Professional Documents
Culture Documents
!
Developed by
Prof. Arun (Bobby) Gokhlay
On behalf of
Prin. L.N. Welingkar Institute of Management Development & Research
!
Advisory Board
Chairman
Prof. Dr. V.S. Prasad
Former Director (NAAC)
Former Vice-Chancellor
(Dr. B.R. Ambedkar Open University)
Board Members
1. Prof. Dr. Uday Salunkhe
2. Dr. B.P. Sabale
3. Prof. Dr. Vijay Khole
4. Prof. Anuradha Deshmukh
Group Director
Chancellor, D.Y. Patil University, Former Vice-Chancellor
Former Director
Welingkar Institute of Navi Mumbai
(Mumbai University) (YCMOU)
Management Ex Vice-Chancellor (YCMOU)
CONTENTS
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FEATURES OF FINANCIAL MANAGEMENT
CHAPTER 1
FEATURES OF FINANCIAL MANAGEMENT
“Financial management in recent years has become much more analytical with emphasis
on decision-oriented approaches to problems. It is no more a matter of keeping data and
records.”
Objectives:
Structure:
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FEATURES OF FINANCIAL MANAGEMENT
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FEATURES OF FINANCIAL MANAGEMENT
Now, the Chief Accountant is involved in each and every business decision.
He/she is expected to have deep knowledge of economics for decision-
making in areas of risk analysis, pricing based on demand-supply analysis
and risk-return analysis. Economics governs the environment in which all
business entities operate. To steer the entity towards steady growth, it was
necessary for him/her to take cognizance of several economic variables
such as inflation, gross domestic product, disposable income, employment,
interest rates, competition, government levies and many more. The role of
Chief Accountant matured into that of Chief Finance Manager.
One significant task for the Chief Finance Officer now was to conduct
decision-oriented process of allocating entity’s funds (either owned or
borrowed) for projects involving acquisition of building, plant and
equipment, etc. With rise in business competition, more care and caution
was needed for all decisions related to receivables and inventory
management, capital structures or dividend policy.
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FEATURES OF FINANCIAL MANAGEMENT
Financial Management
Any business organization has first to be clear about the exact business
activity it wants to conduct to meet its objective of maximizing the gains
for the owners. A detailed business strategy that covers all aspects of the
business is the first step in this direction. This strategy will spell out all the
facilities the organization needs to start and conduct its business from year
to year on a continuous basis. Business (or Strategic) management is the
art, science and craft of formulating, implementing and evaluating cross-
functional decisions that will enable an organization to achieve its long-
term objectives. It is the process of specifying the organization’s mission,
vision and objectives, developing policies and plans, often in terms of
projects and programs, which are designed to achieve these objectives.
Once these objectives are finalized, the next step constitutes allocation of
both financial and non-financial resources to implement the policies, and
plans, projects and programs that are expected to meet the business
objectives. Thus, strategic management seeks to coordinate and integrate
the activities of the various functional areas of a business in order to
achieve long-term organizational objectives.
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FEATURES OF FINANCIAL MANAGEMENT
We are now ready with the exact amounts of funds required for various
corporate projects and time frame for their acquisition. The next task in
financial management is to determine how this requirement of funds is
going to be financed.
Here, the Chief Finance Officer has to arrange for a major decision as to
what part of the total requirements is to be financed from business entity’s
own funds. The balance portion will have to be financed by borrowing from
the capital market. This exercise is known as determining the debt-equity
ratio* in financing the capital expenditure. Here what we are trying to build
is a capital structure for the business entity.
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FEATURES OF FINANCIAL MANAGEMENT
Thus, you will observe that on March 2015, RIL has a debt-equity ratio of
89/216 or 0.41. It is claimed that lower the debt-equity ratio higher the
security enjoyed by the creditors. That is the reason why with this low
debt-equity ratio, RIL finds no difficulty in arranging finances for its
expansion projects.
High creditworthiness
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FEATURES OF FINANCIAL MANAGEMENT
lot of money on a small base of owners’ funds. It is then said that the
business is highly leveraged—which in turn means that lenders are more
exposed to potential problems than investors.
In case of equity, the CFO has to decide which capital markets to access
and how should the issue be timed. A decision has also to be taken about
the type of specific equity instruments that are to be employed. Allied issue
is the dividend distribution policy for these capital instruments that would
make them attractive to potential investors. While determining the debt-
equity ratio, the goal is to ensure that the selected pattern would maximize
the earnings per share that would increase the market value of the entity’s
scrips traded on the stock exchanges. Similar issues have to be addressed
when the decision is to use debt funds to meet long-term capital
requirements. The aim is always to optimize the cost of financing and
increasing investor confidence in the entity. A firm always attempts to find
a minimum cost of capital through varying the mix of its sources of
financing. This cost eventually increases as more and more capital is drawn
from the capital markets.
To run business activities, the entity needs working capital to finance its
current assets mainly in the form of inventories in various stages from raw
materials, work-in-progress, finished goods, inventory ready for storage,
inventory in discreet stores and warehouses awaiting delivery to retail sales
outlets or customers. The quantum of the inventory at various locations
changes drastically with raw material availability and spurts in consumer
demand during busy seasons and festivals. Financial management has to
get geared to finance this short term but substantial requirement of what is
termed working capital.
A majority of sales do not take place on cash on delivery terms. This fact
results in another current asset on the balance sheet known as sundry
debtors or accounts receivables. Many times, amount of receivables is as
large as that for inventory. In competitive markets, adequate credit needs
to be offered to customers to retain your market share. Funds have to be
arranged to finance this current asset which is a significant part of entity’s
working capital. This is the third feature of financial management that
keeps the CFO busy all throughout the year.
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FEATURES OF FINANCIAL MANAGEMENT
Net working capital consists of current assets and current liabilities and
thus includes three accounts (accounts payables, accounts receivables and
inventory) which are of special importance. These accounts represent the
areas of the business where managers have the most direct impact. An
increase in net working capital indicates that the business has either
increased current assets (that it built up inventories or is unable to collect
receivables on time) or has decreased current liabilities—for example has
paid off some short-term creditors, or a combination of both. The Working
Capital Cycle (WCC) is the amount of time it takes to turn the net current
assets and current liabilities into cash. The longer the cycle is, the larger
the amount of cash a business is tying up in its working capital without
earning a return on it. Therefore, financial management strives to reduce
the working capital cycle by collecting receivables quicker or sometimes
stretching accounts payable.
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Accounts Receivables
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FEATURES OF FINANCIAL MANAGEMENT
Some other issues the CFO has to handle at this stage include what is the
optimum levels of inventory the entity needs to hold, what are its ideal
receivables days, what are its cost-effective sources of short-term funds
and where can it place its excess cash (if any) to earn decent interest
income.
Self-training Exercise: 1
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FEATURES OF FINANCIAL MANAGEMENT
You are required to draw the balance sheet after two years from today
after implementation of CEO’s decision above.
1 . 6 F i n a n c i a l M a n a g e m e n t i n D i f f e r e n t Fo r m s o f
Organizations
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FEATURES OF FINANCIAL MANAGEMENT
1.6.2 Partnership
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FEATURES OF FINANCIAL MANAGEMENT
“partners” and collectively ‘a firm’ and the name under which their
business is carried on is called the ‘firm name’. The Indian Partnership Act,
1932 is an Act enacted by the Parliament of India to regulate partnership
firms in India. It received the assent of the Governor-General on 8 April
1932 and came into force on 1 October 1932. Before the enactment of this
Act, partnerships were governed by the provisions of the Indian Contract
Act.
With more than one owner, partnership firm has greater capacity to raise
capital and can have wider talent to run operations. At the same time, key
decisions get delayed because one partner is traveling or other on family
way. Not all partners have the same appreciation for financial dynamics or
client relations or other business nuances, and only a few appear to
appreciate the “ways of the future.” Because no single partner is
accountable, lots of decisions never take place. The distinction between
ownership and management is thin. As such, this business form has
advantages as well as disadvantages more or less similar to Sole
Proprietorship.
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FEATURES OF FINANCIAL MANAGEMENT
The Limited Liability Partnership Act 2008 was published in the Official
Gazette of India on January 9, 2009 and has been notified with effect from
31 March 2009. In Limited Liability Partnership, each member is protected
from personal liability, except to the extent of the capital contribution in
the LLP. To start a Limited Liability Partnership, at least two members are
required initially. However, there is no limit on the maximum number of
partners. The LLP Act makes a mandatory statement where one of the
partners to the LLP should be an Indian. In India, for all purposes of
taxation, an LLP is treated like any other partnership firm. LLP is a body
corporate and a legal entity separate from its partners. It has perpetual
succession. Indian Partnership Act, 1932 is not applicable to LLPs.
Like a company, LLP also has a separate Legal Entity. So, the partners in
the company and LLP are distinct from each other. This is like a company
where shareholders are different from the company. In case of companies,
there should be a minimum amount of capital that should be brought by
the members/owners who want to form it. But to start an LLP, there is no
requirement of minimum capital.
The LLP, being a firm, does not attract minimum alternative tax on its book
profits and is not subject to dividend distribution tax. Remuneration and
interest paid to partners on their investments can be shown as an expense
of the firm; however, the same will be taxed at the hands of the receiving
partners.
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FEATURES OF FINANCIAL MANAGEMENT
1.6.3 Company
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FEATURES OF FINANCIAL MANAGEMENT
To cite one example, Reliance Industries Ltd. shows a Share Capital of Rs.
3,236 crores from its 27,31,295 shareholders spread over the entire
country at different levels of rich and not-so-rich individuals.
For entities with substantial business volumes, a company is the best form
of organization to operate and grow. The risk to investors is limited;
potential for growth of the business is continuous as there is an access to
capital markets for sourcing funds as and when they are required for
expansion. Owners find their investments are liquid as the shares they own
can be sold/transferred on the Stock Exchanges to receive cash in a couple
of days.
Self-training Exercise: 2
Deepak Shah and Harish Parekh are two partners of Bhale Padharo
Automobiles Pvt. Ltd.. Their business is steadily growing and they are
required to open new sales outlets and service centres in metro cities in
India. Deepak knows that to support this growth, partnership form of
business organization is no more viable. Write a letter on his behalf to the
partner Harish, highlighting the reasons why they should form a private
limited company to change over to Bhale Padharo Automobiles Pvt. Ltd.
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FEATURES OF FINANCIAL MANAGEMENT
Tax Liability Profits Profits taxed Profits taxed Profits and Profits and
taxed as at the at the dividends dividends
owner’s specified specified taxed at taxed at the
income rate rate the specified
specified rates
rates
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FEATURES OF FINANCIAL MANAGEMENT
1.7 Summary
The Chief Finance Manager of any business organization has a major task
of managing funds for the organization. Business strategy spells total
assets required while capital plan spells total funds required and finance
plan spells sources for acquisition of funds. Strategies are typically
planned, crafted or guided by the Chief Executive Officer, approved or
authorized by the board of directors, and then implemented under the
supervision of the organization’s top management team of senior
executives. Strategic management provides overall direction to the
enterprise. The capital plan is then prepared and approved to specify funds
that are required for research and development laboratories, factory
buildings, plant and machinery, equipment, distribution stores, showrooms,
etc. required by the business entity and when would these funds required.
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FEATURES OF FINANCIAL MANAGEMENT
To run business activities, the entity needs working capital to finance its
current assets mainly in the form of inventories in various stages from raw
materials to finished goods at the points of sale and accounts receivables.
Control over working capital is a major concern in financial management
under intense competition.
The public limited companies, because of limited liability, can have large
number of owners contributing large amounts capital at inception as well
as during expansions of their business. They need to pay tax on both their
profits and dividends they distribute to shareholders. The process of
formation of a public limited company is complex and long, however for
entities with substantial business volumes, a company is the best form of
organization to operate and grow.
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FEATURES OF FINANCIAL MANAGEMENT
1. The capital plan for the year 2016 prepared by the Chief Engineer of
Rajesh Soaps detailed each and every asset (mixer, blender, stamping
machines, wrapping machines, main store equipment, fork lift, etc.)
that was to be acquired in the next three years with total cost to acquire
it. The CFO, however, could not work on it as __________.
2. You have just joined the State Bank of India, Shahpur branch as a
Manager. There are four requests for bank finance from following
companies. Other factors remaining constant which one would you
select for lending?
a. Company P - Net worth Rs. 49. lakhs and total assets Rs. 1.0 crore
b. Company Q - Net worth Rs. 49 lakhs and total assets Rs. 1.5 crore
c. Company R - Net worth Rs. 1.0 crore and total assets Rs. 2.25
crore
d. None of the above
3. The firm Shah Brothers wanted to increase their Machine Shop capacity
substantially. The founding partner was planning to convert the firm into
a private limited company. He was not certain how many shareholders
can he have in the new company. Will you please guide him?
a. Minimum five maximum twenty-five
b. Minimum two maximum two hundred
c. Maximum twenty-five
d. Minimum seven
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FEATURES OF FINANCIAL MANAGEMENT
5. On joining Bharat Mall in Kolkata, you find that its working capital
requirements are well above the industry average. Which of the
following will be your focus point to correct the situation?
a. Quality Control
b. Distribution management
c. In-process check system
d. Supply chain management
Answers:
1. (c)
2. (a)
3. (b)
4. (c)
5. (d)
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FEATURES OF FINANCIAL MANAGEMENT
REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter
Summary
PPT
MCQ
Video Lecture
! !24
RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT
CHAPTER 2
RELEVANCE AND SIGNIFICANCE OF
FINANCIAL MANAGEMENT
Objectives
Structure:
2.1 Introduction
2.2 Management of Cash Flows
2.3 Bank and Financial Institute Relationships
2.4 Handling Employee Reward Systems
2.5 Management of Purchases
2.6 Management of Finance Side of Sales
2.7 Management of Shareholder Relations
2.8 Financing Expansion and Diversification
2.9 Summary
2.10 Multiple Choice Questions
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RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT
2.1 Introduction
For every growing business firm, the main financial tasks include
management of cash flows, bank relationships, payroll and purchases, both
of capital items as well as raw/packaging materials and acquisition of
finances to run the show. The chief finance officer has also to find
opportunities to set aside funds to carry research and development
activities in a robust manner in order to stay ahead of ever increasing
competition. CFO also cannot afford to ignore the interest rate, exchange
rates and pulse of the capital market. All these factors are responsible in
making finance an integral part of the business activity. No business
decision can be undertaken unless the financial implications are thoroughly
analyzed to determine its impact on the entity’s income and growth.
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Retu
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Finance Manager
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RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT
financial data to the users in the form of income statement, balance sheet
or fund flow statement. Finance provides a bridge between economic
theory and number of accounting. CFO must use and interpret this data in
the attempts to maximize the entity’s returns and net worth. All company
executives whether in production, sales, research, marketing or general
management must familiarize themselves with the accounting data
presented to them from time to time so that they can assess for
themselves how their function is contributing to the corporate business
strategy.
The all-important profit and loss account statement (and for that matter
the balance sheet) of the organization is based on the principle of accrual.
Thus, if a sale of Rs. three lakhs takes place in January 2015, it will be
reflected as income in the profit and loss statement for 2014-15 even
though actual payment for this sale may take place in April 2015. The
income from this sale is recorded in 2014-15 because all the expenses
incurred against the sale were incurred in that year. To reflect true income,
it is necessary to match revenues and expenses in the period in which they
occur.
Statement of cash
flows:The objective is to emphasise
the critical nature of clash flows to the day to
day functions of the business entity. Here the
focus is on translating the accrual based net
income into actual rupee terms
The cash flow statement emphasizes the critical nature of cash flows to the
firm’s operations. Here, cash means cash as well as cash equivalents that
can easily be converted into cash within ninety days. Independent study of
cash flows is necessary and you can watch it in following situations. A firm
reports a net loss of three lakhs in a particular period where it provided
four lakhs of depreciation. The latter being a non-cash expense the firm is
still having one lakh cash on hand at the end of the period. On the other
hand, a firm reporting three lakhs of net profit can have a lakh of less cash
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RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT
at the end of the period if it invests four lakhs to buy a machine, the item
that does not appear on an income statement but only on the firm’s
balance sheet.
Self-training Exercise: 1
Prepare a fund flow statement from following data indicating closing cash
on hand.
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RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT
Once the firm has its own equity funds, it can scout for further funds for
the business by debt financing. Debt financing, by contrast to equity, is
cash borrowed from a lender at a fixed rate of interest and with a
predetermined maturity date. The principal must be paid back in full by the
maturity date, but periodic repayments of principal may be a part of the
loan arrangement. Debt may take the form of a loan or the sale of bonds/
debentures; the form itself does not change the principle of the
transaction: the lender retains a right to the money lent and may demand
it back under conditions specified in the borrowing arrangement. While
tapping this source of finance, again firm’s bank and financial institute
relationships matter in obtaining required amounts of funds at the most
economic terms with respect to rate of interest and period for repayment
of the principal.
Once the business operations start, the Chief Finance Officer of the entity
has to rely on the firm’s standing with the banks to get fresh finance for
expansion or major capital expenditure from banks themselves or other
financing institutions like Industrial Finance Corporation of India, Industrial
Development Bank of India, State Industrial Development Corporations,
etc.
Last but not the least, firms need short-term capital to fill in the gaps in
their working capital management by borrowing short-term funds as and
when required. CFO normally arranges for long-term overdraft agreement
with one or more banks to fulfill this fund requirement.
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RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT
The Chief Financial Officer has dual function in employee reward systems.
The first is ensuring that the wage packet finalized for each employee is
delivered to her/him on regular basis on the due dates and, more
importantly without any errors. With automation of payrolls, any errors in
processing the data have been eliminated but great degree of caution is to
be exercised to ensure accuracy of the periodic input data. Amounts
deducted from salaries for provident fund, income tax, etc. have to be paid
to the authorities within prescribed time frames.
The second part of the employee rewards is framing the pay package that
is attractive to all employees as well as economic to the organization. Here,
it is necessary to structure the packet that provides salaries to employees
that are commensurate with their individual performance and contribution
to the profitability and growth of the organization. It is also necessary to
consider what the firm is expecting from an individual in the next financial
year/s and required incentives have to be incorporated in the pay package
to ensure that the employees remain motivated to achieve the individual
targets set for them.
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RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT
for their failures to meet agreed delivery schedules that can cause
production interruptions and costly idle time.
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RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT
This arrangement removes the credit risk, the seller knows conditions that
need to be fulfilled to get payments from the customer and it offers safety
to the customer that payments are arranged in conformity of the conditions
specified in the letter of credit issued by him.
Any company has two major choices in determining its credit policy for its
customers. On one hand, it can adopt a strict credit policy and decide not
to grant any credit to a customer account however strong its credit rating
can be. On the other end, a firm can have a liberal credit policy and grant
say a 30 days’ credit to all customer accounts irrespective of the credit
rating. The strict credit policy has adverse effect on sales but reduces
collection costs, bad debts and the size of the receivables. Liberal credit
policy encourages sales and therefore profits, but at the same time, it does
increase collection costs, bad debts and the size of the receivables.
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RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT
Self-training Exercise: 2
Asha Metal Foundry finds that due to fierce competition, marketing team
has to grant generous credit terms to maintain its market share. This has
put pressure on collection team and accounts receivables have increased to
60 days sales. The company currently pays 15% interest on bank loans
obtained to sustain this high level of receivables.
The Chief Finance Officer’s goal of maximizing income of the entity results
in accumulation of more and more funds for the entity. These funds can
either be retained within the firm to increase its net worth or distributed to
shareholders as dividends. Dividend Payout Ratio is the percentage of
dividends to net earnings after taxes. It can be computed by dividing
dividends per share by net earnings per share.
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RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT
dividends. The CFO has to make sure that each potential project of the
corporation must provide a higher rate return than shareholder could
achieve on other investments. If that is not the case, it is imperative that
funds are distributed to shareholders as dividends. This, in other words, is
the opportunity cost of using shareholders’ funds. (More in Chapter # 13 –
Dividend Policy and Decisions).
In the initial growing stage in the life of a corporation, funds are needed for
growth and expansion of the firm where they are expected to yield higher
returns. As such, ‘moderate cash dividends’ is the policy for the entity. As
the firm grows and reaches the maturity stage, more and more funds are
released for payment of dividends.
One major flaw in the use of the marginal principle of retained earnings for
declaration of dividends is that it fails to consider the shareholders’
expectations from the company in which they have invested their funds
and wish to stay invested. Many prudent corporations temper the dividends
based on reliance on the marginal principle of retained earnings by
weighing the preferences of the shareholders and release higher amounts
for dividends. This step resolves uncertainties in minds of the share
owners.
There are some more factors to consider in finalizing dividend policy. The
firm has to take a long-term view to make sure that it can maintain
stability in dividend payments. Variations in dividends paid can send wrong
signals to share markets and investors. A thorough funds flow exercise has
to be conducted before establishing dividend decisions. The firms that have
easy access to capital markets for more funds through rights issue of
equity or debentures can afford to increase dividend payout ratio in
relatively bad years to maintain stable dividends policy.
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RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT
The equity source is one of the usually costliest sources of finance. The
rate of return expected by equity shareholders is generally higher than the
rate required by other investors. The dividends have to be paid out of
after-tax earnings while interest paid on debt reduces tax burden as the
expense is tax deductible. It has costs associated with managing the equity
issue to the potential investors which are significant compared to other
sources. In case of smaller companies, in particular, the issue of additional
equity reduces the control over the firm of the existing share owners.
Preference Shares
Internal Reserves
Equity
If the finance manager decides to meet the need for long-term finance
through issues of preference shares, she has to face with similar
advantages and disadvantages as above. However, preference shares do
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RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT
not carry voting rights and hence do not dilute control of the present share
owners. The preference shares issue increases the company’s net worth
and advantages associated with it.
Many finance companies offer hire purchase facility to acquire the asset.
Here, the asset is purchased by the finance company and offered for use to
your firm. For the duration of the hire purchase agreement, you pay
periodic (monthly or quarterly) installments consisting of interest and
return of the capital and at the end of this period, ownership of the asset is
transferred to you.
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RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT
2.9 Summary
For every growing business firm, the main financial tasks include
management of cash flows, bank relationships, payroll, and purchases,
both of capital items as well as raw/packaging materials and acquisition of
finances to run the show. The chief finance officer has also to find
opportunities to set aside funds to carry research and development
activities in a robust manner and to get ready with required funds when
opportunity arises for expansion or diversification.
The Chief Financial Officer has dual function in employee reward systems
so necessary to keep the workforce motivated and productive. The first is
ensuring that the wage packets finalized for each employee is delivered to
her/him on regular basis on the due dates and without any errors. The
second part of the employee rewards is framing the pay package that is
attractive to all employees and economic to the organization.
! !37
RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT
both the buyer and supplier. In capital goods industries, finance must get
involved when a sales negotiation is being prepared for the project or sale
of equipment. If your firm is a leader in the industry, you are entitled for
better credit terms based on your trustworthy past performance. You need
to study the credit terms common in the industry and strive to get better
terms.
Any company has two major choices in determining its credit policy for its
customers. On one hand, it can adopt a strict credit policy and decide not
to grant any credit to a customer accoun;t however strong its credit rating
can be. On the other end, a firm can have a liberal credit policy and grant
say a 30 days’ credit to all customer accounts irrespective of its credit
rating. To minimize trade receivables in themselves and costs incurred in
follow-ups to collect them, Finance manager has to decide whether to offer
a cash discount.
The Chief Finance Officer’s goal of maximizing income of the entity results
in accumulation of more and more funds for the entity. These funds can
either be retained within the firm to increase its net worth or distributed to
shareholders as dividends. There are quite a few factors to consider in
finalizing dividend policy for the firm.
! !38
RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT
a. Accounting
b. Philosophy
c. Economics
d. Finance
a. Trial Balance
b. Income Statement
c. Balance Sheet
d. Statement of Cash Flows
3. For __________ items ordered regularly, the Chief Finance Officer can
assist Purchase Officer to enter into annual contract with approved
vendors for supplies.
a. Low value C
b. High value A
c. Average value B
d. Spares
! !39
RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT
4. One major flaw in the use of the marginal principle of retained earnings
for declaration of dividends is that it fails to consider __________ the
company.
a. Long-term debt
b. Loan from financial institutes
c. Equity capital
d. Hire purchase agreement
Answers:
1. (c)
2. (d)
3. (b)
4. (a)
5. (c)
! !40
RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT
REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter
Summary
PPT
MCQ
Video Lecture
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GOALS AND OBJECTIVES
CHAPTER 3
GOALS AND OBJECTIVES
“In recent times, the goals of the Chief Finance Officer have undergone major expansion
and assumed complex nature. They cover among others maximization of earnings and
company value, welfare of stakeholders, legal compliance and corporate social
responsibility.”
Objectives
• Profitability
• Firm’s value
• Shareholders’ wealth
• Strong and effective management
• Earnings per share – EPS
• Legal compliance
• Leadership
• Employee welfare and customer satisfaction
• Corporate Social Responsibility
Structure:
3.1 Introduction
3.2 Maximize Profits of the Business Entity
3.3 Maximize Business Entity’s Value
3.4 Maximize Shareholders’ Wealth
3.5 Strengthen Management Power
3.6 Maximize Earnings Per Share – EPS
3.7 Ensure Legal Compliance
3.8 Attain Market Leadership
3.9 Promote Employee Welfare
3.10 Ensure Customer Satisfaction
3.11 Meet Corporate Social Responsibility
3.12 Summary
3.13 Multiple Choice Questions
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GOALS AND OBJECTIVES
3.1 introduction
A century ago, the main goal of the finance function in India was to
prepare accounting statements like trial balance, income statement and
firm’s balance sheet. With Independence, industrial revolution, economic
growth and liberalization, the scope of finance function has grown at
accelerated speed. There is no economic field left where the finance
function has no positive role to play.
This has resulted in a variety of goals being set for finance managers in
addition to the traditional central goal of profit maximization set by owners
of the entity. In modern economic scenario, finance manager is looked
upon by the management team as an important in-house source available
to them for achieving their individual as well as corporate goals.
CEO
Marketing Manager
Materials Manager
CFO
HR Manager
Plant Engineer
Branch Managers
!
The most obvious and pervasive goal set for finance managers who hold
the keys to the entity’s money chest, is to maximize the profits for the
organization legally and with integrity. They need to put all their physical
assets and manpower together to generate more and more net income for
the benefit of the owners and employees. Every time any business decision
has to be taken, its effect on profits will be considered and if it is positive,
then only it will be implemented.
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GOALS AND OBJECTIVES
No doubt, profits are the primary measure of the success of any business.
It is the acid test of the economic strength of the firm. Economic theory
makes fundamental assumption that maximizing profit is the basic
objective of every firm. However, this assumption does not always hold
true, as in practice, the firms may not always try to maximize profits.
There are many factors that render profit maximization objective
secondary.
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GOALS AND OBJECTIVES
In view of the various factors listed earlier that question the propriety of
focusing on profits alone, it may be prudent to adopt a valuation approach
in determining finance management goals. This approach is based on the
premise that the ultimate measure of firm’s financial management is not
what the firm earns, but how the earnings are valued repeat valued by the
investor. In analyzing firm’s financial management, the investor in addition
to earnings will also consider the risk inherent in the firm’s operation, the
time pattern over which the firm’s earnings increase or decrease, the
quality and reliability of reported income and many such factors.
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GOALS AND OBJECTIVES
The broad goal of the firm is often to increase the wealth of the
shareholder by financial management attempting to achieve highest
possible value for the firm. This increase in shareholders’ wealth is a
complex target as finance managers do not have any direct control on
market prices of the firm’s shares traded on exchanges. But while
arranging for any decision, the finance manager can certainly ascertain the
effect the decision can have on what is expected by its shareholders. This
is critical because share prices are governed not solely on entity’s past
earnings but on shareholders’ expectations about the entity’s future
earnings and current economic environment. Here, the focus is always on
the long-term wealth maximization rather than on day-to-day share price
fluctuations. This long-term focus is called for because of the fact, that
even best companies find their share price going south in declining stock
markets.
The CEOs of Nifty companies time and again assure the shareholders in
their annual reports that, “in everything that we do, we have only one
supreme goal, that is to maximize your wealth as members of India’s
largest investor family”; Reliance Industries Ltd.; or “all of us are beginning
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GOALS AND OBJECTIVES
Two metrics are commonly used to examine a firm’s dividend policy. Payout
ratio is calculated by dividing the dividend paid by the company’s earnings
per share. A payout ratio greater than one, which is rare, means the
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GOALS AND OBJECTIVES
company, is paying out more in dividends for the year than its earnings
that year. This can happen when otherwise profitable company is
undergoing bad earnings phase in a particular year but wishes to maintain
its dividend track record. This step ensures that firm’s share prices remain
stable.
A sole proprietorship calls for compliance with Shops and Establishment Act
1948 for day-to-day operations. Further, the CFO has to arrange finance for
different acts that call for payment of excise duty under Central Excise Act
1944, customs duty under Customs Act 1962, sales tax under Central
Sales Tax Act 1956, income tax under Income Tax Act 1961, etc. In
addition to timely payments of dues per provisions of these acts, there is
additional responsibility to file stipulated returns and documents as per
prescribed schedules.
Central Excise
Companies
Act 1944
Act 2013
Income Tax
Shops & Establishment
Act 1961
Act 1948
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GOALS AND OBJECTIVES
A partnership firm has to comply with all above laws plus with provisions
related to Partnership Act 1952. Partners are individually responsible for
consequences in case there is any non-compliance.
Requirements under other tax laws are both voluminous and complex and
therefore not summarized here.
In markets where the business entity has a dominant market share, prices
need to be decided in a manner that will allow better margins after
recovery of most fixed costs. On the other hand, in competitive domestic
markets, to stay ahead of the competition, it may be necessary to lower
the share of fixed costs that have to be recovered from the selling price.
This allows the firm to arrive at sale prices that competitors would find very
difficult to match.
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GOALS AND OBJECTIVES
Further, finance manager has a vital role in preparing pay packages for
employees based on inputs from human resource function. The object here
is to control turnover, eliminate disruption caused by resignations and
avoid large retraining costs. This task is crucial for employees who are
critical to the progress of the business entity. Care has to be exercised in
ensuring that packages so designed do offer maximum after tax income to
the employees.
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GOALS AND OBJECTIVES
Various types of discounts and other financial benefits are offered to the
potential customers on occasions of product launches in new markets and
at regular intervals thereafter to ensure customer loyalty. Finance
managers have to study legal requirements on prices and monopoly
practices if applicable to the industry in which the business entity is
operating.
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GOALS AND OBJECTIVES
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GOALS AND OBJECTIVES
The Section 135 and Schedule VII of the Companies Act, 2013, relates to
Corporate Social Responsibility (CSR) and is effective from April 01, 2014
as a part of the current Companies Act. The CSR norms will apply to
companies with: (a) net profit of Rs. 5 crore and above or (b) turnover of
Rs. 1,000 crore and above or (c) the net worth of Rs. 500 crore and above.
To decide if a company is eligible for mandatory CSR spending, its profit
from overseas branches and dividend received from other companies in
India will be excluded from the net profit criteria.
These companies will have to spend minimum two per cent of their three-
year average annual net profit on CSR activities in each financial year,
starting from FY15. “The rules have been finalized after extensive
consultations with all stakeholders and provide for the manner in which
CSR committee shall formulate and monitor the CSR policy, manner of
undertaking CSR activities, role of the board of directors therein and
format of disclosure of such activities in the board’s report” announced the
Minister of Corporate Affairs when this section was introduced.
According to the norms, the CSR activities will have to be within India, but
will apply to foreign companies registered in the country. The Ministry has
also listed out permissible activities and said companies will need to take
approval from their board for CSR activities in accordance with its CSR
policy and the decision of its CSR committee.
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GOALS AND OBJECTIVES
Self-training Exercise: 1
You firm’s CFO has completed the following tasks. Has she completed the
task correctly and fully?
Yes No
1 All taxes were paid before the due dates.
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GOALS AND OBJECTIVES
3.12 Summary
A century ago, the main goal of the finance function in India was to
prepare accounting statements like trial balance, income statement and
firm’s balance sheet. But with economic growth and competition, a variety
of goals are being set for finance managers in addition to the traditional
central goal of profit maximization set by owners of the entity.
The most obvious and pervasive goal set for finance managers who hold
the keys of the entity’s money chest, is to maximize the profits for the
organization legally and with integrity. However, for maintaining customers’
goodwill, it may be necessary to hold or reduce sale price. Higher level of
profits in business is considered as an index of monopoly power that makes
the business entity vulnerable for takeover by giants in the industry or
government intervention.
Since the propriety of focusing on profits alone has its challenges, it may
be prudent to adopt a valuation approach in determining finance
management goals. This approach is based on the premise that the
ultimate measure of firm’s financial management is not what the firm
earns, but how the earnings are valued by the investor.
Another broad goal of the firm is often to increase the wealth of the
shareholder by financial management attempting to achieve highest
possible value for the firm. This increase in shareholders’ wealth is a
complex target as finance managers do not have any direct control on
market prices of the firm’s shares traded on exchanges. It is also a fact
that when management interests are divergent from shareholders’
interests, the objective of shareholder wealth management is set aside.
The situation is, however, turning in favour of shareholders in recent times
as: (i) managements are turning more and more ‘enlightened’; (ii) any
share price fall relative to that of competitors in the industry often leads to
undesirable takeovers; (iii) management often has substantial stock option
incentives and last but not the least (iv) powerful institutional investors are
keen to ensure that finance manager is always focused on shareholder
interests.
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GOALS AND OBJECTIVES
require payment of excise duty, sales tax, income tax, etc. In addition to
timely payments, stipulated returns and documents need to be filed as per
prescribed schedules.
You will notice that goals set to finance managers are complex but if
achieved lead the business entity to profitable growth.
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GOALS AND OBJECTIVES
a. Customer satisfaction
b. Earnings per share
c. Profit optimization
d. Employee welfare
a. Customer satisfaction
b. Earnings per share
c. Profit optimization
d. Shareholders’ wealth
a. Partnership
b. Hindu joint family
c. Public limited company
d. Private limited company
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GOALS AND OBJECTIVES
Answers:
1. (c)
2. (d)
3. (c)
4. (a)
5. (a)
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GOALS AND OBJECTIVES
REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter
Summary
PPT
MCQ
Video Lecture
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REPORTING FINANCIAL RESULTS
CHAPTER 4
REPORTING FINANCIAL RESULTS
“The days when the focus of financial reporting was only on factual disclosure of all
financial transactions of a business entity in a summarized form with complete clarity are
over. These days, CFOs additionally have to analyze the results, interpret them and with
their expertise,discuss opportunities available and how to exploit them, plus threats
faced by the business entity and how they are to be overcome.”
Objectives
Structure:
4.1 Introduction
4.2 Income Statement
4.3 Balance Sheet
4.4 Statement of Fund Flows
4.5 Other Financial Reports
4.6 Summary
4.7 Multiple Choice Questions
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4.1 introduction
There is a general belief that all financial data is fully reported in just the
income statement along with the balance sheet. But this is no more true.
Unless you study firm’s cash flow statement that contains critically
important analytical data, you cannot have full picture of the firm’s
financial standing. It is important to note that it is futile to take a one-
size-fits-all approach. The firm’s business structure, the products and
services offered in the markets in which it operates, configuration of the
stockholders’ needs, etc.; all are to be considered with required diligence in
collecting, collating and presenting financial reports.
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The income statement is the one of the three major financial statements
that need to be presented each year. The other two are the balance sheet
and the statement of cash flows. The income statement is divided into two
parts: the operating and non-operating activities.
The portion of the income statement that deals with operating items is
interesting to investors and analysts alike because this section discloses
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information about revenues and expenses that are a direct result of the
regular business operations. For example, if a business creates sports
equipment, then the operating items section would talk about the revenues
and expenses involved with the production of sports equipment. It
discloses margins earned on sale of equipment.
Other Income items as appearing in the income statement of L&T Ltd. for
2014-15. Please refer 4.2.3(i) below.
1. Interest Income:
From current investments:
a. Subsidiary companies
b. Others
From others:
c. Subsidiary and associate companies
d. Others
2. Dividend income:
a. From long-term investments:
• Subsidiary companies
• Associate companies
• Other trade investments
b. From current investments
5. Lease rental
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REPORTING FINANCIAL RESULTS
4.2.2 Structure
4.2.3 Contents
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In the account format, you will observe we have listed all expenses in the
debit column to show individual expenses for the year adding up to Rs.
45,934.20 not shown in there. On credit side, sales and other income adds
up to Rs. 50,802.20. These two numbers provide us a balancing figure of
profit of Rs. 4,868.20. We do not have any clear number for the operating
profit, profit after depreciation or effect of other income on the net profit.
These numbers are clearly shown in the income statements in report
format published by the companies. Let us, therefore, have a clear idea
about these numbers in the income statement published in the common
report format by Maruti Udyog Limited for the year ended March 2015.
Figures for the previous year again are not shown here.
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REPORTING FINANCIAL RESULTS
Income
Expenses
Material consumed 35,257.20
Manufacturing expenses 712.30
Personnel expenses 1,606.60
Selling expenses –
Administrative expenses 5,681.60
Cost of sales 43,257.70
Operating Profit 6,712.90
Other recurring income 831.60
Adjusted PBDIT 7,544.50
Financial expenses 206.00
Depreciation 2,470.30
Other write-offs –
Adjusted PBT 4,868.20
Tax charges 1,157.00
Adjusted PAT 3,711.20
Non-recurring items –
Net Profit 3,711.20
The net profit number of Rs. 3,711.20 crores is common in both the
formats but additional information about effect of depreciation, other
income and taxes is brought about only in the report format and not so in
the account format. Hence, all major companies publish the income
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REPORTING FINANCIAL RESULTS
a. Sale of products
b. Sale of services and
c. Other operating revenue.
Operating income also known as net sales is the sum of invoice price of
goods sold and services rendered during the accounting period. The cut-
off point here is the acceptance of goods sold by customers and not the
date on which they arranged payment against goods received by them.
This figure is adjusted for the value of goods returned by the customers
and excise and other taxes included in the value which is to be paid back
to the tax authorities.
4. Personnel expenses include wages and salaries paid to the workers and
other employees including employer’s contribution to provident fund,
employee insurance, bonus and other labor related expenses. Payments
under incentive schemes and performance bonus are also included here.
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7. Cost of sales also called cost of goods sold represents total cost
products and services sold during the accounting period. For a
distribution activity, cost of sales is the acquisition cost of inventories
sold and for manufacturing firm, it is total of material cost, labor cost
and overhead expenses.
9. Other recurring income represents revenue that does not have direct
relation with the unit’s main business and can include cash discounts
earned, profit on sales of assets, etc. to cite a few examples.
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REPORTING FINANCIAL RESULTS
13.Adjusted Profit Before Tax (PBT) reflects the profit generated by the
entity during the accounting year after taking care of all normal as well
other expenses incurred during the accounting year. Profit After Tax
(PAT) reflects amount available at the end of the year after payment of
income and other taxes for determining the change in owners’ equity
arising out of the total revenues and total expenses for the accounting
year. PAT is also known as the net profit of the entity.
14.PAT is also known as the bottom line of the business entity and when
the amount is positive, the firm is said to be running in ‘black’ but if it is
negative, the firm has incurred net loss, the firm is said to be running in
‘red’.
4.2.4 Principles
Similarly, sales are recorded when customers have accepted the goods and
services during the accounting period not considering the actual date of
payment. The amount paid by customer with the order in the accounting
year, therefore, would not form a part of sales if the goods against the said
order are not accepted by the customer during the period. On the other
hand, if customers accept materials and services in the accounting period,
they form sales for the period even though customers may pay for them
any time after the close of the accounting period.
Expenses for the accounting period are accrued and included in the income
statement. Thus, rent for March 15 has to be included in the income
statement in spite of the fact that actual payment happens in the first week
of April 15, i.e., after the accounting period is over.
4.2.5 Drawbacks
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The finance manager uses the accrual and not the cash principle in
preparing income statement. In reality, it is the cash flow that determines
a unit’s net worth. You need cash to grow or to declare dividends for stock
owners.
Similarly, over the time, the assets lose their economic value which is
difficult to quantify for a particular accounting year. The finance manager
uses the principle of dividing the asset acquisition value over its useful life
to arrive at depreciation for the accounting year. Actual loss in value of an
asset does not follow this logic. Normally, the loss in asset value is smaller
initially and significant prior to the end of life of the asset. Depending upon
the method of straight line or diminishing value used for calculation of
depreciation, the asset value loss remains constant or goes on decreasing
in the income statement.
The last but not the least, economic inflation increases the market value of
the firm’s most assets. This increase in value is never reflected in the
income statement and to that extent, it fails to exhibit increase in net
wealth of the business entity.
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a. How much did the firm make (or lose) in the given accounting period?
You will notice from above that while the income statement provides
results of the accounting period; the balance provides net worth since
inception as on the last day of the same period.
For judging asset performance, the Fixed Asset Turnover Ratio is quite
revealing. Property, Plant and Equipment (PP&E), or fixed assets, is
another of the “big” numbers in a company’s balance sheet. In fact, it often
represents the single largest component of a company’s total assets. A
company’s investment in fixed assets is dependent, to a large degree, on
its line of business. Some businesses are more capital-intensive than
others. Service companies and computer software producers need a
relatively small amount of fixed assets. Mainstream manufacturers
generally have around 30-40% of their assets in a fixed category;
accordingly, fixed asset turnover ratios will vary among different industries.
The fixed asset turnover ratio is calculated as:
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REPORTING FINANCIAL RESULTS
This fixed asset turnover ratio indicator, looked at over time and compared
to that of competitors, provides the investor an idea of how effectively a
company’s management is using its large and important assets. It is a
rough measure of the productivity of a company’s fixed assets with respect
to generating sales. The higher the ratio better the asset utilization.
Obviously, analysts/investors should look for consistency or increasing
fixed asset turnover rates as positive balance sheet investment qualities.
4.3.2 Structure
The balance sheet that shows the financial condition of a business unit at
given point of time shall be either in the account form or in the report
form. However, the current Companies Act 2013 prescribes only the report
form for preparing balance sheet for joint stock companies. Thus, the
option of account form is available to proprietary and partnership business
units alone.
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REPORTING FINANCIAL RESULTS
Total Total
And the balance sheet in the report format prescribed by the Companies
Act 2013 under Schedule III appears like this:
1 2 3 4
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REPORTING FINANCIAL RESULTS
Liabilities Assets
(b) Inventories
(c) Trade receivables
Total Total
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REPORTING FINANCIAL RESULTS
4.3.3 Contents
in Rs. crores
Sources of Funds
Total Share Capital 801.55
Equity Share Capital 801.55
Share Application Money 0.00
Preference Share Capital 0.00
Reserves 29,881.73
Net Worth 30,683.28
Secured Loans 0.02
Unsecured Loans 38.69
Total Debt 38.71
Total Liabilities 30,721.99
Application of Funds
Gross Block 21,392.12
Less: Revaluation Reserves 52.41
Less: Accumulated Depreciation 7,213.63
Net Block 14,126.08
Capital Work-in-progress 2,114.14
Investments 8,405.46
Inventories 7,836.76
Trade Receivables 1,722.40
Cash and Bank Balance 7,588.61
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REPORTING FINANCIAL RESULTS
** Please note that Previous year’s data is omitted for this exercise.
1. Equity and preference capital: Under liabilities, the first item is total
share capital that consists of equity capital and preference capital.
Equity capital also known as ordinary capital is a risk capital as there is
no commitment for distribution of dividends at any fixed rate. Equity
shareholders are the owners of the company. The preference capital is
not considered risky as preference shareholders are entitled to a fixed
rate of dividend. Cumulative preference shareholders are entitled to the
dividend whether company earns a profit or not. In absence of profit,
the company may not declare dividend and pay them but the amount is
carried forward (accumulated) for payment later. Unless this
accumulated amount is paid first, the company cannot declare dividends
to equity shareholders. Dividends have to be paid first to non-
cumulative preference shareholders before dividend to equity
shareholders can be declared in any year.
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REPORTING FINANCIAL RESULTS
4. Reserves and surplus: There are two broad kinds of reserves: (i)
capital reserve and (ii) revenue reserve. The first capital reserve
includes share premium, revaluation reserve, and capital redemption
reserve. The capital reserve is not available for distribution of dividends
to shareholders. Revenue reserve is generated through accumulation of
retained earnings, i.e., profits after taxes not distributed as dividends.
You should recognize here that the paid-up capital along with reserves
constitute shareholders’ funds or net worth Rs. 30,683.28 in case of ITC
in its balance sheet above.
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REPORTING FINANCIAL RESULTS
6. Unsecured loans: These loans are provided by the banks and other
financial institutes against the general creditworthiness of the borrower.
No specific asset is pledged to get the loan. Term loans or working
capital loans are typical forms of unsecured loans. ITC being a strong
net worth company only small amount of Rs. 38.71 is reported as total
debt in its balance sheet above.
7. Thus, you will note that paid equity capital, reserves and loans together
constitute total liabilities of a business entity and it is reported as the
first part of the report from balance sheet.
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REPORTING FINANCIAL RESULTS
_________________________ _________________________
Net Value Net value
a. This net value of the tangible and intangible assets appears as Net
Block in the balance sheet at Rs. 14,126.08 in the ITC balance sheet
above.
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4.3.4 Principles
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REPORTING FINANCIAL RESULTS
Except in the case of the first financial statements laid before the company
(after its incorporation), the corresponding amounts (comparatives) for the
immediately preceding reporting period for all items shown in the Financial
Statements including notes shall also be provided to allow better analysis.
4.3.5 Drawbacks
Most of the values stated in the balance sheet are stated on historical or
original cost basis. These values have no relation to their market value.
This causes a major difficulty in understanding real value of plant and
machinery and inventory held by the business firm. The actual value could
be as high as three to four times the value reported. From a negative point
of view, firm may need much larger amounts than stated in the balance
sheet to replace the present plant or inventories.
It is argued that benefit from a sale is available for the business unit only
when cash against the sale is received. The balance sheet (as is the case
with the income statement) data is based on accrual principle and not on
actual cash basis.
The accountants’ cost principle and the monetary unit assumption limits
correct presentation of real value of the assets reported on the balance
sheet. Assets will be reported:
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This means that a company’s creative and effective management team will
not be listed as an asset. Similarly, a company’s outstanding reputation, its
unique product lines, and brand names developed within the company will
not be reported on the balance sheet. As you may surmise, these items are
often the most valuable of all the things owned by the company. However,
brand names if purchased from another company will be recorded in the
company’s accounting records at their cost.
While depreciation is reducing the book value of certain assets over their
useful lives, the current value (or fair market value) of these assets may
actually be increasing. (It is also possible that the current value of some
assets—such as computers—may be decreasing faster than the book
value.)
Long-term liabilities such as Notes Payable (not due within one year) or
Bonds Payable (not maturing within one year) will often have current
values that differ from the amounts reported on the balance sheet due to
inflation in the economy.
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4.4.1 Definition
There is a general belief that all financial data is fully reported in just the
income statement and the balance sheet. But this is not true. Unless you
study firm’s cash flow statement that contains critically important analytical
data, you cannot have full picture of the firm’s financial standing. Funds
Flow is a statement prepared to analyze the reasons for changes in the
financial position of a company between two income statements and
balance sheets. In the statement of cash flows, these two reports are
translated into a statement that shows the inflow and outflow of funds. It
reflects sources and applications of funds for the selected period. The
statement considers cash flows in three major areas:
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REPORTING FINANCIAL RESULTS
Operations Activities
You need to have a six-step approach to arrive at net cash flows from
operating activities as under:
3. Is there an increase in the current assets? If so, it means you used cash
to acquire them and hence you need to deduct the amount from total of
cash above.
Investment Activities
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Financing Activities
When you add the net cash flows from all three activities, you arrive at net
increase (decrease) in cash flows for the period under review.
4.4.3 Structure
Sources
Uses
Fund Inflows Fund Outflows
Total Total
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Funds flow statement can also be prepared in the report format which is
more popular.
Net profit
Depreciation
Sale of assets
Issue of shares/debentures
Long-term borrowings
Total Cash Inflows (A) ——————————
——————————
Dividend paid
Income taxes paid
Redemption of shares/debentures
Total Cash Outflows (B) ——————————
——————————
Illustration 4.1
East and West Air Coolers reported following financial results for the year
20XX that showed net profit of Rs. 166,525.
Other transactions in that year were as under:
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4. Its opening inventory was Rs. 125,560 and closing inventory was at Rs.
124,710.
5. Sundry creditors showed a rise of Rs. 1,560 while sundry creditors of
Rs. 775.
6. In the year, additional long-term loan was arranged for Rs. 25,000.
7. Dividends on equity shares paid during the year amounted to Rs.
33,500
What would be the company’s net cash flow at the end of the year?
Now let us have a look at Funds Flow statement based on above
information:
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Self-training Exercise: 1
Tick under A, B or C.
A B C
1 Increase in Sales
4 Depreciation
5 Reduction in Purchases
10 Income Tax
Answers:
1. C, 2. A, 3. A, 4. A, 5. C, 6. B, 7. B, 8. A, 9. B, 10. B.
4.4.4 Contents
Inflows
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3. Sale of Assets: Business units are required to sell machinery that has
outlived its productive life or to sell software that has become outdated/
unsuitable for the business unit. This transaction does not appear in the
income statement and hence has to be added as cash inflow.
Outflows
1. Net Loss: If the business unit has incurred a loss, it has a cash outflow
to that extent and it becomes the typical part of outflow from business
operations.
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4.4.5 Principles
Both increase and decrease in short-term liabilities provide you with cash
flows from operations. While both increase and decrease in assets provide
you with cash flows from investing activities, the third increase and
decrease in owners’ equity and long-term liabilities result into cash flows
caused by firm’s financing activities.
4.4.6 Drawbacks
Cash flow statements, just like Income Statements and Balance Sheets,
are prepared using past information. They, therefore, do not provide
complete information to assess the future cash flows of an entity. On its
own, the statement of cash flows cannot be used to determine the financial
prospects of a company.
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Cash flow statements are not suitable for judging the profitability of a firm,
either as of today or in future.
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financial statements that give a true and fair view. This step is necessary in
order to design audit procedures that are appropriate in the circumstances.
An audit also includes evaluating the appropriateness of the accounting
policies used and the reasonableness of the accounting estimates made by
the Company’s Directors, as well as evaluating the overall presentation of
the financial statements. We now assume that the business unit, under
audit, has successfully complied with all legal obligations and proceed
further. The auditor then certifies that they believe that the audit evidence
they obtained is sufficient and appropriate to provide a basis for the audit
opinion on the standalone financial statements.
Then the auditor provides an opinion that states “In our opinion and to the
best of our information and according to the explanations given to us, the
aforesaid standalone financial statements give the information required by
the Act in the manner so required and give a true and fair view in
conformity with the accounting principles generally accepted in India, of
the state of affairs of the company as at 31 March 20XX and its profit and
its cash flows for the year ended on that date.”
a. We have sought and obtained all the information and explanations which
to the best of our knowledge and belief were necessary for the purposes
of our audit.
c. The balance sheet, the statement of profit and loss and the cash flow
statement dealt with by this report are in agreement with the books of
account.
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2. The Company has made provision, as required under the applicable law
or accounting standards, for material foreseeable losses, if any.
6. The Company has granted loans to XXX bodies corporate covered in the
register maintained under Section 189 of the Companies Act, 2013 (‘the
Act’).
7. In the case of the loans granted to the bodies corporate listed in the
register maintained under section 189 of the Act, the borrowers have
been regular in the payment of the interest as stipulated. Repayments
have been arranged per the terms of repayment schedule and there
have been no defaults.
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10.The Company has not accepted any deposits from the public. (If yes,
there are no defaults in repayments).
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Notes then confirm that the Financial Statements of the Company have
been prepared in accordance with Generally Accepted Accounting Principles
in India (Indian GAAP). The Company has prepared these Financial
Statements to comply in all material respects, with the Accounting
Standards notified under the Companies (Accounting Standards) Rules and
the relevant provisions of the Companies Act, 1956. The Financial
Statements have been prepared on an accrual basis and under the
historical cost convention. Further, Directors reiterate that the accounting
policies adopted in the preparation of financial statements are consistent
with those of previous year except for the change in accounting policy, if
any explained separately.
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6. Borrowing Cost: How some costs (if any) are capitalized and rest
expensed.
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Our aim is to build a culture within the Company that delivers innovation to
clients. We create the required environment, structures, ecosystems and
economic models that will spur innovation across the Company. We are
using Design Thinking methods to elicit new problem statements and bring
together our deep knowledge of client industries and emerging
technologies to solve problems for our clients.
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biggest assets. To meet the evolving need of our clients, our priority is to
attract and engage the best talent in the right locations with the right
skills. We are fully committed to strengthening our brand to continue to be
the ‘employer of choice’. A series of measures have been initiated to
empower our employees through trust and accountability. We have
overhauled our performance management system to bring in more
objectivity, created internal marketplace for employees to work on
challenging assignments, and increased the focus on providing a safe and
transparent working environment.
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4.6 Summary
The income statement as its name suggests has to have all types of
revenues earned by the business entity. This includes net sales (after
discounts, etc.), interest earned, proceeds from sale of used assets and
any other non-operating income. On the expense side, it shows purchases,
wages and salaries, and other expenses like depreciation, manufacturing,
selling and distribution expenses as well as value (net of depreciation) of
assets disposed of. The income statement has to be prepared on principle
of accrual and not on cash basis.
The finance manager uses the accrual and not the cash principle in
preparing income statement. In reality, it is the cash flow that determines
a unit’s net worth. You need cash to grow or to declare dividends for stock
owners.
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The balance sheet is prepared to display the nature and value of assets
owned by the firm and how are these assets financed by the owners’ funds
or firm’s borrowings appearing as liabilities. Income statement and balance
sheet together provide answers to owners’ and financiers’ two queries:
i. How much did the firm make (or lose) in the given accounting
period?
The balance sheet that shows the financial condition of a business unit at
given point of time shall be in either in the account form or in the report
form. However, the current Companies Act 2013 prescribes only the report
form for preparing balance sheet for joint stock companies.
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a. Investors
b. Finance Managers
c. Financial Analysts
d. Each one of above
2. The increase in net wealth of the business entity is never reported in the
annual income statements and to that extent it fails to reflect economic
income. This is due to the fact that income statement __________.
a. in a report format
b. on a quarterly basis
c. in T format
d. on an annual basis
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REPORTING FINANCIAL RESULTS
a. Operations
b. Financial
c. Investing
d. All of the above
Answers:
1. (d)
2. (c)
3. (a)
4. (d)
5. (b)
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REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter
Summary
PPT
MCQ
Video Lecture
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FINANCIAL ANALYSIS FOR MANAGEMENT DECISIONS
CHAPTER 5
FINANCIAL ANALYSIS FOR MANAGEMENT
DECISIONS
Objectives
Structure:
5.1 Introduction
5.2 Ratio Analysis
5.3 Trend Analysis
5.4 Summary
5.5 Multiple Choice Questions
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FINANCIAL ANALYSIS FOR MANAGEMENT DECISIONS
5.1 introduction
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5.2.1 Classification
We shall use the following Income Statement and Balance Sheet of Larsen
and Toubro Ltd. to measure and understand various financial ratios that are
used for analysis.
Larsen & Toubro Ltd. Profit and Loss A/c: Income Statement for
the year ended March 2015
FY 2015 FY 2014
Parameters Rs. Crores Rs. Crores
Gross Sales 57,558.07 57,163.85
Less: Excise 540.66 564.93
Net Sales 57,017.41 56,598.92
Increase/Decrease in Stock –268.18 110.2
Raw Materials Consumed 25,283.30 24,031.75
Power and Fuel Cost 685.6 656.73
Employee Cost 4,150.84 4,656.90
Other Manufacturing Expenses 16,808.97 16,762.27
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FY 2015 FY 2014
Parameters Rs. Crores Rs. Crores
Equity and Liabilities
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Two types of ratios are commonly used to examine financial leverage: (a)
Structural or debt utilization ratios and (b) Coverage ratios. Structural or
debt utilization ratios allow the analyst to measure the entity’s prudence in
managing its debt. This use of debts to finance business is also known as
leveraging business. While debt capital is cheaper source of finance, it is
equally risk prone. Coverage ratios are meant to focus on the relationship
between debt servicing commitments, i.e., ability to pay interest and repay
the debt on its maturity.
This ratio is also known as debt asset ratio. The ratio attempts to
determine the extent to which borrowed funds support the firm’s total
assets. Here, the numerator consists of long-term loans, debentures and
other forms of debts. This sum is divided by the total assets of the firm.
Generally, lower the ratio better the debt management system of the
business entity. The prudent ratio is supposed to be 0.5.
In case of L&T Ltd., the ratio for FY 2015 is Rs. 9,341.66 crores ÷ Rs.
90,132.05 crores = 0.10 and for the FY 2014, it is Rs. 6,281.24 crores ÷
Rs. 78,304.58 crores = 0.08. Thus, L&T Ltd. has one of the best debt
management as its ratio is much below 0.5 considered prudent by
analysts. The ratio for FY 2014 was better than that for FY 2015. If you
were to look at the numbers from M&M Ltd. balance sheet, you will find
total debt of Rs. 2620.38 crores versus total assets of Rs. 21875.47 for FY
2015 providing you with 0.12 another strong debt asset ratio.
Debt to Equity
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In case of L&T Ltd., the ratio for FY 2015 is Rs. 9,341.66 crores ÷ Rs.
37,084.58 crores = 0.25 and for FY 2014 Rs. 6,281.24 crores ÷ Rs.
33,661.83 crores = 0.19 thereby establishing once again that this company
has built-up reserves to raise its equity to four times the amount it needs
to pay back its lenders. For FY 2015, M&M Ltd. – another financially sound
corporation – has built-up capital and reserves of Rs. 19255.09 crores to
service debt of only Rs. 2620.38 crores – thus providing strong debt/equity
ratio of 0.14. From the study of published accounts of about of 3114
companies in 2007-08, it was observed that the average debt/equity ratio
for all industries was 0.44.
Given that the debt/equity ratio measures a company’s debt relative to the
total value of its stock, it is most often used to gauge the extent to which a
company is taking on debts as a means of leveraging (attempting to
increase its value by using borrowed money to fund various projects). A
high debt/equity ratio generally means that a company has been
aggressive in financing its growth with debt. Aggressive leveraging
practices are often associated with high levels of risk. This may result in
volatile earnings as a result of the additional interest expense.
Like with most ratios, when using the debt/equity ratio, it is very important
to consider the industry in which the company operates. Because different
industries rely on different amounts of capital to operate and use that
capital in different ways, a relatively high D/E ratio may be common in one
industry while a relatively low D/E may be common in another.
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Another important point to consider when assessing D/E ratios is that the
“Total Long-term Liabilities” portion of the formula may often be
determined in a variety of ways by different companies, some of which are
not actually the sum of all of the company’s liabilities. In some cases,
companies will only incorporate debts (like loans and debt securities) into
the liabilities portion of the formula, while omitting other kinds of liabilities
(unearned revenue, etc.). In other cases, companies may calculate D/E in
an even more specific way, including only long-term debts and excluding
short-term debts and other liabilities. Yet, “long-term debt” here is not
necessarily a term with a consistent meaning. It may include all long-term
debts, but it may also exclude long-term debts nearing maturity, which are
then categorized as “short-term” debts. Because of these differentiations,
when considering a company’s D/E ratio, one should try to determine how
the ratio was calculated and should be sure to consider other ratios and
performance metrics as well.
This ratio is determined by dividing the sum of profit before interest and
taxes by the total interest burden arising from the debts. The taxes are
added to the profit as the ability of the firm to pay interest does not get
affected by taxes as interest happens to be a tax deductible expense.
Higher the ratio, greater the firm’s ability to pay interest even if there is a
partial drop in it profits. The high ratio attracts investors to the business
entity.
For L&T Ltd., the ratio for FY 2015 is Rs. 8,280.07 crores ÷ Rs. 1,578.85 =
5.24 showing that the company has robust earnings to cover the interest
burden. The ratio for FY 2014 works to 7.01 much stronger because of high
figure of interest plus profits of Rs. 8,476 crores earned that year.
In case of M&M Ltd. for FY 2015, it has Rs. 8,904 crores to support interest
burden of Rs. 3050 crores providing a ratio of 2.92 which is sound but not
as sound as that of L&T Ltd.
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This ratio is determined by dividing the sum of profit before interest and
taxes by the total burden arising from the fixed charges. This ratio takes a
wider look at debt management than the one taken to use interest
coverage ratio. By measuring this ratio, the analyst judges the firm’s
sustained ability to meet its, not only interest but, all fixed financial
obligations based on the assumption that failure to meet any financial (not
interest alone) burden would endanger the credit rating of the business
entity.
After reviewing the firm’s prudence in managing its debt that take care of
long-term obligations, next area for analysis is how does the management
handle its short-term day-to-day financial obligations like disbursing wages
and salaries, paying its suppliers of goods and services and meeting
operating expenditure. As a consequence, these ratios focus on firm’s
current debts and liabilities. We examine two ratios now.
Current Ratio
Current assets like inventory and debtors get converted repeatedly into
cash. This cash is used to meet short-term liabilities of the firm and pay off
its creditors. Therefore, current ratio is calculated by dividing firm’s current
assets by its current liabilities. In the numerator, you will find a total of
cash, current investments (maturity < one year) debtors, inventory, loans
and advances and prepaid expenses. While current liabilities include loans
both secured/unsecured, creditors and provisions for expenses.
From the balance sheet of L&T above, you can derive current ratio of 1.41
for the FY 2015 by dividing current assets valued at Rs. 61,629.14 by
current liabilities of Rs. 43,705.81. In case of M&M, the current assets in
2015 were Rs. 11698.49 crores and current liabilities of Rs. 2,620.38
providing a still better current ratio of 4.46. The study of 3114 companies
mentioned earlier provides 1.30 as the average current ratio for all
industries. Accounts of M&M Ltd. for FY 2015 reveal that it heldRs. 11,698
crores of current assets to support 2,620 crores of current liabilities to
provide a very strong current ratio of 4.46.
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Higher the current ratio, better liquidity available to the firm to meet its
financial obligations in the near term. It must be noted here that you must
look closely at the type of assets included in the numerator. Two firms can
have the same liquidity ratio. But one with a high proportion of cash and
debtors in the numerator is much more liquid than the firm with high
proportion of inventories.
Quick Ratio
This ratio is also known as Acid Test Ratio and is used to measure firm’s
liquidity in a much stricter manner than the current ratio above. Its
numerator consists of really liquid assets. To measure this numerator, you
need to deduct value of inventories from total current assets to arrive at a
sum of cash and bank balances, sundry debtors and short-term current
investments. We do not consider inventories for this stringent ratio because
inventories are considered less liquid among all current assets.
In case of L&T, the ‘Quick Ratio’ for 2015 works out to Rs. 59,420 ÷ Rs.
43,705 = 1.36 versus current ratio of 1.41 calculated above. The all
industry average quick ratio was 0.54 (against 1.30 current ratio)
indicating major part of current assets consists of inventories.
The main objective of any business unit is to earn profits for the owners.
Its efficiency in achieving this goal is measured through use of profitability
ratios. It is a class of financial metrics that is used to assess a business’s
ability to generate earnings as compared to its expenses and other relevant
costs incurred during a specific period of time. For most of these ratios,
having a higher value relative to a competitor’s ratio or the same ratio from
a previous period is indicative that the company is doing well.
This ability is reflected in two different manners, one deals with efficiency
with which profits are earned while carrying the business activity (i.e.,
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sales) and the other is how profitably the owners’ funds have been
deployed.
In the first category, we have earnings or profit margin ratios which are
further broken into gross margin, operating margin and net margin ratios.
In the second category fall return on assets and return on equity ratios.
This ratio is calculated by dividing gross profit by net sales where gross
profit = net sales minus cost of goods sold. The ratio indicates how much
money is available per hundred rupees of sales for meeting selling and
administration expenses and taxable profits for the owners. Some analysts
include depreciation in cost of goods sold while others exclude it and add it
to the sales and administration expenses.
This ratio for L&T Ltd. for 2015 is gross margin of Rs. 8,931.06 divided by
net sales of Rs. 57,017.41 resulting in 15.6%. While in the previous year, it
was (Rs. 8,931.06 ÷ Rs. 56,598.92) a little lower at 15.3%. Compared to
this for Mahindra’s, the ratio in the year 2015 was (Rs. 10,381 ÷
Rs.715,539) 10.04%. This lower rate could be contributed to the
competitive auto market in which it is operating.
The ratio measures both how effectively production costs are controlled
and how remunerative is the firm’s pricing policy. Further analysis can be
conducted to observe how each element of production cost (material, labor
and overheads) is affecting the gross margin.
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For FY 2014 ——> (Rs. 6,575.48 ÷ Rs. 56,598.92) same 11.6% indicating
steady profitability of operations.
Difference between 15.6% gross profit margin ratio and 11.6% operating
profit margin ratio equal to 4.0% indicates that selling and administration
expenses of the company for FY 2015 were 4% of its net sales.
This ratio is calculated by dividing net profit by net sales where net profit =
operating profit minus interest and other financing costs as well as taxes
paid. Net profit, in other words, is the amount available for distribution to
both ordinary and preference shareholders. The ratio indicates firm’s
efficiency in overall as well as finance and tax management.
There is a clear indication that tax and finance management was better in
FY 2014. It can also be seen from the interest burden of Rs. 1,208.32
crores in the year 2014 versus higher burden of Rs. 1,578.85 in the
following year.
Using the above formula for L&T Ltd. for the year ending March 2015, the
ROA is Rs. 5,056 ÷ Rs. 90,132 = 5.6%; indicating profitable utilization of
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the assets. The same ratio for the previous year was Rs. 78,304 ÷ Rs.
5,493 = 7.0%. This clearly indicates that the assets were more profitably
turned around by the company in FY 2014.
Further, assets are stated at their depreciated book value and therefore, in
inflationary economy, the ratio provides much higher numbers that could
not be reflecting the real profitability of the assets.
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Shareholders’ Equity. Net income is for the full fiscal year (before dividends
paid to common stockholders but after dividends to preferred stock).
Shareholders’ equity does not include preferred shares but includes paid-up
capital, reserves, and surplus or retained earnings. For FY 2015, L&T Ltd.
reported net income of Rs. 5056 crores on equity of Rs. 186 crores thereby
indicating a strong ROE of 27%.
Receivables Turnover
The ratio is determined by dividing the net credit sales (and if this data is
not there in published accounts then net sales) by average debtors/
receivables per day in the year. Higher ratio, therefore, indicates efficient
formulation and implementation of credit policy and business entity’s credit
terms for its customers.
In case of L&T Ltd. for 2015, the receivables turnover would be Rs. 57,017
÷ Rs. 23,051 = 2.47 and for the previous year 2014, it would be Rs.
56,598 ÷ Rs. 21.538 = 2.63. This leads us to conclude that receivables
turnover dropped from 2.63 to 2.47 in 2015 almost a 6% drop in efficiency
in management of trade debtors. Or to put in other words, management’s
inability to retain debtors at Rs. 21,679 (Rs. 57,017 ÷ 2.63) and allowing
them to climb to Rs. 23,051 in the year 2015. The ratio for all industries in
2007-08 was 15. L&T, being a construction company, the ratio is very less.
The ratio for M&M Ltd. for the year 2015 was 28.
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For L&T for the year 2015, the ratio is as per calculations below:
• Rs. 23,051 debtors ÷ Rs. 156.2 sales per day = 147 days is the
collection period.
The collection period for a year can also be determined by the formula 365
÷ receivables turnover. The all industries average is 24. For M&M Ltd. for
the year 2015, it would be 365 ÷ 28 = 13 days much better than all
industries average mainly because it sells vehicles to selling agencies on a
wholesale basis.
The efforts for improving the collection period start when the business
entity determines terms of sale at the time of seeking a sales order from
its customers. If the terms of payments are correctly defined, understood
and agreed upon by the customer, the job of collecting debts gets simple
and effortless. But if this step is not properly handled, a lot of efforts are
required to keep receivables under control.
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c. Consumables: These are the materials like oils, cotton waste, cleaning
agents, etc. which are needed for smooth running of the manufacturing
process.
d. Finished Goods: These are the final output of the production process
of the business concern. These materials are ready for shipment to
consumers and lastly.
e. Spares: These spare parts are required for upkeep of equipment and
form a part of inventories.
If the inventories are not turned over from raw materials to finished goods
regularly, there is vast scope for it to get obsolete. Continuous movement
of materials is a key to better inventory turnover ratio. On one hand, we do
not want to lock up our funds in idle stocks and on the other, we do not
wish to cause an interruption in production for want of a single component.
Many corporations adopt a “Just-in-time (JIT)” philosophy to ensure that
there is no over-stocking or idle stocks in the factories or warehouses of
the business entity.
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80% items are again broken into B class items causing higher consumption
value and balance C class items with lesser consumption value. B class
items can be procured quarterly and C class low consumption value items
can be procured annually. ABC system minimizes cost of procurement but
increases turnover.
For L&T Ltd., the ratio for FY 2015 will work to Rs. 57,017.41 net sales ÷
Rs. 7,490.43 fixed assets = 7.61. For the previous year, it is a little less at
7.37 (Rs. 56,598 net sales ÷ Rs. 7,677 fixed assets = 7.37).
Care must be exercised in analyzing this ratio, as with the age of the fixed
assets, their book value goes down through accounting for depreciation
with no corresponding loss in efficiency of the equipment. Just because of
this decrease in value, your ratio may indicate better asset utilization!
A little variation from above is the total asset turnover ratio. This ratio is
used to determine how efficiently investment in the total assets of the firm
is being put to profitable use. The business unit that creates maximum sale
from say one crore of total assets is naturally putting the total assets to
better use. Here, net sales of the organization are divided by the total
assets at the end of the year.
For L&T Ltd., the fixed assets turnover rate in 2015 works out to Net sales
of Rs. 57,017.41 ÷ Total assets of Rs. 90,132.05 = 0.63. While for the
previous year it is Net sales of Rs. 56,598.92 ÷ Total assets of Rs.
78,304.58 = 0.72. The fall in the rate could be attributed to increase of
over ten thousand worth of current assets.
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These ratios are popular with investors to find which company is returning
more value to shareholders both in the form of dividends and increase
(decrease) in its share prices in the stock market. With valuation ratios, a
company’s stock price enters your investment analysis. Valuation ratios
include the ever-popular yield, Price to Earnings (P/E) ratio, along with
Price to Sales (P/S) and Price to Book. (P/B). Valuation ratio measures
what the firm has earned for its equity holders through its own earnings
and increase (decrease) in market price of its share. This category of ratio
is considered to be most comprehensive.
Yield
Price to Earnings
This is the most common ratio with all investment analysts world over. It is
arrived at by simply dividing the market price of the share by the earnings
per share. Here, earnings mean after tax profit for the year less dividends
to preference shareholders (if any) divided by total number of equity
shares outstanding at the year end. With the P/E ratio, investors can
evaluate the difference between what they are paying for the stock and its
earning power. A company with a P/E of 40 is trading at a level 40 times
higher than its earnings, while a company with a P/E of 20 is trading at a
level 20 times its earnings.
P/E = {(Profit after Tax – Preference Share Dividend for the year) ÷
Number of Equity Shares Outstanding.}
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L&T Ltd. normally is traded at around 30 P/E. A high P/E ratio may signify
that the company is overvalued, which means that eventually market
forces will drive the price down. On the other hand, a high P/E could
indicate great earning power and the possibility that profitability will
increase over time, justifying the higher price. The price earnings ratio is
influenced by the earnings and sales growth of the firm, the risk (or
volatility in performance), the debt/equity structure of the firm, the
dividend policy, quality of management and many such factors.
A low P/E may indicate the potential for strong future performance.
Companies with low P/Es may be undervalued or trading at a price lower
than the company’s fundamentals merit. In that case, earnings may
increase dramatically in future weeks and years. Or, a low P/E could just as
easily denote a faltering company that would be an inadvisable investment.
The bottom line is that while P/E is a valuable tool, it does not provide all
the information you need to make an informed decision.
In some cases, a company that you are seeking to value does not have any
current earnings. In other cases, the company is very young or might be
experiencing a cyclical low in their earnings cycle. Additionally, a variety of
accounting rules can make a profitable company appear to have no
earnings due to special write-offs specific to that industry. For all of the
above-mentioned reasons, some prefer to use a ratio of current price to
sales of the company. The ratio is calculated as:
As with most ratios, the lower the ratio, the better the expected value of
those companies’ shares. However, much like the P/E ratio, it fails to
account for future growth and therefore can give you misleading results if
used alone.
This is also known as the price-to-book ratio, or P/B ratio and the price-to-
equity ratio (which should not be confused with the price-to-earnings
ratio). It is a financial ratio used to compare a company’s current market
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price to its book value. The calculation can be performed in two ways, but
the result should be the same each way. In the first way, the company’s
market capitalization can be divided by the company’s total book value
from its balance sheet. The second way, using per-share values, is to
divide the company’s current share price by the book value per share (i.e.,
its book value divided by the number of outstanding shares).
As with most ratios, it varies by a fair amount per industry. Industries that
require more infrastructure capital (for each dollar of profit) will usually
trade at P/B ratios much lower than, for example, consulting firms. P/B
ratios are commonly used to compare banks, because most assets and
liabilities of banks are constantly valued at market values. A higher P/B
ratio implies that investors expect management to create more value from
a given set of assets, all else being equal (and/or that the market value of
the firm’s assets is significantly higher than their accounting value). P/B
ratios do not, however, directly provide any information on the ability of
the firm to generate profits or cash for shareholders. This ratio also gives
some idea of whether an investor is paying too much for what would be left
if the company went bankrupt immediately.
Book Value literally means the value of the business according to its
“books” or financial statements. In this case, book value is calculated from
the balance sheet, and it is the difference between a company’s total
assets (Rs. 90,132.05 crores in case of L&T Ltd. in 2015) and total
liabilities (Rs. 53,047.47 crores in case of L&T Ltd. in 2015). Note that this
is also the term for shareholders’ equity (37,084.58 for L&T Ltd.). L&T’s
market capitalization in that year was around Rs. 1, 43,700 crores
providing a P/B of 2.7.
The difference between market value and book value can depend on
various factors such as the company’s industry, the nature of a company’s
assets and liabilities, and the company’s specific attributes. There are three
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FINANCIAL ANALYSIS FOR MANAGEMENT DECISIONS
(a) If Book Value Greater than Market Value: The financial market values
the company for less than its stated value or net worth. When this is
the case, it’s usually because the market has lost confidence in the
ability of the company’s assets to generate future profits and cash
flows. In other words, the market doesn’t believe that the company is
worth the value on its books. Value investors often like to seek out
companies in this category in hopes that the market perception turns
out to be incorrect. After all, the market is giving you the opportunity
to buy a business for less than its stated net worth.
(b) If Market Value Greater than Book Value: The market assigns a higher
value to the company due to the earnings power of the company’s
assets. Nearly, all consistently profitable companies (like L&T Ltd.) will
have market values greater than book values.
Another way to understand why the market may assign a higher value than
stated book is to understand that book value is not necessarily an accurate
value of a company’s net worth. Book value is an accounting value, which
is subject to many rules like depreciation that require companies to write
down the value of certain assets. But if those assets are consistently
generating greater profit, then the market understands that those assets
are really worth more than what the accounting rules dictate.
When computing financial ratios and when doing other financial statement
analysis, always keep in mind that the financial statements reflect the
accounting principles. This means assets are generally not reported at their
current value. It is also likely that many brand names and unique product
lines will not be included among the assets reported on the balance sheet,
even though they may be the most valuable of all the items owned by a
company. Same is the situation of the skills with which the business of the
firm is managed by managers. They are just beyond quantification.
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FINANCIAL ANALYSIS FOR MANAGEMENT DECISIONS
against which they are measured. That leaves analysts with alternative of
comparing the ratios with those available of other business units in the,
preferably, same industry. When the two companies are of substantially
different size, age and diversified products, comparison between them will
be more unrealistic.
Financial statements are based upon past performance and past events
which can only be guides to the extent they can reasonably be considered
as meaningful indicators for the future. Great amount of care and caution,
therefore, has to be exercised, in arriving at any conclusions based on
study of above-mentioned financial ratios of any business entity.
All firms publishing their accounts under Companies’ Act 1956 have to
attach Notes to Accounts as prescribed by this Act. These need to be
carefully studied. Otherwise you will arrive at incorrect conclusion after
examining financial ratios. Mumbai Machinery Ltd. and Kolkata Machinery
Ltd. started their operations in fiscal 2010 with Rs. 40 crores of Fixed
Assets. In fiscal 2015, both the companies reported net profit of Rs. 23.5
crores over net sales of Rs. 100 crores. In other words, both firms were
equally efficient in running their operations as they achieved same
quantum of sales and returns after putting to use the initial investment of
Rs. 100 crores.
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When you study the assets turnover ratio and return on asset ratio, you
are certain to conclude that Mumbai Machinery Ltd. is more efficient in
utilizing its fixed assets and that to more profitably as both its Asset
Turnover and ROA is more than its competitor. But when you read the
notes to the accounts, you will observe that Mumbai Machinery Ltd.
depreciates its assets at 10% on straight line basis while its competitors
adopt reducing balance method to calculate depreciation. And this
difference in depreciation calculating methods misguided you in comparing
the firms’ asset utilization efficiency.
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FINANCIAL ANALYSIS FOR MANAGEMENT DECISIONS
Self-training Exercise: 1
Ratio Classification
Ratio Classification
Debt to Equity Y
Interest coverage
Return on Assets
Return on Equity
Debt to Equity
Current
Inventory Turnover
Quick
! !132
FINANCIAL ANALYSIS FOR MANAGEMENT DECISIONS
Let us study sales revenue, cost of goods sold and gross profit of ABC Ltd.
for four years.
ABC Ltd.
In Rs. crores
lt
e su
r p
a su
s
A of i t
%
pr 10 .
by p.a
The sales revenue trend indicates that in four years under review there is
an increase of 22%. When the company started exports in 2013, there was
a significant increase of 16%. Thereafter, the sales are showing healthy
growth.
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FINANCIAL ANALYSIS FOR MANAGEMENT DECISIONS
The company is successful in holding its costs for the last three years even
though volumes have increased, may be by gradually filling its capacity.
This has resulted in profit percentage going up by 10% each year. The
trend is likely to continue till the business unit fills up its capacity fully.
In Rs. crores
Period 60 58 54 53
Decrease 0.97 0.91 0.89
n
c tio
lle d
Co erio ed
p uc n
d e
re sev
.
by ays
d
From fiscal 2012 to fiscal 2015, sales have grown by 22%, but debtors only
by 8% from Rs. 96,555 to Rs. 104,365 only thereby reflecting efficient
receivables management.
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FINANCIAL ANALYSIS FOR MANAGEMENT DECISIONS
5.4 Summary
Two types of ratios are commonly used to examine financial leverage: (i)
Structural or debt utilization ratios and (ii) Coverage ratios. Structural or
debt utilization ratios allow the analyst to measure the entity’s prudence in
managing its debt. Coverage ratios are meant to focus on the relationship
between debt servicing commitments, i.e., ability to pay interest and repay
the debt on its maturity.
There are two major liquidity ratios; current ratio and quick ratio or acid
test ratio both measure firm’s liquidity by dividing the current assets by
current liabilities. The second stricter ratio excludes inventories while
determining the ratio.
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FINANCIAL ANALYSIS FOR MANAGEMENT DECISIONS
Yield ratio, Price to Earnings (PE), market value to book value, price to
sales ratio, market value to book value and Price to Book (P/B) ratios
together are known as Valuation Ratios. They in their own way assist
determination of the firm’s value in financial terms.
While using these financial ratios, you must bear in mind that the numbers
under scrutiny are arrived at after following stipulated accounting
principles. Assets, for example, are stated at their historical value that
bears no relation to their value on the day of analysis. Valuable but
intangible assets find no place in ratio analysis. Analysts do not have any
standard metrics against which the ratio can be gainfully compared. While
making decisions based on ratio analysis, you need to assume past trend
would continue in future, which you know has doubtful element of truth.
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FINANCIAL ANALYSIS FOR MANAGEMENT DECISIONS
a. Coverage
b. Utilization
c. Profitability
d. Liquidity
a. Debt Equity
b. Return on Assets
c. PBT
d. Price Earnings
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FINANCIAL ANALYSIS FOR MANAGEMENT DECISIONS
Answers:
1. (a)
2. (c)
3. (b)
4. (d)
5. (d)
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FINANCIAL ANALYSIS FOR MANAGEMENT DECISIONS
REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter
Summary
PPT
MCQ
Video Lecture
! !139
MANAGEMENT OF WORKING CAPITAL
CHAPTER 6
MANAGEMENT OF WORKING CAPITAL
“Management of working capital is a see-saw exercise for the finance manager. On one
hand, it is to be ensured that materials and other facilities are readily available whenever
required; and on the other hand, the quantum of funds required for materials and other
facilities are always to be maintained at their minimum.”
Objectives
Structure:
6.1 Introduction
6.2 Gross and Net Working Capital
6.3 Cash Management
6.4 Why Do Current Assets Grow?
6.5 Forecasting Working Capital Requirements
6.6 Ideal Level of Gross Working Capital
6.7 Working Capital – Operating and Other Cycles
6.8 Factors Influencing Working Capital
6.9 Financing Working Capital
6.10 Cash Requirement for Working Capital
6.11 Summary
6.12 Multiple Choice Questions
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MANAGEMENT OF WORKING CAPITAL
6.1 introduction
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MANAGEMENT OF WORKING CAPITAL
Gross working capital consists of all current assets that normally self-
liquidate in a period of a year or less than a year. Current assets include:
2. Trade receivables that increase and decrease with volume of sales and
are defined by the prevailing terms of payments as agreed with sole
selling agents, wholesalers and direct retailers.
4. Cash and bank balances on hand which if expected to lie idle need to be
invested on a short-term basis.
Net working capital consists of all the current assets as above less current
liabilities consisting of:
Illustration 6.1
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MANAGEMENT OF WORKING CAPITAL
The cost structure for the company’s product for the above activity level is
as under:
(a) Past experience indicates that raw materials are held in stock, on an
average for two months.
Solution:
Output per annum = 30,000 units and hence per month 2,500 units
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MANAGEMENT OF WORKING CAPITAL
Current assets
Managing of this most liquid and non-earning asset has become both an art
and science in current global electronic age. Since childhood, you have
been learning about the virtues of cash. But today’s Chief Finance Officer is
busy in maintaining this idle asset to its minimum. The less cash you have,
generally speaking, better off you are. But at the same time, you do not
ever wish to be caught without cash when you need it to liquidate
payments on their due dates.
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MANAGEMENT OF WORKING CAPITAL
c. Meet precautionary needs. The needs arise when cash inflows are less
than expectations. These needs are critical for business units operating
in seasonal/cyclical industries where cash inflows are more uncertain
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MANAGEMENT OF WORKING CAPITAL
Customers
Sales
Trade Trade
Receivables Receivables
Cash
!
Figure 6.1
Sales income has its own pattern depending on the geographic locations of
customers, types of products they buy and their individual volume of
transactions. Trade receivables will generate cash based on credit terms
granted which could 0-15 days, 16-30 days, 31-60 days, 61 days and
above. Then there are cash outflows on account of interest and dividends
as well as local, state and central taxes payable by the business unit. Cash
goes out not only for inventory inputs but also for wages, purchase of
spares, supplies and other sales and administrative expenses. The diagram
plans to emphasize main drivers alone.
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MANAGEMENT OF WORKING CAPITAL
established business units and provides a much needed float to the finance
manager. To achieve this objective, avoid the early payment of cash; the
firm should pay its trade payables only on the last day of the payment. If
the firm avoids early payment of cash, the firm can retain the cash with it
and that can be used for other purpose. Next, centralize the disbursement
system. Just as decentralized collection system ensures speedy cash
collections, centralized disbursement of cash system takes time for debiting
our accounts. Next, you can prioritize payments and maintain stipulated
dates.
This efficient cash management system has its costs. Your banker either
will levy specific charges per type of transactions or demand maintenance
of an amount of cash balance in the bank large enough to justify waiving of
the bank fees. As we noticed, M&M Ltd. indicated trade receivables of Rs.
2,558 crores as on 31.03.15. If their CFO arranges to reduce time interval
between deposit of cheques by customers to receipt into corporate’s
treasury account by a day, it will have (2,558 ÷ 365) seven crores of cash
to use elsewhere. This benefit has to be compared with incremental bank
charges to arrange a decision.
But as the volume grows, your firm has to hold inventory of higher
amounts, and before it gets converted into saleable outputs, you have
fresh inputs into the inventory to cater to orders being accepted on a day-
to-day basis. Initially, the firm was holding inventory for your first product,
but with business growth and changing customer behavior, you now need
inventory for more and more products. This growth in inventories built is
further accelerated when you expand and start producing and/or selling
from more than one location. You hold inventory for each product at each
location. To maintain and accelerate business activities, a variety of
products and additional business locations are essential.
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MANAGEMENT OF WORKING CAPITAL
Business managers often do not consider the fact that in current assets in
addition to a large quantum of self-liquidating inventory and trade
receivables, you also carry the anomaly of significant quantum of
permanent current assets.
Rs.
Crores
Self-liquidating Current Assets
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MANAGEMENT OF WORKING CAPITAL
Rs.
Crores
Self-liquidating Current Assets
A TIMES
*These along with your fixed assets are firm’s total assets that appear on
the balance sheet.
Here, we have to recognize the fact that a part of your inventories does not
self-liquidate in a period of a year because of miscalculations, the changing
patterns of manufacture, types of machines used and variations in
customer demands. This part then stays either in a dormant condition or
gets obsolete.
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MANAGEMENT OF WORKING CAPITAL
2015 2014
in Rs. crores
Total Current Assets 61,629.14 51,114.61
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MANAGEMENT OF WORKING CAPITAL
For almost the same volume of sales turnover, there is a rise of Rs. 10,515
crores in one year.
Within the year also, these requirements change significantly. For auto
industry, the activity is intense during festive seasons – when larger
working capital is needed to support it; while prior to rainy days when the
demand is slack, it is not necessary to build inventory and working capital
requirements fall for a couple of months. As stated earlier, integrated
approach from all business functions is a must for successful working
capital forecasts.
Another decision that finance manager has to deal with concerns the
working capital policy of the business entity. Here, two choices are
available. The first conservative policy is fancied by both productions as
well as marketing functions. Under this flexible policy, the investment in
current assets is high as by policy adequate stocks of inventories are
maintained all through the year so that there is hardly any interruption in
production or deliveries to customers. The policy calls for high level of
trade receivables as the marketing objective is to offer adequate credit to
customers to retain and attract more sales.
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MANAGEMENT OF WORKING CAPITAL
Less funds in inventory Few bad debts Lost production due to stock-outs
! !152
MANAGEMENT OF WORKING CAPITAL
Figure 6.5
Operating Cycle: This cycle covers the period from (c) receipt of raw
materials to (i) receipt of cash from the customer.
Trade payables cycle: Starts from (d) receipt of invoice for materials to
(f) payment of cash to vendor.
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MANAGEMENT OF WORKING CAPITAL
Cash cycle: Starts from (f) payment of cash to vendors to (i) receipt of
cash from customer.
Inventory cycle: Starts from (c) receipt of materials from vendors to (g)
delivery of finished goods to customer.
You will observe from above that operating cycle is the sum of inventory
period and trade receivables cycle [(c) to (i)] and that cash cycle is
operating cycle minus trade payables cycle [(f) to (i)].
These various phases of overall working capital cycle can also be measured
in days. Here are the formulae that can be used by you in your analysis of
working capital.
Let us measure these parameters for L&T Ltd. for the year 2015.
Cost of Goods Sold Rs. 46,618 Trade Receivables Rs. 23,051 Rs.
23,051
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MANAGEMENT OF WORKING CAPITAL
Amounts in crores.
! !155
MANAGEMENT OF WORKING CAPITAL
terms larger the trade payables and therefore, working capital. Let us
study all these factors on individual basis:
! !156
MANAGEMENT OF WORKING CAPITAL
! !157
MANAGEMENT OF WORKING CAPITAL
! !158
MANAGEMENT OF WORKING CAPITAL
Rs.
Crores
Founds
Founds
Fixed Assets
!
To summarize:
Asset Classification Funds required for finance Means of finance
Long-term loans
Current Assets:
Permanent portion Long-term Funds Long-term loans
! !159
MANAGEMENT OF WORKING CAPITAL
Figure 6.7
! !160
MANAGEMENT OF WORKING CAPITAL
By adopting this measure of utilizing long-term funds for all permanent and
a part of temporary current assets, this business entity is ensuring that
adequate funds are available all throughout. To illustrate further, the
business unit prefers to arrange a long-term loan of a crore rupees for a
ten-year period rather than borrowing a crore at the start of each year.
On the other hand, and which is the case with smaller businesses, a
business entity can finance even a part of permanent current assets
through short-term finance as shown in the Figure 6.8.
This arrangement recognizes the fact that if short funds are available with
lower costs, then the finance manager has an option available to use the
funds for temporary self-liquidating funds as well as for a part of
permanent current assets. Thus funding of working capital requirements
can be quite innovative.
! !161
MANAGEMENT OF WORKING CAPITAL
Self-training Exercise: 1
Increase Decrease
(A) (B)
*Cash on Delivery.
! !162
MANAGEMENT OF WORKING CAPITAL
After determining overall levels of working capital, the next step for finance
manager is to determine cash part of the working capital. Towards this
end, it is necessary, first, to review value of current assets as shown in the
projected balance sheet and reduce profit element and non-cash expense
of depreciation from it to arrive at cash cost of current assets. The second
step is to reduce total of: (a) trade payables and (b) unpaid expenses to
arrive at cash requirement. First, let us see how to calculate cash cost of
trade receivables.
Illustration 6.2:
Assume one unit of product X was sold at a selling price of Rs. 5,000 to a
customer on credit.
This includes say Rs. 500 as profit which has no cash cost.
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MANAGEMENT OF WORKING CAPITAL
So, cash cost of the Trade Receivable = Rs. 5,000 less (Rs. 500 and Rs. 50)
is equal to Rs. 4,450.
Let us make this concept clearer. Arun Industries holds Rs. 2,00,00,000 as
Trade Receivables in the balance sheet for 2015. Their profit margin is
15%, if depreciation was excluded, it would have been 18%. Calculate cash
cost of Trade Receivables.
Problem:
Notes:
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MANAGEMENT OF WORKING CAPITAL
Solution:
Wages 120
300
Less: Depreciation 30
Cash Manufacturing cost 420
! !165
MANAGEMENT OF WORKING CAPITAL
A. Current Assets
B. Current Liabilities
Trade Payables 180 ÷ 12 × 3 45.0
To sum up, cash requirement for working capital can be determined by:
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MANAGEMENT OF WORKING CAPITAL
6.11 Summary
Gross working capital consists of all current assets that normally self-
liquidate in a period of a year or less than a year and include inventories,
trade receivables, loans, advances and cash and bank balances of a firm.
To arrive at net working capital, you subtract current liabilities like trade
payables, trade advances, short-term borrowings both from commercial
banks and other lenders.
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MANAGEMENT OF WORKING CAPITAL
After determining overall levels of working capital, the next step for finance
manager is to determine cash part of the working capital. For this purpose,
it is necessary to remove profit margin and non-cash expenses like
depreciation included in the balance value of current assets.
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MANAGEMENT OF WORKING CAPITAL
a. Current assets
b. Spontaneous current liabilities
c. Permanent current assets
d. Fixed assets
2. Shalini insisted that by their very nature are self-liquidating and have to
be classified as current assets. Malini explained with details how a part
of trade receivables and inventory always fails to self-liquidate and
hence has to be considered as permanent current assets. But when
Shalini asked “What happens to the volume of permanent current assets
as business grows?” Malini was confused. How will you answer the
question?
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MANAGEMENT OF WORKING CAPITAL
a. Equal
b. Maximum
c. Falling
d. Minimum
Answers:
1. (c)
2. (a)
3. (b)
4. (d)
5. (b).
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MANAGEMENT OF WORKING CAPITAL
REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter
Summary
PPT
MCQ
Video Lecture
! !171
MANAGEMENT OF TRADE RECEIVABLES
CHAPTER 7
MANAGEMENT OF TRADE RECEIVABLES
“Number of day’s sales locked in trade receivables are on rise partly due to the
changeover from seller’s market to competitive buyer’s market the world over. But you
cannot deny that many a times, this is used as an excuse for management’s laxity in its
focus on working capital in general and trade receivables in particular.”
Objectives
Structure:
7.1 Introduction
7.2 Trade Credit Terms
7.3 Cash Discount
7.4 Customer Credit Index (CCI)
7.5 Asset Management Committee
7.6 Control of Receivable Levels
7.7 Indian Scenario
7.8 Summary
7.9 Multiple Choice Questions
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MANAGEMENT OF TRADE RECEIVABLES
7.1 introduction
The volume of this current asset should not be judged on the basis of
business unit’s historical data or the industry norm. Trade receivables is an
investment, hence the test should be to examine the level of returns the
firm is obtaining from this asset vis-à-vis potential gains from other
investments. If we increase receivables days by, say five, the firm’s
investment in trade receivables will increase causing a drain in marketable
securities or bring down the inventory beneath established norms.
The past records of private local companies indicate that the number of
day’s sales locked in trade receivables are on rise partly in view
changeover from seller’s market to competitive buyer’s market. But main
reason for this increase is often laxity exercised by management in its
focus on working capital in general and trade receivables in particular.
Days of easy availability of credit may already be past. Firms now have to
compete for funds in the financial market which itself is under pressure
with all-round economic growth. Financial management has, therefore, to
focus internally and gear up its machinery for working capital management
with special attention to trade receivables where its funds get locked.
Further, just like receivables are unavoidable for any business entity
operating in competitive markets, they also result in certain costs that
reduce firm’s income. First, there is the cost of capital that gets locked in
this current asset. Next, there is cost of collection. Many follow-up visits
have to be arranged with the customers before and after the due date of
payment followed by phone calls and reminders. On many occasions, the
focus on new sales and new customers is shifted when more time has to be
spent by sales workforce in collecting overdue receivables. Collection
efforts are supported by administrative costs in preparing and updating
statement of customer accounts, analysis of debts and preparation of
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MANAGEMENT OF TRADE RECEIVABLES
appropriate periodic reports for guidance of the collection staff. Last, but
not the least, when these collection efforts do not yield results, the
business unit has to provide for doubtful debts and write off bad ones
generating income loss.
One must note here that, any liberal terms agreed with your customers or
clients reduce the benefit you have obtained through trade credit
negotiations with your vendors and suppliers. Credit terms will differ from
business to business and industry to industry. Businesses that receive
payments on delivery, for example online shopping sites, may have a
shorter credit term than an industrial manufacturer or those working on
contractual jobs.
! !174
MANAGEMENT OF TRADE RECEIVABLES
! !175
MANAGEMENT OF TRADE RECEIVABLES
Credit
Decision
Character
Strong Weak
Capacity Capacity
Strong Weak Strong Weak
Weak Weak
! !176
MANAGEMENT OF TRADE RECEIVABLES
• Collaterals: These are assets that client can pledge for the credit
granted. This C is more applicable to short-term bank loans and not for
trade credit.
Cash discounts improve business cash flow and reduce bad debts, but they
cut into the seller’s profit margin. Fewer collection efforts and faster cash
flow are main gains from cash discount. Many customers have a system for
arranging payments regularly. Offering cash discounts to them will have no
significant effect on cash inflows from them but sales income will get
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MANAGEMENT OF TRADE RECEIVABLES
Cash Discount
Benefits Drawbacks
We observed how five C’s are used to classify customers into various credit
categories as per their individual credit risk scenario. This method is
judgmental. There is one more method that uses systematic numerical
credit scoring system.
3. Usually, a five point scale now is employed to rate each customer on the
factors selected as above.
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MANAGEMENT OF TRADE RECEIVABLES
4. For each factor, multiply the factor rating (step # 3) by the factor weight
(step # 2).
5. Once you add the scores obtained in the step # 4, you are ready with
the customer credit index.
6. Consider customer’s CCI when you extend credit for any transaction.
1 2 3 4 5
A customer with the best credit standing will have rating of five on all
factors and thus will score CCI of five which is the maximum.
Shreeram Industries Ltd. as shown above has scored 3.05 which is equal to
61%.
Self-training Exercise: 01
On 1st April, the CFO decided to revise factor weights for credit parameters
of Shreeram Industries Ltd. as below. There were no changes against the
rating for each factor. Calculate fresh CCI for Shreeram Industries Ltd. with
these new weightages.
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MANAGEMENT OF TRADE RECEIVABLES
1 2 3 4 5
Current Ratio 25 √
Debt/Equity Ratio 20 √
Payment Performance 20 √
Return on Assets 15 √
Total 100
The typical agenda consists of review of all large receivables as and when
they are generated. The review requires all functions to assert that
activities under their control were satisfactorily concluded; if not, how the
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MANAGEMENT OF TRADE RECEIVABLES
Ratio analysis offers a tool for finance and marketing to hold control over
the size of the receivables. Receivables Turnover ratio is determined by
dividing annual (or any other period) credit sales of a business entity by its
average receivables during the selected period. Higher the ratio lesser the
quantity of working capital locked in trade receivables. This ratio can be
compared with industry average to determine the degree of success in
managing receivables. Separate ratios can be calculated for different
branches of an entity to determine efficiency of each branch manager in
managing its receivables. Branches with lower ratios can learn about some
practices followed by branches with highest turnover.
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MANAGEMENT OF TRADE RECEIVABLES
trade receivables by the average daily sales over a year or for a particular
product line or location.
Mumbai 35* 25
Delhi 21 35
Chennai 15 28
Kolkata 13 32
*(6240 ÷ 180)
Now, marketing manager knows that greater collection efforts are required
in Delhi and Kolkata to bring back their collection period to thirty days.
Here, it is necessary to find what Mumbai region is doing differently to
maintain the collection period around twenty-five days. What are collection
practices adopted by them?
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MANAGEMENT OF TRADE RECEIVABLES
Self-training Exercise: 02
On March 31, 20XX, the marketing manager of Arunoday Pharma calls for
fresh receivables data as all branch managers had attempted to improve
their receivables position by adopting successful practices of the Mumbai
Region. Following accounting data was provided by the finance function.
The firm’s policy aimed at collection period of thirty days.
Find out which region now has the lowest collection period.
The aging of receivables is one more report that works as a primary tool
used by collection personnel to determine which invoices are overdue for
payment. Given its use as a collection tool, the report may be configured to
also contain contact information for each customer. The report is of use to
marketing and finance managers to determine the effectiveness of the
credit and collections functions.
A typical aging report lists invoices in 30-day “buckets,” where the columns
contain the following information:
(a)The left-most column contains all invoices that are 30 days old or less.
(b)The next column contains invoices that are 31-60 days old.
(c)The next column contains invoices that are 61-90 days old.
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MANAGEMENT OF TRADE RECEIVABLES
Shrikrishna Industries
If you want to compare the aging of receivables of each customer with the
company average, you can add %s in the columns as shown below,
! !184
MANAGEMENT OF TRADE RECEIVABLES
Shrikrishna Industries
You can now see that Bajaj Mart is better pay master (84% paid within 60
days) and Chennai Depot and Detroit Express need more collection efforts
as they have over 23% beyond 60 days.
The aging report is also used as a tool for estimating potential bad debts,
which are then used to revise the allowance for doubtful accounts. The
usual method for doing so is to derive the historical percentage of invoice
dollar amounts in each date range that usually become a bad debt, and
apply these percentages to the column totals in the most recent aging
report.
Problem:
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MANAGEMENT OF TRADE RECEIVABLES
above data, how will Oxford Leather Mart CFO prepare a provision for bad
debts as of 30.09.20XX.
Solution:
Finally, the company’s auditors may use the report to select invoices for
which they want to issue confirmations as part of their year-end audit
activities.
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MANAGEMENT OF TRADE RECEIVABLES
• ‘A’ items – 20% of the items accounts for 70% of the annual
consumption value of the items.
‘B’ items – 30% of the items accounts for 25% of the annual
consumption value of the items.
‘C’ items – 50% of the items accounts for 5% of the annual consumption
value of the items.
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The figures of receivables above are based on an assumption that they are
fully collected in 30 days leaving no balance for the following month. Thus
collection efforts and results are constant from April to July. But if you
judge collection efforts just by receivables turnover you will (wrongly)
conclude that there is a steady deterioration.
In this case, we do not know volume of sales each month but we know
collection efforts are bearing fruits and 2/3rds of credit sales were
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converted into cash within 60 days in July and August and credit sales in
full collected in 120 days.
If such trend analysis charts are prepared for, say four regions (north,
east, south and west) of all-India operations, the Chief Finance Officer can
determine which region is the most successful in collecting cash and
liquidating receivables. The practices followed in the best region can then
be repeated in other regions.
However efficient your credit control system and methodical your efforts to
collect trade receivables, bad debts – some customers failing to make
payments over a long time and forcing you to write them off as your claims
– is a fact of business life. No doubt having good credit control is certainly
important for maintaining a healthy cash flow and a profitable business.
While good credit control can help avoid late payments becoming a serious
problem, there may still be times when a customer cannot or just will not
pay.
2. Set reasonable but fair credit limits and instruct your staff to notify you
if a customer wishes to exceed an agreed credit limit. Here, you need to
balance your sales targets with the need for realistic revenue generation
goals. After all, each bad debt is a loss of revenue.
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b. Keep an up-to-date record of what each customer owes you and note
any customers approaching their credit limit.
d. By your collection efforts, you need to make it clear that you expect to
be paid on time, every time, and always making certain there is a
follow-up if payment is late. This way you are more likely to be in front
of mind when customers schedule payments. This means a customer
juggling payments because of cash flow problems is more likely to allot
you higher priority than a business whose systems are more relaxed.
Many people or businesses ‘pay the ones that make the most noise’.
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lever to get paid promptly. This might cost you some business, but it will
also reduce the risk of being exposed to bad debts. Similarly, stop
supplying goods to customers in excess of their credit limit. This does
not mean that you will not increase the limit if requested, but it gives
you the opportunity to reassess the creditworthiness of your customer
before increasing your debt exposure.
The investigation into the reasons why your customer has not paid that
resulted into loss through bad debts is required to avoid repetitive losses.
Some probable causes could be:
a. The customer has a problem with your product, service or invoice. If so,
identify the issues as soon as possible and reach an acceptable solution.
d. If all else fails, then debt collection agencies or your lawyer will help you
find the most effective way to recover your debt. But before you take
this step, carry a cost-benefit analysis. Firstly, find out exactly how
much the collection service will cost. Ask your auditors to recommend a
few debt collectors or lawyers who specialize in debt collection. You can
then compare costs and services.
Last but not the least, the loss through bad debts is a part and parcel of
risks involved in carrying any business. So, accept them but always
minimize the loss.
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References from two other business entities satisfy the Indian businessman
to extend credit. Prospective customer’s income statement and balance
sheet are hardly sought and never analyzed. Credit rating agencies are just
appearing on the scene and may be business units will start employing
them as competition gets fierce over next few decades.
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7.8 Summary
Credit policy of a business unit is a guide for use by marketing and finance
personnel. It sets limits on how credit is to be granted to attract customers
to place orders with the business unit and when the sale takes place; its
finance function is able to collect cash with the least efforts. Financiers
usually talk about five C’s while granting credit to any account – character,
capital, capacity, conditions and collaterals. These five C’s decide whether
payment after delivery of goods is going to be arranged on agreed dates or
on dates thereafter or never.
Cash discount offers benefits such as: (i) quick cash inflow, (ii) low level of
receivable, (iii) savings in collection efforts and (iv) reduction in bad debts.
But it has certain drawbacks as:(a) lesser profit margin, (b) sour customer
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relations – when the customer cannot avail the discount and (c) addition in
accounting efforts.
Next, the aging of receivables is one more report that works as a primary
tool used by collection personnel to determine which invoices are overdue
for payment. Another tool that is used to control trade receivables is ABC
analysis. To use this measure, it is necessary to arrange receivables in
descending value with the largest receivable at the top and the lowest at
the bottom.
Many times, Finance Officers prepare a trend analysis chart that indicates
payment behaviour of customers. In the matrix that is constructed for this
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However efficient your credit control system and methodical your efforts to
collect trade receivables, bad debts – some customers failing to make
payments over a long time and forcing you to write off your claims – is a
fact of business life. The investigation into the reasons why your customer
has not paid that resulted into loss through bad debts is required to avoid
repetitive losses.
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a. C
b. B and C
c. More often D
d. A
a. C
b. B and C
c. More often D
d. A
Answers:
1. (c)
2. (d)
3. (a)
4. (d)
5. (a).
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REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter
Summary
PPT
MCQ
Video Lecture
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MANAGEMENT OF INVENTORY
CHAPTER 8
MANAGEMENT OF INVENTORY
“Managing inventory is like tight rope walking. To satisfy customers, you must maintain
a continuous record of on-time (on-demand?) deliveries; at the same time to protect
margins, you need to minimize costs involved in holding inventory. It is no more a
matter of keeping data and records.”
Objectives
• Categories of inventory
• Inventory management is a multi-function task
• When do business entities hold large inventory?
• Inventory carrying costs and inventory ordering costs
• Decisions on economic order quantities
• Ways of classifying inventory for greater control
• Alternative methods to value inventory
• Benefits from Just-in-time inventory
Structure:
8.1 Introduction
8.2 Fundamentals of Inventory
8.3 Cost of Carrying Inventories
8.4 Cost of Ordering Inventories
8.5 Inventory Management Techniques
8.6 Economic Order Quantity
8.7 EOQ vs. Quantity Discounts
8.8 Inventory Analysis
8.9 Methods for Valuing Issues
8.10 Just-in-time Inventory (JIT) Management
8.11 Summary
8.12 Multiple Choice Questions
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8.1 Introduction
All the three categories have to be financed through working capital of the
business entity and their efficient management has a direct impact on
firm’s revenues. Business entity does not have full control over its volume
as quantity of materials required is determined by supply chain, market
conditions, production cycles, distribution channels and customer demand.
For many items like, say, automobiles, the demand is seasonal. So, stocks
have to be built up prior to festive seasons. If the festive demand is
underestimated, the automaker can lose market share for want of ready
stocks for delivery. On the other hand, if it is overestimated, there would
be a huge pile up of idle stocks at the end of the season.
You must bear in mind that inventory is the least liquid of current assets
and hence it must provide the highest yield to justify investment. While
you as a Chief Finance Officer have a certain degree of control over
management of cash, marketable securities and trade receivables, control
over inventory is a joint effort that has to be shared with assistance from
purchasing, production and marketing heads of your business entity.
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b. Interrupt production line so that an odd high value order from the
customer for item not in inventory can be quickly fulfilled and
b. Decrease the number of plants and warehouses with the same objective
in mind;
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Illustration 8.1
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When funds are utilized to build inventory, they seize to earn income. Thus,
there is carrying cost involved in holding inventory. In spite of these costs,
there are business pressures that encourage business units to hold large
inventories. Creating large inventory, speeds delivery to customers and
improves the business’s record of on-time delivery of goods and services.
Whatever customers want is always maintained in this high level of
inventory. This holding of all items creates customer goodwill and builds
business unit’s brand equity, a must for long-term returns. Large
inventories reduce the potential for stock-outs and back orders which are
key concerns of both wholesalers and retailers. A large stock of raw
materials ensures no interruptions in production. On the other hand, any
stock-out means:
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You know that ordering costs per year increase with the number of orders
placed throughout the year. They remain constant whatever be the batch
size that is on order. If you need to reduce number of orders per year, you
have to hold larger inventory. Costs incurred each time an order is placed
include the following five elements:
b. Travelling and living and other expenses of expeditors who have to visit
suppliers.
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For manufactured items, you incur set-up cost which is common for the
industry where production takes place in batches. The cost involved in
changing over a machine or workspace after one batch has been completed
and a new batch has to be commenced to produce a different item,
referred to as ‘changeover’ cost is often termed the set-up cost. It includes
labour and time, to arrange the changeover, cleaning and sometimes
mounting new tools and equipment. By holding larger inventory, one can
reduce a number of orders in a year and consequently annual set-up costs.
(i) Direct reduction in the number of production set-ups which add no value
to a service or the product;
(iii)Stabilizing the output rate all through year even though demand for the
product is cyclical or seasonal, no overtime nor rush purchases of inputs
and
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Finance managers must build these cost advantages into account when
they decide levels of inventory to be maintained for smooth and profitable
business operations and for customer satisfaction or delight.
Illustration 8.2
The inventory carrying cost (or holding cost) is the sum of cost of funds
invested in stocks of materials plus the variable costs of maintaining
materials on hand such as storage and handling costs; shrinkage,
deterioration and obsolescence costs; taxes and insurance. As these
expenses change with inventory levels, so does the holding cost. (Refer to
Illustration 8.2 above.)
At this stage, one must remember that cost of invested funds in inventory
could be out-of-pocket costs or opportunity costs for the funds tied up in
inventory. To finance inventory it holds, a business unit may obtain loan
finance from its banks at an interest charge or forgo the opportunity of
assigning its accumulated funds in most promising investment. Inventory
needs to be received, stored, counted and issued. This activity can be
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Like any other asset, inventory also has to be insured against theft, fire,
deluge and other risks that can destroy it. Insurance premiums also form a
part of inventory handling cost. Sometimes, a business unit is required to
pay taxes on inventory held to local or state authorities and this also
constitutes inventory handling cost. Over a time, material stored in
warehouses suffers from shrinkage in value.
Total inventory carrying costs can vary from 18% to 30% of the inventories
held. (Refer Illustration 8.3 below for the detailed break-up). If a business
unit is carrying inventory of, say, 20% of its sales, then its profit margins
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Minimum Maximum
Cost of capital 10 14
Loss/breakage 2 5
Inventory management 1 2
Depreciation 1.5 2
Plant maintenance 1 2
Disposal/obsolescence 1 2
Taxes 1 2
Insurance 0.5 1
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holding costs are under control here, the system may result in multiple
orders that will increase business unit’s ordering costs.
B. You can also practice Fixed Order Quantity: Here, the business has
fixed some arbitrary quantity for each unit in stock that has to be
ordered when stocks need to be replenished. This is a very simple
system to operate. But other than simplicity in its operation, it has no
other advantage. While determining the fixed order quantity for an item,
effect of the chosen quantity on neither the inventory holding cost not
the ordering cost is considered. This system is often employed along
with what is known as minimum/maximum inventory levels. Here, an
ordering point is determined for each item of inventory by adding safety
stock quantity and estimated quantity that will be consumed during the
lead time for the order placed to realize. (Receipt in stores of ordered
quantity.)
E. The period order quantity lot size: This concept is based on the
same theory as the economic order quantity. It uses the EOQ formula to
calculate the economic time between orders. This time interval is
calculated by dividing the EOQ by demand rate. This provides a time
interval for which orders are placed. Instead of ordering the same
quantity as per EOQ method, orders are placed for requirements for that
item for the time interval decided earlier as above.
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The number of orders placed is same as in the EOQ system, but the
quantity ordered each time differs as per requirements. Thus, the ordering
costs are same, but since the quantity ordered each time varies, inventory
carrying cost is reduced.
Ordering costs are incurred by a business unit every time stocks have to be
replenished by placing order on vendor or on the business unit’s factory.
This cost has no bearing on quantity ordered as it is one-time cost that
occurs once the order is released until it is completed. Every order to be
released has to be scheduled, released, expedited and closed. Lot of
technical data has to be collated and attached to the order. Full-fledged
materials control or production control organization has to work to handle
on-time release of orders on outside suppliers and business unit’s factory
or factories. These production control costs form a main component of
inventory ordering costs. They include staff salaries, records and
maintenance of software used.
When order is released on business unit’s own factory work centers have to
set up equipment for the new item has to be procured and dismantled
when the order quantity is delivered. This one-time cost does not change
with quantity ordered but with number of orders released in a year.
Whenever production of a new item is commenced, there are initial startup
problems, rejections or seconds until the production process is stabilized.
This waste also forms a part of ordering cost. The time taken in setting up
the production line for the new item and time taken to tear it down
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constitutes factory idle time and this lost capacity cost is second
component of ordering cost.
This ordering cost can be reduced by releasing fewer orders but with larger
quantities. As noted earlier while ordering costs are reduced by this action,
it generates larger inventory and resulting higher inventory holding costs.
We need a solution to this conflict and Economic Order Quantity attempts
to provide one.
Refer 8.8
Refer 8.6
Determination Economic
of Stock Order
!
Chart 1
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Maintenance of trim and agile body provides you with many benefits in
your career development as well as in your personal life. Maintenance of
bare minimum inventory to run operations with maximum efficiency offers
similar benefits to the financial well-being of every business unit. The
primary reason for keeping inventories small is that inventory represents a
temporary monetary investment. As such, the business unit incurs an
opportunity cost, which is termed the cost of capital, arising from the
money tied up in inventory that could be beneficially put to use for other
business purposes.
For low value Class V items (Refer ABC Analysis 8.8.1 below), this simple
stock level control can be exercised to have good results with the least
efforts. When re-order level is reached, an order of predetermined quantity
is released and stock levels remain within prescribed limits so long as
consumption pattern remains the same and materials are delivered per
agreed lead times. When stocks cross the prescribed levels, signals are
provided to management to intervene for corrective action.
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B. Maximum Level
This is the maximum quantity that stock of an item is allowed to form.
It is normally reached when there is a fresh replenishment on supply
against order due. It can be calculated by formula:
Maximum level = (Re-order level + Re-order quantity) – (Minimum
consumption × Minimum delivery period)
If stocks cross this level, management has to re-examine inventory
usage assumptions to check whether there has been fall in average
consumption of an item and if so, reset inventory levels. The situation
can also arise if receipts occurred before the due dates for delivery.
C. Re-order Level
When stocks of an item reach this level, arrangements have to be
initiated for replenishment through a fresh order for pre-determined
quantity. The re-order level is calculated by the formula:
Maximum consumption per day × Maximum lead time in days for
replenishment order
You will recall that in a continuous or fixed order quantity system, when
inventory reaches a specific level, referred to as the re-order point, a pre-
fixed quantity is ordered. The most widely used and traditional means for
determining how much to order in a continuous system is the Economic
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Order Quantity (EOQ) model, also referred to as the economic lot size
model.
b. Materials manager does not have any constraints (like plant capacity,
vendor schedules, lead times, etc.) in determining the lot size of the
order.
d. In material handling there are only two costs – ordering and holding –
that are to be considered.
e. Materials are delivered per agreed lead time and always in a single lot.
There are neither delays in deliveries nor partial deliveries either from
the factory workshop or from the vendor.
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Graph 8.2
Let us assume that 7,800 units of Part Y are used annually and 300 pieces
are ordered every time to replenish the stocks. Since 300 units are ordered
each time, this quantity should last 2 weeks; so, every 2 weeks, new
stocks will arrive and inventory will move between 0 to 300 pieces resulting
in average inventory of 150 pcs. Please note that if annual consumption of
the item was to be 5,200, with the same order quantity of 300, fresh
stocks will arrive after every 3 weeks but average inventory continues to
be 150. On the other hand, with the same annual consumption of 7,800
units, if 500 pieces were ordered every time, the average inventory will
increase from 150 pieces to 250 pieces as shown in the Graph 8.7. You will
observe that now orders are placed after 3.3 weeks instead of every two
weeks earlier.
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Graph 8.3
Now, we know that while determining order quantities, we need to consider
effect of quantity on number of orders that have to be released to fulfill
annual requirements and cost of such orders. Ordering cost is reduced
when order quantity increases as shown below.
Graph 8.4
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Graph 8.5
• Number of orders per year decrease and ordering costs are reduced
(Illustration 8.6).
We should now draw a graph that combines curves for holding costs and
ordering cost. The point of intersection will minimize the total of the two
costs (Illustration 8.8 below.
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Graph 8.6
Any business unit, therefore, has to release orders of that quantity where
the curve of ordering costs meets the one of inventory carrying/holding, as
at that point total of the ordering and holding costs would be minimum.
This then is known as Economic Order Quantity. There is a formula
available to arrive at the economic order quantity.
!
where,
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Activity
Arundhati Cutting Tools Pvt. Ltd. needs 4,000 units of hammer heads every
year. The cost of the hammer head is Rs. 40 each. The company has
inventory carrying cost of 20%. What should be the EOQ for the hammer
head?
EOQ determined as above need not be always the final quantity that the
business unit utilizes. The materials manager has to modify the EOQ under
certain circumstances like:
i. When the vendor offers significant price discount for quantity purchases,
the EOQ may have to be increased to avail of the lower prices.
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iii. The annual demand divided by the EOQ may not result in whole number
(if annual demand is 5,300 and the EOQ 500, the materials manager
has to place 10.6 orders) Here, the EOQ has to be modified to 530.
iv. The vendor may stipulate a certain minimum order quantity acceptable.
If that quantity exceeds EOQ, change in EOQ is necessary to comply
with vendor’s requirement.
vi. The item may have to be imported in which case the import licence
decides quantity to be ordered.
Use of the EOQ is justified when you follow a “make to stock” strategy and
the item has relatively stable demand. It is also recommended when the
business unit observes that carrying cost per unit and set-up or ordering
costs of the unit are known and relatively stable. The EOQ was never
intended to be inventory optimizing tool. Nevertheless if you need to
determine a reasonable lot size for purchase of an item, it can be helpful in
many situations.
TC = D/Q + Co + Q/2 Cc + Dp
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Since, for the first time, we are considering two prices (one normal and
other lower with quantity discount) Q/2 Cc as well as Dp values will change
with prices. Hence, we shall have to modify the above equation to take
care of this situation.
Let us apply these two equations to assist Laxmi Stores which sells 25,000
soft drink bottles a year at Rs. 10 each. The store has determined its
ordering cost at Rs. 10 each and its inventory carrying cost of 20%. It was
ordering soft drinks bottles at the EOQ so far, but now the supplier has
offered 2% discount if order is placed for Rs. 10,000 or more.
Should Laxmi Stores accept the discount and revise its order quantity?
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= 2,51,000
= 2,46,230
The business unit has to weigh the first two against the last and find out if
there is a saving to accept the discount. Then there is a non-monetary
issue about availability of additional storage space. After Laxmi Stores
accepts the discount, it will have to carry average inventory of 500 bottles,
instead of 250 bottles as per earlier EOQ ordering (EOQ * 1/2).
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When we apply EOQ formula for determining the most profitable order
quantity, we assume that the price per unit is constant through the year.
But in our Indian economy, prices are always on the increase. Let us
consider how the inflation in the economy alters the EOQ. If the rate of
inflation can be predicted with any degree of accuracy, the above EOQ
formula can be certainly applied with just one modification. We need to
readjust the annual carrying cost by deducting the rate of inflation. The
rise in inventory value caused by inflation offsets the carrying cost
associated with inventory holding to some extent. This adjustment
suggests that the EOQ and therefore the average inventory during the year
increases due to inflation factor.
However, this is not the whole truth. Just like inflation increases, the unit
price of the item held in inventory, it also correspondingly increases the
percentage of inventory holding cost. This lowers the EOQ and then
average inventory levels throughout the year. As a result, the effect of
inflationary trends in the economy have on EOQ are marginal but still
should be explicitly considered.
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‘B’ items are important, but of course less important than ‘A’ items and
more important than ‘C’ items. Therefore, ‘B’ items are intergroup items.
‘C’ items are many but marginally important and cause about 20% of total
material consumption. A set ordering pattern can be set for them which
then can be reviewed may be at quarterly intervals.
• ABC analysis is very easy to use and can be carried from data that, in
most cases, already exists in the organization. Most IT software contains
ABC analysis modules. Separation into three classes can be carried by
adopting uniform A = 10%, B = 20% and C = 70% formula or by
modifying it to suit your individual business unit.
The ABC technique has to be practiced with some caution in view of its
three limitations:
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100% 100%
A general problem that occurs when performing ABC analysis (or XYZ
analysis) is the precise definition of the borders among the classes. The
definition of class boundaries for specific critical value portions is,
therefore, a subjective decision and depends on the characteristics of
individual business unit. Available SAP or MRP software does provide some
standard classifications and these can modified for your business
requirements.
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Thus, Class A items, termed vital few, are most important and have
maximum scope for inventory optimization. These vital but few items in
Class A are selected for very strict control which is exercised by high
authority. Safety stocks for A items are very low (or nil) and service levels
are maintained through frequent ordering and staggered supply.
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Moderate control
Periodic follow-up
Safety stocks for B items are larger than those for A items and orders for B
items can be released once in two months or a quarter. Past consumption
can be safely used for materials planning. Three to four reliable vendors
are supposed to maintain supplies of Class B items. The Class B contains
roughly 15% to 20% of inventory items that account for equal percentage
of the entire annual material consumption in the business unit. It is
worthwhile to loosen the controls for these average materials.
This class covers the least important around 70% of the inventory items
that account for approximately 20% of entire annual usage of materials.
Consequently, business unit can afford to keep more buffers in safety
stocks of class C items and arrange their bulk purchases once or twice a
year. Quantities would be decided either on the basis of past consumption
or rough estimates.
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where,
This technique is ideally suited for spare parts inventory management like
ABC analysis. Stocks of spares are classified by maintenance engineers into
three categories on the basis of their usage.
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Under this analysis, inventories are classified into three categories on the
basis of the value of the inventories held on hand. Instead of annual usage
which is the key for ABC analysis, individual price of an item is the criterion
applied for classification.
You have option to use a typical method of pricing inventory issues which
suits your business unit and your objective. Inventory valuation methods
are used to calculate the cost of goods sold (or materials issued from
stock) and cost of ending inventory. If the changes in the price at which
you receive materials are not significant, each method will provide you with
more or less same results. However, in rising and falling prices, there can
be a pronounced difference. The method you decide to adopt for pricing
issues has no relationship with the actual physical movement of items.
Physically oldest items in the stock are always issued first to ensure stock
on hand is fresh and obsolesce is minimized.
According to FIFO, it is assumed that items from the inventory are sold (or
issued) in the order in which they are purchased or produced. This means
that cost of older inventory is charged to cost of goods sold first and the
ending inventory consists of those goods which are purchased or produced
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later. Materials are issued in strict chronological order. This is the most
widely used method for inventory valuation. FIFO method is closer to
actual physical flow of goods because companies normally sell goods in
order in which they are purchased or produced. In the economy with rising
prices (which is the normal trend in India), this method understates the
cost of sales as replacements are at higher prices than that used in cost of
sales. If there are many changes in the prices, the process becomes very
cumbersome.
The last in, first out (LIFO) method is used to place an accounting value on
inventory. The LIFO method operates under the assumption that the last
item of inventory purchased is the first one sold or issued. Picture a store
shelf where a clerk adds items from the front, and customers also take
their selections from the front; the remaining items of inventory that are
located further from the front of the shelf are rarely picked, and so remain
on the shelf – that is a LIFO scenario. While valuing issues under LIFO, the
last price paid for the item available in stock is applied. If a company were
to use the process flow embodied by LIFO, a significant part of its
inventory would be very old, and likely to get obsolete. Nonetheless, a
company does not actually have to experience the LIFO process flow in
order to use the method to calculate its inventory valuation.
The reason why companies use LIFO is the assumption that the cost of
inventory increases over time, which is a reasonable assumption in times
of inflating prices. If you were to use LIFO in such a situation, the cost of
the most recently acquired inventory will always be higher than the cost of
earlier purchases, so your ending inventory balance will be valued at earlier
costs, while the most recent costs appear in the cost of goods sold. By
shifting high-cost inventory into the cost of goods sold, a company can
reduce its reported level of profitability, and thereby defer its recognition of
income taxes. Since income tax deferral is the only justification for LIFO in
most situations, it is banned under international financial reporting
standards (though it is still allowed in the United States under the approval
of the Internal Revenue Service).
As stated earlier, in rising prices (which is the normal trend in India), this
method understates the cost of inventory on hand as it is valued based on
old (lower) prices. To that extent, current value of this asset is not
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reflected in the balance sheet. If there are many changes in the prices, the
process becomes very cumbersome.
Average Price
In this method, the issues are valued on the basis of a simple average
price. The prices of purchases prior to any issues are added and average
price is calculated by dividing the total value by number of prices used.
Issues as well as stock are valued at this average price.
The method has only one advantage and that is it is easy to use. If price
fluctuations are minor, it can provide realistic valuations. But if prices
fluctuate, the method does not provide a true picture as prices are not
weighed by the quantities purchased at each price.
In this method, the issues are valued on the basis of a weighted average
price of materials in stock from which the issues is arranged. The value
(Price × Quantity) of purchases prior to any issues is divided by the
quantity to arrive at the weighted average price. It is a realistic method as
it reflects the price levels resulting in stabilization of cost figures. A new
rate for issue needs to be calculated at each new purchase and can be
used to value issues until a fresh purchase takes place.
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MANAGEMENT OF INVENTORY
This method is also known as market value method. When this method is
adopted, the material issues are priced not at the rates at which the stock
was purchased, but at the current market price of the item ruling on the
date of issue. The principle applied here is that materials issued for sale or
production of any job on a particular date should be charged at the rate at
which the materials consumed could be replaced immediately from fresh
purchases. This ensures that costs are current and profit earned indicates
correct margins on the transaction and the price at which materials were
purchased (either higher or lower) has no influence on reported profits.
The impact of price variations based on date of purchase is neutralized.
It is, however, difficult to obtain the ruling market price every time the
materials are issued from the store room. Under inflationary conditions,
stock on hand is understated as issues are priced at the rates that are
higher than the rates paid to acquire materials. In case the prices were to
fall, the stock will be overvalued requiring write-offs to bring it to realistic
levels.
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MANAGEMENT OF INVENTORY
Here are some potential uses for standard costs: (1) Budgeting, (2)
Inventory costing, (3) Overhead application and (4) Price formulation.
Under this method, the most realistic price to be used for pricing issues is
pre-determined after considering all the economic factors – market
conditions, usage rates, market trends, etc. Unless there is any major
change to any of these factors, this rate – termed standard rate – is used
all throughout the accounting period. Materials receipts are recorded at
actual costs and issues are priced at standard rate. The difference between
the two is charged to material price variance account. This account is also
known in accounting terms as Purchase Price Variance or PPV. The net
balance to this account at the yearend is charged to the income statement
directly and thus amount does not form a part of product cost. If standard
prices are determined with required accuracy and market prices behaviour
stays as anticipated when the standard price was fixed, the PPV balance at
the end of accounting period is not a concern. But if these conditions do
not exist and PPV balance is significant, net income figure seizes to be
realistic, that can create audit and tax complications.
The use of inflated price method has resolved the problem of how to
account for wastage by spreading the same evenly over total production.
The success of the method again depends upon how correctly the wastage
percentage used for inflation of price is determined.
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MANAGEMENT OF INVENTORY
JIT inventory management was designed for Toyota by the Japanese and
now enjoys universal acceptance. Business entities adopting JIT have
reported significant reduction in the inventory to net sales ratio some very
significant. The JIT inventory management is a part of total production
concept that interfaces with Total Quality Management (TQM).
It is important to note that JIT is compatible with EOQ system. The focus is
to balance reduced carrying costs from maintaining less inventory stocks
with increased ordering costs. With annual contracts and online materials
management, cost per order is on the decline.
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MANAGEMENT OF INVENTORY
8.11 Summary
In spite of the fact that funds get locked in inventory, there are business
pressures that encourage business units to hold large inventories. These
include – assured on-time (sometimes on demand) deliveries to customers,
fear of stock-outs and resulting production stoppages, desire to reduce
number of orders and anticipated increase in prices, etc.
The inventory carrying cost (or holding cost) is the sum of cost of capital
plus the variable costs of keeping materials on hand such as storage and
handling costs; shrinkage, deterioration and obsolescence costs; taxes and
insurance. As these expenses change with inventory levels, so does the
holding cost. These costs can vary from 18% to 30% of the inventories
held.
Ordering costs are incurred by a business unit every time stocks have to be
replenished by placing order on vendor or on the business unit’s factory.
This cost has no bearing on quantity ordered as it is one-time cost that
occurs once the order is released. Every order to be released has to be
scheduled, released, expedited and closed.
Management goal is to place orders in such a way that above two costs of
holding and ordering inventory together are minimized. EOQ or economic
order quantity technique is the answer here. The EOQ needs revision in
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MANAGEMENT OF INVENTORY
certain cases when quantity discounts are offered or prices are expected to
increase.
VED analysis technique is ideally suited for spare parts in the inventory
management like ABC analysis. Stocks of spares are classified into three
categories on the basis of their usage V = Vital item of inventory. Frequent
scrutiny carried out; E = Essential item of inventory – Periodical scrutiny
and D = Desirable item of inventory – No scrutiny.
Under HML analysis, inventories are classified into three categories on the
basis of the value of the inventories held on hand. Instead of usage which
is the key for ABC analysis, individual price of an item is the criterion
applied for classification. H = High value of inventories; M = Medium value
of inventories and L = Low value of inventories.
You have option to use that method of evaluating inventory which suits
your business unit and your objective. Different methods available to you:
(a) FIFO – First in First Out; (b) LIFO – Last in First Out; (c) Average Price
and Weighted Average; (d) Actual Price; (e) Replacement Price or Current
Value; (f) Standard Price or Standard Cost and the last (g) Inflated Price.
JIT inventory management was designed for Toyota by the Japanese and
now enjoys universal acceptance. Business entities adopting JIT have
reported reduction in the inventory to net sales ratio some very significant.
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MANAGEMENT OF INVENTORY
! !238
MANAGEMENT OF INVENTORY
1. Ashok and Ravi did not agree in determining responsibility for inventory
control. Ashok, appearing for M.Com., insisted that the CFO is
responsible; while Ravi appearing for B.E. Claimed, it was the marketing
manager’s responsibility so that customer orders are delivered on time.
What is your decision in the matter? Who should manage inventory?
a. CFO
b. Marketing Manager and Purchase Manager
c. Supply chain managers
d. Both marketing and finance managers
2. Asha claims that ordering costs are fixed. Do you agree? If not, what is
the factor that influences them?
a. Order Quantity
b. Number of orders issued
c. None above
d. Both (a) and (b) above
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MANAGEMENT OF INVENTORY
a. A
b. B
c. C
d. All three
a. VED
b. JIT
c. HML
d. ABC
Answers
1. (c)
2. (d)
3. (c)
4. (a)
5. (b)
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MANAGEMENT OF INVENTORY
REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter
Summary
PPT
MCQ
! !241
FINANCIAL AND OPERATING LEVERAGE
CHAPTER 9
FINANCIAL AND OPERATING LEVERAGE
“The operating leverage is about how much the business entity invests in fixed assets
and the financial leverage is about how the operations are financed – with owner’s equity
capital or through debts and borrowings. CFO needs to employ these leverages in a
skillful manner to maximize business unit’s net earnings.”
Objectives
Structure:
9.1 Introduction
9.2 Operating Leverage
9.3 Financial Leverage
9.4 Combined Leverage
9.5 Summary
9.6 Multiple Choice Questions
! !242
FINANCIAL AND OPERATING LEVERAGE
9.1 Introduction
$Rs.€
$Rs.€ $Rs.€
$Rs.
$Rs.€
Figure 9.1
! !243
FINANCIAL AND OPERATING LEVERAGE
Next, it is now time to decide how you will finance your investments, with
your own capital or with debts, and in what proportions:
(a) Here, again if you rely on debt financing and business is successful,
certainly you will generate attractive profits as an owner. But if
business does not grow as per your expectations, you are saddled
with fixed interest costs of debts which you may not be in a position
to service or repay. In extreme case, you may be forced to declare a
bankruptcy. While leverage magnifies profits when the returns from
the asset more than offset the costs of borrowing, losses are
magnified when the opposite is true.
(b) You have an alternate course of action available where you sell
equity rather than borrow, a step that will lower your own profit to a
certain degree (you are sharing it with others) but minimize your
! !244
FINANCIAL AND OPERATING LEVERAGE
If you elect to invest heavily in automatic plant and machinery, you have
opted for ‘operating leverage’. And in the next decision where you seek the
option to utilize debt to finance your operations, you are employing what is
termed as ‘financial leverage’ – the use of borrowed money to increase
production volume, and thus sales and earnings. It is measured as the
ratio of total debt to total assets. The greater the amount of debt, the
greater the financial leverage. Since interest is a fixed cost (which has to
be written off against revenue), a loan allows an organization to generate
more earnings without a corresponding increase in the equity capital
requiring increased dividend payments (which cannot be written off against
the earnings).
! !245
FINANCIAL AND OPERATING LEVERAGE
Expenses like raw material, wages and salaries, power, etc., on the other
hand, constitute components of variable expenses that increase or
decrease directly with the volume of production and sales. There are in
addition semi-variable expenses like repairs, maintenance, electricity,
supervision, etc. which are partly constant and partly vary with volumes of
production and sales. For our financial analysis hereafter, we shall include
these into variable expenses for the sake of simplicity.
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FINANCIAL AND OPERATING LEVERAGE
You can now observe that Oxford incurs fixed costs of sixty million A – B
irrespective of volume of sales and variable cost at Rs. 800 per unit is
added to obtain total costs A – C. The total revenue P – Q is indicated by
multiplying sales units by its selling price of Rs. two thousands. You should
now also notice that up to sales volume of 50,000 pairs the line AC total
costs is higher than the line PQ of sales revenue and the firm is incurring
loss. But after the break-even point of 50,000 units (where AC = PQ),
Oxford is making profits as now PQ is higher than AC.
! !247
FINANCIAL AND OPERATING LEVERAGE
after fifty thousand pairs of shoes are sold. But once this threshold is
crossed, operating income increases very rapidly – as shown in Table 9.1
below.
Table 9.1
A B C D
This cost structure is typical of an airline that must carry a certain number
of passenger-miles to break-even. But thereafter the journey shows
excellent returns on investments. This also is one of the reasons for the
airlines to announce lower fares to attract passengers.
But not all business entities would show the courage to operate at such a
high degree of operating leverage. The fear of failing to reach the target of
selling at least 50,000 pairs discourages companies form heavy
employment of fixed assets. Such companies may prefer to move over to
more expensive variable costs by employing skilled workforce that can
operate less sophisticated or automated plant equipment. The reduction in
total fixed costs results in a fall in the break-even point that will not be
very difficult to cross every year. Such business entities need to be
satisfied with more certain but less significant profit margins.
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FINANCIAL AND OPERATING LEVERAGE
If the sale of these two companies was, say 50,000 pairs each, Oxford will
hit the break-even and will have no profit to declare; while Cambridge will
have a profit of Rs. [( 50 × 2)100 revenue – (30 + 60)] 90 cost providing a
profit of 10 million to declare. Here, Cambridge’s conservative approach
has succeeded. But if both the companies were to sell 100,000 pairs, the
picture will change and Oxford will be earning more profits as under:
Oxford Cambridge
Revenue 200 200
Fixed Cost 60 30
Variable Cost 80 120
! !249
FINANCIAL AND OPERATING LEVERAGE
For every additional 10,000 pairs sold, Oxford will add twelve million to its
profits, i.e., fifty per cent more against only eight million of Cambridge.
This is the payoff for risk undertaken by Oxford in arranging for operating
leverage in its business.
Precentagechangeinoperatingincome(prfitbeforeintrestandtaxes)
DOL = ——————————————————————————————————
Percentagechangeinsalesvolume
Let us now determine DOL for the two shoe firms we studied above.
OXFORD
70,000 60 116 140 24
2.5
(c) Degree of leverage b/a !
! !250
FINANCIAL AND OPERATING LEVERAGE
Figure 9.2
CAMBRIDGE
! !251
FINANCIAL AND OPERATING LEVERAGE
! !252
FINANCIAL AND OPERATING LEVERAGE
Figure 9.3
! !253
FINANCIAL AND OPERATING LEVERAGE
A company should keep its optimal capital structure in mind when making
financing decisions. It needs to ensure any increase in debt and preferred
equity optimizes the value of the business entity. Once the sales volume
grows beyond the break-even point, the incremental earnings are available
to shareholders alone as interest cost is fixed. The common example of
exploitation of financial leverage is that of a typical builder who collects
hundred per cent funds from buyers of the tenements in consecutive
construction projects and operates on hardly any capital of his own and
earns profits on his zero investment. But if there is any problem in
completions or slump in real estate industry, this builder is the first to
declare bankruptcy. Financial leverage results from utilizing debt to finance
assets. The greater the ratio of funds contributed by creditors compared to
funds contributed by stockholders, the greater the firm’s financial leverage.
Financial leverage magnifies changes in net income compared to changes
in operating income. For example, financial leverage might cause a firm’s
reported net income to increase by 30% when operating income increases
by 20%.
To understand the impact, let us consider two different financial plans for
Godavari Tractors Ltd. It needs totally forty million rupees for its total
operations. Under plan A, it decides to have equity of ten million rupees
(1,000,000 shares of Rs. 10 each) and balance thirty million through long-
term debts at 10% interest per annum. Under plan B, it decides to have
equity of thirty million rupees (3,000,000 shares of Rs. 10 each) and
balance ten million through long-term debts at 10% interest per annum.
Corporate income tax is assumed at 30%. Now, let us tabulate earnings
per share of Godavari Tractors Ltd. at different levels of earnings before
interest and income taxes.
! !254
FINANCIAL AND OPERATING LEVERAGE
Plan A Plan B
! !255
FINANCIAL AND OPERATING LEVERAGE
The results are dramatic. With equal increases in earnings before interest
and taxes, the EPS under the two plans shows a vast variance especially at
higher levels of earnings. Up to five million of earnings, EPS difference is
not significant. But beyond that level, EPS under plan A is almost double
that under conservative plan B. Under leveraged plan A, net earnings are
more as interest is tax deductible expense. At the EBIT of Rs. 7.5 million,
the tax payable under conservative plan B is Rs. 1.95 million while under
leveraged plan A, it is less T Rs. 1.35 million. Increase in after tax earnings
is distributed over just one million shares (against three under conservative
plan B) in the leveraged plan A thereby providing higher EPS. EPS under
Plan A and B is reflected in Graph 9.4 below.
! !256
FINANCIAL AND OPERATING LEVERAGE
Calculate the financial leverage assuming that the company is in 50% tax
bracket.
Solution:
Statement of Profit
Earning Before Interest and Tax (EBIT) 50,000
Interest on Debenture (125,000 × 8 × 100) 10,000
Earning before Tax (EBT) 40,000
Income Tax 20,000
Earning after Tax (EAT) 20,000
OperatingProfit (OP)
Financialleverage = —————————————
OprofitbeforeTax(PBT)
50,000
= ——————-
40,000
= 1.25
! !257
FINANCIAL AND OPERATING LEVERAGE
Self-training Exercise: 01
The CFO of Ashok Mega Mart has following quarterly report for
presentation to the CEO.
Rs. crores
Net Sales 154
Gross Margin 64
Interest 40
Net Margin 24
The CEO is naturally going to be upset that almost 63% of the gross
margin is being eaten by interest expense.
! !258
FINANCIAL AND OPERATING LEVERAGE
Prepare a report addressed to the CEO explaining how and when this 63%
share taken up by interest is going to be less and less each quarter.
(Include projections.)
The first leverage – operating is about how much the business entity
invests in plant and machinery and the second leverage – financial is about
how the operations are financed – with owner’s capital (equity shares) or
through preference shares and borrowings.
You can also perceive these two leverages as two parts of the business
entity’s balance sheet.
Balance Sheet
Assets Liabilities
Rate of interest and taxes not relevant Rate of interest and taxes is very
relevant
! !259
FINANCIAL AND OPERATING LEVERAGE
! !260
FINANCIAL AND OPERATING LEVERAGE
EPS Rs.40 m
Operating
leverage
Net sales
Rs. 175 m
! !261
FINANCIAL AND OPERATING LEVERAGE
Sugars Ltd. (as shown in the Table 9.2 above), the resulting change in its
EPS is from Rs. 2.50 to Rs. 1.58 – a whopping 40% drop as can be
observed in Table 9.3 below.
With high combined leverage, business entities have to protect their sales
volume at all costs and take whatever action that is necessary to stop any
loss in sales volume. Such firms have to be aggressive and competitive to
justify their high fixed assets and high debts. By use of both leverages, the
firm is exposing itself by piling risk on risk. It could be a wise policy to
balance high operating leverage by adopting a conservative financial
leverage and vice versa.
! !262
FINANCIAL AND OPERATING LEVERAGE
The sensitivity of profit before tax (or profit after tax or earnings per
share) to changes in quantity sold is denoted by degree of combined
leverage. This degree is defined as:
!
If you use data from Table 9.3
In use of both leverages, the firm is exposing itself by piling risk on risk. It
could be a wise policy to balance high operating leverage by adopting a
conservative financial leverage and vice versa.
! !263
FINANCIAL AND OPERATING LEVERAGE
9.5 Summary
! !264
FINANCIAL AND OPERATING LEVERAGE
Here, we must clarify that financial leverage yields results; but only up to a
certain level. Beyond this point, it may be harmful for the firm. This risk
arises from financial institutes that provide debt finance. If adequate equity
is absent, the institutions either may not lend, or if they do the interest
burden will be very heavy. The lenders can demand certain restrictions on
the business entity’s operations.
The first leverage – operating is about how much the business entity
invests in plant and machinery and the second leverage – financial is about
how the operations are financed – with owner’s capital (equity shares) or
through preference shares and borrowings. Can we then further increase
earnings by employing both of them? The answer is positive. Operating
leverage increases returns from operations and financial leverage
determines how these benefits are distributed among debt holders and
equity holders. Since returns to debt lending institutions are constant
based on rates of interest, increase in incremental earnings accrue only to
equity holders.
! !265
FINANCIAL AND OPERATING LEVERAGE
1. Aditya was repeating that both operating and financial leverages are like
a two-edged sword. When Ameya questioned him why a two-edged
sword, his response was they __________.
2. The analysis that is carried by business units to determine how does the
volume of operations affects its costs and therefore profits is termed
__________.
a. Break-even analysis
b. Degree of operating leverage
c. Liquidity ratio
d. Fund flow analysis
a. Operating
b. Combined
c. Financial
d. Total
! !266
FINANCIAL AND OPERATING LEVERAGE
a. Yamuna Sugars
b. Narmada Sugars
c. Irawati Sugars
d. Godavari Sugars
5. The study of several large business entities in Japan established the fact
that by employing __________ leverage the firm is exposing itself by
piling risk on risk.
a. Financial
b. Combined
c. Reverse
d. Operating
Answers:
1. (c)
2. (a)
3. (c)
4. (d)
5. (b)
! !267
FINANCIAL AND OPERATING LEVERAGE
REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter
Summary
PPT
MCQ
Video Lecture
! !268
COMMON AND PREFERRED STOCKS
CHAPTER 10
COMMON AND PREFERRED STOCKS
“Common and Preferred Stocks are two common means of raising long-term finance
available to joint stock companies and both possess their own personalities to serve the
investors.”
Objectives
Structure:
10.1 Introduction
10.2 Categories of Equity Capital
10.3 Rights of Equity Holders
10.4 Common Stock – Benefits and Drawbacks
10.5 Preferred Stock – Features
10.6 Preferred Stock – Classification
10.7 Preference Stock – Benefits and Drawbacks
10.8 Common Stock, Preferred Stock and Debt Instruments – A
Comparison
10.9 Summary
10.10 Multiple Choice Questions
! !269
COMMON AND PREFERRED STOCKS
10.1 Introduction
When an investor pays any company money in return for part ownership,
the corporation issues a certificate of ownership interest to the stockholder.
This certificate is known as a stock certificate, capital stock, or stock.
(Today, all corporations handle the shares or stock electronically.) Stock is
the evidence of an ownership interest, it is not a loan to the corporation;
common stock does not come with due date or maturity. A stockholder
owns the stock until he/she decides to sell it. If stockholders want to sell
their stock, they must find a buyer usually through the services of a
stockbroker. Nowhere on the stock certificate is it indicated what the stock
is worth (or what price was paid to acquire it). In a market of buyers and
sellers, the current value of any stock fluctuates moment-by-moment. It
has value on its face that indicates what proportion in total ownership the
owner enjoys. Total common stock consists of a certain amount (Rs. one
crore) divided into a certain number of shares (Rs. twenty lakhs) of face
value that is indicated in the share certificate (Rs. five).
As per Section 2(46) of the Indian Companies Act 1956, “share” means
share in the share capital of a company, and includes stock except where a
distinction between stock and shares is expressed or implied.
! !270
COMMON AND PREFERRED STOCKS
Most large public corporations have their equity distributed over a large
number of shareholders. They together enjoy the rewards and bear the
risks of ownership. It must be noted here that their liability, unlike the
liability of a proprietor or a partner of a business unit, is limited to the
amount they paid, get the shares in their name.
You can study how such spread in ownership of the business entity is
arranged by Larsen Toubro Ltd. from the data for 2014-15 published by the
company in its balance sheet for the year.
! !271
COMMON AND PREFERRED STOCKS
! !272
COMMON AND PREFERRED STOCKS
When a corporation sells some of its authorized shares, the shares are
described as “issued”. The number of issued shares is often considerably
less than the number of authorized shares. Corporations issue (or sell)
shares of stock to obtain cash from investors, to acquire another company
(the new shares are given to the owners of the other company in exchange
for their ownership interest), to acquire certain assets or services, and as
an incentive/reward for key employees of the corporation.
! !273
COMMON AND PREFERRED STOCKS
Because of those existing laws whenever a share of stock is issued, the par
value is recorded in a separate stockholders’ equity account in the general
ledger. Any proceeds that exceed the par value are credited to another
stockholders’ equity account. This required accounting (discussed later)
allows you to determine the number of issued shares by dividing the
balance in the par value account in the balance sheet by the par value per
share.
If a share of stock has been issued, i.e., offered to the public for
subscription, and has not been reacquired by the corporation, it is said to
be “outstanding.” For example, if a corporation initially sells 2,000 shares
of its stock to investors, and if the corporation did not reacquire any of this
stock, this corporation is said to have 2,000 shares of stock outstanding.
The number of outstanding or subscribed shares is always less than or
equal to the number of issued shares. The number of issued shares is
always less than (or equal to) the authorized number of shares.
The actual amount paid by the investors against the number of shares they
had subscribed constitutes paid-up capital. Typically, the issued, subscribed
and paid-up capital of a corporation are the same. To quote Larsen and
Toubro Ltd., again its issued and paid-up capital stands at Rs. 185.9 crores
in March 2015 (against a Rs. 26 crores in March 2005) as indicated above.
When you examine the data published by corporates about common stock
in their published year end accounts, you will come across various terms
as:
! !274
COMMON AND PREFERRED STOCKS
• Par Value
• Issue Value or Price
• Book Value
• Market Value
Par Value: The par value of an equity share is the one which is indicated in
the memorandum of association of the corporation. It is also reflected in
the body of the share certificate issued to the equity holder. Equity capital
of the corporation is determined by multiplying the number of shares by
this par value. Par values generally are stated at Rs. 1, Rs. 2, Rs. 5, or Rs.
10. Higher par values are quite infrequent.
Issue Value or Price: Initially, new corporations entering the stock market
for the first time, issue their shares at a par value. At that stage, they have
just started the business activity and need long- term finance to run
operations by installing fixed assets. On many occasions, well established
firms with excellent earnings record enter the capital market for seeking
long-term finance for expansion as well as to liquidate (costly) long-term
debts. Other established corporations which had issued earlier shares at
par value too enter the market to satisfy their needs for long-term finance.
These business entities wish to seek returns on their financial
achievements and hence issue equity at prices higher than the par value.
Indigo Airlines operating for many successful years entered equity market
in 2015 with an issue in the price band of Rs. 700-765 per share having a
face value of Rs. 10 each.
! !275
COMMON AND PREFERRED STOCKS
** The difference between par value and issue price of the share is known
as share premium.
The issue price of these shares was ultimately determined at Rs. 765.
Investors are prepared to pay share premium in view of the past financial
record of the corporation that assures them of long-term returns. Investors
were so impressed with financial performance of Indigo Airlines that they
overwhelmingly responded to this initial public offer and the issue was
oversubscribed (the quantity of shares for which investors subscribed was
in multiples of that which was offered by the corporation). When the shares
were traded for the first time on exchanges, the price was 15% above the
issue price providing the investors immediate returns. It may well be noted
here that this issue value or issue price, by law, cannot be less than the
par value. In other terms, equity cannot be issued at discount.
Illustration
From this issue of the stock, RFL collected Rs. fifteen crores from common
stockholders. How can now its paid-up capital ( Rs. fifteen crores) be more
than its authorized capital? Will RFL distribute an amount of Rs. one-and-
half crores (10% of Rs. fifteen crores) as dividend to the common
stockholders?
Solution:
The amount of Rs. fifteen crores collected by RFL consist of Rs. five crores
only as paid-up capital and balance amount of Rs. ten crores belongs to
Share Premium account. Thus, its capital structure indicates Authorized
Capital of Rs. ten crores and out of this paid-up capital is Rs. five crores.
! !276
COMMON AND PREFERRED STOCKS
10% dividend declared has to be distributed on the paid-up capital and the
amount to be distributed isRs. half crore.
Book Value: The book value of an equity share is equal to a sum of paid-
up equity capital and reserves and surplus divided by number of
outstanding shares of the corporation. This book value increases as the
corporation starts earning profits and creating reserves. Larsen Toubro Ltd.
in its balance sheet as of 31.03.2015 showed
2014- 2013- 2012- 2011- 2010- 2009- 2008- 2007- 2006- 2005-
15 14 13 12 11 10 09 08 07 06
398.78 362.95 317.09 274.35 238.96 202.46 141.54 108.63 67.43 55.67
This increase in book value goes a long way to prove that the corporation is
living to its vision statement below which states that it is committed to
enhance shareholder value.
! !277
COMMON AND PREFERRED STOCKS
corporation’s market prices for the year 2014-15 on the National Stock
Exchange were as under:
2015
This table once again indicates how shareholders benefit from the rise in
market prices of the L&T shares in which they decided to invest. These
market prices in addition to the past financial performance of the company
depend on many factors like current earnings, growth prospects, risk and
company size. These prices are further governed by external factors like
state of the industry, national economy and mood prevailing on the stock
exchanges both domestic as well as international.
If the company is listed but if its shares are not traded frequently, the price
at which shares were traded last is available but that prices fails to reflect
company’s current share market price. For the companies which are not
listed on the stock exchanges, no such prices are available and their share
market price can be just anybody’s estimate.
! !278
COMMON AND PREFERRED STOCKS
All incoming cash flow is utilized by business entities to pay out for its
expenses and its creditors. If it has issued preference stock, then the
preference stockholders have a claim on the balance. Thereafter the
residual income belongs to equity holders. Whether it is distributed to
stakeholders by way of dividends or retained as reserves in the company
does not affect their claim. It is just a matter of timing. In the fiscal
2014-15, ITC Ltd. reported net Profit After Tax (PAT) ofRs. 3,711 crores
which was available to equity holders. Out of this amount, Rs. 601 crores
was distributed as dividends, Rs. 153.80 crores paid as tax on dividends
(ITC paid it as shareholders receive dividend income tax free) and rest
transferred to reserves and surplus which then accounted for Rs.
20,261.70 crores. This surplus is for re-investment in the business for the
benefit of equity holders; with the hope of providing even greater income,
dividends and price appreciation in the future.
You can now understand how the ITC shareholders have benefitted from
ITC earnings for the year 2014-15. First, they received tax free dividend
income of Rs. 601 crores as the dividend tax of Rs. 153.80 crores were
paid by ITC Ltd. Next, they can now expect appreciation in market value of
their shares through reinvestment in business of Rs. 447 crores.
This right to income is not legal and cannot be enforced in courts of law.
Declaration of dividends is entirely a prerogative of the Board of Directors
of ITC Ltd. If it declares lesser dividends or skips it altogether in any year,
shareholders do not have any recourse to legal action. This needs to be
contrasted with the rights of long-term lenders and bondholders who on
non-payment of interest can force ITC Ltd. into bankruptcy. Equity owners
have to accept circumstances about dividends as they are or attempt to
change the management if a revised dividend policy is desired. This
objective can be reached by exercising their next right “to vote” explained
in 10.03.02.
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COMMON AND PREFERRED STOCKS
investment, the latest trend indicates that more and more individual
investors are staying away from investing directly into specific joint stock
companies. Instead they prefer to invest indirectly through financial
institutes and mutual funds.
To quote shareholding pattern of L&T Ltd. again, about 37% of shares are
held by three financial groups as under:
Equity holders, being owners of the joint stock company, exercise their
right to vote and appoint a Board of Directors to manage operations of the
company. Directors to this board are elected in the corporation’s annual
general body (of equity holders) meeting every year. These board directors
serve on different committees that look after Risk Management, Corporate
Social Responsibility, Employee Administration and Welfare, Internal Audit,
etc. Shareholders are also required to vote on resolutions on all significant
financial matters presented in this meeting. The shareholders either can
vote themselves or appoint a proxy (either in management or in any
outside group) to vote on their behalf.
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COMMON AND PREFERRED STOCKS
In the last two decades, a new wrinkle was added to the meaning of rights
of equity shareholders. As stated above, many business families were able
to manage large joint stock companies with shareholding of about 20% to
25%. These families in control of the corporation often perceive a threat
from another business unit which is gradually acquiring more and more of
their company’s share capital to gain control of the company from these
families. To thwart these attacks, these families have provided new thrust
to the rights of the shareholders.
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COMMON AND PREFERRED STOCKS
Tata Consultancy Services Ltd. has paid-up share capital of Rs. 1958.7
million as of 31.03.15. Suppose it plans to issue additional capital of Rs.
195.87 million to meet its financial needs. The existing shareholder Shri
Ramnik Shah owns 10,000 shares. In this public offer, Shri Shah has the
right to acquire 1,000 shares and these have to be reserved for him. Shri
Shah may, however, decide to buy only 500 shares or ignore the offer
totally. However, if Shri Shah fails to take advantage of the ‘rights’ shares,
the value of his portfolio is bound to suffer a loss as under. Let us assume
that market price of TCS share is Rs. 2,500 today and the rights offer is at
Rs. 2,000. After the rights issue is fully subscribed, TCS paid-up capital will
increase by 10% and its market price (theoretically speaking) will drop by
10% to Rs. 2250.
Value of Portfolio
Initial Value of Holdings 10,000 × Rs. 2,500 = 10,000 × Rs. 2,500 = Rs.
Rs. 20,500,00 25,000,000
After Rights Issue 10,000 × Rs. 2250 = Rs. 11,000 ×Rs. 2250 = Rs.
22,500,000 24,750,000
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COMMON AND PREFERRED STOCKS
A bonus share issue indicates that the company is confident about the
business’s capacity to generate value for a larger capital owned by
investors. It also helps boost trading of the shares in the stock market as
more number of shares is traded. The drop in the share price after bonus
issue can attract small investors into the share market. Moreover, while
issuing more shares, the company avoids paying the ‘dividend distribution
tax’. This helps reduce costs for the company as well as stockholders. Like
in earlier years, Infosys issued bonus shares along with the usual dividend
payment in 2014. The IT major has a large cash reserve of around Rs.
30,000 crores. Investors have been asking the company to use the cash –
either for acquisitions or return it to shareholders. This amount could have
been used for expansion or purchasing a new company – either of which
could help improve its profitability. This acquisition is a continuous process
for this profitable company. But it also arranges bonus issues. This shows
the company values giving back to shareholders more and does not foresee
better use for the money lying idle.
When a company announces a bonus share issue, it gives a ratio with it.
Infosys said it will issue bonus shares in the 1:1 ratio. This means, for
every share an investor already holds, it will issue one additional share. So,
effectively, your portfolio will double in size. For example, if you held 1,000
shares of Infosys, you will now hold 2,000 shares. Not every bonus share
issue has the same ratio. The company decides how many new shares it
wants to issue.
Until the ‘Record’ date, price of the stock usually rises as more investors
want to be eligible for the extra stocks. However, it may not be so if the
company is under performing or it has poor fundamentals. The day after
the bonus is distributed, the share price is adjusted. This is called the ex-
bonus price. So, if the company has issued a 1:1 bonus share, then the
price of the shares will fall to nearly half of its original price. Share’s price
is a reflection of the company’s value in the market. A bonus issue does
not change the share’s inherent value. Only the total number of shares
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COMMON AND PREFERRED STOCKS
floating in the market is increased. So, the prices of the shares fall
temporarily. One study observed that of the top thirty companies which
announced bonus issues between January 2001 and July 2010, the share
price of twenty-one companies rose till the record date. Also, stocks of
twenty-four companies rose in the year after the record date.
We must also know how different the bonus issue is from a stock split. On
the face of it, a bonus share issue is remarkably similar to a stock split –
the number of shares a person holds increases while the price falls in
tandem. However, there are some differences. Firstly, every share has a
face value. It could be Rs. 1, Rs. 5 or Rs. 10. In a stock split, the face
value of the share falls. So, if your shares had a face value of Rs. 10 before
a 1:1 stock split, you would now have two shares with a face value of Rs.
5. This is not so in a bonus stock issue. There you will hold two shares with
a face value of Rs. 10. This means you get a greater piece of the surplus
available for distribution to share owners.
• Similarly, unlike long-term debts, common stock does not have any
maturity date on which the shares have to be redeemed. Common stock
is a permanent fund.
• Investors do not have to pay the income tax on dividends they receive.
• However, company has to pay dividend distribution tax (15% in the year
2015) with surcharge and cess. Plus unlike interest on long-term debt,
dividends can be distributed only out of after tax earnings of the business
entity. Interest paid is a tax deductible expense but not dividends.
! !284
COMMON AND PREFERRED STOCKS
! !285
COMMON AND PREFERRED STOCKS
Common stockholders are the owners of the company and as such have a
right on residual income while preferred stockholders are entitled to a fixed
amount of dividend and must receive it before the payment of dividends to
common stockholders is arranged. But this right of preference stockholders
to dividend is not mandatory as is the case with interest on long-term debt
instruments. Dividends on preferred stocks can be skipped if the board of
directors feels that the earnings of the year are inadequate.
In the year when there are positive earnings and if the board of directors
feels they are adequate for declaration of dividends, it may declare and pay
the dividend to preference shareholders. The amounts so paid have to be
at the stipulated rate of 10%.
! !286
COMMON AND PREFERRED STOCKS
share capital. This right arises because such resolutions affect preference
stockholders’ interests. (B) Preference stockholder acquire voting rights if
the company fails to pay them dividends for two years prior to the annual
general meeting in case of cumulative and three years non-cumulative
stocks.
For this class of stock, if dividend is not declared in any year, it does not
lapse. Unpaid dividend is carried over and holders have a claim of unpaid
dividends on future earnings of the company. Until this accumulated
dividend amount is paid, the company cannot declare dividend on common
stock. Thus, due to inadequate earnings, a company does not pay dividend
on 10% Cumulative Preference Stock for, say, three years, preference
! !287
COMMON AND PREFERRED STOCKS
Redeemable preferred stock contains a call option that allows the issuer to
forcibly redeem the shares on or after a specified call date. You call shares
by canceling them and paying a preset price plus any dividends due.
Issuers value the call option because it allows them to replace preferred
shares with lower yielding ones if interest rates fall. You are under no
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COMMON AND PREFERRED STOCKS
obligation to call the shares if interest rates remain steady or rise. Because
call options favor issuers, redeemable preferred stock will raise less money
than will equivalent shares without the call option. Unlike equity shares,
redeemable preference shares allow Indian companies to access capital
without any equity dilution of the existing Indian equity shareholders.
Further, such redeemable preference shares could be allotted to foreign
investors without offering them any voting rights or control in respect of
the Indian company. There is a prescribed limit on the maximum dividend
that can be paid. So, preference shares could not work as an instrument
for unfettered outflow of the profits of Indian companies. Also, there has
never been any guaranteed payout of dividends on preference shares
since, under Indian Companies Act, dividends can be paid only out of
distributable profits.
Under a specific circular (New Circular) dated 8 June 2007 issued by the
Reserve Bank of India (RBI), it has revised its guidelines pertaining to issue
of preference shares to foreign investors. Now, only those preference
shares that are fully and mandatorily convertible into equity shares within
a specified time will be considered a part of the investee company’s share
capital—and only such preference shares will be issued to foreign investors
under the automatic approval route (that is, without requiring permission
from the Ministry of Commerce). Foreign investments in non-convertible,
optionally convertible or partially convertible preference shares are now
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COMMON AND PREFERRED STOCKS
considered to be debt finance, that is, akin to a loan, and are required to
conform to the stringent guidelines relating to External Commercial
Borrowings (ECBs).
Benefits
• Issue of preference stock does not call for any mortgage of company’s
assets which remain available for raising debt as and when required.
Drawbacks
! !290
COMMON AND PREFERRED STOCKS
Self-training Exercise: 01
3 Common Equity
!
4 Secured Debt
!
5 Preference Stock
!
6 Unsecured Debt
!
Shalini was analyzing above six alternatives available for investment. She
wants to rearrange them in such a way that the option with the least risk/
return appears first (1) and the one with the highest risk/return appears
last (6). Can you assist her by inserting 1 to 6 in the above boxes?
All business entities have three major sources for long-term financing, viz.,
• common stock,
• preference stock and
• long-term debt instruments like bonds and debentures.
Each source has its own advantages and costs. These have been defined in
the table below.
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COMMON AND PREFERRED STOCKS
Risk/return Highest risk and Moderate risk and Lowest risk and
hence highest fixed return fixed return
return
! !292
COMMON AND PREFERRED STOCKS
10.9 Summary
When an investor pays any company money in return for part ownership in
it, the company issues a certificate of ownership interest to the
stockholder. This certificate is known as a stock certificate, capital stock, or
stock. Of course, these days, all stock records are handled electronically.
Most large public corporations have their equity distributed over a large
number of shareholders to ensure control over the company continues with
its promoters. They together enjoy the rewards and bear the risks of
ownership.
It must be noted here that their liability, unlike the liability of a proprietor
or a partner of a business unit, is limited to the amount they paid to get
the shares in their name. When a business entity applies for incorporation
to the Registrar of Companies, its application will specify the classes (or
types) of stock, the par value of the stock, and the number of shares it is
authorized to issue. This constitutes authorized capital of the company.
Companies ask for a larger amount of authorized capital to avoid any
revision when the need for capital increases with the growth of the
business.
When a corporation sells some of its authorized shares, the shares are
described as “issued”. The number of issued shares is often considerably
less initially than the number of authorized shares. The value of issued
shares constitutes company’s subscribed capital. If a share of stock has
been issued, i.e., offered to the public for subscription, and has not been
reacquired by the corporation, it is said to be “outstanding”. Value of such
shares when fully subscribed constitutes company’s paid-up capital.
Value indicated on the share certificate is its face or par value. Shares are
often issued at a premium, face value plus such premium is termed paid-
up value. After satisfying the claims of all others, value of assets with the
company that belongs to common stockholders when divided by number of
fully paid shares provides you with the book value of the common stock.
The prices at which the shares are bought and sold on stock exchange are
termed its market value.
All incoming cash flow is utilized by business entities to pay out for its
expenses and its creditors. If it has issued preference stock, then the
preference stockholders have a claim on the balance. Thereafter equity
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COMMON AND PREFERRED STOCKS
holders have sole right on the residual income. A company can retain this
net balance as reserves to meet company’s future requirements of long-
term finance or distribute it to equity holders as dividends. Common
stockholders enjoy another right to vote on resolutions presented by
company’s board of directors. This right provides them with a control over
the company in proportion to the number of shares owned.
! !294
COMMON AND PREFERRED STOCKS
! !295
COMMON AND PREFERRED STOCKS
a. Rights
b. Preference
c. Bonus
d. Debenture
2. Bharat Ceramics Ltd. announced a rights issue at 1:1 basis. Anil owned
1,000 equity shares in this company and wanted to participate in this
rights issue. How many shares can he apply for?
a. 1000
b. 500
c. 250
d. Any one of above
a. Common stock
b. Preference stock
c. Debenture
d. Each one above
! !296
COMMON AND PREFERRED STOCKS
Answers:
1. (c)
2. (d)
3. (b)
4. (a)
5. (d)
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COMMON AND PREFERRED STOCKS
REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter
Summary
PPT
MCQ
! !298
DEBENTURES
CHAPTER 11
DEBENTURES
“There is always demand for limited risk investment products which can offer attractive
returns. In view of this, many companies enter markets with debenture issues to raise
capital from the market to fund long-term business investments”.
Objectives
Structure:
11.1 Introduction
11.2 Attributes
11.3 Terminology Associated with Long-term Debt
11.4 Debenture Indenture
11.5 Debenture Classification
11.6 Benefits and Drawbacks
11.7 Two Debenture Issues
11.8 Bonus Debentures – A New Concept
11.9 Popularity of Debentures
11.10 Summary
11.11 Multiple Choice Questions
! !299
DEBENTURES
11.1 Introduction
! !300
DEBENTURES
Indian Companies Act, 1956 does not provide for any definition of a
debenture. Any debenture stock, bonds and any other securities of a
company whether constituting a charge on the assets of the company or
not, as per the Act, are included in the term debenture.
11.2 Attributes
Debenture holders are creditors of the company. As such, they do not have
a right to vote and so they do not possess any controlling power over the
company. Nor do they have a privilege to attend the annual general body
meetings of the company.
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DEBENTURES
Most debentures are released on electronic forms and (if issued by larger
companies) they are listed on the stock exchanges thereby offering
liquidity to the investors. The trades in debentures take place in their
demat format.
1. Call Option: A call provision that allows the company to retire the
debenture before its date of maturity. If this provision is included in the
indenture of the debenture, the company usually offers a premium of
five to ten per cent over par value. This option is exercised after a lapse
of a few years after the issue and when the ruling interest rates in the
market allow the company to obtain funds at rate cheaper than the
coupon rate.
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DEBENTURES
3. Coupon rate: This reflects the actual rate of interest payable on the
principal amount to the debenture holder. The extent to which the rates
of interest prevailing in the market fluctuate from this coupon rate is
reflected in the market price of debentures. Usually, this rate is fixed
throughout the life of the bond. Interest can be paid at different
frequencies: generally semi-annual, i.e., every six months, or annual.
4. Maturity: Reflects the period after which the issuer has to repay the
principal amount to the bondholder. The principal amount is due for
repayment on the maturity date. As long as all due payments have been
made, the issuer has no further obligations to the bondholders after the
maturity date. Virtually, all bonds have a maturity date and company
agrees to pay off in cash the outstanding debentures at a fixed date.
5. Nominal, principal, par or face value: This is the initial value of the
bond. The interest is paid to the debenture holder on this amount.
6. Put Option: A put provision allows the holder to redeem the debenture
at specified time before its date of maturity. If this provision is included
in the indenture of the debenture, the prices at which such redemption
can take place are specified.
8. Tenor: The length of time until the maturity date is often referred to as
the tenor of a bond. Thus, a debenture that matures after ten years for
repayment carries a ten-year tenor.
! !303
DEBENTURES
The bond indenture is created during the bond issuing process when bond
issuers are receiving approval from state and central governments to issue
bonds to the public. After an agreed upon amount of bonds is authorized
by the applicable government agency, the company issuing the bonds must
construct a bond indenture.
Students should not get the two terms indenture and debenture confused.
A bond indenture is the contract between the bond issuer and the
bondholder. A debenture is simply a financial instrument with certain terms
and conditions. Indenture is essentially a legal document while debenture a
financial one.
This trustee is most often a bank or some other financial institution. If the
company breaks the agreement set forth in the bond indenture, the trustee
can sue the company on behalf of the bondholders.
The indenture specifies all the important features of a bond, such as its
maturity date, timing of interest payments, method of interest calculation,
callable/convertible features if applicable and so on. The indenture also
contains all the terms and conditions applicable to the bond issue. Other
critical information included in the indenture includes the financial
covenants that govern the issuer and the formulas for calculating whether
the issuer is within the covenants.
Should a conflict arise between the issuer and bondholders, the indenture
is the reference document used for conflict resolution. As a result, the
indenture contains all the minutiae of the bond issue. The bondholders can
! !304
DEBENTURES
also voice complaints to the trustee in an effort to raise legal action against
the issuing company.
Article 1 Interpretation
Article 8 Default
Article 9 Satisfaction and discharge
Article 10 Successors
Article 11 Compulsory acquisition
! !305
DEBENTURES
For example, a zero-coupon bond with a Rs. 10,000 par value and ten
years to maturity is trading at Rs. 6000 ; if you buy this bond, you pay
Rs. 6,000 today for a bond that will be worth Rs. 10,000 in 10 years.
The issue price of Zero-coupon Bonds is inversely related to their
maturity period, i.e., longer the maturity period lesser would be the
issue price and vice versa.
Debenture Classification
Rate Frequency
Convertible
Non-convertible
Fixed Rate Partially Convertible
Cumulative
Floating Rate
Non-cumulative
Zero Coupon
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DEBENTURES
! !307
DEBENTURES
Benefits
Debenture holders do not acquire any control over company as they do not
possess any voting rights. Thus, debenture financing does not result in
dilution of control.
! !308
DEBENTURES
Drawbacks
NEW DELHI: Country’s largest mortgage lender HDFC Ltd. said the bid to
raise up to Rs. 5,000 crore via Non-convertible Debentures and warrants
! !309
DEBENTURES
Let us have look at two recent debenture issues arranged by HDFC Bank
(shown above) and Axis Bank.
“We will issue, offer and allot warrants exchangeable for equity shares
simultaneously with secured redeemable non-convertible debentures of
face value of Rs. 1 crore each to eligible Qualified Institutional Buyers
(QIBs) by way of Qualified Institutional Placement (QIP),” it said in the
filing.
“In case warrants are exchanged with equity shares of the company, it
would result in a maximum issue of 3.65 crore equity shares of face value
of Rs. 2 each of the Corporation. The floor price of the warrants shall be
Rs. 1,189.66 per warrant,” it added.
The company said the NCDs will mature in March 2017, while the exercise
period of the warrants will be 36 months from the date of allotment of
warrants. Also, it said the bidder will be entitled and eligible to apply for at
least 7,300 warrants for each NCD applied for in the issue.
The Housing Development Finance Corporation (HDFC) Ltd. will use the
proceeds from the issue to boost lending operations and meet its future
capital needs.”
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DEBENTURES
Usually, for equity investors, bonuses come in free bonus shares – ‘x’
number of bonus shares on ‘y’ number existing shares held. But sometime
back, NTPC declared the issue of bonus debentures to its shareholders. A
bonus debenture is a free debt instrument issued to a company’s
shareholders as a reward. When the company declares a bonus debenture,
you will receive bonds from the company for a specific face value. Interest
will be paid on these debentures every year. They will be redeemed after a
specific period, when you will receive a lump-sum payment. Take NTPC’s
case. Suppose you hold 100 shares of the company, you will receive 100
debentures with a face value of Rs. 12.5 each, valued at Rs. 1,250. The
interest paid on this debenture is at a floating rate. The interest rate is
pegged 50 basis points higher than the prevailing yield of 10-year
government bonds. The debentures are valid for 10 years and will be
redeemed in three installments at the end of which you would have
received Rs. 1,250.
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DEBENTURES
Benefits
One, as the debentures are redeemed after many years, the company will
not see its reserves deplete drastically at one go as is the case with bonus
shares. The company will be able to hold on to them for expansion
projects.
Unlike bonus shares, a bonus debenture issue does not increase the equity
share base, which dents the earnings per share. They do not squeeze
return on equity, or bump up valuations.
Drawbacks
Bonus debentures do sound like an all-round winner, but they are not. Here
is the flip side. When your company declares a bonus share issue, the
entire lot of shares is credited to you at zero cost. If you sell them, you can
stand to make gains. These gains are tax-free if you hold them for more
than a year, as they are equity instruments.
But for bonus debentures, the redemption amount will come in only at the
end of the period, which can be long. In NTPC’s case, given that the
interest is linked to G-Sec yields, the amount you receive will fluctuate and
is uncertain. Bonus debentures also do not enjoy similar tax breaks to
bonus shares. First, under Income Tax rules, the amount of the bonus
issue is considered to be ‘deemed dividend’ and will attract dividend
distribution tax. Two, the interest will be taxable in your hands at your slab
rate just like your fixed deposit interest.
! !312
DEBENTURES
exit at a profit, short-term or long-term, capital gains tax will apply. But in
order to calculate the gains, it is unclear what exactly will tax authorities
determine as an acquisition cost.
PVR gets
shareholders’ nod to rise ‘500
crore via Non-convertible Debentures
September 29,2015|PT|
NEW DELHI: Multiplex operator PVR today said its
shareholder have approved raising ‘500 crore
through issuance of Non-convertible Debentures
(NCDs)on private placement basis. Shareholders
have approved “subscription of Non-convertible
debentures for an amount not exceeding ‘500
crore on private placement,” PVR said in
BSC filing.
! !313
DEBENTURES
! !314
DEBENTURES
11.10 Summary
Several specific terms are associated with debentures. Call Option is a call
provision that allows the company to retire the debenture before its date of
maturity. Convertibility clause allows the company to convert outstanding
debentures into common stock at rates specified in the indenture. Coupon
rate is the rate of interest payable on the principal amount to the
debenture holder. Maturity denotes the period after which the issuer has to
repay the principal amount to the bondholder. Nominal, principal, par or
face value is the initial value of the bond. Put Option allows the holder to
redeem the debenture at specified time before its date of maturity. The
length of time until the maturity date is often referred to as the tenor of a
bond.
! !315
DEBENTURES
Convertible Debentures are bonds that can be converted into equity shares
of the issuing company after a pre-determined period of time in the ratios
specified at the time of issue. Convertibility clause turns bonds of profitable
companies more attractive to investors and can be issued at lesser rate of
interest. Non-convertible debentures, on the other hand, carry higher
interest rates as investors do not have option of conversion into company’s
equity.
! !316
DEBENTURES
a. Call option
b. Put option
c. Pull option
d. Zero coupon
a. Call option
b. Put option
c. Convertibility
d. Floating rate
! !317
DEBENTURES
a. Rights
b. Bonus share
c. Fraction
d. Bonus debenture
Answers:
1. (d)
2. (a)
3. (c)
4. (c)
5. (d)
! !318
DEBENTURES
REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter
Summary
PPT
MCQ
Video Lecture
! !319
CAPITAL STRUCTURE – EQUITY VS. DEBT
CHAPTER 12
CAPITAL STRUCTURE – EQUITY VS. DEBT
“Firms have always to arrange for fresh investment in projects that enable them to
sustain and prosper. These projects are expected to generate future cash inflows over
the life of the project. How do you decide whether to fund them through equity or debt?”
Objectives
Structure:
12.1 Introduction
12.2 Cost of Capital Theory
12.3 Ideal Capital Structure
12.4 Ensure Your Capital Structure Decision is Error-free
12.5 Factors Affecting WACC
12.6 Summary
12.7 Multiple Choice Questions
! !320
CAPITAL STRUCTURE – EQUITY VS. DEBT
12.1 Introduction
(i) Equity Shares and Debentures (i.e., Long-term debt including Bonds,
etc.),
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CAPITAL STRUCTURE – EQUITY VS. DEBT
But these assumptions are not valid in real economic environment. Each
source of long-term finance has its own costs and returns and hence
capital structure needs to be composed in such a way that business entity’s
value is maximized.
12.1.2 Objectives
4. F i r m ’s m a n a g e m e n t a r ra n g e s t h e d e c i s i o n s t h a t ra i s e i t s
creditworthiness and this action allows it to borrow long-term funds at
lower interest rates and raise equity at higher premium value. (Rights
issue of share with par value of Rs. 10 at say Rs. 500.)
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CAPITAL STRUCTURE – EQUITY VS. DEBT
You can understand from following table how some companies floated
shares at an offer price as high as Rs. 1,020 for a share with par value
of Rs. 10 each.
To sustain and expand business, every entity needs funds. How does the
firm determine the cost of these funds required or, more properly stated,
the cost of capital? The knowledge of cost of capital is necessary to decide
earnings that can be achieved through different investment proposals. If
the cost of capital is 10% and investment proposal to install a conveyer
system is expected to yield 8%, then it has to be dropped. But investment
proposal to open a new sales depot with 12.5% rate of return can be put
through. A factor to remember here is that, for such investment decisions,
we have to consider total cost of capital and not that of debt or equity
alone. Similarly, historical cost of capital is not relevant here as with
changed economic circumstances that cost has undergone changes. We
need to find out the yield on the capital employed as explained next.
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To arrive at cost of debt, this yield has to be adjusted for the tax effect, as
interest on debt is an expense to be reduced from taxable income. If the
corporate tax happens to be 30%, the cost to the business entity for this
debt comes down to 6.68%.
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CAPITAL STRUCTURE – EQUITY VS. DEBT
The cost of preferred stock is similar to the cost of debt as earnings per
year are constant. But dissimilar as there is no maturity date on which
repayment has to be arranged. So, to determine the cost of preference
stock, we divide annual dividend payable by the market price of the stock.
A minor adjustment needs to be carried here to subtract cost of floating
preference stock from its market price.
As dividends on preference shares are not expenses and are paid out of
after tax earnings, the adjustment for tax effect is not necessary while
determining cost of preference stock. The yield to the stockholder is equal
to the cost for the issuer.
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ITC declared a dividend of 6.25 in the year 2015 on its common stock and
market price of the stock was around 350/-. Thus, for ITC, the first factor
dividend/price is 1.8% and if we assume factor B to be 8%, the required
rate of return is 9.8% or 10%. For publicly traded companies, we can
easily obtain the dividends declared by them over last, say six years, to
determine dividend growth rate.
1 26 – –
2 28 2.00 7.69
3 30 2.00 7.14
4 34 4.00 13.33
5 37 3.00 8.82
6 40 3.00 8.11
45.09
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CAPITAL STRUCTURE – EQUITY VS. DEBT
Under CAPM method, the required return for the common equity is
ascertained by the formula:
where,
To further understand the problem, let us assume that the expected return
in the market on the particular stock is 15%, the risk-free interest on
government bonds is 9% and ß of the said company is 0.8. In such
situation using CAPM formula, required rate on the equity works out to:
Earlier, we had noted that CAPM methodology is not practical and this
stand is based after consideration of the following assumptions that
underlie the CAPM:
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CAPITAL STRUCTURE – EQUITY VS. DEBT
(d) Investors can borrow or lend freely at the risk-free interest rates.
If you study each of the above assumptions, you are bound to conclude
that all of them are not realistic enough to support CAPM.
These accumulated earnings are the net sum of previous earnings less
distributed dividends in the past. The earnings are to be used to declare
further dividends and also for re-investment in the business entity.
Thus, one can assume that this is a free source for supply of funds. But
that is not the case, as there is an opportunity cost that needs to be
considered. The retained earnings can always be distributed to equity
holders of the business entity as dividends, and on their receipt, equity
holders are free to reinvest them for their further benefit.
This new reinvestment must at least earn the stockholders in this business
entity same return as was available to them from their initial investment. It
is reasonable to restate that the cost of equity in the form of retained
earnings equals the required rate of return on firm’s stock and it is
determined as under:
CRE = D/SP + g
where,
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CAPITAL STRUCTURE – EQUITY VS. DEBT
To repeat earlier example, ITC declared a dividend of Rs. 6.25 in the year
2015 on its common stock and market price of the stock was around Rs.
350. Thus, for ITC, the first factor dividend/price is 1.8% and if we assume
factor B to be 8%, the required rate of return using above equation is
9.8% or 10%.
Here, it is worth noting that when the firm’s shares are traded in the
market at higher values, the cost of capital gets reduced, the high market
value being an indicator of firm’s strong creditworthiness. This factor, thus,
is external to firm’s cost of capital. On the other hand, if the dividend
amount is higher, the cost of capital increases as higher dividend indicates
firm’s tendency to distribute retained earnings as dividends rather
employing them for re-investment. This dividend declaration is an internal
factor to cost of capital.
We are now able to determine the cost of various elements that together
form a business entity’s capital structure. To arrive at optimal capital
structure for the firm, it is now necessary to assign weights to each
element of capital. How will you assign weights for debt or debenture,
preferred stock, and common equity? Debt being the cheapest, your first
choice naturally is debt which you would assign maximum weight. But debt
has to be used within limits, otherwise financial stability of the firm is
affected. Interest on debt is a continuous burden whether there are
supporting earnings or not. Naturally, you do not wish to over expose the
firm to debt and create fears of bankruptcy.
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Total 10.9%
Total 10.5%
Total 11.0%
Total 11.4%
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CAPITAL STRUCTURE – EQUITY VS. DEBT
When you study the above table, you will note that up to 40% debt,
Shobha Developers are in a position to reduce weighted average capital
cost, but once the debt crosses 50%, the weighted average capital cost
starts increasing. That is the main reason why most businesses maintain
their debt/equity ratio to less than 50 thereby satisfying both the creditors
and investors.
Self-training Exercise: 1
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CAPITAL STRUCTURE – EQUITY VS. DEBT
You are in the process of putting down your recommendation on paper for
submission to the Managing Director.
5 The returns from the additional capacity will vary from year to
year. !
Here are some common mistakes financial planners commit. You should
ensure you do not fall prey to them.
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CAPITAL STRUCTURE – EQUITY VS. DEBT
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CAPITAL STRUCTURE – EQUITY VS. DEBT
• Interest rates: The ruling rates of interest determine the WACC. If the
rates in the market rise, there will be direct increase in the WACC. If the
interest rates fall, cost of capital will decrease. When we calculated cost
of capital by the popular Capital Asset Pricing Method (CAPM), we
adopted RFR which stood for risk-free interest rate.
• Risk factor: To estimate cost of capital, we start with the rates of return
required on the firm’s existing equity and debt sources of funds. This
permits us to gauge the firm’s risk appetite. If the new projects to be
undertaken are at the same risk level, the marginal cost of capital is not
likely to vary much. If not, then the new level of risk needs to be
considered while determining the weighted average cost of capital.
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12.6 Summary
The cost of preferred stock is similar to the cost of debt as earnings per
year are constant. As dividends are not expenses and are paid out of after
tax earnings, above adjustment for tax effect is not necessary while
determining cost of preference stock.
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We must realize the fact that the business entity has one more important
and many times quite significant source of ownership or equity capital in
the form of retained earnings. The cost of equity in the form of retained
earnings equals the required rate of return on firm’s stock and it is
determined by dividing the dividend per share earned at the end of the
year by its ruling market price and adding this rate to constant growth rate
in previous dividends.
We are now able to determine the cost of various elements that together
form a business entity’s capital structure. To arrive at optimal capital
structure for the firm, it is now necessary to assign weights to each
element of capital. Debt being the cheapest, your first choice naturally is
debt which you would assign maximum weight. But debt has to be used
within limits, otherwise financial stability of the firm is affected. Interest on
debt is a continuous burden whether there are supporting earnings or not.
With up to 40%, debt firms are normally in a position to reduce weighted
average capital cost, but once the debt crosses 50%, the weighted average
capital cost starts increasing.
While determining weighted average cost of capital, you must avoid these
common six errors: (1) Considering (WACC) as a purely academic exercise,
(2) Accounts payables and provisions form a part of capital, (3) Present
pre-tax rate of current debt is cost of debt, (4) Dividend rate reflects cost
of equity, (5) Retained earnings are undistributed dividends and hence cost
free and(6) WACC is uniform to all projects to be undertaken by a firm.
There are three external factors that affect cost of capital: (a) Interest
rates prevailing in the market, (b) Risk premium in equity market and (c)
Income tax rates as announced by the central government. Balance three
factors internal to the business entity that affect WACC are: Risk appetite
of the firm (x), Capital structure preferred by the firm (y) and Firms
established dividend policy (z).
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5. Suresh, Ramesh and Harish all agreed that, while calculating cost of
debt, income tax rate plays a significant role to make debt an attractive
source. The relevant rate per Suresh was corporate tax rate, per
Ramesh it was the rate on capital gains and Harish insisted it was
personal income tax rate. Who was right among the group?
a. Suresh
b. Ramesh
c. Harish
d. All three
Answers:
1. (c)
2. (d)
3. (c)
4. (c)
5. (a)
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REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter
Summary
PPT
MCQ
Video Lecture
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DIVIDEND POLICY AND DECISIONS
CHAPTER 13
DIVIDEND POLICY AND DECISIONS
“In addition to possessing a good product/service brand and sound market position for
the business entity, the CEO should also pursue a beneficial dividend policy to ensure
continuous growth of the organization.”
Objectives
Structure:
13.1 Introduction
13.2 The Need for Dividends
13.3 Factors that Influence Dividend Decisions
13.4 Companies Act Provisions on Declaration of Dividends
13.5 Dividend Policy and Market Value of Equity Shares
13.6 Model Dividend Policy
13.7 Stock Dividends
13.8 Stock Splits
13.9 Summary
13.10 Multiple Choice Questions
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13.1 introduction
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grow. Question of paying dividends in any form does not arise in this initial
stage.
If the company succeeds in finding a place for itself in the market, the
demand for its products or services creates growth in sales, earnings and
assets. Now, the firm has entered the growth stage. In this stage too, the
rate at which the sales and earnings rise keeps on increasing. Earnings
available are still required for reinvestment. But the firm can keep equity
holders satisfied by declaring bonus issue of equity. Thus, stock dividends
are possible but not cash dividends as retained earnings are fully required
for reinvestment alone. In the later part of this stage, the firm can consider
issue of low cash dividends to assure its equity holders that their decision
to invest in the said firm is bearing fruits.
All along, we are assuming that dividends are to be paid out only if the
business entity cannot make better use of the available retained earnings.
The active base for issue of dividends is retained earnings and not the need
for dividends.
Ask the average Indian what he wants from his investments and the
answer would probably be, ‘stable returns’. This is why bank fixed deposits
and small savings schemes are so popular while stocks account for less
than 5% of total household wealth. Individuals stay away from stocks
because it is a volatile asset class. But take a closer look and you will find
that many companies have given steady income to investors to meet their
shareholders’ preference; they have consistently given back a significant
chunk of their net profits to shareholders in the form of dividends.
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current returns whichever provides better results. They are in no hurry for
immediate funds. In such a situation, decisions arranged under 13.1.1 will
satisfy the stockholders.
However, this may not always be the case as other stockholders prefer
immediate returns in the form of dividends instead of longer term returns
through reinvestment of retained earnings. In this situation, decisions
under 13.1.1 do not fulfill stockholders’ preference. Then the management
cannot engage itself only in determining whether retained earnings or
dividends in hands of stockholders provide higher returns and decide when
to distribute dividends. It has to also consider stockholders’ preference.
Here, the issue is not that shareholders can invest their funds for better
use than their company can. The real issue is what do shareholders desire?
And answer from all shareholders is some funds today rather than all (even
though more) tomorrow. As a result, most companies in India determine
reinvestment opportunities relative to required returns and then modify
resulting decision by their assessment of shareholders’ preference.
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DIVIDEND POLICY AND DECISIONS
Companies with high business growth potential retain most of the retained
earnings for investment and declare modest dividends. Thus, high growth
companies enjoy a low payout ratio and those mature companies with
slower business growth potential have a high dividend payout ratio.
Some financial analysts argue that investors are not concerned with a
company’s dividend policy since they can satisfy their need for current
funds as they can sell a portion of their portfolio of equities if they want
cash. This evidence is called the “dividend irrelevance theory,” and it
essentially indicates that an issuance of dividends should have little to no
impact on stock price. But each investor cannot be expected to sell a
portion of her shares in lieu of dividends as this is very complex alternative
to receipt of dividends direct into her bank account.
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Let us consider FMCG diversified conglomerate ITC. Its shares have yielded
an impressive 26% CAGR in the past ten years (2005-2015), while
maintaining a track record of generous dividend payouts, averaging more
than 50% of the net profit during this period. In the past 10 years, the
company has made a net profit of Rs. 44,925 crore. Of this, Rs. 25,350
crore has been given out as dividend to its shareholders.
A company with substantial net earnings has to consider its cash position
before a decision about dividends can be arranged. Retained earnings are
not fully reflected by liquid cash in the balance sheet. They are often
reflected by inventory and receivables which can be substantial, especially
when sales volumes are increasing. As sales and earnings expand rapidly
there is bound to be an inventory and receivables build-up. It restricts
generation of cash flow and it is uneconomic to liquidate these non-cash
assets for immediate satisfaction of shareholders.
Even if liquid funds are available today from which dividends can be paid
out, it is necessary for the CFO to look at the cash forecast for the next
year before any decision can be arranged. It is quite likely that a major
part of available liquid assets has already been earmarked for execution of
incomplete projects on hand.
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However, a company with sound financial past record can have an easy
access to financial markets and it can arrange funds for dividends through
increasing its debt. Declaration of dividend this way ensures stability in
dividend payout which in turn has positive impact on the firm’s credit
standing. The healthy record of stabile dividends established by this
measure can also permit the company to issue fresh stock later and
liquidate the incremental debt caused by distribution of dividends. In other
words, if retained earnings are on the rise, funds can be raised through
debt to stabilize dividend payout.
Today, the situation has changed. Shareholders do not have to pay any
income tax on dividend income. It is tax free. Companies, on the other
hand, are required to pay dividend distribution tax which is around 15%.
This dividend income exemption has prompted many companies to declare
higher dividends than before claim certain studies by different scholars.
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As per the guideline dated February 11, 1998 from the Government of
India, all profit - making PSUs which are essentially commercial
enterprises should declare the higher of minimum dividend of 20% on
equity or a minimum dividend payout of 20% of post-tax profit. The
minimum dividend pay-out in respect of enterprises in the oil,
petroleum, chemical and other infrastructure sectors such as us should
be 30% of post-tax profits.
!
Dividend should be paid out of: (i) the profit of the company for the
financial year; or (ii) profits for the previous financial years which have not
been transferred to reserves; or (iii) out of both. It has to be ensured that
the board of directors has arranged to set off entire previous losses and
depreciation not provided in previous year or years. Company should pay
dividend to preference shareholders before dividend is paid to the equity
shareholders of the company.
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In any year in which the profits are inadequate or there are no profits, the
company may declare and pay dividend out of past year profit earned and
transferred to reserves subject to the provision of the Companies
(Declaration and Payment of Dividend) Rules, 2014. These rules stipulate
that for the purpose of declaration of dividend out of reserves, company
shall have to fulfill the following conditions:
(i) The rate of dividend shall not exceed the average of three years
immediately preceding that year. (Above condition shall not apply to
the company which has not declared any dividend in each of the three
years immediately preceding that year.)
(ii) The total amount to be drawn from such accumulated profit shall not
exceed 1/10th of the sum of its paid-up share capital and free reserves
as appearing in the latest audited financial statement.
(iii) The amount so withdrawn shall first be utilized to set off the losses
incurred in the financial year in which dividend is declared before any
dividend in respect of equity shares is declared.
(iv) The balance of reserves after such withdrawal shall not fall below 15%
of its paid-up share capital as appearing in the latest audited financial
statement.
The Act further states that after declaration of the dividend, the company
shall deposit amount of dividend (including interim dividend) in separate
account with a scheduled bank. Such amount must be deposited within five
days from the date of declaration of dividend. The dividend must be paid
within thirty days from the date of declaration of dividend. Dividend shall
be paid in cash, i.e., it shall not be paid in kind.
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Two economists, Miller and Modigliani, have propagated that market value
of a company depends on its earning power and whether these earnings
are retained in the business for reinvestment or distributed to its
shareholders in the form of dividends has no relationship with firm’s
market value of shares.
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(b) Transaction cost for buying and selling securities as well as bankruptcy
cost is nil.
(d) The cost of borrowing is the same for investors as well as companies.
(e) Debt financing does not affect companies EBIT (Earnings Before
Income Tax).
(f) Modigliani and Miller approach indicates that value of a leveraged firm
(firm which has a mix of debt and equity) is the same as the value of
an unleveraged firm (firm which is wholly financed by equity) if the
operating profits and future prospects are the same. That is, if an
investor purchases shares of a leveraged firm, it would cost him the
same amount required to buy the shares of an unleveraged firm.
There are some economists who while studying a firm’s dividend policy
assume that its investment decisions are independent of dividend policy,
others argue that dividend and investment decisions are related. We shall
look at two models, one presented by James Walter and other by Myron
Gordon.
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Walter’s Model
1. The firm finances all investment through retained earnings; that is debt
or new equity is not issued.
2. The firm’s internal rate of return (r) and its cost of capital (k) remain
constant.
4. The values of the earnings per share (E), and the divided per share (D)
may be changed in the model to determine results, but any given values
of E and D are assumed to remain constant forever in determining a
given value.
Walter’s formula to determine the market price per share (P) is as follows:
D+(E-D)r/K
P = ———————-
K
where,
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DIVIDEND POLICY AND DECISIONS
The above equation clearly reveals that the market price per share is the
sum of the present value of two sources of income:
(a) The present value of an infinite stream of constant dividends (D/K) and
(b) The present value of the infinite stream of firm’s earnings [r (E – D)/K/
K].
(a) When the rate of return is greater than the cost of capital, the price
per share increases and dividend payout ratio decreases.
(b) When the rate of return is equal to the cost of capital, the price per
share remains constant and does not change with dividend payout
ratio.
(c) When the rate of return is lesser than the cost of capital, the price per
share decreases and dividend payout ratio increases.
(ii) The optimal payout ratio for a normal firm is irrelevant; and
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DIVIDEND POLICY AND DECISIONS
Gordon’s Model
Second very popular model explicitly relating the market value of the firm
to dividend policy is developed by Myron Gordon.
3. The internal rate of return (r) of the firm on its investments is constant.
4. The appropriate discount rate (K) of the firm remains constant and is
greater than the growth rate.
7. The retention ratio (b), once decided upon, is constant. Thus, the
growth rate (g) = br is constant forever.
E1 + (1 - b)
P0 = ———————-
K - br
where,
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The model is based on the premise that what matters is not the actual
dividend amount but the difference between what was expected to happen
and the actual event. This was enunciated by John F. Muth in his paper
entitled “Rational Expectations and the Theory of Price Movements.”
When we apply this theory to the relationship between dividends and price
of scrip on the markets, we arrive at the following conclusions.
However, if the dividend declared was higher than the market expectations,
investors start revising their estimates of firm’s future earnings. This
upward revision to future earnings initiates upward movement in the firm’s
share prices.
Dividend lower than what the market was expecting sets downward trend
in expected future earnings from the firm and drop in share prices. Here
again, the fact that the current year dividend is higher than previous year’s
dividend amount has no upward impact on the share prices. This is
explained by the fact that the market had discounted the dividend that was
higher than the one announced into the price ruling on the day of dividend
announcement.
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Dividend declared in above three situations is the same, but because of the
changing market expectations prices move differently.
Thus, on one hand, we have academicians who proclaim that share prices
are independent of dividend decisions and practical thinkers who prove that
dividends do influence market prices of shares.
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• At the same time, if the business entity is on a growth path and funds
are required for business investments a residual dividend policy may be a
right dividend decision.
1. State of Economy
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DIVIDEND POLICY AND DECISIONS
2. Capital Markets
On the other hand if the capital market is under pressure it is prudent for
the business entity to conserve its surplus funds to be ready to face any
possible liquidity challenges. In a tight capital market conditions, funds are
not freely available; and funds that are available carry a high interest
burden. Under such situation, by restricting the payout ratio, the CFO
preserves internal funds for use whenever required. These ploughed back
funds are there at economic rates compared to what debt funds command
in a tight capital market.
3. Legal Constraints
The Company Law earlier had imposed upon the management certain
percentages of the retained earnings that must be transferred to the
general reserve. The amounts to be transferred increased with the rise in
the rate of dividends. In 2013, these provisions were withdrawn and now it
is left to management to decide what part of earnings to transfer to
reserve and what part to utilize for dividend distribution.
Today, dividend earnings at the hand of shareholders are tax free. The
move is expected to attract investors into share market and thus contribute
to the growth of the organized sector. The company has to pay dividend
distribution tax. But in countries where such exemption on dividend income
does not exist, the CFO has to consider the shareholders’ preferences in
restricting their tax burden. If shareholders are in the upper income
bracket, the dividends earned by them attract a high rate of income tax.
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They prefer to see the price of their shares rising so that they can cash on
capital gains that attract lesser income tax rates. Lower dividend policy can
satisfy these shareholders as with low payout ratio the price of equity
receives healthy lift and opens an opportunity for capital gains.
But when internal funds are required for business growth and shareholders
also want dividends in the form of current income instead of capital gains
later, the CFO has unenviable task of balancing the two opposing demand
for fixed amount of funds. The net returns on funds with shareholders in
the form of dividends and return on the projects that can be executed by
investing retained earnings, have to be compared to arrive at a dividend
decision.
2. Business Nature
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But if the nature of the business is cyclical and future earnings are
variable, a conservative dividend policy suits the situation. Even in a
business boom, a large portion of net earnings has to be carried forward to
take care of ensuing slack phase. The conservative dividend policy also
suits the business units in their early stages of growth when opportunities
for profitable projects exist.
3. Availability of Funds
Companies with healthy credit standing and resulting easy access to capital
markets can, if they find it economical, fulfill opportunities for
remunerative projects through finance from capital market in the form of
debt. Here, the CFO has no compulsions to restrict dividend distribution.
On the other hand, if the company is small, new or otherwise risky or has
already having a high debt-equity ratio, the CFO may find using larger
retained earnings for projects on hand profitable than borrowing from
outside. This situation imposes limits on dividend distribution power of the
CFO.
Normally, newer business units need a major part of earnings for growth
through expansion of activities. The rate at which they grow is on the
increase. Consequently, the number of opportunities for investment with
attractive rate of returns is greater. Naturally, the company will follow a
conservative dividend policy. As the company grows and reaches a stable
rate of growth, requirement for internal funds for investment is normal as
number of opportunities for investment at attractive rates are limited and
there is reasonable access to outside funds at affordable costs. The CFO at
this stage can think of declaring larger dividends. Since the company has
matured, a smaller part of earnings has to be earmarked for investment
and larger portion is available for dividend distribution.
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Available cash is often required to meet debt obligations. Here, the CFO
has to balance the requirements of cash today and tomorrow with cash
required to maintain stable dividends. Adequate working capital to sustain
business takes priority over declaration of larger dividends. One of the
factors behind success of business units is their ability to retain adequate
working capital and maintaining large reserves. Liquidity requirements,
thus, play a major part in deciding how much dividend to be paid and
when.
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DIVIDEND POLICY AND DECISIONS
7. Debt Agreements
Companies with a high debt-equity ratio often are forced to enter into debt
agreements where lenders impose total restriction on distribution of
dividends or permit partial distribution. This restriction allows creditors to
ensure that liquidity of the borrower company is not at stake because of
use of net earnings to declare dividends. If the business entity has entered
in any such type of agreements, then the CFO has to review them before
she makes any announcement of dividends to shareholders.
8. Expansion Plans
These are the major external and internal factors that play an important
role in the dividend distribution process.
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Until now, we confined our study of dividends that are distributed to equity
holders in cash. We, therefore, provided to importance to the fact whether
in addition to net earnings, the business entity also had cash reserves or
liquidity to enable it to declare dividends.
After issue of one share as stock dividend for five shares held
Issue of stock dividends does not increase equity holders’ cash earnings
per se. But if the firm declares the same percentage of cash dividends next
year, their cash earnings are expected to increase by 20%. Further,
marketability of shares is widened as there are more shares floating in the
market than before. Shareholders have an option to sell additional shares
received and thus book capital gains.
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It must be remembered here that before arranging for stock dividends, the
company must assure itself that its earnings are continuing to be robust. If
not, with the distributable surplus showing no growth, it may have to lower
dividend rate as the amount has to be distributed over wider capital (the
effect of bonus shares). This will have negative impact on its shareholders
and its image in the share market.
The Company Law provides for certain pre-conditions for issue of bonus
shares related to: (i) availability of sufficient distributable profits, (ii)
absence of partly paid shares, (iii) use of only free reserves or share
premium received in cash for capitalization, (iv) minimum residual reserve
percentage, etc.
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DIVIDEND POLICY AND DECISIONS
offered one share of company B for every ten shares held by them in
company A. This one for ten ratio looks unattractive to shareholders of
company A. Hence, prior to the scheme of amalgamation is planned, the
company B announces a stock split of five shares at par value of Rs. 2 for 1
share of par value Rs. 10 held earlier. Now when merger scheme is
announced, the company B can offer its five shares (instead of two if stock
split was not there) to shareholders of company A against 10 shares held
by them in company A. The ratio 5 for 10 or 1 for every 2 shares now looks
quite attractive to shareholders of company A.
Before
After issue of one share as stock dividend for five shares held
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DIVIDEND POLICY AND DECISIONS
Thus, you will observe that unlike stock dividend, the stock split does not
increase total equity value of shares held by a shareholder prior to offer of
stock split.
But there are few indirect advantages that can accrue to the shareholders.
To start with, let us assume that shares of the ABC Co. Ltd. were traded at
Rs. 3,500 on stock exchanges. After the split, the market share price drops
down to Rs. 700 (Rs. 3,500 ÷ 5). Many small investors who were not
willing to trade in ABC CO. Ltd. shares earlier because of its high market
price of Rs. 3,500 will now enter the market as the price has come down to
only Rs. 700 which is well within their reach. With more number of
investors for ABC in the market, the share price of ABC now can go up.
However, this is hard to prove as there are several other factors that
influence share prices.
Companies normally do not prune down the dividends after the split by the
split ratio. If ABC had declared a dividend of Rs. 10 per share prior to split,
it will not bring down the dividend for the following year to Rs. 2 (Rs. 10 ÷
5). It will in all probability declare a dividend of at least Rs. 2.50. Thus,
shareholders are going to receive Rs. 12.50 (Rs. 2.50 × 5) against Rs.
10.00 they received per share last year.
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13.9 Summary
However, when investors put their funds into company’s equity stock, they
expect to receive returns, usually more than what they would receive from
investment in term loans/deposits. Some want this return immediately and
at a reasonable fixed rate and balance wish long-term gains usually in the
form of appreciation the market value of their shares. Additionally, there is
a class of investors who want both above. Shareholders’ preference along
with the need for funds by the company together is considered by CFOs to
determine the part of the net earnings to be distributed as dividends.
Other factors that influence dividend decisions are the need for informing
investors about company’s bright prospects, availability of liquid assets,
access to the Financial Markets and Income Tax considerations.
The Companies Act 2013 allows CFOs to determine what proportion of net
earnings has to be retained by them as reserves with the company. Earlier,
these percentages were defined by the Act. The Act further states that,
after declaration of the dividend, the company shall deposit amount of
dividend (including interim dividend) in separate account with a scheduled
bank.
Two economists, Miller and Modigliani, have propagated that market value
of a company depends on its earning power and whether these earnings
are retained in the business for reinvestment or distributed to its
shareholders in the form of dividends has no relationship with firm’s
market value of shares. On the other hand, Professor James E. Walter
argues that the choice of dividend policies almost always affects the value
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of the enterprise. Second very popular model explicitly relating the market
value of the firm to dividend policy is developed by Myron Gordon.
The third school of thought on dividends is based on the premise that what
matters is not the actual dividend amount but the difference between what
was expected to happen and the actual event. This was enunciated by John
F. Muth in his paper entitled “Rational Expectations and the Theory of Price
Movements”.
External factors that affect company’s dividend policy include: (a) state of
economy, (b) capital markets, (c) legal constraints and (d) corporate tax
structure. While internal factors that determine dividend policy include: (a)
firm’s need for funds, (b) business nature, (c) availability of funds, (d)
maturity of business unit, (e) availability of liquid funds, (f) debt
agreements and (g) company’s’ expansion plans.
Dividends are sometimes also offered in the form stock dividends or stock
splits.
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DIVIDEND POLICY AND DECISIONS
a. Liquid assets
b. Funds in the general reserve
c. Credit manager’s approval
d. Stock dividends
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DIVIDEND POLICY AND DECISIONS
a. John F. Muth
b. Myron Gordon
c. James E. Walter
d. Modigliani-Miller
Answers:
1. (c)
2. (d)
3. (a)
4. (c)
5. (a)
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REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter
Summary
PPT
MCQ
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