing the Net Present Value (or wealth) of a course of action. The Net present value of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action which has a positive Net Present Value creates wealth and there fore it is desirable. A financial action resulting in negative NPV should be rejected. Between a number of desirable
UNIT 2. SOURCE OF FINANCE Business is concerned with the production and distribution of goods and services for the satisfaction of needs of society. For carrying out various activities, business requires money. Finance, therefore, is called the life blood of any business. The financial needs of a business can be categorised as follows: (a) Fixed capital requirements: In order to start business, funds are required to purchase fixed assets like land and building, plant and machinery, and furniture and fixtures. This is known as fixed capital requirements of the enterprise. The funds required in fixed assets remain invested in the business for a long period of time. (b)Working Capital requirements: No matter how small or large a business is, it needs funds for its day-today operations. This is known as working capital of an enterprise, which is used for holding current assets such as stock of material, bills receivables and for meeting current expenses like salaries, wages, taxes and rent. For financing such requirements short-term funds are needed.
CLASSIFICATION OF SOURCE OF FUNDS.
A. Period Basis.
On the basis of period, the different sources of funds can be categorized into three parts. These are long-term sources, medium-term sources and short-term sources. The long-term sources fulfill the financial requirements of an enterprise for a period exceeding 5 years and include sources such as shares and debentures, long-term borrowings and loans from financial institutions. Such financing is generally required for the acquisition of fixed assets such as equipment, plant, etc.
Where the funds are required for a period of more than one year but less than five years, medium-term sources of finance are used. These sources include borrowings from commercial banks, public deposits, lease financing and loans from financial institutions. Short-term funds are those which are required for a period not exceeding one year. Trade credit, loans from commercial banks and commercial papers are some of the examples of the sources that provide funds for short duration. Short-term financing is most common for financing of current assets such as accounts receivable and inventories.
(iv) It may lead to increase in the market price of the equity shares of a company.
B. Ownership Basis.
On the basis of ownership, the sources can be classified into owners funds and borrowed funds. Owners funds means funds that are provided by the owners of an enterprise, which may be a sole trader or partners or shareholders of a company. Apart from capital, it also includes profits reinvested in the business. The owners capital remains invested in the business for a longer duration and is not required to be refunded during the life period of the business. Such capital forms the basis on which owners acquire their right of control of management. Issue of equity shares and retained earnings are the two important sources from where owners funds can be obtained. Borrowed funds on the other hand, refer to the funds raised through loans or borrowings. The sources for raising borrowed funds include loans from commercial banks, loans from financial institutions, issue of debentures, public deposits and trade credit. Such sources provide funds for a specified period, on certain terms and conditions and have to be repaid after the expiry of that period. A fixed rate of interest is paid by the borrowers on such funds. At times it puts a lot of burden on the business as payment of interest is to be made even when the earnings are low or when loss is incurred. Generally, borrowed funds are provided on the security of some fixed assets. LONG TERM FUNDS 1. Retained Earnings. A company generally does not distribute all its earnings amongst the shareholders as dividends. A portion of the net earnings may be retained in the business for use in the future. This is known as retained earnings. It is a source of internal financing or self financing or ploughing back of profits. The profit available for ploughing back in an organisation depends on many factors like net profits, dividend policy and age of the organisation. Merits. The merits of retained earning as a source of finance are as follows: (i) Retained earnings is a permanent source of funds available to an organisation; (ii) It does not involve any explicit cost in the form of interest, dividend or floatation cost; (iii) As the funds are generated internally, there is a greater degree of operational freedom and flexibility;
2. Trade Credit. Trade credit is the credit extended by one trader to another for the purchase of goods and services. Trade credit facilitates the purchase of supplies without immediate payment. Such credit appears in the records of the buyer of goods as sundry creditors or accounts payable. Trade credit is commonly used by business organisations as a source of short-term financing. It is granted to those customers who have reasonable amount of financial standing and goodwill. The volume and period of credit extended depends on factors such as reputation of the purchasing firm, financial position of the seller, volume of purchases, past record of payment and degree of competition in the market. Terms of trade credit may vary from one industry to another and from one person to another. A firm may also offer different credit terms to different customers. 3. Factoring. Factoring is a financial service under which the factor renders various services which includes: (a) Discounting of bills (with or without recourse) and collection of the clients debts. Under this, the receivables on account of sale of goods or services are sold to the factor at a certain discount. The factor becomes responsible for all credit control and debt collection from the buyer and provides protection against any bad debt losses to the firm. There are two methods of factoring recourse and non-recourse. Under recourse factoring, the client is not protected against the risk of bad debts. On the other hand, the factor assumes the entire credit risk under non-recourse factoring i.e., full amount of invoice is paid to the client in the event of the debt becoming bad. The organizations, that provide such services include SBI Factors and Commercial Services Ltd., Canbank Factors Ltd., Foremost Factors Ltd.etc. 4. Lease Financing. A lease is a contractual agreement whereby one party i.e., the owner of an asset grants the other party the right to use the asset in return for a periodic payment. In other words it is a renting of an asset for some specified period. The owner of the assets is called the lessor while the party that uses the assets is known as the lessee (see Box A). The lessee pays a fixed periodic amount called lease rental to the lessor for the use of the asset. The terms and conditions regulating the lease arrangements are given in the lease contract. At the end of the lease period, the asset goes back to the lessor. Lease finance provides an important means of modernization and diversification to the firm. Such type
of financing is more prevalent in the acquisition of such assets as computers and electronic equipment which become obsolete quicker because of the fast changing technological developments. While making the leasing decision, the cost of leasing an asset must be compared with the cost of owning the same. 5. Public Deposits. The deposits that are raised by organisations directly from the public are known as public deposits. Rates of interest offered on public deposits are usually higher than that offered on bank deposits. Any person who is interested in depositing money in an organisation can do so by filling up a prescribed form. The organisation in return issues a deposit receipt as acknowledgment of the debt. Public deposits can take care of both medium and short-term financial requirements of a business. The deposits are beneficial to both the depositor as well as to the organisation. While the depositors get higher interest rate than that offered by banks, the cost of deposits to the company is less than the cost of borrowings from banks. Companies generally invite public deposits for a period up to three years. The acceptance of public deposits is regulated by the Reserve Bank of India. 6. Commercial Paper (CP). Commercial Paper emerged as a source of short term finance in our country in the early nineties. Commercial paper is an unsecured promissory note issued by a firm to raise funds for a short period, varying from 90 days to 364 days. It is issued by one firm to other business firms, insurance companies, pension funds and banks. The amount raised by CP is generally very large. As the debt is totally unsecured, the firms having good credit rating can issue the CP. Its regulation comes under the purview of the Reserve Bank of India. 7. Issue of Shares. The capital obtained by issue of shares is known as share capital. The capital of a company is divided into small units called shares. Each share has its nominal value. For example, a company can issue 1,00,000 shares of Rs. 10 each for a total value of Rs. 10,00,000. The person holding the share is known as shareholder. There are two types of shares normally issued by a company. These are equity shares and preference shares. The money raised by issue of equity shares is called equity share capital, while the money raised by issue of preference shares is called preference share capital.
represent the ownership of a company and thus the capital raised by issue of such shares is known as ownership capital or owners funds. Equity share capital is a prerequisite to the creation of a company. Equity shareholders do not get a fixed dividend but are paid on the basis of earnings by the company. They are referred to as residual owners since they receive what is left after all other claims on the companys income and assets have been settled. They enjoy the reward as well as bear the risk of ownership. Their liability, however, is limited to the extent of capital contributed by them in the company. Further, through their right to vote, these shareholders have a right to participate in the management of the company. Merits. The important merits of raising funds through issuing equity shares are given as below: (i) Equity shares are suitable for investors who are willing to assume risk for higher returns; (ii) Payment of dividend to the equity shareholders is not compulsory. Therefore, there is no burden on the company in this respect; (iii) Equity capital serves as permanent capital as it is to be repaid only at the time of liquidation of a company. As it stands last in the list of claims, it provides a cushion for creditors, in the event of winding up of a company; (iv) Equity capital provides credit worthiness to the company and confidence to prospective loan providers; (v) Funds can be raised through equity issue without creating any charge on the assets of the company. The assets of a company are, therefore, free to be mortgaged for the purpose of borrowings, if the need be; (vi) Democratic control over management of the company is assured due to voting rights of equity shareholders. Limitations. The major limitations of raising funds through issue of equity shares are as follows: (i) Investors who want steady income may not prefer equity shares as equity shares get fluctuating returns; (ii) The cost of equity shares is generally more as compared to the cost of raising funds through other sources; (iii) Issue of additional equity shares dilutes the voting power, and earnings of existing equity shareholders; (iv) More formalities and procedural delays are involved while raising funds through issue of equity share.
(b) Preference Shares.

The capital raised by issue of preference shares is called preference share capital. The preference shareholders enjoy a preferential position over equity
(a) Equity Shares.

Equity shares is the most important source of raising long term capital by a company. Equity shares
shareholders in two ways: (i) receiving a fixed rate of dividend, out of the net profits of the company, before any dividend is declared for equity shareholders; and (ii) receiving their capital after the claims of the companys creditors have been settled, at the time of liquidation. In other words, as compared to the equity shareholders, the preference shareholders have a preferential claim over dividend and repayment of capital. Preference shares resemble debentures as they bear fixed rate of return. Also as the dividend is payable only at the discretion of the directors and only out of profit after tax, to that extent, these resemble equity shares. Thus, preference shares have some characteristics of both equity shares and debentures. Preference shareholders generally do not enjoy any voting rights. A company can issue different types of preference shares. Types of Preference Shares ; 1. Cumulative and Non-Cumulative: The preference shares which enjoy the right to accumulate unpaid dividends in the future years, in case the same is not paid during a year are known as cumulative preference shares. On the other hand, on non-cumulative shares, dividend is not accumulated if it is not paid in a particular year. 2. Participating and Non-Participating: Preference shares which have a right to participate in the further surplus of a company shares which after dividend at a certain rate has been paid on equity shares are called participating preference shares. The non-participating preference are such which do not enjoy such rights of participation in the profits of the company. 3. Convertible and Non-Convertible: Preference shares that can be converted into equity shares within a specified period of time are known as convertible preference shares. On the other hand, non-convertible shares are such that cannot be converted into equity shares. Merits. The merits of preference shares are given as follows: (i) Preference shares provide reasonably steady income in the form of fixed rate of return and safety of investment; (ii) Preference shares are useful for those investors who want fixed low risk; (iii) It does not affect the control of equity shareholders over the management as preference shareholders dont have voting rights; (iv) Payment of fixed rate of dividend to preference shares may enable a company to declare higher rates of dividend for the equity shareholders in good times;
(v) Preference shareholders have a preferential right of repayment over equity shareholders in the event of liquidation of a company; (vi) Preference capital does not create any sort of charge against the assets of a company. 8. Debentures. Debentures are an important instrument for raising long term debt capital. A company can raise funds through issue of debentures, which bear a fixed rate of interest. The debenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money, which it promises to repay at a future date. Debenture holders are, therefore, termed as creditors of the company. Debenture holders are paid a fixed stated amount of interest at specified intervals. Public issue of debentures requires that the issue be rated by a credit rating agency like CRISIL (Credit Rating and Information Services of India Ltd.) on aspects like track record of the company, its profitability, debt servicing capacity, credit worthiness and the perceived risk of lending. A company can issue different types of debentures . Issue of Zero Interest Debentures (ZID) which do not carry any explicit rate of interest has also become popular in recent years. The difference between the face value of the debenture and its purchase price is the return to the investor. Types of Debentures. 1. Secured and Unsecured: Secured debentures are such which create a charge on the assets of the company, thereby mortgaging the assets of the company. Unsecured debentures on the other hand do not carry any charge or security on the assets of the company. 2. Registered and Bearer: Registered debentures are those which are duly recorded in the register of debenture holders maintained by the company. These can be transferred only through a regular instrument of transfer. In contrast, the debentures which are transferable by mere delivery are called bearer debentures. 3. Convertible and Non-Convertible: Convertible debentures are those debentures that can be converted into equity shares after the expiry of a specified period. On the other hand, non-convertible debentures are those which cannot be converted into equity shares. 4. First and Second: Debentures that are repaid before other debentures are repaid are known as first debentures. The second debentures are those which are paid after the first debentures have been paid back. Merits. The merits of raising funds through debentures are given as follows:
(i) It is preferred by investors who want fixed income at lesser risk; (ii) Debentures are fixed charge funds and do not participate in profits of the company; (iii) The issue of debentures is suitable in the situation when the sales and earnings are relatively stable; (iv) As debentures do not carry voting rights, financing through debentures does not dilute control of equity shareholders on management; (v) Financing through debentures is less costly as compared to cost of preference or equity capital as the interest payment on debentures is tax deductible. 9. Commercial Banks. Commercial banks occupy a vital position as they provide funds for different purposes as well as for different time periods. Banks extend loans to firms of all sizes and in many ways, like, cash credits, overdrafts, term loans, purchase/discounting of bills, and issue of letter of credit. The rate of interest charged by banks depends on various factors such as the characteristics of the firm and the level of interest rates in the economy. The loan is repaid either in lump sum or in installments. Bank credit is not a permanent source of funds. Though banks have started extending loans for longer periods, generally such loans are used for medium to short periods. The borrower is required to provide some security or create a charge on the assets of the firm before a loan is sanctioned by a commercial bank. Merits The merits of raising funds from a commercial bank are as follows: (i) Banks provide timely assistance to business by providing funds as and when needed by it. (ii) Secrecy of business can be maintained as the information supplied to the bank by the borrowers is kept confidential; (iii) Formalities such as issue of prospectus and underwriting are not required for raising loans from a bank. This, therefore, is an easier source of funds; (iv) Loan from a bank is a flexible source of finance as the loan amount can be increased according to business needs and can be repaid in advance when funds are not needed. 10. Special Financial Institutions. After independence a large number of financial institutions have been established in India with the primary objective of providing long-term financial assistance to industrial enterprises. Some of these institutions have been set up on the initiative of the Central Government, while others have been set up in different states on the initiative of the concerned State Governments. Thus there are all-India institutions like Industrial Finance Corporation of India (IFCI), Industrial Credit and Investment Corporation of India
(ICICT), Industrial Development Bank of India (IDBI), and Industrial Reconstruction Corporation of India (IRCI). They mainly provide long-term finance for large companies. On the other hand, at the state level there are State Financial Corporations (SFCs) and Industrial Development Corporations (SIDCs). These state level institutions mainly provide long-term finance to relatively smaller companies. These institutions (both national level and state level) are known as 'Development Banks' because their main objective is to provide financial assistance to industrial enterprises for investment projects, expansion or modernisation of plants in accordance with the priorities laid down in the Five Year Plans. Besides the development banks, there are several other institutions known as investment companies or investment trusts which subscribe to the shares and debentures offered to the public by companies. For example, the Life Insurance Corporation of India (LIC), General Insurance Corporation of India (GIC), the Unit Trust of India (UTI), etc., come under this category. Merits. The merits of raising funds through financial institutions are as follows: (i) Financial institutions provide long term finance, which are not provided by commercial banks; (ii) Besides providing funds, many of these institutions provide financial, managerial and technical advice and consultancy to business firms; (iii) Obtaining loan from financial institutions increases the goodwill of the borrowing company in the capital market. Consequently, such a company can raise funds easily from other sources as well; (iv) As repayment of loan can be made in easy installments, it does not prove to be much of a burden on the business; (v) The funds are made available even during periods of depression, when other sources of finance are not available. 11. International Financing.
In addition to the sources discussed above, there are various avenues for organisations to raise funds internationally. With the opening up of an economy and the operations of the business organisations becoming global, Indian companies have an access to funds in global capital market. Various international sources from where funds may be generated include: (i) Commercial Banks ( Foreign): Commercial banks all over the world extend foreign currency loans for business purposes. They are an important source of financing non-trade international operations. The types
10 Financial Management
of loans and services provided by banks vary from country to country. For example, Standard Chartered emerged as a major source of foreign currency loans to the Indian industry. (ii) International Agencies and Development Banks: A number of international agencies and development banks have emerged over the years to finance international trade and business. These bodies provide long and medium term loans and grants to promote the development of economically backward areas in the world. These bodies were set up by the Governments of developed countries of the world at national, regional and international levels for funding various projects. The more notable among them include International Finance Corporation (IFC), EXIM Bank and Asian Development Bank. (iii) International Capital Markets: Modern organisations including multinational companies depend upon sizeable borrowings in rupees as well as in foreign currency. Prominent financial instruments used for this purpose are: (a) Global Depository Receipts (GDRs): The local currency shares of a company are delivered to the depository bank. The depository bank issues depository receipts against these shares. Such depository receipts denominated in US dollars are known as Global Depository Receipts (GDR). GDR is a negotiable instrument and can be traded freely like any other security. In the Indian context, a GDR is an instrument issued abroad by an Indian company to raise funds in some foreign currency and is listed and traded on a foreign stock exchange. A holder of GDR can at any time convert it into the number of shares it represents. The holders of GDRs do not carry any voting rights but only dividends and capital appreciation. Many Indian companies such as Infosys, Reliance, Wipro and ICICI have raised money through issue of GDRs. (b) Foreign Currency Convertible Bonds (FCCBs): Foreign currency convertible bonds are equity linked debt securities that are to be converted into equity or depository receipts after a specific period. Thus, a holder of FCCB has the option of either converting them into equity shares at a predetermined price or exchange rate, or retaining the bonds. The FCCBs are issued in a foreign currency and carry a fixed interest rate which is lower than the rate of any other similar nonconvertible debt instrument. FCCBs are listed and traded in foreign stock exchanges. FCCBs are very similar to the convertible debentures issued in India. SHORT TERM FUNDS. After establishment of a business, funds are required to meet its day to day expenses. For example
raw materials must be purchased at regular intervals, workers must be paid wages regularly, water and power charges have to be paid regularly. Thus there is a continuous necessity of liquid cash to be available for meeting these expenses. For financing such requirements short-term funds are needed. There are a number of sources of short-term finance which are listed below: 1. Trade credit 2. Bank credit Loans and advances Cash credit Overdraft Discounting of bills 3. Customers advances 4.. Loans from co-operatives. 5. Indigenous bankers.
1. Trade Credit.
Trade credit refers to credit granted to manufactures and traders by the suppliers of raw material, finished goods, components, etc. Usually business enterprises buy supplies on a 30 to 90 days credit. This means that the goods are delivered but payments are not made until the expiry of period of credit. This type of credit does not make the funds available in cash but it facilitates purchases without making immediate payment. This is quite a popular source of finance. 2. Bank Credit. Commercial banks grant short-term finance to business firms which is known as bank credit. When bank credit is granted, the borrower gets a right to draw the amount of credit at one time or in installments as and when needed. Bank credit may be granted by way of loans, cash credit, overdraft and discounted bills. (i) Loans When a certain amount is advanced by a bank repayable after a specified period, it is known as bank loan. Such advance is credited to a separate loan account and the borrower has to pay interest on the whole amount of loan irrespective of the amount of loan actually drawn. Usually loans are granted against security of assets. (ii) Cash Credit It is an arrangement whereby banks allow the borrower to withdraw money upto a specified limit. This limit is known as cash credit limit. Initially this limit is granted for one year. This limit can be extended after review for another year. However, if the borrower still desires to continue the limit, it must be renewed after three years. Rate of interest varies depending upon the
amount of limit. Banks ask for collateral security for the grant of cash credit. In this arrangement, the borrower can draw, repay and again draw the amount within the sanctioned limit. Interest is charged only on the amount actually withdrawn and not on the amount of entire limit. (iii) Overdraft When a bank allows its depositors or account holders to withdraw money in excess of the balance in his account upto a specified limit, it is known as overdraft facility. This limit is granted purely on the basis of credit-worthiness of the borrower. Banks generally give the limit upto Rs.20,000. In this system, the borrower has to show a positive balance in his account on the last friday of every month. Interest is charged only on the overdrawn money. Rate of interest in case of overdraft is less than the rate charged under cash credit. (iv) Discounting of Bill Banks also advance money by discounting bills of exchange and promissory notes.. When these documents are presented before the bank for discounting, banks credit the amount to cutomers account after deducting discount. The amount of discount is equal to the amount of interest for the period of bill. 3. Customers Advances. Sometimes businessmen insist on their customers to make some advance payment. It is generally asked when the value of order is quite large or things ordered are very costly. Customers advance represents a part of the payment towards price on the product which will be delivered at a later date. Customers generally agree to make advances when such goods are not easily available in the market or there is an urgent need of goods. A firm can meet its short-term requirements with the help of customers advances. 4. Loans from Co-operative Banks Co-operative banks are a good source to procure short-term finance. Such banks have been established at local, district and state levels. District Cooperative Banks are the federation of primary credit societies. The State Cooperative Bank finances and controls the District Cooperative Banks in the state. They are also governed by Reserve Bank of India regulations. Some of these banks like the Vaish Co-operative Bank was initially established as a co-operative society and later converted into a bank. These banks grant loans for personal as well as business purposes. Membership is the primary condition for securing loan. The functions
of these banks are largely comparable to the functions of commercial banks. 5. Indigenous Bankers. They are private individuals engaged in the business of financing small and local business units. They provide short term and medium term loans. However they charge very high rates of interest and are, therefore, considered only as a last resort of finance.
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Unit 3. WORKING CAPITAL MANAGEMENT Introduction Capital required for a business can be classified under two main heads: i. Fixed Capital ii. Working Capital Fixed capital / Long term funds is required to meet long term obligations namely purchase of fixed assets such as plant & machinery, land, building, furniture etc. Any business requires funds to meet shortterm purposes such as purchase of raw materials, payment of wages and other day-to-day expenses. These funds are called Working capital. In short, Working Capital is the funds required to meet day-to-day operations of a business firm. And hence study of Working capital is considered to be very significant. An inefficient management of working capital leads to not only loss of profits but also to the closure of the business firm. There are two concepts of Working capital namely, 1. Gross Working Capital (GWC) 2. Net Working Capital. Generally working capital refers to the gross working capital and represents funds invested in total current assets of the firm. That means according to this concept working capital means Total Current Assets. Net Working Capital is often referred to as circulating capital and represents the excess of current assets over current liabilities. Current liabilities are short-term obligations which are to be paid in the ordinary course of the business within a short period of one accounting year. Net working capital is positive when current assets exceed current liabilities. It is negative when current liabilities exceed current assets. Working capital management is concerned with the problems that arise in attempting to manage the current assets, current liabilities and the inter relationship that exist between them. The goal of working capital management is to manage firms current assets and current liabilities in such a way that a satisfactory level of working capital is maintained. This is so because, if the firm cant maintain a satisfactory level of working capital, it is likely to become insolvent. TYPES OF WORKING CAPITAL
Sometimes, working capital is divided into two varieties as: i) Permanent working capital ii) Variable working capital Permanent Working Capital: (Fixed working capital):- Though working capital has a limited life and usually not exceeding a year, in actual practice some part of the investment in that is always permanent. Since firms have relatively longer life and production does not stop at the end of a particular accounting period some investment is always locked up in the form of raw materials, work-in-progress, finished stocks, book debts and cash. The investment in these components of working capital is simply carried forward to the next year. This minimum level of investment in current assets that is required to continue the business without interruption is referred to as permanent working capital.
Fluctuating (Variable Working Capital): This is also known as the circulating or transitory working capital. This is the amount of investment required to take care of the fluctuations in the business activity. While permanent working capital is meant to take care of the minimum investment in various current assets, variable working capital is expected to care for the peaks in the business activity. NEED FOR WORKING CAPITAL - OPERATING CYCLE. The basic aim of Financial management is to maximize the wealth of the share holders and in order to achieve this; it is necessary to generate sufficient sales and profit. However sales do not convert in to cash instantly. The time between purchase of inventory items
(raw material or merchandise) for the production and their conversion into cash is known as operating cycle or working capital cycle.. A study of the operating cycle would reveal that the funds invested in operations are re-cycled back into
cash. The cycle, of course, takes some time to complete. The longer the period of this conversion the longer is the operating cycle. A standard operating cycle may be for any time period but does not generally exceed a financial year.
If it were possible to complete the sequence instantly, there would be no need for current assets( working capital). But since it is not possible, the firm is forced to have current assets. Since cash inflows and outflows do not match, the firm has to keep cash for meeting short term obligations. FACTORS DETERMINING THE WORKING CAPITAL REQUIREMENTS. The total working capital requirement of a firm is determined by a wide variety of factors. These factors affect different organisations differently and they also vary from time to time. In general the following factors are involved in a proper assessment of the amount of working capital needed. 1. General nature of business. The working capital requirements of an enterprise are basically related to the conduct of those business. Enterprises fall in to some broad categories depending on the nature of their business. For instance, public utilities have certain features which have a bearing on their walking capital needs. The two relevant features are Cash nature of business; and Sale of services than commodities. In view of these features they do not maintain big inventories and have there fore, probably little or least requirement of working
capital. At the other extreme are trading and financial enterprises. The nature of their business is such that they have to maintain a sufficient amount of cash, inventories and book debts. They have necessarily to invest proportionately large amount in working capital. 2. Production Cycle. Another factor which affects is production cycle. The term production cycle refers to the time involved in the manufacture of goods. It covers the time span between the purchase of raw materials and the completion of the manufacturing process leading to the production of finished goods. Funds will have to be necessarily tied up during the process of manufacture, necessitating enhanced working capital. The longer the time span (production cycle), the larger will be the funds tied up and there fore, the larger the working capital needed and vice versa. Further even within the same group of industries, the operating cycle may be different due to technological considerations. For economy in working capital, that process should be selected which has a shorter manufacturing process. Appropriate policies concerning terms of credit for raw materials and other supplies and advance payment from customers can help in reducing working capital requirement. 3. Business cycle. The working capital requirements are also determined by the nature of the business cycle. During the boom period the
need for working capital is likely to grow to cover the lag between increased sales and receipt of cash as well as to finance purchases of additional material to face the expansion of the level of activity. The decline stage in the business cycle will have exactly an opposite effect on the level of working capital requirement. The decline in the economy is associated with a fall in the volume of sales, which will lead to a fall in the level of inventories and book debts. The need for working capital in recessionary condition is bound to decline.
4. Production policy. The quantum of working capital is also determined by production policy. In the case of certain lines of business, the demand for the product is seasonal ie they will be purchased during certain months of the year. Such companies may either confine their production only to periods when goods are purchased or they follow a steady production policy through out the year. In the former case there will be serious production problems. During slack season the firm will have to maintain its working force and physical facilities with out adequate production and sales. A steady production through out the year will cause large accumulation of finished goods. This will require additional working capital. 5. Credit Policy. The level of walking capital is also determined by the credit policy which relates to sales and purchase. The credit sales will result in higher amount of debtors and more working capital. On the other hand if liberal credit terms are available from the suppliers of goods the need for working capital will be less. The walking capital requirements of a business are, thus, affected by the terms of purchase and sales. 6. Growth and Expansion. As a Co grows it is logical to expect that a larger amount of working capital will be required. It is difficult to determine the relationship between the growth in the volume of business of a Co and the increase in the working capital. Other things being equal, growing Go's need more working capital than those that are static. 7. Availability of Raw Material. The availability of Raw material without interruption would some times affect working capital. There may be some material which cant be procured easily either because their sources are few or irregular. To sustain smooth production the firm might be compelled to purchase and stock them in large quantities. This will result in excessive inventory of such materials. 8 Profit level.
Higher profit margin of a Co would generate more internal funds.. Net profit is a source of working capital to the extent that it has been earned in cash. The availability of such funds for working capital would depend upon level of tax, dividend and reserves, and depreciations. a. Level of Tax:- The amount of tax to be paid is determined by the prevailing tax regulations and very often taxes have to be paid in advance. An adequate provision for tax is an important aspect of working capital planning. If tax liability increases, it will lead to an increase in the level of working capital and vice versa. b. Dividend Policy:- The payment of dividend consumes cash resource and affects working capital. If the firm does not pay dividend and but retains the profit, working capital will increase. c. Depreciation Policy. :- as depreciation charges do not involve any cash out flow, the amount so retained can be used as working capital. 9 Price Level Changes. Changes in the price level also affect the requirement of working capital. Rising prices would necessitate the use of more funds for maintaining an existing level of activity. For the same level of materials and assets higher cash out flows are required. The effect of rising prices will be that a higher level of working capital is needed. MANAGEMENT OF CASH. Cash is an important current asset for the operations of business. Cash is the basic input that keeps business running continuously and smoothly. Too much cash and too little cash will have a negative impact on the overall profitability of the firm as too much cash would mean cash remaining idle and too less cash would hamper the smooth running of the operations of the firm. Therefore, there is need for the proper management of cash to ensure high levels of profitability. It is a usual practice to include near cash items such as marketable securities and bank term deposits in cash. The basic characteristics of near cash items is that, they can be quickly and easily converted into cash without any transaction cost or negligible transaction cost. Motives for Holding Cash. The firms need to hold cash may be attributed to the three motives given below: The transaction motive. The precautionary motive. The speculative motive. The Compensation motive.
1.Transaction Motive: The transaction motive requires a firm to hold cash to conduct its business in the ordinary course and pay for operating activities like purchases, wages and salaries, other operating expenses, taxes, dividends, payments for utilities etc. The basic reason for holding cash is non-synchronization between cash inflows and cash outflows. Firms usually do not hold large amounts of cash, instead the cash is invested in market securities whose maturity corresponds with some anticipated payments. Transaction motive mainly refers to holding cash to meet anticipated payments whose timing is not perfectly matched with cash inflows. 2.Precautionary Motive: The precautionary motive is the need to hold cash to meet uncertainties and emergencies. The quantum of cash held for precautionary objective is influenced by the degree of predictability of cash flows. In case cash flows can be accurately estimated the cash held for precautionary motive would be fairly low. Another factor which influences the quantum of cash to be maintained for this motive is, the firms ability to borrow at short notice. Precautionary balances are usually kept in the form of cash and marketable securities. The cash kept for precautionary motive does not earn any return, therefore, the firms should invest this cash in highly liquid and low risk marketable securities in order to earn some returns. 3. Speculative Motive. A firm also keeps cash balance to take advantage of un expected opportunities, typically outside the normal course of business. Such motive is, there fore, of purely speculative nature. For e.g., a firm may like to take advantage of an opportunity of purchase raw materials at the reduced price on payment of immediate cash. Similarly it may like to keep some cash balance to make profit by buying securities in times when their prices fall. 4. Compensation Motive. Another motive to hold cash balance is to compensate banks for providing certain services and loans. Banks provide a variety of services to business firms such as clearance of cheque, supply of credit information, transfer of funds and so on. While for some of these services banks charge a commission or fees, for others they seek indirect compensation. Usually clients are required to maintain a minimum balance of cash at the bank. Since this balance cant be utilised by the firms for transaction purpose, the bank themselves can use the amount to earn a return. Such balances are called as compensating balances. OBJECTIVES OF CASH MANAGEMENT. The basic objectives of cash management are two fold. Meeting payment schedule and minimising funds locked up as cash balance. A. Meeting Payment Schedule.
In the normal course of business, (inns have to make payment of cash on a regular and continuous basis to suppliers of goods, employees, and so on. At the same time there is a constant inflow of cash through collections from debtors. A basic objective of cash management is to meet the payment schedule, that is to have sufficient cash to meet the cash disbursement needs of a firm It prevents insolvency or bankruptcy arising out of the in ability of a firm to meet its obligations. It also helps in keeping good relation with banks and creditors. Cash discount can be availed of, if the payment is made within the due date. B. Minimising Funds Locked up as Cash Balance. In minimising the cash balance, two conflicting aspects have to be reconciled. A higher cash balance ensures proper payment with all its advantages. But this will result in a large balance of cash remaining idle. Low level of cash balance may result in failure of the firm to meet the payment schedule. The finance manager should, there fore, try to have an optimum amount of cash balance, keeping in view the above factors. CASH MANAGEMENT TECHNIQUES / PROCESS. The strategic aspect of an efficient cash management are: 1. Preparation of cash budget 2. Efficient Inventory Management 3. Speedy Cash collection 4. Delaying Payments. SPEEDY CASH COLLECTION. In managing cash efficiently, the cash inflow process can be accelerated through systematic planning and refined techniques. There are two broad approaches to do this. In the first place the customers should be encouraged to pay as quickly as possible. Secondly the payment from the customers should be converted in to cash with out any delay. A. Prompt payment by customers. One way to ensure prompt payment by customers is prompt billing. What the customer has to pay and the dale and period of payment should be notified accurately and in advance. The use of mechanical devises for billing along with a self addressed return envelope will speed up the payment. Another technique is offering cash discount. The availability of discount implies savings to customers. To avail these facility, customers would be eager to make payment early. B. Early conversion of payment in to cash.
A firm can conserve cash and reduce its requirements for cash balance, if it can speed up its cash collections. Cash collection can be accelerated by reducing the time gap between the time the customer pays the bill and the time the cheque is collected and funds become available for the firms use. Three steps are involved in this time interval. 1 Transit or Mailing time :- This is the lime taken by the post office too transfer the cheque from the customers to the firm. This delay is referred to as Postal Float. 2. Time taken in processing the cheque within the firm before they are deposited in the Bank. 3. Collection time within the bank called Bank Float. The early conversion of payment in to cash, as a technique to speed up collection , is done to reduce the time lag between depositing of the cheque by the customer and the realisation of money by the firm. The collection of account receivable can be accelerated, by reducing transit, processing and collection time. An important cash management technique adopted for this is Decentralised Collection. The principal methods of establishing a decentralised collection network are; A. Concentration Banking . This is a system of operating through a number of collection centres, instead of a single collection centre at the head office. Under this arrangement, the customers are required to send their payments (cheques) to the collection centres covering their region. It reduces the mailing time, & time involved in sending the bill to the customers.
1. Avoidance of early payment 2. Centralised disbursement 3. Floats 4. Accruals 1.Avoidance of early payments. One way to delay payments is to avoid early payments. According to the terms of credit, a firm is required to make payment within a stipulated period. If the firm pays it accounts payable before the due date, it has no special advantage. Thus a firm would be well advised not to make payments early, i.e. not before the due date. 2.Centralised Disbursements. All the payments should be made by the head office from a centralised disbursement account. Such an arrangement would delay payments, because it involves increase in the transit time. The remittance from the head office to the customers in distant places would involve more mailing time. 3. Floats It refers to the amount of money tied up in cheques that have been written, but not yet en cashed It is due to transit and payment delays. There is a time lag between the issue of a cheque and its presentation. So although the cheque has been issued, cash would be required later, when the cheque is presented for encashment. There fore a firm can send remittance, although it does not have cash in its Bank A/C at the time of issue of cheque. There are two ways of doing it. 1. Paying from a distant Bank: The firm may issue a cheque on banks away from the creditor's bank. This would involve relatively longer transit time for the creditor's bank to gel payment and thus enable the firm to use its funds longer. 2. Cheque Encashment Analysis : Another way is to analyse on the basis of past experience, the time lag in the issue of cheques and their encashment. For E.g.: Cheques issued to pay wages and salary may not be cashed immediately, it may be spread over a few days, say 25% on first day, 50% on the second day and balance 3r day. It would mean that the firm should keep in the bank, not the entire amount of a pay roll, but only a fraction represented by actual withdrawal each day. This would enable to save operating cash. 3. Accruals: - These are liabilities, that represent a service/goods received by a firm, but not yet paid for. For e.g.: Salary to employees who render service in advance and receive payment later. They extend a credit to the firm for a period at the end of which they are paid (a week or a month). The longer the period, the greater is the amount of free financing and the smaller is the amount of cash balance required.
B. Lock Box System. Under this system, a firm arranges a Post office Lock Box at important collection centres. The customers are required to remit payments to the Post office lock box. The firms local bank is given the authority to pick up the remittances directly from the Box. The bank pick ups the mail several times a day and deposits the cheques in the firms A/C. after crediting the A/C, the bank sends a deposit slip along with the list of payments and other enclosures if any. Although the use of concentration banking and lock box system accelerates the collection of cash, they involve a cost, (cost in terms of maintenance of collection centres, compensation to the bank for services etc.). If the income exceeds the cost, the system is profitable. DELAYING PAYMENTS. Apart from speedy collection of cash , the operating cash requirements can be reduced by slow disbursement of A/C Payable. Slow disbursement represent a source of fund requiring no interest payment. There are several techniques to delay payment of A/C payable, namely
MANAGEMENT OF RECEIVABLES. An efficient control of stocks and liquid resources in conjunction with credit facility is an essential part of management control. Credit and collection policies significantly influence working capital requirements. With proper credit terms, the flow of cash from receivables is synchronised to liquidate current expenses with out requiring additional funds from short term sources. Accounts receivables constitute a significant portion of the total current assets of the business. They are a direct result of 'trade credit' which has become an essential marketing tool in modern business. When a firm sells goods for cash, payments are received immediately and there fore, no receivables are created How ever when a firm sells goods or services on credit, the payments are postponed to future dates and receivables are created. Meaning of Receivables. The term receivables is defined as "debt owed to the firm by customers arising from sale of goods or service in the ordinary course of business." Account receivables represents an extension of credit to customers, allowing them a reasonable period of time to pay for the goods purchased. Receivables are a direct result of credit sales. Credit sale is resorted to, by a firm to push up its sales which ultimately results in pushing up the profits earned by the firm. At the same time, selling goods on credit result in blocking of funds in Accounts Receivables. Additional funds are, there fore, necessary for the operational needs of the business, which involve extra cost in terms of interest. Moreover increase in receivables also increases the chance of bad debts. Thus creation of account receivable is beneficial as well as dangerous. Management of account receivables may, there fore, be defined as the process of making decisions relating to the investment of funds in this asset which will result in maximising the over all return of the investment of the firm. Thus the objective of receivables management is to promote sales and profits until that point is reached , where the return on investment in further funding of receivables is less than the cost of funds raised to finance that additional credit. Objectives of credit sales. The major objectives of credit sales are, 1. Achieving growth in sales: If a firm sells goods on credit, it will generally be in a position to sell more goods than if it insisted on immediate cash payment. This is because many customers are either
not prepared or not in a position to pay cash when they purchase goods . the firm can sell goods to such customers , in case it gives credit. 2. Increasing Profits. Increase in sales results in higher profits for the firm, not only because of increase in the volume of sales but also because of the firm charging a higher margin of profit on credit sales as compared to cash sales. 3. Meeting Competition. A firm may have give credit facilities to its customers because of similar facilities being granted by the competing firms to avoid the loss of sales from customers who would buy else where if they did not receive the expected credit. The over all objective of committing funds to A/C receivable is to generate a large flow of operating revenue and hence profit than what would be achieved in the absence of no such commitment. Cost of maintaining receivables. The costs with respect to maintenance of receivables can be identified as follows. 1. Capital Costs Maintenance of A/C receivables results in blocking of the firms financial resources in them. This is because there is a time lag between the sale of goods to customers and the payments by them. The firm has, there fore, to arrange for additional funds to meet its own obligations, such as payment to employees, suppliers of raw materials, etc while awaiting for payments from its customers. Additional funds may either be raised from outside or out of profits retained in the business. In both cases the firm incurs a cost. In the former case, the firm has to pay the interest to the outsider, while in the second case there is an opportunity cost to the firm. - i.e. the money the firm could have earned otherwise by investing the funds else where. 2 Administrative Cost. The firm has to incur additional administrative cost for maintaining Account Receivables in the form of salaries to the staff kept for maintaining accounting records relating to customers, cost of conducting investigation regarding customers credit worthiness etc. 3. Collecting Cost. The firm has to incur costs for collecting payments from its credit customers. Some times additional steps may have to be taken to recover money from defaulting customers. 4. Defaulting Cost.
Some times after making all serious efforts to collect money from defaulting customers, the firm may not be able to recover the over dues because of the in ability of the customers. Such debts are treated as bad debts and have to be written off since they cant be realised.
volume of receivables will also be large. If the firm supplies goods on installment basis its balance in receivables will be high. SYSTEM OF CONTROL OF RECEIVABLES. It is in the interest of the enterprise to keep the investment in receivables in a controllable limit. The financial management should consider the following four factors which control the receivables management cost at a minimum point. 1. Deciding acceptable level of Risk. The first consideration in this regard is to decide to whom goods are to be sold bearing in mind the risk involved. Because every credit transaction involves risk element, the financial management should consider the credit capacity of every customer before allowing any credit to him. Capacity of a customer can be judged by understanding his Character, Capacity^ Capital, Collateral Security offered and Conditions of sales. 2. Terms of Credit Sales. The next thing the company has to decide is the Credit Terms and the Level of Discount. The extension of credit represents an investment having some cost of capital. It will increase the sale of the organisation resulting in larger profits. In deciding upon the credit terms the firm should think over certain basic issues involved in it - such as cost of capital, cash discount, volume of sales, period of credit sales, and so on. By considering all these factors, i.e. the Cost and the Benefits the financial manager should fix the most desirable credit terms. 3. Credit Collection Policy. After granting the credit sale, the Co. should try to get the amount collected from its customers as early as possible. It needs a sound and strict collection policy to keep bad debts and losses at the minimum. The must also provide a certain amount as reserve for bad debt. The company should follow a collection procedure in a clear cut sequence. i.e. polite letter, strong worded reminders, personal visits and then legal action. 4. Analysing the Investments in Receivables. The last step is to analyse the amount of receivables from time to time with the help of certain ratios such as calculation of average collection period, debtors turn over ratio, ratio of receivables to current assets etc. A proper analysis of receivables will help the management in keeping the amount of receivables within reasonable limits.
FACTORS AFFECTING THE SIZE OF RECEIVABLES. The size of Account Receivables is determined by a number of factors. Some are: 1. Level of sales. This is the most important factor in determining the size of receivables. Generally in the same industry, a firm having a largo volume of sales will be having u larger level of receivables as computed to a firm with a small volume of sales. 2. Credit Policies. The term credit policy refers to those decision variables that influence the amount of trade credit, i.e. investment in receivables. These include total amount of credit to be accepted, the length of the credit period to be extended, and the cash discount to be given. A firms credit policy determines the amount of risk the firm is willing to under take in sales activities. If a firm has a liberal credit policy, it will experience a higher level of receivables as compared to a firm with rigid policy. 3. Terms of Trade. The size of receivables is also affected by the terms of trade (or credit terms) offered by the firm, the two important components are credit period and cash discount. A. Credit Period The term credit period refers to the time duration for which credit is extended to the customers. It is generally expressed in terms of "net date". For eg, if a firms credit terms are 'net 15' it means the customers are expected to pay within 15 days from the date of credit sale. B. Cash Discount. Most of the firms offer cash discounts to their customers for encouraging them to pay their dues before the expiry of the credit period. Allowing cash discounts results in a loss to the firm because of recovery of less amount than what is due from the customer, but it reduces the volume of receivables and puts extra funds at the disposal of the firm for alternative investment. The amount of loss thus suffered is, there fore, compensated by the income otherwise earned by the firm.' 4 Stability of sales. In the business of seasonal character, total sales and the credit sales will go up in the season and there fore
Unit 4
FINANCIAL STATEMENT ANALYSIS.
The financial statements are prepared for the purpose of presenting a periodical review or report of the progress made by the concern. It shows the 'status of the investment' in the business, and 'results achieved' during the accounting period. Financial statements refer to at least two statements which are prepared at the end of a given period. These statements are Income Statement (P'&L Account ) and Position Statement, (i.e. Balance Sheet). The purpose of' Income statement' is to ascertain the net result of trading activities. Position statement is prepared to find out the financial position of the business as on a particular date. According to John. N .Myer, " the financial statements provide a summary of the accounts of a business enterprise, the balance sheet reflecting the assets and liabilities and the income statement showing the results of operations during a certain period. In addition to P&L A/C and Balance sheet, Statement of Retained Earnings, Fund Flow Statement and cash flow Statements are also considered as important financial statements. The financial statements are of much interest to a number of groups of persons. These groups are very much interested in the analysis of financial statements. The process of critical evaluation of the financial information contained in the financial statements in order to understand and make decisions regarding the operations of the firm is called Financial Statement Analysis. It is basically a study of relationship among various financial facts and figures as given in a set of financial statements, and the interpretation thereof to gain an insight into the profitability and operational efficiency of the firm to assess its financial health and future prospects. Analysis means to put the meaning of a statement in to simple terms for the benefit of a person. Analysis comprises resolving the statements by breaking them in to simpler statements by a process of re arranging, regrouping, and collection of information
Broadly the term is applied to almost any kind of detailed enquiry in to financial data. A financial manager has to evaluate the past performance, present financial position, liquidity situation, enquire in to profitability of the firm and to plan for future operations. For all this, they have to study the relationship among various financial variables in a business as disclosed in various financial statements. USERS OF FINANCIAL STATEMENT ANALYSIS. Analysis of financial statement is an attempt to measure the enterprises liquidity, profitability, solvency and other indicators to assess its efficiency and performance. Analysis of financial statements is linked with the objective and interest of the individual / agency involved. Some of the agencies interested include Management, investors, creditors, bankers, workers, Government, and public at large. 1 MANAGEMENT. Management is interested in the financial performance and financial condition of the enterprise. It would like to know about its viability as an on going concern, management of cash, debtors, inventory and fixed asset and adequacy of capital structure. Management would also be interested in the overall financial position and profitability of the enterprise as a whole and its various departments and divisions. 2. INVESTORS An investor is interested in the profitability and safety of his investment and would like to know whether the business is profitable, has growth potential and is progressing on sound lines. The present investors want to decide whether they should hold the securities of the company or sell them. Potential investors, on the other hand, want to know whether they should invest in the shares of the company or not. Investors (Shareholders or owners) and potential investors, thus, make use of the financial statements to judge the present and future earning capacity of the business, to judge the operational efficiency of the business and to know the safety of investment and growth prospects. 3. BANKERS AND LENDERS Bankers and lenders are interested in serving of their loans by the enterprise, i.e. regular payment of interest and repayment of principal amount on schedule
dates. They also like to know the safety of their investment and reliability of returns. 4. SUPPLIERS/ CREDITORS. Creditors dealing with the enterprise are interested in receiving their payments as and when fall due and would like to know its ability to honor its shortterm commitments. 5. EMPLOYEES Employees interested in better emoluments, bonus and continuance of the business, would like to know its financial performance and profitability. 6. GOVERNMENT Government and regulatory authorities would like to ensure that the financial statements prepared are as per the specified laws and rules, and are to safe guard the interest of various concerned agencies. E.g.: Taxation authorities would be interested in ensuring proper assessment of tax liability of the enterprise as per the laws. Stock exchange uses the financial statements to analyze and thereafter, inform its members about the performance, financial health, etc. of the company. 7. CUSTOMERS Customers are interested to ascertain continuance of an enterprise. For example, an enterprise may be supplier of a particular type of consumer goods and in case it appears that the enterprise may not continue for a long time, the customer has to find an alternate source. 8.. PUBLIC Enterprises affect members of the public in a variety of ways. For example, enterprises may make a substantial contribution to the local economy in many ways including the number of people, they employ and their patronage of local suppliers. Financial statements may assist the public by providing information about trends and recent developments in the prosperity of the enterprise and the range of its activities. Different agencies thus look at the enterprise from their respective viewpoint and are interested in knowing about its profitability and financial condition. In short a detailed cause and effect study of profitability and financial condition is the over all objective of financial statement analysis. TYPES OF FINANCIAL ANALYSIS Following are the various types of financial analysis. A. On the basis of material used.
External analysis Analysis of financial statements may be carried out on the basis of published information. i.e information made available in the Annual Report of the enterprise. Such analysis are usually carried out by those who do not have access to the detailed accounting records of the Co. ie Banks, Creditors etc. 2 Internal Analysis. Analysis may also be based on detailed information available within the Co, which is not available to the outsiders. Such analysis is called internal analysis. This type of analysis is of a detailed one and is carried out on behalf of the management for the purpose of providing necessary information for decision-making. Such analysis emphasizes on the performance appraisal and assessing the profitability of different activities. B. According to objectives of analysis. 1. Short Term Analysis Short term analysis is mainly concerned with the working capital analysis. In the short run, a Co must have ample funds readily available to meet its current needs and sufficient borrowing capacity to meet the contingencies. In short term analysis the current assets and current liabilities are analyzed and liquidity is determined. 2. Long Term Analysis. In the long term a Co: must earn a minimum amount sufficient to maintain a reasonable rate of return on the investment to provide for the necessary growth and development of the Co; and to meet the cost of capital. Financial planning is also desirable for the continued success of a Co. Thus in the long term analysis the stability and the earning potentiality of the Co is analyzed, i.e fixed assets, long term debt structure and the ownership interest is analyzed. C. According to the Modus Operandi of analysis. 1. Horizontal Analysis. Analysis of financial statements involves making comparisons and establishing relationships among related items. Such comparison or establishing of relationship may be based on financial statements of a Co for a number of years and the financial statements of different Co's for the same year. Such analysis is called Horizontal Analysis. It may take the following two forms. A. Comparative Financial Statement Analysis B. Trend Analysis. 2. Vertical Analysis. Analysis of financial data based on relationship among items in a single period of financial statement is
called vertical analysis. From a single Balance Sheet or P&L A/C, relationships of various items may be established. E.g., various assets can be expressed as percentage of total assets. Statements containing such analysis are also called as common size statements. The common size P&L A/C is more useful in analyzing the operating results and costs during the year. It shows each element of cost as a percentage of sales. Similarly common size Balance Sheet shows fixed assets as a percentage to total assets. TOOLS OF FINANCIAL ANALYSIS (METHODS). The analysis of financial statements consist of a study of relationship and trends to determine whether or not the financial position of the concern and its operating efficiency have been satisfactory. In the process of this analysis various tools or methods are used by financial analyst. These tools are, 1. Comparative statements 2. Common size statements 3. Trend Analysis 4. Average Analysis 5. Statement of changes in working capital 6. Fund Flow Analysis 7 Cash Flow analysis & 8. Ratio Analysis. COMPARATIVE FINANCIAL STATEMENTS. The preparation of comparative financial statement is an important device of horizontal analysis. Financial data becomes more meaningful when compared with similar data for a previous period or a number of periods. Statements prepared in a form that reflect financial data for two or more periods are known as comparative statements. Annual data can be compared with similar data for prior years. Such statements are very helpful in measuring the effects of the conduct of a business during the period under consideration. Financial statements of two or more firms may also be compared for drawing inferences. This is known as inter-firm comparison. Comparative statements can
be of two types. Comparative Balance Sheet and Comparative P&L A/C.
The following steps may be followed to prepare the comparative statements: Step 1 : List out absolute figures in rupees relating to two points of time (as shown in columns 2 and 3) Step 2 : Find out change in absolute figures by subtracting the first year (Col.2)from the second year (Col.3) and indicate the change as increase (+) or decrease () and put it in column 4. Step 3 : Preferably, also calculate the percentage change as follows and put it in Column 5. Change in absolute figure First year figure x 100
Advantages 1. These statements indicate trends in sales, cost of production, profits, etc., helping the analyst to evaluate the performance, efficiency and financial condition of the undertaking. For example, if the sales are increasing coupled with the same or better profit margins, it indicates healthy growth. 2. Comparative statements can also be used to compare the position of the firm with the average performance of the industry or with other firms. Such a comparison facilitates the identification or weaknesses and remedying the situation.
Illustration 1. Convert the following Income Statement into a comparative income statement of BCR Co. Ltd and interpret the changes in 2005 in the light of the conditions in 2004.
Interpretation.
1. The Company has made efforts to reduce the cost which is evident from the fact that the cost of goods sold has not increased in the same ratio as the amount sales. 2. The gross profit has increased in 2005 as compared to 2004 considerably, 33.64% with an increase 20% in sales. 3. The company has also concentrated on reducing the operating cost; hence the percentage of
operating profit has also considerably increased, i.e 106.07%.
Thus the overall performance of the Co has immensely improved in the year 2005.
Illustration 2. From the following income statement of Madhu Co Ltd, prepare comparative income statement for the year ended 31st march, 2005 and 2006 and interpret the same. Particulars 2005 2006 Sales 4 00 000 6 50 000 Purchases 2 00 000 2 50 000 Opening stock 20 600 32 675 Closing stock 32 675 20 000 Salaries 16 18 000 Rent 010 6 000 Postage and stationary 5 4 100 Advertising 100 4 600 Commission on sales 3 200 3 500 Depreciation 2 600 500 Loss on sale of plant 3 160 2 000 Profit on sale of investments 200 4 500 4 000 3 000
Interpretation.
1. The comparative balance sheet of the company reveals that there has been an increase in sales by Rs 2 500 000, ie 62.5% where as cost of goods sold has increased only by Rs 74 750. Ie 39.78%. This reveals that the company has made efforts to reduce the cost of goods sold thereby the gross profit of the company has increased by Rs 1 75 250. Ie 82.64%. 2. The expenses of the Co have increased by R s 6430 ie 21.24% only, and the operating profit has increased by Rs 1 68 820, ie 92.86%. 3. The net profit of the Co has increased by 95.31%
4.
The overall performance of the Co is good.
Interpretation.
1. The comparative balance sheet of the company reveals that during the year 2006, there has been an increase in fixed assets by Rs.1,10,000, i.e. 13.5% while long-term liabilities have relatively increased by Rs.1,50,000 and equity share capital has increased by Rs.2 lakhs. This fact depicts that the policy of the company is to purchase fixed assets from long-term source of finance, thereby not affecting the working capital. 2. The current assets have increased by Rs.1,52,000, i.e. 24.52%. The current liabilities have increased only by Rs.20,000, i.e. 12.9%. This shows an improvement in the liquid position of the Company. 3. Shareholders funds (share capital plus reserves) have shown an increase of Rs. 92,000. 4. The overall financial position of the company is satisfactory.
Illustration 4
From the following information, prepare a comparative Balance Sheet of Deepti Ltd. :
Particulars
31.3.2003 (Rs.) 50,00,000 72,00,000 1 2,00,000 1 0,00,000 30,00,000 21,00,000 11 ,00,000
31,3.2002 (Ks.) 50,00,000 60,00,000 1 0,00,000 10,00.000 30,00,000 30,00,000 10,00,000
Equity share capital Fixed assets Reserves and surplus Investments Long-term loans Current assets Current liabilities
Solution :
Comparative Balance Sheet

as on 31.3.2002 and 31.3.2003 2002 Rs. 2003 Rs. Absolute Change Percentage Rs. Change (%)
Assets Fixed assets Investments Current assets Total assets
60,00,000 10,00,000 30,00,000 1,00,00,000
72,00,000
12.00,000 10,00,000 21,00,000 (9,00,000) 1.03,00,000 50,00,000 12.00,000 30,00,000 1 1 ,00,000 1,03,00,000 3,00,000 2,00,000 1,00,000 3,00,000
20 - 30 3 20 10 1
50,00,000 Liabilities and Capital 10,00,000 Equity share capital Reserves and surplus Long-term loans 30,00,000 10,00,000 Current liabilities 1 ,00,00,000
Debentures Long-term loans on Mortgage Total Liabilities Equity Share Capital Reserve & Surpluses Total
2,00,000 1 .50,000 5,05000 6,00,000 3,30.000 14.35,000
3,00,000 2.00,000 6,75,000 8.00,000 2.22.000 1 6,97.000
+ 1,00.000 +50.000 + 1.70.000 +2.00.000 - 1 08,000 +2.62.000
+50 +33 +33.66 +33 -32.73 + 1K.26
Interpretation (1) The comparative balance sheet of" the company reveals that during 2002 there has been an increase in fixed assets of 1,10,000 i.e 13.49% while long-term liabilities to outsiders have relatively increased by Rs. 1,50,000 and equity share capital has increased by Rs. 2 lakhs. This fact depicts that the policy of the company is to purchase fixed assets from the long-term sources of finance thereby not affecting the working capital. (2) The current assets have increased by Rs. 1,52,000 i.e.24.52% and cash has increased by Rs.60.000. On the other hand, there has been an increase in inventories amounting to Rs, 1 lakh. The current liabilities have increased only by Rs.20,000. i.e. 12.9%. This further confirms that the company has raised long-term finances even for the current assets resulting into an improvement in the liquidity position of the company. (3) Reserves and surpluses have decreased from Rs.3,30,000 to Rs.2,22,000 i.e.,32 73% which shows that the company has utilised reserves and surpluses for the payment of dividends to shareholders either in cash or by the issue of bonus shares. (4) The overall financial position of the company is satisfactory.
Illustration 6.
The income statements of a concern are given for the year ending on 31st Dec., 200 8and 2007. NSS College. Rajakumari.
Re-arrange the figures in a comparative form and study the profitability position of the concern.
200 7 Rs.(OOO) 2008 Rs.(OOO) 900 500
Net sales Cost of goods sold Operating Expenses: General and administrative expenses Selling expenses Non-operating Expenses : Interest paid Income -tax
785 450
70 80
72 90
25 70
30 80
Solution :
Comparative Income Statement
for the year ended 3 1st Dec. 2007 and 2008 31 December 2007 Rs. ('000) Net Sales Less : Cost of goods sold Gross Profit Operating Expenses: General & Administrative Selling Expenses Total Operating Expenses Operating Profit Less : Other deductions Interest paid Net profit before tax Less : Income tax Net Profit after tax 785 450 335 2008 (Rs. ('000) 900 500 400 Increase(+) Decrease (-) Rs. ('000) Increase(+) Decrease (-) (Percentages)
+ 115 +50 +65
+ 14.65 + 11.0 + 19.40
Expenses 70 80 150 185 25 160 70 90
72 90 162 238 30 208 80 128
+2 + 10 + 12 +53 +5 +48 + 10 +38
+2.8 + 12.5 +8.0 +28.65 +20 +30.0 + 14.3 +42.22
Interpretation NSS College. Rajakumari.
The comparative income statement given above reveals that there has been an increase in net sales of 14.65% while the cost of goods sold has increased nearly by 11 % thereby resulting in an increase in the gross profit of 19.4%. Although the operating expenses have increased by 8% the increase in gross profit is sufficient to compensate for the increase in operating expenses and hence there has been an overall increase in operational profits amounting to Rs.53,000 i.e. 28.65% in spite of an increase in financial expenses of Rs.5,000 for interest and Rs. 10,000 for income -tax. There in an increase in net profits after tax amounting to Rs.38,000 i.e. 42.22%. It may be concluded that there is sufficient progress in the company and the overall profitability of the company is good. . Balance sheet. This statement establishes relation between each asset and total value of asset and each liability against total liabilities. COMMON SIZE STATEMENTS. Common Size Income Statement. A Common Size Income statement is a statement in which each item of Comparative statements that give only the expense is shown as a percentage of net sale. A vertical percentage ratio for financial data with out significant relationship can be established between giving Rupee values are known as common size items of income statement and volume of sales. statements For example, if the Balance sheet items are expressed as the ratio of each asset to total assets The following procedure may be adopted for preparing and the ratio of each liability to total liabilities, it will be the common size statements. called a common size balance sheet. Thus a common size statement shows the relation of each component 1. List out absolute figures in rupees at two points of to the whole. It is useful in vertical financial analysis time, say year 1, and year 2 (Column 2 & 4 of Exhibit and comparison of two business enterprises at a 2) certain date.Common size statements include : 2. Choose a common base (as 100). For example, Common size Balance Sheet and Common size Sales revenue total may be taken as base (100) in Income Statement. case of income statement, and total assets or total liabilities (100) in case of balance sheet. Common size Balance Sheet - A statement in which 3. For all items of Col. 2 and 4 work out the Balance Sheet items are expressed as percentage of percentage of that total. Column 3 and 5 show these each asset to total asset and percentage of each percentages. liability to total liabilities is called Common Size
Illustration 1.
Interpretation : 1. In 2005, both current assets and current liabilities decreased as compared to 2004, but the decrease in current assets is more than the decrease in the current liabilities. As a result, the firm may face liquidity problem. 2. In 2005 both fixed assets and the long-term liabilities increased, but the increase in the fixed assets is more than the increase in long-term liabilities. The firm sold some investments to acquire fixed assets and used short-term funds to purchase fixed assets. 3. The firm has undertaken expansion programme reflected in addition to land and buildings. The overall financial position of the firm is satisfactory. It should improve its liquidity.
Illustration 2.
From the following financial statements, prepare Common Size Statements for the year ended March 31, 2004 and 2005.
Interpretation :
1. On comparison of the percentage of the cost of goods sold, it is observed that the company has tried to reduce its cost to improve its profit margin. 2. The profitability of the company has improved as compared to the previous year as the profit after tax percentage has gone up by 13.28%. 3. The company has issued share capital in order to finance the purchase of fixed assets like furniture and land and buildings. 4. The company has improved its liquidity position as reflected in the increase of its current assets. Thus, there is an improvement in the working of the company.
Illustration 3.
Prepare Common Size Statement from the following income statement of Karan Ltd. for the year ended March 31, 2006.
Illustration 4.
From the profit and loss accounts of Dharmasa Ltd for the years ended on 31st December, 2006, 2007, and 20089 prepare common size statement and interpret.
DHARMASA LTD PROFIT AND LOSS ACCOUNTS. For the years ended December31.
Interpretation. The absolute figures in rupees show that sales, cost of goods sold and gross profit all have
continuously increased since 2007. But common-size statement reveals that cost of goods sold in relation to sales decreased in 2008 and again increased in 2009. Consequently rate of gross profit in 2008 over 2007 increased but in 2009 over 2008 decreased. Similarly, net profit after tax, in absolute figures, shows an increasing trend since 2007 but the rate of net profit on sales in 2009 is 4.4 in contrast to 6.2 in 2008 and 5.4 in 2007.
FUND FLOW ANALYSIS The technique of fund flow has been developed to account for changes in assets and liabilities that take place in the course of the accounting year. Financial accounting has a very limited role to perform in this regard. Financial accounting provides essential basic accounting information. But its utility is very much limited for analysis and interpretation. The balance sheet is a
static summary of assets and liabilities on a particular date. It doesnt highlight the factors that were responsible for changes in balance sheet figures relating to two periods. Certain important transactions which might take place during the accounting year may not find any place in the balance sheet. To highlight changes in assets and liabilities, a statement is prepared which is called a fund flow statement.
Fund flow analysis is the second tool of analysis of financial statement. (Ratio analysis occupies the first position.). If we look at the balance sheets of a Company on two different days, we notice differences in the figures of assets and liabilities. A fund flow statement attempts to account for this difference. In fact Fund Flow analysis measures the changes in the assets and liabilities of a Company. The changes in Current Assets and Current Liabilities are shown in the Schedule of changes in the Working Capital and the changes in non current assets and non current liabilities are shown in Fund Flow Statement. Fund Flow statement is also known as statement of sources and applications of funds. MEANING OF FUND FLOW. The term Fund has been used to convey a variety of meanings. To many writers the term fund means cash. To others the term fund means working capital. These are the two extreme opinions. There are also two concepts of working capital- Gross Concept and Net Concept. Gross working capital refers to firms investments in total current assets. Net working capital refers to the excess of current assets over current liabilities. The most widely acceptable view of fund is the Net Working capital, which is the excess of Current Assets over Current Liabilities. Thus the term fund means Net Working Capital. The term Flow means movement or change. There fore, fund flow means change in funds. In other words, fund flow means flaw of funds in and out of the area of net working capital. Thus fund flow statement broadly measures the flow of fund in and out of the area of net working capital. There are many transactions which result in the flow of fund, while there are transactions which do not result in the flow of fund. Any external transaction which increases net working capital would be taken as a source of fund and any such transaction which decreases net working capital will be considered as application of fund. 1. Schedule of Changes in Working Capital. Many expert have opined that only the net change in working capital should be shown in the fund flow statement in place of individual changes in all current assets and current liabilities. For this purpose, a separate statement or schedule of working capital is being prepared in which net change in the working capital is ascertained. The increase in working capital
is treated as application of fund and decrease in working capital is termed as source of fund. This statement or schedule is prepared in such a way as to indicate the amount of working capital at the end of two years as well as increase or decrease in the individual items of current assets and current liabilities. The difference in the amount of working capital at the end of two years will depict either increase or decrease in net working capital. While ascertaining the increase or decrease in individual items of current assets and current liabilities and its impact on working capital, the following rules should be taken in to account. Increase in the items of current asset will increase the working capital 2. Decrease in the items of current asset will decrease the working capital. 3. Increase in items of current liabilities will decrease working capital. 4. Decrease in items of current liabilities will increase working capital. The following points should be taken in to consideration, while preparing a fund flow statement. 1. All changes in Current Assets and Current Liabilities are shown in the Schedule. 2. The schedule should be prepared exclusively from the items given in the Balance Sheet. The items given in the adjustments do not affect the preparation of this schedule. 3. Current Assets or Current Liabilities, once taken in the schedule, will not require any further treatment else where. Treatment of Provision for Bad debt. Some times it is shown as reserve for bad debt. This item should be shown along with current liabilities, in the schedule of changes in working capital. Provision for Tax. 1. If the problem itself classifies the provision for tax under current liabilities, then treat it as a current liability. Once it is taken in the schedule, it will not find any place in the fund flow statement. 2. If this item is not specifically classified as a current liability, but is merely shown as one of the items on the liability side, then this item may be taken as a non current liability. Thus it goes to the fund flow statement. Proposed dividend.
The same procedure is followed in respect of proposed dividend as has been given for provision for tax.
Application (Uses) of fund. 1. Redemption of Preference shares. 2. Redemption of debentures 3. Repayment of Loan 4. Purchase of Fixed Assets 5. Dividend Paid 6. Income Tax paid etc 3. Calculation of FUND FROM OPERATION.
2. Fund Flow statement This is second, but most important part of fund flow analysis. It is prepared on the basis of changes in fixed assets, long term liabilities and share capital on the basis of values of these items shown in the balance sheet. Of course additional information must also be considered. Increase in fixed assets is application of fund and decrease in fixed asset on account of sale is a source of fund. Increase in long term liabilities is source of fund and decrease in long term liabilities is application. Thus the preparation of fund flow statement involves the ascertainment of increase or decrease in the various items of fixed assets, long term liabilities, and share capital, in the light of additional information given. Sources of Fund. 1. Issue of shares 2. issue of debentures 3. Raising of new loans 4. Sale of fixed assets 5. Fund from operation 6. Non trading income like dividend received, interest on deposit etc. Less: Dividend received Profit on sale of asset Fund from Operation. xx xx ----------------xxxx ----------------P&L A/C closing balance Less: P&L A/C opening balance Current year profit. Add: Depreciation Provision for tax Proposed Dividend Interim dividend paid Loss on sale of asset Amortisation of goodwill Preliminary expenseswritten off Transfer to reserve xx xx xx xx xx xx xx xx --------------xxxx xxx xxx --------xxx
CASH FLOW ANALYSIS Cash flow analysis is another important technique of financial analysis. It involves preparation of cash flow statement for identifying sources and application of cash. The term cash here stands for cash and bank balance. A cash flow statement is a statement depicting changes in cash position from one period to another. It explains the reasons for such inflows or out flows of cash . A cash flow statement can be prepared on the same pattern on which a fund flow statement is prepared. The changes in cash position from one period to another is computed by taking in to account Sources and Applications of cash. Format of cash flow statement. Source Opening balance: Cash Bank Rs XXX XXX Application Decrease in liabilities Increase in asset Redemption of preference Rs XXX XXX XXX
Sources of cash. Increase in liabilities Decrease in current assets Issue of shares Raising of long term loans Sale of fixed assets Short term borrowings. Cash from operations. XXX XXX XXX XXX XXX XXX XXX XXXX Calculation of cash from operation (Refer calculation of fund from operation.)
shares Repayment of loan Purchase of fixed asset Tax paid Dividend paid
XXX XXX XXX XXX
Closing balance Cash Bank
XXX XXX XXXX
RATIO ANALYSIS. A companies financial information is contained in 3 basic financial statements- the Balance Sheet, the Trading and P&L Account and the P&L Appropriation Account. These statements are very useful to different partiers concerned such as management, creditors, investors and so on. These statements may be more fruitfully used if they are analysed and interpreted to have an insight into the strengths and weakness of the firm. Analysis of statements means such a treatment of the information contained in the two statements as to afford a diagnosis of the profitability and financial position of the firm concerned. In the analysis of financial statements, the analyst has a variety of tools available from which he can choose those best suited to his specific purpose. The most important tools used now a days are Ratio analysis, Fund flow analysis and Comparative and common size statements. Ratio Analysis. Ratios are well known and most widely used tools of financial analysis. A ratio gives the mathematical relationship between one variable and another. Accounting ratios are relationships, expressed in quantitative terms, between figures which have a cause and effect relationship or which are connected with each other in some manner or the other. The analysis of a ratio can disclose the relationships as well as bass of comparison that reveal conditions and trends that cant be detected by going through the individual components of the ratio. The usefulness of ratios is ultimately dependent on their intelligent and skillful interpretation. Classification of Ratios.
Ratios can be grouped into various classes according to financial activity or function to be evaluated. In view of the requirements of the various users of ratios, we can classify them into the following categories. Liquidity ratios. Profitability Ratios Solvency ratios. Liquidity Ratios. Liquidity ratios measure the firms ability to meet current obligations; ie the ability to pay its obligations as and when they become due. They show whether the firm can pay its short term obligations out of short term resources or not. They establish a relationship between cash and other current assets to current liabilities. If a firm has sufficient net working capital it is assumed to have enough liquidity. The most common ratios which indicate the extent of liquidity are current ratio and quick ratio. Current Ratio. It is calculated by dividing the Current Assets by Current Liabilities. Current ratio = Current Asset -------------------------Current Liabilities.
Current assets include cash, securities, debtors B/R, stock etc and current liabilities include creditors, B/P, accrued expense, short term loan etc. Current ratio is a measure of the firms short term solvency. It indicates the availability of a current asset in rupees for every one rupee of current liability . a ratio greater than 1 means that the firm has more current assets than current claims against them.
As a conventional rule, a Current ratio of 2:1 or more is considered satisfactory. This rule is based on the logic that in a worse situation even the value of CAs(current assets) becomes half, the firm will be able to meet its obligations. The higher the current ratio, the more will be the firms ability to meet its current obligations. In inter firm comparison, the firm with the higher current ratio has better liquidity or short term solvency. Quick Ratio. (Acid Test Ratio) This ratio establishes a relationship between quick or liquid assets and current liabilities. An asset is liquid, if it can be converted in to cash immediately or reasonably soon without a loss of value. Cash is the most liquid asset. QA also include debtors, B/R and securities. Inventories are considered less liquid. They normally require some time for realising in to cash. Quick assets Quick Ratio = -------------------------Current Liabilities. Quick assets = Current Assets Inventories or stock Generally a QR of 1:1 is considered to represent satisfactory current financial position. Cash Ratio (Absolute Liquid Ratio). Since cash is the most liquid asset, a financial analyst may examine the ratio of cash and its equivalent to current liabilities. Trade investments or marketable securities are equivalents to cash.
Cash / Bank + Marketable securities
Cost of goods sold means sales gross profit. Average inventory refers to the simple average of the opening and closing sock. The ratio indicates how fast inventory is sold. A high ratio is good from the view point of liquidity. A low ratio would signify that inventory does not sell fast. Debtors Turn over Ratio. It is determined by dividing the net credit sales by average debtors outstanding during the year. Net credit sales Debtors turnover Ratio = -----------------------Average Debtors. Net credit sales consists of gross sales sales returns if any from debtors. Average debtors is the simple average of opening balance of debtors and closing balance. Average debt collection period in days Debtors + B/R =------------------------- X 365 Net credit sales Average debt collection period in months Debtors + B/R =------------------------ X 12 Net credit sales 12 months Or Debt collection period = -------------------------Debtors turnover. Debtors turnover measures how rapidly debts are collected. A high ratio is indicative of shorter time lag between credit sales and cash collection. A low ratio shows that debts are not being collected rapidly. Creditors Turnover Ratio. Its the ratio between net credit purchases and average amount of creditors outstanding during the year. It is calculated as follows. Net credit purchase CTR = ------------------------------------------Average Creditors. Net credit purchase = Gross credit purchase returns to suppliers. Average creditors is the simple average of creditors at the beginning and at the end. Average debt Payment period in days Creditors + B/P = --------------------------------- x 365
Cash Ratio = ----------------------------------Current Liabilities.
Turn Over Ratio. The liquidity ratios discussed so far relate to the liquidity of a firm as a whole. Another way of examining the liquidity is to determine how quickly certain current assets are converted in to cash. The ratios to measure these are referred to as turnover ratios. Inventory Turnover Ratio. It is computed by dividing the cost of goods sold by the average inventory. Cost of goods sold Inventory turnover Ratio = -------------------------Average inventory.
Net credit purchases.
Or Net profit ratio 100
-------------------------X Sales
Creditors + B/P = --------------------------------- x 12 Net credit purchases 12 months Or Credit payment period = -----------------------Creditors turnover. A low turnover reflects liberal credit terms granted by suppliers, while a high ratio shows that accounts are to be settled rapidly. The creditors turnover ratio is an important tool of analysis as a firm can reduce its requirements of current assets by relying on the suppliers credit. Profitability Ratios.
The net profit margin is indicative of managements ability to operate the business with sufficient success not only to recover from revenues, but also to leave a reasonable margin to the owners. A high net profit margin would ensure adequate return to the owners as well as enable a firm to face adverse economic conditions. Expenses ratio. Another profitability ratio related to sales is expense ratio. It is computed by dividing expenses by sales. Cost of goods sold Ratio
A measure of profitability is the over all measure of efficiency. The management of the firm is naturally eager to measure its operating efficiency. Similarly is the share holders or owners who invest their funds in the expectation of reasonable returns. The profitability of a firm can be measured by its profitability ratios. Profitability ratios can be determined on the basis of either sales or investments. Gross profit margin. The gross profit margin ratio is calculated as Gross profit --------------------------------- X 100. Sales This ratio shows the profit relative to sales. A high ratio of gross profits to sales is a sign of good management as it implies that the cost of production of the firm is relatively low. Net Profit margin. This measures the relationship between net profit and sales of a firm. Depending on the concepts of the net profit employed, this ratio can be computed in two ways. Operating profit Ratio = 100 Sales Earning after Interest and tax (EAIT) Net profit Ratio = --------------------------------------X 100 Sales Net profit Earning Before interest and Tax (EBIT) ---------------------------------------------------X
Cost of goods sold --------------------------------------X100 Net sales
Administrative expense = Administrative expense ratio ---------------------------------------X 100 Net sales
Operating expense Operating expense Ratio = -------------------------------------- X 100 Net sales Selling expense Ratio. Selling expense. =--------------------------------------X 100 Net sales The expense ratio is closely related to the profit margin, gross as well as net. The cost of goods sold ratio shows what percentage share of sales is consumed by cost of goods sold and what proportion is available for meeting expenses such as selling and general distribution expense as well as financial expenses consisting of taxes, interest, dividends and so on. The expense ratio is very important for analysing the profitability of a firm. It should be compared over a period of time with the industry average as well as firms of similar type. A low ratio is favourable and a high ratio is unfavourable. Profitability ratios related to Investments.
The profitability ratios can be computed by relating the profits of a firm to its investments. Such ratios are popularly known as Return On Investments (ROI). There are 3 different concepts of investments and based on each of them, there are 3 broad categories of ROIs. Return on Asset. Here the profitability ratio is measured in terms of the relationship between net profits and assets. It is also called profit to asset ratio. Net profit after tax Return on Asset = --------------------------------- X100 Average total assets. Return on capital employed. Here the profits are related to total capital employed. The term capital employed refers to long term funds supplied by the creditors and owners of the firm. A comparison of those with similar firms, and with the industry average would provide sufficient insight in to how efficiently the long term funds of owners and creditors are being used. The higher the ratio, the more efficient is the use of capital. Return on capital employed = Net profit after tax /EBIT --------------------------------------------- X 100 Average total capital employed. Return on Total shareholders equity. According to this ratio, profitability is measured by dividing the net profits after tax by the average total shareholders equity. The term share holders equity includes (1) preference share capital, (2) ordinary share holders equity consisting of equity share capital, share premium, and reserves and surplus less accumulated losses. Return on total shareholders equity Net profit after tax = ------------------------------------------------ X 100. Average total shareholders equity. The ratio reveals how profitably the owners funds have been utilised by the firm. A comparison of this ratio with that of similar firms will show the performance of the firm. Return on ordinary shareholders equity.(Net worth) The real owners of the business are the ordinary share holders who bear all the risk, participate in management and are entitled to profit remaining after all outside claims, including preference dividends are met in full. Return on Equity Fund
Net profit after tax- Preference dividend = ---------------------------------------------------------Average ordinary shareholders equity. This is probably the single most important ratio to judge whether the firm has earned a satisfactory return for its equity share holders or not. Earning Per Share. EPS measures the profit available to the equity shareholders on a per share basis. ie the amount that they can get on every share held. The profits available to the ordinary shareholders are represented by the net profits after taxes and preference dividend. Net profit available to equity shareholders EPS -----------------------------------------------------------Number of ordinary shares outstanding. Dividend Per Share. This is the dividend paid to the shareholders on a per share basis. It is net distributed profit belonging to the shareholders dividend by the number of ordinary shares. Dividend paid to equity shareholders DPS = -------------------------------------------------Number of equity shares. Dividend Pay Out Ratio. This is also known as pay out ratio. It measures the relationship between the earnings belonging to the ordinary shareholders and the dividend paid to them. It can be calculated by dividing the total dividend paid to the owners by the total profits available to them. Total dividend to equity shareholders DPR =---------------------------------------------- X 100. Net profit belonging to equity shareholders =
Or
DPS ------------------ X 100 EPS
Price Earning Ratio This ratio gives the relationship between the market price of the stock and its earnings by revealing how earnings affect the market price of the firms stock.
Market price of share P E Ratio = -------------------------------EPS. Other important Ratios. Debt Equity Ratio. The relationship between borrowed funds and owners capital is a popular measure of the long term financial solvency of the firm. This relationship is shown by the debt equity ratio. It indicates the relative proportion of debt and equity in financing the assets of a firm.
the proportion between fixed income bearing securities and non fixed income bearing securities. The former includes preference share capital and debentures and the later includes equity share capital and reserves and surplus. Capital gearing Ratio = Fixed interest bearing funds --------------------------------------------------Equity share capital + Reserves and Surplus. Working Capital Turnover This reflects the turnover of the firms net working capital in the course of the year. Working capital --------------------------turnover Net sales Ratio =
Debt Outsiders fund Debt Equity Ratio = --------- or ------------------Equity. Share holders fund. The term debt refers to the total outside liabilities. It includes all current liabilities and other outside liabilities like loan debenture etc. The term equity refers to networth or shareholders fund. Proprietary ratio. This ratio shows the long term solvency of the business. It is calculated by dividing shareholders funds by total assets. Share holders fund Proprietary ratio = ------------------------------Total assets. Capital gearing ratio. This is also known as Leverage ratio. This is mainly used to analyse the capital structure of a company. The term capital gearing normally refers to
Net working capital. Operating Ratio. It shows the proportion that the cost of sales bears to sales. Cost of sales includes direct cost of goods sold as well as other operating expenses. It is calculated by dividing the total operating cost by net sales. Total operating expenses include all costs like administration, selling and distribution expenses etc, but do not include financing cost and income tax. Lower the ratio, the more profitable are the operations indicating an efficient control over costs and appropriate selling price. Operating Ratio = (Cost of goods sold + Operating expense) --------------------------------------------------x 100
Net sales
Illustration : 1 From the following compute current ratio: Rs. Stock 36,500 Sundry Debtors 63,500 Cash in hand & bank 10,000 Bills receivable 9,000 Short term investments 30,000 Solution:
Rs. Prepaid expenses 1,000 Bank overdraft 20,000 Sundry creditors 25,000 Bills payable 16,000 Outstanding expenses 14,000
Current Assets Current Liabilities Current Assets = Stock + Sundry debtors + Cash in hand and bank + Bills receivable + Short term investments + Prepaid expenses = 36,500 + 63,500 + 10,000 + 9,000 + 30,000 + 1,000 Current Ratio =
43 Financial Management = Rs. 1,50,000 Current Liabilities = Bank overdraft + Sundry creditors + Bills payable + Outstanding expenses = 20,000 + 25,000 + 16,000 + 14,000 = Rs. 75,000. 1,50,000 Current Ratio = 75,000 =2:1
Illustration :2 Calculate Debt Equity Ratio from the following information. Rs. Debentures 2,00,000 Loan from Banks 1,00,000 Equity share capital 1,25,000 Reserves 25,000 Solution: Total Long Term Debt Debt - Equity Ratio = Shareholders funds Total long term debt = Debentures + Loans from Bank = 2,00,000 + 1,00,000 = Rs. 3,00,000 Shareholders funds = Equity Share Capital + Reserves. = 1,25,000 + 25,000 = Rs. 1,50,000 3,00,000 Debt-Equity Ratio = = 2:1 1,50,000 From the following particulars ascertain gross profit ratio Rs. Cash sales 40,000 Sales return Credit sales 65,000 Gross profit Solution: Gross Profit Gross Profit Ratio = x 100 Sales Sales = Total Sales Sales Returns = 40,000 + 65,000 5,000 = Rs. 1,00,000 40,000 = x 100 = 40% 1,00,000
Problem 3 The following is the Balance sheet of ABC ltd as on 31st December 2005. Balance Sheet
Rs. 5,000 40,000
Liabilities Share capital Reserves and surplus Creditors Bills payable Bank overdraft Outstanding expense Provision for tax
Rs 2 00 000 30 000 20 000 5 000 17 000 8 000 20 000 3 00 000
Assets Fixed assets Stock Debtors Bills receivable Prepaid expense Cash at bank Cash in hand
Rs 1 60 000 50 000 20 000 15 000 5 000 30 000 20 000 3 00 000
Calculate 1) Current ratio, 2) Quick ratio, 3) Absolute liquid ratio. Answer. Current asset Current ratio = -------------------------Current Liability Quick ratio = Quick asset -------------------Current Liability 1 40 000 = -------------------= 2:1 70 000 = 85 000 ----------------- = 1.21 :1 70 000
cash and bank balance 50 000 Absolute liquid asset. = --------------------------------------- = --------------------- = 0.71 :1 Current liabilities 70 000
Calculate profitability ratios. Solution: Gross Profit 1. Gross Profit Ratio = x 100 Sales 1,80,000 = x 100 4,00,000 = 45% Net Profit 2. Net Profit Ratio = x 100 Sales 1,55,000 = x 100 4,00,000 = 38.75% Operating Profit 3. Operating Profit Ratio = x 100 Sales Operating Profit = Net Profit + Non-operating expenses Non-operating income = Net Profit + Interest + Loss on sale of machinery Dividend = 1,55,000 + 2,000 + 5,000 2,000 = Rs. 1,60,000 1,60,000 Operating Profit Ratio = -------------------- x 100 4,00,000
Cost of goods + Operating Expenses 4. Operating Ratio = Sales Cost of goods sold = Sales Gross Profit = 4,00,000 1,80,000 = Rs. 2,20,000
47 Financial Management Operating Expenses = Administration + Selling Expenses = 10,000 + 10,000 = Rs. 20,000 2,20,000 + 20,000 Operating Ratio = x 100 = 60%* 4,00,000 * Note : Operating ratio = 100% Operating profit ratio = 100% 40% = 60%
Illustration 5 Calculate the current ratio from the following information : Working capital Rs. 9,60,000; Total debts Rs.20,80,000; Long-term Liabilities Rs.16,00,000; Stock Rs. 4,00,000; prepaid expenses Rs. 80,000. Solution Current Liabilities = Total debt- Long term debt = 20,80,000 16,00,000 = 4,80,000 Working capital 9,60,000 Current Assets Quick Assets = Current Assets Current liability = Current Assets 4,80,000 = 14,40,000 = = = = = = = = = Current Assets (stock + prepaid expenses) 14,40,000 (4,00,000 + 80,000) 9,60,000 Current Assets / Current liabilities 14,40,000/4,80,000 3:1 Quick Assets / Current liabilities 9,60,000/4,80,000 2:1
Current ratio Quick ratio Illustration 6
From the following information, calculate Debt Equity Ratio, Debt Ratio,Proprietary Ratio and Ratio of Total Assets to Debt. Balance Sheet as on December 31, 2006 Equity share Capital Preference Share Capital Reserves Profit & loss A/C 11 % Mortgage Loan Current liabilities 3,00,000 1,00,000 50,000 65,000 1,80,000 1,20,000 8,15,000 Fixed Assets Current Assets Preliminary Expenses 4,50,000 3,50,000 15,000
8,15,000
Solution Shareholders Funds = Equity Shares capital + Preference Shares capital + Reserves + profit % loss A/C - Preliminary Expenses = Rs. 3,00,000 + Rs. 1,00,000 + Rs.50,000 + Rs. 65,000- Rs. 15,000 = Rs. 5,00,000 Debt Equity Ratio = Debt / Equity NSS College. Rajakumari.
= Rs. 1,80,000/Rs. 5,00,000 = 0.36: 1
Proprietary Ratio = Proprietary funds / Total Assets = Rs. 5,00,000/Rs. 8,00,000 = 0.625:1 Total Assets to Debt Ratio = Total Assets / Debt = Rs. 8,00,000/Rs. 1,80,000 = 4.44:1
Illustration 7 Calculate the Gross profit Ratio, Net Profit Ratio and Operating Ratio from the given the following information: Sales Cost of Goods Sold Selling expenses Administrative Expenses Rs. Rs. Rs. Rs. 4,00,000 2,20,000 20,000 60,000
Solution
Gross Profit = Sales Cost of goods sold = Rs. 4,00,000 Rs. 2,20,000 = Rs. 1,80,000
Gross Profit Ratio = Gross s Profit X 100 Sales = Rs. 1 ,80,000 X 100 Rs 4 ,00,000 = 45 % Net Profit = Gross Profit Indirect expenses = Rs. 1,80,000 (Rs. 20,000 + Rs. 60,000) = Rs. 1,00,000 Net Profit Ratio = Net profit / Sales 100 = Rs.(1,00,000/ 4,00,000) X 100 = 25 % Operating Expenses = Selling Expenses + Administrative Expenses = Rs. 20,000 + 60,000 = Rs. 80,000 Operating Ratio = Cost of goods + Operating Expenses X 100 Net Sa les = Rs. 2 ,20,000 + Rs. 80,000 X 100 Rs4, 00,000 = 75 %
Illustration 8
Problem
Problem 2. The following is the Balance sheet of XYZ ltd, as on 31st March 2005. Liabilities Equity share capital Preference share capital General reserve Profit and loss account 12 % debentures Creditors Bills payable Rs 2 00 000 2 00 000 80 000 40 000 2 20 000 1 00 000 50 000 8 000 90 Assets Land and buildings Plant and machine Furniture Stock Debtors Bills receivable Cash at bank Cash in hand Rs 1 50 000 2 50 000 50 000 1 50 000 70 000 80 000 1 00 000 40 000 8 90 000
Calculate 1). Current Ratio. 2) Quick ratio, 3) debt Equity ratio, 4) Proprietary ratio, 5)Fixed asset to net worth, 6) Capital gearing ratio. Answer. Current assets Current ratio = -----------------------Current liabilities 4 40 000 = ---------------------- = 2.93 :1 1 50 000
Quick assets 2 90 000 Quick ratio = -------------------------- = ----------------- = 1.93 : 1 Current liabilities 1 50 000 Debt Debt equity ratio = -----------------Equity (Debt = debenture + creditors + bills payable Equity = Equity share capital + Pref share + General reserve + P& L account ) Shareholders fund 5 20 000 Proprietary ratio = ---------------------------------- = ---------------------- = 0.58 : 1 Total assets. 8 90 000 (Where, share holders fund = 2 00 000+ 2 00 000+ 80 000+ 40 000 = 5 20 000). Fixed asset 4 50 000 Fixed asset to net worth ratio = -------------------= -------------------Net worth.(share holders fund) 5 20 000 Preference share capital + debentures Capital gearing ratio = Equity share capital + Reserves and surplus. = 2 00 000 + 2 20 000 2 00 000 + 80 000+ 40 000 = 1.31:1
= .86 :1.
Problem 3 From the following, work out 1) Gross profit ratio, 2)Net profit ratio, 3)Operating profit ratio, and 4)Operating ratio. Trading and P&L Account. particulars Rs To Opening stock 40 000 Purchases 4 00 Direct expenses 000 Gross profit c/d 60 000 1 00 000 To operating expense 6 00 Administration 000 exp Selling expense Finance expense 20 000 Income tax 10 000 Net profit 20 000 10 000 40 000 1 00 000 Gross profit ratio = gross profit Sales Particulars By Sales Closing stock Rs 5 00 000 1 00 000 6 00 000 By gross profit b/d 1 00 000
1 00 000
x 100
1 00 000 x 100 5 00 000 x 100 = 40 000 x 100 = 8 %. 5 00 000

Net profit ratio = Net profit after interest and tax Net sales
Operating ratio = cost of goods sold + operating expense x 100 Net sales
Cost of goods sold = sales gross profit ( ie opening stock + purchases + direct expense ) Closing stock ie 5 00 000 1 00 000 = 4 00 000. Operating ratio = 4 00 000 + 30 000 5 00 000 x 100 = 86 %.
Operating profit ratio = 100 Operating ratio. = 100 86 = 14 %.
Illustration : 5 From the following calculate Proprietory Ratio Rs. Equity share capital 1,00,000 Preference share capital 75,000 Reserves & surplus 25,000 Machinery 30,000 Goodwill 5,000 Solution : Shareholders funds Proprietory Ratio = Total tangible assets.
Rs. Furniture 10,000 Bank 20,000 Cash 25,000 Stock 15,000
Shareholders fund = Equity capital + Preference Share Capital + Reserve & Surplus = 1,00,000 + 75,000 + 25,000 = Rs. 2,00,000 Total tangible assets= Machinery + Furniture + Bank + Cash + Stock = 30,000 + 10,000 + 20,000 + 25,000 + 15,000 = Rs. 1,00,000 2,00,000 = = 2:1 1,00,000
From thew following, Calculate Stock Turnover.

Problem
Problem. 4 The following are the final accounts of Tata consultancy limited for the years ended 31st March 2005 and 2006. BALANCE SHEET LIABILITIES 2004 2005 ASSSETS 2004 2005
Share capital Equity shares of 10 each 14% Preference shares P&L Account General Reserve 12 % debentures of Rs100 Sundry creditors Outstanding expense Other current liabilities
2 39 150 32 650 82 050 2 13 430 3 20 000 1 03 680 13 090 55 890 10 59 940 2 32 570 0 62 280 1 61 560 92 500 53 370 6960 28 670 6 37 910
Property, plant and equipment Less depreciation Patent etc Other fixed assets Current assets Stock Book debts Prepaid expense Bank
6 08 060 2 00 830 4 07 230 0 4 290 2 32 820 2 90 530 6 640 1 18 430 10 59 940
3 67 730 1 02 810 2 64 920 2 490 800 68 690 1 92 500 4 150 1 04 360 6 37 910
REVENUE STATEMENT Cost of sales Gross profit Administration and selling expense . Bonus paid Interest paid Provision for taxation Transfer to reserve Net income 2005 12 84 340 6 47 790 19 32 130 2 63 690 98 310 38 400 1 47 120 37 200 72 630 6 57 350 2004 6 07 760 3 11 780 9 19 540 1 38 440 41 670 11 100 69 340 36 300 17 660 3 14 510 Sales 2005 19 32 130 19 32 130 Gross profit Other income . 6 47 790 9 560 2004 9 19 540 9 19 540 3 11 780 2 730
6 57 350
3 14 510
From the above, 1) Work out various ratios for the management. 2) With the help of ratios, give a clear account of the profitability and financial condition of the Co in 2004 05 a comparative scale. Solution: Ratios Profitability Ratios. Return on capital employed based on operating profit, before interest and tax. 2005 2 85 790 --------------x 100 = 32.21 % 8 87 280 2 85 790 ------------ x 100 = 14.79 % 19 32 130 6 47 790 -------------- x 100 = 33. 53 % 19 32 130 12 84 340 -------------- x 100 = 66. 47 % 2004 1 31 670 ------------ x 100 = 23.99% 5 48 910 1 31 670 ------------ x 100 = 14.32 % 9 19 540 3 11 780 --------------- x 100 = 33.91% 9 19 540 6 07 760 -------------- x 100 = 66.09% NSS College. Rajakumari. , on
Net profit Ratio
Gross profit ratio
Cost of sales ratio(cost of sales / sales)
19 32 130 16 46 340 --------------- x 100 = 85. 21% 19 32 130
9 19 540 7 87 870 ---------------- x 100 = 85.68% 9 19 540
Operating Ratio. (cost of sales + operating exp) ------------------------------------ x 100 Sales Turnover Ratios. General turn over ratio (sales / capital employed) Turn over of fixed capital
19 32 130 -------------- = 2.18 8 87 280 19 32 130 --------------- = 4. 74 4 07 230 19 32 130 -------------- = 4. 06 4 75 760 12 84 340 -------------- = 5.52 2 32 820 2 90 530 ------------ x 12 = 1.8 months 19 32 130 6 48 420 --------------- = 3.76 : 1 1 72 660 4 08 960 -------------- = 2.37 : 1 1 72 660 3 20 000 -------------- = 0.36 8 87 280 4 07 230 ---------------- = 0.51 :1 8 05 230 1 09 830 -------------- = Rs 4. 59 23 915
9 19 540 ---------------- =1. 68 5 48 910 9 19 540 ---------------- = 3.44 2 67 410 9 19 540 ------------------ = 3. 28 2 80 700 6 07 760 ----------------- = 8.85 68 690 1 92 500 ------------x 12 = 2.51months 9 19 540 3 69 700 ------------- = 4.15 : 1 89 000 2 96 860 ---------------- = 3.3.4 :1 89 000 92 500 --------------- = 0.17 5 48 910 2 67 410 --------------= 0.55 :1 4 86 630 53 960 --------------- = Rs 2.32 23 257
Turnover of net working capital Stock turnover ratio (cost of sales/ closing stock.)
Average debt collection period Financial Position Ratios. Current ratio
Liquidity ratio
Debt equity ratio
Fixed asset ratio
EPS
ASSESSMENT.
The activity of the company (derived from sales figures) during 2005 as compared to 2004 has more than doubled. Correspondingly, the gross profit has also more than doubled. He overall profitability ( return on capital employed) has shown a rise. It means in the year 2005 the profit has increased not only in volume corresponding to the increase in sales, but more than proportionate to the increase in sales. Though the net profit and gross profit ratio were almost maintained, still the return on capital employed has increased. This is mainly due to the increase in turnover of the capital employed. On the whole the performance is satisfactory.
On the financial side there have been some setbacks. The liquidity position has worsened and so has debt equity ratio. Though the situation is not serious yet a close watch should be kept. Ther have been very heavy long term borrowings. During the year money has been raised from preference shares and debentures from long term assets. This has pushed the debt equity ratio to a level beyond which probably it cannot go. It may be better for the company to broaden the equity base by reducing outstanding debentures and raising additional funds from equity shares. Problem 5 The ratios relating to Cosmos Limited are given below as follows. Gross profit ratio : 15 % Stock velocity : 6 months Debtors velocity : 3 months Creditors velocity : 3 months Gross profit for the year ending 31 st December amounts to Rs 6 00 000. Closing stock is equal to opening stock. Find out 1) sales, 2) Closing stock, 3 ) Sundry debtors, 4 ) Sundry creditors. Solution. Gross profit ratio = 15% Sales Closing Stock. Stock velocity = Cost of goods sold Average stock Cost of goods sold = Sales Gross profit = 4 00 000 60 000 = 3 40 000. 12 = 3 40 000 x 6 = Rs 1 70 000. 6 12 Since opening and closing stock are the same ; closing stock is Rs 1 70 000. Sundry Debtors Debtors velocity = Total debtors x No of months Sales 3= Total debtors x 12 4 00 000 Total debtors = 4 00 000 x 3 = 1 00 000. 12 Sundry Creditors For calculating sundry creditors, the figure for credit purchases will be required. Cost of goods sold = Opening stock + Purchases Closing stock Rs 3 400 000 = Rs 1 70 000 + Purchases Rs 1 70 000 Purchases = Rs 3 40 000. Creditors velocity = 3= Total creditors x No of months Purchases Total creditors x 12 3 40 000 = 3 40 000 x 3 = Rs 85 000. 12
Gross profit x 100 Sales
Rs 6 00 000 Sales = 6 00 000 x 100 = 4 00 000. 15
Total creditors
Problem 6 Prepare a Balance sheet in the given format, with the help of the following ratios. Total assets / Net worth : 3.5 Sales / Fixed assets :6 Sales / current assets :8 Sales / Inventory : 15 Sales / debtors :18 Current ratio : 2.5 Annual sales : Rs 25 00 000. Balance sheet Rs Assets ------ Fixed assets ----Inventory ----Debtors Liquid ------ assets -
Liabilities Net worth Long term debt Current liabilities
Rs -----------------------
Solution. 1. Sales / Fixed assets Sales Fixed assets 2. Sales / Current assets Sales Current assets 3. Sales / Inventory Inventory 4. Sales / Debtors Debtors = 6 :1 = Rs 25 00 000 ( ie 6) = 25 00 000 x 1 = Rs 4 16 667. 6 = 8 :1 = Rs 25 00 000 ( ie 8) = 25 00 000 x 1 = Rs 3 12 500. 8 = 15 times. = 25 00 000 x 1 15 = 18 times. = 25 00 000 x 1 18 = Rs 1 66 667.
= Rs 1 38 889.
5. Current assets = Inventory + Debtors+ Liquid assets There fore, liquid assets = current assets (inventory + debtors) Liquid assets Liquid assets 6. Current Ratio Current assets Current liabilities 7. Total assets / Networth = 3 12 500 (1 66 667 + 1 38 889) = Rs 6 944. = Current assets Current liabilities = 3 12 500 (ie 2.5) = 3 12 500 2.5 x 1 = 2.5
= Rs 1 25 000. = 3.5 :1
= Total assets Networth
Where total assets Total assets Networth 8. Long term debt Long tem debt = Fixed assets +Inventory +Debtors +Liquid assets. = 4 16 667 + 1 66 667 + 1 38 889 + 6 944 = Rs 7 29 167. = 7 29 167 x 1 3.5 = Rs 2 08 333.
= Total liabilities (current liabilities + net worth) = 7 29 167 - ( 1 25 000 + 2 08 333) = Rs 3 95 834.
Liabilities Net worth Long term debt Current liabilities
Balance sheet Rs Assets 2 08 Fixed assets 333 Inventory 3 95 Debtors 834 Liquid 1 25 assets 000 7 167 29
Rs 4 16 667 1 66 667 1 38 889 6 944 7 29 167
Problem 7 You are given the following figures. Current ratio -2.5 Stock turnover - 6 times Average debt collection period - 2 months. Gross profit ratio 20 % Liquidity ratio- 1.5 Net working capital-Rs 300 000 Gross profit ratio 20 % Fixed asset turnover ratio Fixed asset / shareholders net (on cost of asset)- 2 times worth 0.08 Reserves and surplus to capital 0.50
Draw up the Balance Sheet of the company. Solution. Working capital:If current liabilities are 1, current assets are 2.5. It means the difference or working capital 1.5. Working capital Rs 3 00 000. There for current assets = 3 00 000 X 2.5 = 5 00 000. 1. 5 Current liabilities = 3 00 000 X 1 = 2 00 000. 1.5
As liquidity ratio = 1.5 and current liabilities 2 00 000, Liquid assets are = 2 00 000 x 1.5 = 3 00 000. Stock ( 5 00 000 3 00 000, ie current assets liquid assets ) Rs 2 00 000. Cost of sales ( as stock turnover ratio is 6) = 12 00 000. Sales ( as gross profit ratio is 20 % 12 00 000 + 20 x 12 00 000 = 15 00 000. 80
Fixed assets are ( since fixed assets turnover ratio is 2 ) Rs 12 00 000 = 6 00 000.
2
Debtors are ( since debt collection period is 2 months )15 00 000

6
= 2 50 000.
Shareholders Net worth 6 00 000 = 7 50 000 0.80 Out of shareholders net worth reserves and surplus = 2 50 000 There fore share capital = 5 00 000. Liabilities Share capital Reserves and surplus Long term borrowings ( balancing figure ) Current liabilities Rs 5 00 000 2 50 000 1 50 000 2 00 000 11 000 00 Assets Fixed assets Stock Debtors bank . Rs 6 00 000 2 00 000 2 50 000 50 000 11 00 000
Income Statement Model form.

Rs Sales Less sales returns Net sales. Less. Cost of goods sold Opening stock of material Add: Purchases of material Add: Direct expense Manufacturing expense Less: Closing stock of material Cost of production Add: Opening stock of finished product Less :Closing stock of finished product (Cost of goods sold) Gross profit Less. Operating expense Administration exp Selling and distribution exp Operating exp Add: Non trading income Less: Non trading expense XXX XXX XXX XXX X XXX XXX X XXX XXX XXX X XXX XXXX XXX Xxx Xxx Xxx Xxxx Xxx Xxxx Xxx
Rs
X XXX XX X XXX
EBIT ( Earning before Interest and Tax) Less. Interest on debenture Net income Less. Tax Net profit after tax. / EAIT. (Earning After Interest and Tax)
XXXX Xxx Xxxx Xxx
XXX
Problem 8 Following is the P&L Account and Balance Sheet of Jai hind Ltd. Re draft them for the purpose of analysis and calculate the following ratio. 1) Gross Profit Ratio 2) Overall profitability Ratio 3) Current Ratio 4) Debt Equity Ratio 5) Stock Turnover Ratio 6) Liquidity Ratio. P&L Account Particulars Opening stock of finished goods Opening stock of materials Purchases of materials Direct wages Manufacturing expense Administration expense Selling and distribution expense Loss on sale of plant Interest on debentures Net profit Rs 1 00 000 50 000 3 00 000 2 00 000 1 00 000 50 000 50 000 55 000 10 000 3 85 000 13 00 000 Rs 1 00 share 000 1 00 000 1 00 000 2 00 000 1 00 000 50 000 6 000 Solution
Particulars Sales Closing stock of materials Closing stock of finished goods Profit on sale of shares
Rs 10 00 000 1 50 000 1 00 000 50 000
13 00 000
Balance sheet Liabilities Equity share capital Preference capital . Reserves Debentures Sundry debtors Bills payable
Assets Fixed assets Stock of materials . Stock of finished stock Sundry debtors Bank balance
Rs 2 50 000 raw 1 50 000 1 00 000 1 00 000 50 000 6 50 000
50
Income Statement
Sales
Less: Cost of sales: Raw material consumed (Opening stock + Purchases closing stock) . Direct wages Manufacturing expense Cost of production Add : Opening stock of finished goods Less : Closing stock of finished goods Cost of goods sold.
Gross Profit.
10 00 000 2 000 2 000 1 000 5 000 1 000 6 000 1 000 00 00 00 00 00 5 00 000 00 5 00 000 00 1 00 000 4 00 000 50 000 4 50 000 50 000 50 000 55 000 3 95 000 10 000 3 85 000
Less : Operating expense: Administration expense Selling and distribution expense

Net operating profit
Add : Non trading income: Profit on sale of shares Less : Non trading expense or loss. Loss on sale of plant
Income before interest and tax
Less : Interest on debentures

Net profit before tax.
Solution 1) Gross profit Ratio 2) Overall profitability Ratio 3) Current Ratio 4) Debt equity Ratio = Gross profit x 100 Sales = 5 00 000 x 100 = 50 % 10 00 000 4 00 000 x 100 = 80 % 5 00 000 4 00 000 1 50 000 = 2 .67 = 1.17
= Operating profit x 100 = Capital employed = Current assets x 100 = Current liabilities
= External equities x 100 = 3 50 000 Internal equities 3 00 000 Or Total long term debt Share holders fund = 2 00 000 3 00 000 = 5 00 000 2 00 000 = 1 50 000 1 50 000
= 0.67 = 2.5 =1
5) Stock turnover ratio 6) Liquid Ratio
= Cost of goods sold Average Inventory = Liquid Assets Current Liabilities
COST OF CAPITAL
The cost of capital of a firm is the minimum rate of return expected by its investors. It is the weighted average cost of various sources of finance used by a firm. The capital used by a firm may be in the form of debt, preference capital, retained earnings and equity shares. The concept of cost of capital is very important in the financial management. A decision to invest in a particular project depends upon the cost of capital of the firm or the cut off rate which is the minimum rate of return expected by the investors. In case a firm is not able to achieve even the cut off rate, the market value of its shares will fall. In fact, cost of capital is the minimum rate of return expected by its investors which will maintain the market value of shares at its present level. Hence, to achieve the objective of wealth maximisation, a firm must earn a rate of return more than its cost of capital. Further, optimal capital structure maximises the value of a firm and hence the wealth of its owners and minimises the firm's cost of capital. The cost of capital of a firm or the minimum rate of return expected by its investors has a direct relation with the risk involved in the firm. Generally, higher the risk involved in a firm, higher is the cost of capital. Cost of capital for a firm may be defined as the cost of obtaining funds, i.e., the average rate of return that the investors in a firm would expect for supplying funds to the firm. In the words of Hunt, William and Donaldson, "Cost of capital may be defined as the rate that must be earned on the net proceeds lo provide the cost elements of the burden at the time they are due". James C. Van Home defines cost of capital as, "a cut-off rate for the allocation of capital to investments of projects. It is the rate of return on a project that will leave unchanged the market price of the stock." Hampton, John J. defines cost of capital as, "the rate of return the firm requires from its investments, in order to increase the value of the firm in the market place". Thus, we can say that cost of capital is that minimum rate of return which a firm, must and, is expected to earn on its investments so as to maintain the market value of its shares.
SIGNIFICANCE OF THE COST OF CAPITAL
The concept of cost of capital is very important in the financial management. It plays a crucial role in both capital budgeting as well as decisions relating to planning of capital structure. Cost of capital concept can also be used as a basis for evaluating the performance of a firm and it further helps management in taking so many other financial decisions. 1. As an Acceptance Criterion in Capital budgeting. In the words of James T.S. Posterfield 'the concept of cost of capital has assumed growing importance largely because of the need to devise a rational mechanism for making the investment decisions of the firm'. Capital budgeting decisions can be made by considering the cost of capital. According to the present value method of capital budgeting, if the present value of expected returns from investment is greater than or equal to the cost of investment, the project may be accepted; otherwise; the project may be rejected. The present value of expected returns is calculated by discounting the expected cash inflows at cut-off rate (which is the cost of capital). Hence, the concept of cost of capital is very useful in capital budgeting decision. 2. As a Determinant of Capital Mix in Capital Structure Decisions. Financing the firm's assets is a very crucial problem in every business and as a general rule there should be a proper mix of debt and equity capital in financing a firm's assets. While designing an optimal capital structure, the management has to keep in mind the objective of maximising the value of the firm and minimising the cost of capital. Measurement of cost of capital from various sources is very essential in planning the capital structure of any firm. 3. As a Basis for Evaluating the Financial Performance. In the words of S .K. Bhattachary the concept of cost of capital can be used to 'evaluate the financial performance of top management'. The actual profitability of the project is compared to the projected overall cost of capital; and the actual cost of capital of funds raised to finance the project. If the actual profitability of the project is more than the projected and the actual cost of capital, the performance may be said to be satisfactory. 4. As a Basis for taking other Financial Decisions. The cost of capital is also used in making other financial decisions such as dividend policy, capitalisation of profits, making the rights issue and working capital. Computation of cost of capital Computation of cost of capital involves (1) Computation of cost of each specific source of finance and (2) Computation of composite cost termed as weighted average cost.
1. Cost of Debt / Debenture. Debt may be issued at par, at premium or at discount.
Debt issued at par. Cost of debt = Kd = (1 T) R Where; Kd = Cost of debt T = Tax Rate R = Debenture interest rate. For example if a company has issued 9 % Debentures and the tax rate is 50 %, the cost will be Kd = (1-T) R = (1 - .5) 9 = 4.5 %. Debt issued at premium or discount. In case the debentures are issued at premium or discount, the cost of debt should be calculated on the basis of net proceeds realized on account of issue of such debentures or bonds. Kd I . (1 T) NP Where; Kd = Cost of debt after tax I = Annual interest payable NP = Net proceeds of loans or debentures T = Tax rate. 2. Cost of Redeemable Debt. If debentures are redeemable after a fixed period, ( P- NP) ---------------n Kd ( before tax) = ------------------------------------------- x 100 ( P + NP ) ---------------2 Where, I = Annual interest payable P = Par value of debentures. NP = Net proceeds of debentures .n = number of years to maturity. I+ Kd ( after tax) = Kd (before tax) x ( 1 T) =
3. Cost of Preference Capital. DP KP = ---------- x 100. NP Where Kp = Cost of preference capital. DP = Preference dividend. NP = Net proceeds. 4. Cost of Redeemable Preference shares.
( P- NP)
---------------n KP ( before tax) = ------------------------------------------- x 100 ( P + NP ) ---------------2 Where, D = Dividend P = Par value of debentures. NP = Net proceeds of debentures .n = number of years to maturity. 5. Cost of Equity Share Capital. A. Dividend Price Method. ( DP Approach). New Equity Share Capital. D Ke = --------- x 100 NP Where, Existing shares. D Ke = -------- x 100. MP Where, MP = Market Price. B. Earning Price Method. Ke = Or E ---------------------x 100 MP Where, E = Earning per share NP = Net proceeds MP = Market price. Ke = 6. Weighted Average Cost of Capital. After calculating the cost of each component of capital, the average cost of capital is generally calculated on the basis of weighted average method. This may also be termed as overall cost of capital. Weighted average cost of capital is the average cost of the costs of various sources of financing. Weighted average cost of capital is also known as composite cost of capital, overall cost of capital or average cost of capital. Once the specific cost of individual sources of finance is determined, we can compute the weighted average cost of capital by putting weights to the specific costs of capital in proportion of the various sources of funds to the total. The computation of the weighted average cost of capital involves the following steps. 1. Calculation of the cost of each specific source of funds. This involves the determination of the cost of debt, equity capital, preference capital etc. This can be done either on before tax basis or after tax basis.
D+
D = Dividend NP = Net proceeds.
E ------------- x 100 NP
2. Assigning weights to specific costs. This involves determination of the proportion of each source of funds in the total capital structure of the company. This may be done according to marginal weight method, or Historical weights method. 3. Adding of the weighted cost of all sources of funds to get an over all weighted average cost of capital. CAPITAL SRTUCTURE. In order to run and manage a company, funds are needed. Right from the promotional stage up to end, finances play an important role in a company's life. If funds are inadequate, or not properly managed, the entire organisation suffers. It is, therefore, necessary that correct estimate of the current and future need of capital be made to have an optimum capital structure which shall help the organisation to run its work smoothly and without any stress. Capital structure of a company refers to the make up of its capitalisation. A company procures funds by issuing various types of securities i.e. ordinary shares, preference shares, bonds and debentures. According to Gerestenbeg, "Capital structure of a company refers to the composition or make-up of its capitalisation and it includes all long-term capital resources viz : loans, reserves, shares and bonds." The capital structure is made up of debt and equity securities and refers to permanent financing of a firm. It is composed of long-term debt, preference share capital and shareholder's funds.For example, a company has equity shares of Rs. 1,00,000, debentures Rs. 1,00,000, preference shares of Rs. 1,00,000 and retained earnings of Rs. 50,000. The term capitalisation is used for total longterm funds. In this case it is of Rs. 3,50,000. The term capital structure is used for the mix of capitalisation. In this case it will be said that the capital structure of the company consists of Rs. 1,00,000 in equity shares, Rs. 1,00,000 in preference shares, Rs. 1,00,000 in debentures and Rs. 50,000 in retained earnings Before issuing any of these securities, a company should decide about the kinds of securities to be issued. In what proportion will the various kinds of securities be issued, should also be considered.
CAPITALISATION, CAPITAL STRUCTURE AND FINANCIAL STRUCTURE.
The terms, capitalisation, capital structure and financial structure, do not mean the same. Capitalisation refers to the total amount of securities issued by a company while capital structure refers to the kinds of securities and the proportionate amounts that make up capitalisation. For raising long-term finances, a company can issue three types of securities viz. Equity shares, Preference Shares and Debentures. A decision about the proportion among these types of securities refers to the capital structure of an enterprise. Some authors on financial management define capital structure in a broad sense so as to include even the proportion of short-term debt. In fact, they refer to capital structure as financial structure. Financial structure means the entire liabilities side of the balance sheet.
OPTIMUM CAPITAL STRUCTURE; and FACTORS DETERMINING CAPITAL STRUCTURE
The optimum or balanced capital structure means an ideal combination of borrowed and owned capital that may attain the marginal goal, ie maximizing of market value per share or minimization of cost of capital. The market value will be maximised or the cost of capital will be minimised when the real cost of each source of fund is the same. The capital structure of a company is to be determined initially at the time the company is floated. Great caution is required at this stage, since the initial capital structure will have long-term implications. Of course, it is not possible to have an ideal capital structure but the management should set a target capital structure and the initial capital structure should be framed and subsequent changes in the capital structure should be done keeping in view the target capital structure. Thus, the capital structure decision is a continuous one and has to be taken whenever a firm needs additional finances. Following are the factors which should be kept in view while determining the capital structure of a company: (1) Trading on Equity.
A company may raise funds either by issue of shares or by debentures. Debentures carry a fixed rate of interest and this interest has to be paid irrespective of profits. Of course, preference shares are also entitled to a fixed rate of dividend but payment of dividend depends upon the profitability of the company. In case the rate of return (ROI) on the total capital employed (shareholders' funds plus long-term borrowed funds) is more than the rate of interest on debentures or rate of dividend on preference shares, it is said that the company is trading on equity. For example, the total capital employed in a company is a sum of Rs. 2 lakhs. The capital employed consists of equity shares of Rs. 10 each. The company makes a profit of Rs. 30,000 every year. In such a case the company cannot pay a dividend of more than 15% on the equity share capital. However, if the funds are raised in the following manner, and other things remain the same, the company may be in a position to pay a higher rate of return on equity shareholders' funds: (2) Retaining Control. The capital structure of a company is also affected by the extent to which the promoter/existing management of the company desire to maintain control over the affairs of the company. The preference shareholders and debentureholders have not much say in the management of the company. It is the equity shareholders who select the team of managerial personnel. It is necessary, therefore, for the promoters to own majority of the equity share capital in order to exercise effective control over the affairs of the company. The promoters or the existing management are not interested in losing their grip over the affairs of the company and at the same time, they need extra funds. They will, therefore, prefer preference shares or debentures over equity shares so long they help them in retaining control over the company. (3) Nature of Enterprise The nature of enterprise also to a great extent affects the capital structure of the company. Business enterprises which have stability in their earnings or which enjoy monopoly regarding their products may go for debentures or preference shares since they will have adequate profits to meet the recurring cost of interest/fixed dividend. This is true in case of public utility concemes. On the other hand, companies which do not have this advantage should rely on equity share capital to a greater extent for raising their funds. This is, particularly, true in case of manufacturing enterprises. (4) Legal Requirements The promoters of the company have also to keep in view the legal requirements while deciding about the capital structure of the company. This is particularly true in case of banking companies which are not allowed to issue any other type of security for raising funds except equity share capital on account of the Banking Regulation Act. (5) Purpose of Financing The purpose of financing also to some extent affects the capital structure of the company. In case funds are required for some directly productive purposes, for example, purchase of new machinery, the company can afford to raise 4he funds by issue of debentures. This is because the company will have the capacity to pay interest on debentures out of the profits so earned. On the other hand, if the funds are required for non-productive purposes, providing more welfare facilities to the employees such as construction of school or hospital building for company's employees, the company should raise the funds by issue of equity shares. (6) Period of Finance The period for which finance is required also affects the determination of capital structure of companies. In case, funds are required, say for 3 to 10 years, it will be appropriate to raise them by issue of debentures rather than by issue of shares. This is because in case the funds are raised by issue of shares, their repayment after 8 to 10 years (when they are not required) will be subject to legal complications. Even if such funds are raised by issue of redeemable preference shares, their redemption is also subject to certain legal restrictions. However, if the funds are required more or less permanently, it will be appropriate to raise them by issue of equity shares. (7) Market Sentiments The market sentiments also decide the capital structure of the company. There are periods when people want to have absolute safety. In such cases, it will be appropriate to raise funds by issue of debentures. At other periods, people may be interested in earning high speculative incomes; at such times, it will be appropriate to raise funds, by issue of equity shares. Thus, if a company wants to raise sufficient funds, it must take into account market sentiments; otherwise its issue may not be successful. (8) Requirement of Investors Different types of securities are to be issued for different classes of investors. Equity shares are best suited for bold or venturesome investors. Debentures are suited for investors who are very cautious while preference shares are suitable for investors who are not very cautious. In order to collect funds from different categories of investors, it will be appropriate for the companies to issue different categories of securities. This is particularly true when a company needs heavy funds. (9) Size of the Company Companies which are of small size have to rely considerably upon the owners' funds for financing. Such companies find it difficult to obtain long-term debt. Large companies are generally considered to be less risky by the investors
and, therefore, they can issue different types of securities and collect their funds from different sources. They are in a better bargaining position and can get funds form the sources of their choice. (10) Government Policy Government policy is also an important factor in planning the company's capital structure. For example, a change in the lending policy of financial institutions may mean a complete change in the financial pattern. Similarly, by virtue of the Securities & Exchange Board of India Act, 1992 and the Rules made there under, the Securities & Exchange Board of India can also considerably affect the capital issue policies of various companies. Besides this, the monetary and fiscal policies of the Government also affect the capital structure decision. (11) Provision for the Future While planning capital structure the provision for future should, also be kept in view. It will always be safe to keep the best security to be issued in the last instead of issuing all types of securities in one installment. In the words of Gerestenberg, "Manager of corporate financing operations must always think of rainy days or the emergencies. The general rule is to keep your best security or some of your best securities till the last".
DU-PONT CONTROL CHART.
A system of management control designed by an American company named Du-Pont paint Company is popularly called Du-Pont Control Chart., This system uses the ratio inter-relationship to provide charts for managerial attention. The standard ratios of the company are compared to present ratios and changes in performance are judged. The chart is based on two elements i.e., Net profit and capital employed. Net profit is related to operating expenses. If the expenses are under control then profit margin will increase. The earnings as a percentage of sales or earnings divided by sales give us percentage of profitability. Earnings can be calculated by deducting cost of sales from sales. Cost of sales includes cost of goods sold plus office and administrative expenses and selling and distributive expenses. Capital employed, on the other hand, consists of current assets and net fixed assets. Current assets include debtors, stock, bills receivables, cash, etc. Fixed assets are taken after deducting depreciation. So profit margin is divided by capital employed and is multiplied by 100. So ratio will be Profit margin x 100 capital employed .
DU PONT CHART
Net profit ratio
Investment Turnover
Operating profit / Sales
Sales / Investments
Sales
Operating Expense
Investments Fixed assets + Working capital
Cost of goods sold + Selling administrative and others.

The efficiency of a concern depends upon the working operations of the concern. The return on investment becomes a yardstick to measure efficiency because return influences various operations. The profit margin will show the efficiency with which assets of the business have been used. The efficiency can be improved either by a better relationship between sales and costs or through more effective use of available capital. The profitability can be increased by controlling costs and/or increasing sales. The investments turnover can be raised by having a control over investments in fixed assets and working capital without adversely affecting sales. The sales may also be increased with the use of same Capital. The management is able to pinpoint weak spots and take corrective measures. The performance can be better judged by having
inter-firm comparison. The ratios of return on investment, assets turnover and profit margins of comparable companies can be calculated and these can be used as standards of performance.

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1

PROFIT MAXIMISATION APPROACH.

CLASSIFICATION OF SOURCE OF FUNDS.

NSS College. Rajakumari.

(b) Preference Shares.

(a) Equity Shares.

NSS College. Rajakumari.

NSS College. Rajakumari.

NSS College. Rajakumari.

be of two types. Comparative Balance Sheet and Comparative P&L A/C.

NSS College. Rajakumari.

NSS College. Rajakumari.

operating profit has also considerably increased, i.e 106.07%.

NSS College. Rajakumari.

NSS College. Rajakumari.

The overall performance of the Co is good.

NSS College. Rajakumari.

31.3.2003 (Rs.) 50,00,000 72,00,000 1 2,00,000 1 0,00,000 30,00,000 21,00,000 11 ,00,000

31,3.2002 (Ks.) 50,00,000 60,00,000 1 0,00,000 10,00.000 30,00,000 30,00,000 10,00,000

NSS College. Rajakumari.

Comparative Balance Sheet

Assets Fixed assets Investments Current assets Total assets

60,00,000 10,00,000 30,00,000 1,00,00,000

NSS College. Rajakumari.

2,00,000 1 .50,000 5,05000 6,00,000 3,30.000 14.35,000

3,00,000 2.00,000 6,75,000 8.00,000 2.22.000 1 6,97.000

+ 1,00.000 +50.000 + 1.70.000 +2.00.000 - 1 08,000 +2.62.000

+50 +33 +33.66 +33 -32.73 + 1K.26

+ 115 +50 +65

+ 14.65 + 11.0 + 19.40

Expenses 70 80 150 185 25 160 70 90

72 90 162 238 30 208 80 128

+2 + 10 + 12 +53 +5 +48 + 10 +38

+2.8 + 12.5 +8.0 +28.65 +20 +30.0 + 14.3 +42.22

Interpretation NSS College. Rajakumari.

NSS College. Rajakumari.

NSS College. Rajakumari.

NSS College. Rajakumari.

NSS College. Rajakumari.

NSS College. Rajakumari.

NSS College. Rajakumari.

XXX XXX XXX XXX

Closing balance Cash Bank

XXX XXX XXXX

Cash Ratio = ----------------------------------Current Liabilities.

Net credit purchases.

Or Net profit ratio 100

Cost of goods sold --------------------------------------X100 Net sales

Administrative expense = Administrative expense ratio ---------------------------------------X 100 Net sales

DPS ------------------ X 100 EPS

Rs. 5,000 40,000

Rs 2 00 000 30 000 20 000 5 000 17 000 8 000 20 000 3 00 000

Rs 1 60 000 50 000 20 000 15 000 5 000 30 000 20 000 3 00 000

NSS College. Rajakumari.

NSS College. Rajakumari.

Current ratio Quick ratio Illustration 6

= Rs. 1,80,000/Rs. 5,00,000 = 0.36: 1

NSS College. Rajakumari.

NSS College. Rajakumari.

NSS College. Rajakumari.

1 00 000 x 100 5 00 000 x 100 = 40 000 x 100 = 8 %. 5 00 000

Operating profit ratio = 100 Operating ratio. = 100 86 = 14 %.

Rs. Furniture 10,000 Bank 20,000 Cash 25,000 Stock 15,000

NSS College. Rajakumari.