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1 Financial Management

“Financial Management is the application of the


planning and control functions to the finance function.”-
FINANCIAL MANAGEMENT Howard and Upton.

“Financial Management is the operational activity of a


Unit 1. Introduction. business that is responsible for obtaining and effectively,
utilizing the funds necessary for efficient operations.”-
A business is an activity which is carried on Joseph and Massie.
with the intention of earning profits. If the operations of
a typical manufacturing organization are considered, it From the above definitions of the term finance
involves the purchasing of raw material, processing the given above, it can be concluded that the term business
same with the help of various factors of production like finance mainly involves rising of funds and their
labour and machinery, manufacturing the final product effective utilization keeping in view the over all
and marketing and selling the finished product in the objectives of the firm. The management makes use of
market to earn the profits. the various financial techniques, devices etc for
administering the financial affairs of the firm in the most
Thus production, marketing and business effective and efficient way.
financing are the key operational areas in case of any
business organization, out of which finance is the most
crucial one. This is so as the functions of production and FINANCE AND RELATED DISCIPLINES.
marketing are related with the function of finance. If the
Financial management -an integral part of over
decisions relating to money and funds fail, it may result
all management is not a totally independent area. It
into the failure of the business organization as a whole.
draws heavily on related disciplines and fields of study,
Hence, it is utmost important to take the proper financial
such as Economics, Accounting, Marketing, Production,
decisions and that too at a proper point of time.
and Quantitative Methods.
Finance is the life-blood of modern business FINANCIAL MANAGEMENT AND ECONOMICS.
economy. We cannot imagine a business without finance
in the modern world. It is the basis of all economic The relevance of economics to Financial
activities, no matter; the business is big or small. The Management can be described in the lights of the two
problem of finance and that of financial management is broad areas of economics, -macro economics, and micro
to be dealt within every organisation. The problem of economics. Macro economics is concerned with the over
finance is equally important to government, semi- all institutional environment in which the Company
governments and private bodies, and to profit and non- operates. It looks at the Economy as a whole. It is
profit organisations. concerned with the institutional structure of the banking
system, money and capital markets, financial
Definition. intermediaries, monetary credit, and fiscal policies.
Since the business operates in the macro economic
Financial management is that managerial environment, it is important for financial managers to
activity which is concerned with planning and understand the broad economic environment.
controlling of firms financial resources.
Micro economics deals with the economic
According to Paul. G. Hasings, 'Finance' is the decisions of individuals and organizations. It concerns
management of the monetary affairs of a company. It itself with the determination of optimal operating
includes determining what has to be paid for raising the strategies. A financial manger uses these to run the firm
money on the best terms available and devoting the efficiently and effectively.
available resources to best uses."
FINANCIAL MANAGEMENT AND ACCOUNTING.
Kenneth Midgley and Ronald Burns state. "Financing Accounting function is a necessary input in to
is the process of organizing the flow of funds so that a the finance function. ie. accounting is a sub function of
business can carry out its objectives in the most efficient finance. Accounting generates information about a firm.
manner and meet its obligations as they fall due." The end products of accounting constitute financial
statements such as Balance Sheet, P&L Account and the
statement of changes in financial position. The
“Financial Management is an area of financial decision information contained in this reports and statements
making harmonizing individual motives and enterprise assist financial managers in assessing the past
goals.”-Weston and Brigam. performance and taking future decisions of the firm and
in meeting the legal obligations such as payment of
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2 Financial Management
Taxes and so on. Thus accounting and finance are 2. The focus was on financing problems of Corporate
functionally closely related. enterprises (i.e. Companies). Non corporate
organizations lay outside its scope.
FINANCE AND OTHER RELATED DISCIPLINES.
3. The approach laid over emphasis on the problems of
Apart from economics and accounting, finance long term financing. Hence day to day financial
also draws considerably for its key day today decisions- problems and working capital management of a business
on supportive disciplines such as Marketing, Production, did not receive any attention.
and Quantitative methods. For instance financial
managers should consider the impact of new product MODERN APPROACH.
development and promotion plans made in the
marketing area since their plans will require Capital or The modern approach views the term 'Financial
Fund out flows and have an impact on the projected cash management' in a broad sense and provides a conceptual
flows. Similarly changes in the production process may and analytical frame work for financial decision making.
necessitate capital expenditure which the financial According to it Finance function covers both
managers must evaluate and finance. And finally the acquisitions of funds as well as their allocations. Thus
tools of analysis developed in the quantitative the Financial Management, in the modern sense of the
techniques are helpful in analyzing complex financial term, can be broken down in to 3 major decisions as
management problems. functions of Finance.
1. The investment Decision
Thus the marketing, production and quantitative 2. The Financing Decision
techniques are only indirectly related to day to day 3. The Dividend Policy Decision.
decision making by financial managers and are
supportive in nature , while Economics and Accounting
are primary disciplines on which the financial managers FINANCE FUNCTIONS.
draws substantially.
1. INVESTMENT DECISION.

SCOPE OF FINANCIAL MANAGEMENT. The investment decision relates to the selection


The approach to the scope and functions of of Assets in which funds will be invested by a firm. The
financial management is divided in to two broad Assets which can be acquired fall in to two broad
categories. Traditional Approach and Modem Approach. categories.
TRADITIONAL APPROACH.
A. Long Term or Fixed Assets, which yield
The traditional approach to the scope of
a return over a period of time in future.
financial management refers to the subject matter, in
B. Short term or Current Assets which in
academic literature in the initial stages of its
the normal course of business are convertible in
development, as a separate branch of academic study.
to cash usually within a year.
The term 'Corporation Finance' was used to describe
The aspects of financial decision making with
what is known as Financial management. As the name
reference to long term assets is popularly known as
suggests, the concern of 'Corporation Finance' was with
Capital Budgeting and financial decision making with
the financing of Corporate enterprises. In other words
reference to current assets is popularly termed as
the scope of finance function was treated by the
Working Capital Management.
traditional approach in the narrow sense of procurement
of fund by corporate enterprises to meet their financing
needs. So the field of study included, CAPITAL BUDGETING.

1. Institutional arrangements in the form of financial Capital Budgeting is probably the most crucial
institutions which comprise the organization of financial decisions for a firm. It relates to the selection
Capital Market. of an asset or investment proposal or course of action
2. Financial instruments through which Funds are raised whose benefits are likely to be available in future over
from the capital market. & the life time of the project.
3. The Legal and Accounting relationship between a
firm and its sources of funds. The first aspect of capital budgeting decision
The traditional approach was criticized in the following relates to the choice of the new asset out of the
grounds. alternatives available or the reallocation of capital, when
1. The approach equated finance function with raising an existing asset fails to justify the funds committed.
and administering of funds only. The limitation was that Whether an asset will be accepted or rejected will
internal decision-making was completely ignored. depend upon the relative benefits and returns associated
NSS College. Rajakumari.
3 Financial Management
with it. The measurement of worth of the investment pay cash dividend regularly. Periodically additional
proposal is, there for, a major element in Capital shares, called Bonus shares, are also issued to the
budgeting decisions. existing share holders in addition to the cash dividend.

The second element of Capital Budgeting


decision is the analysis of risk and uncertainty. Since the OBJECTIVES OF FINANCIAL MANAGEMENT.
benefits from the investment proposals extend in to the
future, there accrual is uncertain. They have to be Financial management is concerned with the
estimated under various assumptions of the physical efficient use of capital funds. It evaluates how funds are
volume of sales and the level of prices. An element of procured and used. Financial management covers
risk in the sense of 'uncertainty of future benefits' is thus decision making in three inter related areas namely
involved in the capital budgeting. The returns from Investment, Financing and Dividend policy. The
capital budgeting decisions should, there fore, be financial manager has to take these decisions with
evaluated in relation to the risk associated with it. reference to the objectives of the firm. The objectives
provide a frame work for optimal financial decision
making. There are two widely discussed approaches in
WORKING CAPITAL MANAGEMENT. this regard.
Working capital management is concerned with
1. Profit Maximization Approach
the management of current asset. One aspect of working
2. Wealth Maximization Approach.
capital management is the trade off between profitability
and risk. There is a conflict between profitability and
PROFIT MAXIMISATION APPROACH.
liquidity. If a firm does not have adequate working
capital, it may become illiquid and consequently may According to this approach, actions that increase
not have the ability to meet its current obligations. If profits should be undertaken and that decrease profits
current assets are too large, profitability is adversely should be avoided. Profits maximization approach
affected. The key strategies and considerations in implies that the functions of financial management/
ensuring a trade oil' between profitability and liquidity is Decisions taken by financial mangers (i.e. the
one of the major dimensions of working capital investment, financing, and dividend policy decisions)
management. In addition, the individual current asset should be oriented towards maximization of profits or
should be efficiently managed so that neither in Rupee income of the firm. Or the Company should
adequate nor unnecessary funds are locked up. select those assets, projects, and decisions which are
profitable and reject those which are not.
2. FINANCING DECISIONS.
In the Economic theory, the behaviour of a
The second major decision involved in financial
Company is analyzed in terms of profit maximization.
management is the financing decision. The concern of
While maximizing profits, a firm either produces
the financing decision is with the Financing Mix or
maximum output for a minimum input, or uses
Capital Structure or Leverage. The term capital structure
minimum input for a given out put. So the underlying
refers to the proportion of debt (i.e., fixed interest source
logic of profit maximization is efficiency. Profit is a test
of financing) and equity capital (or variable dividend
of economic efficiency and it provides a yard stick by
security). The financing decision of a firm relates to the
which economic performance can be judged.
choice of the proportion of these sources to finance the
investment requirements. A capital structure with a
The profit maximization criterion has however
reasonable proportion of debt and equity capital is called
been criticized on several grounds. The main technical
optimum capital structure.
flaws are ambiguity, timing of benefits and quality of
3. DIVIDEND POLICY DECISION. benefits.

The third major decision of financial 1. AMBIGUITY.


management is the decision relating to dividend policy.
Two alternatives’ are available in dealing with the One practical difficulty with profit
profits of the firm. They can be distributed to the share maximization criterion for financial decision making is
holders in the form of dividends or they can be retained that, the term profit is a vague and ambiguous concept.
in the business itself. The final decision will depend It is amenable to different interpretations by different
upon the preference of the share holders and the people. It is not clear in what sense the term profit has
investment opportunities available within the firm. The been used. It may be total profit before tax or after tax or
optimum dividend policy is one which maximizes the profitability rate. Rate of profitability may again be in
market value of the Co's shares. Most profitable Co's relation to Share capital; owner's funds, total capital
employed or sales. Furthermore, the word profit does
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4 Financial Management
not speak anything about the short-term and long-term mutually exclusive projects, the one with the highest
profits. Profits in the short-run may not be the same as NPV should be adopted.
those in the long run. A firm can maximise its short-
term profit by avoiding current expenditures on The objective of wealth maximisation takes care
maintenance of a machine. But owing to this neglect, the of the questions of the timing and risk of expected
machine being put to use may no longer be capable of benefits. These problems are handled by selecting an
operation after sometime with the result that the firm appropriate rate for discounting the expected flow of
will have to make huge investment outlay to replace the future benefits. It should be remembered that the
machine. Thus, profit maximisation suffers in the long benefits are measured in terms of cash flows. In
run for the sake of maximizing short-term profit. investment and financing decisions it is flow of cash
Obviously a loose expression like profit can't form the which is important, not the accounting profits. The
basis of operational criterion for financial management. Wealth created by a Company through its actions is
reflected in the market value of companies' shares. The
2. TIMING OF BENEFIT value of the companies share is represented by the
market price, which in turn, is a reflection of the firm's
A more important technical objection to profit financial decisions. The market price of the share serves
maximization is that it ignores the differences in the as the performance indicator.
time pattern of the benefits received. The profit
maximization criterion does not consider the distinction
between returns received in different time periods and
treats all benefits irrespective of the timings, as equally
valuable. This is not true in actual practice as benefits in
early years should be valued more highly than
equivalent benefits in later years. The assumption of
equal value is in consistent with the real world situation.

3. QUALITY OF BENEFITS.

Profit maximization ignores the quality aspect


of benefits associated with a financial course of action.
The term quality refers to the degree of certainty with
which benefits can be expected. As a rule, the more
certain the expected return, the higher is the quality of
the benefits. An uncertain and fluctuating return implies
risk to the investors.

To conclude the profit maximization criterion is


unsuitable and in appropriate as an operational objective
of investment, financing and dividend decision of a firm.
It is not only vague and ambiguous, but it also ignores
risk and time value of money.

WEALTH MAXIMIZATION APPROACH.

This is also known as value maximization or


Net Present Worth maximization. It removes the
technical limitations of profit maximization criterion.
(i.e. ambiguity, timing of benefit and quality of benefit.)

Wealth maximization means maximizing the


Net Present Value (or wealth) of a course of action. The
Net present value of a course of action is the difference
between the present value of its benefits and the present
value of its costs. A financial action which has a positive
Net Present Value creates wealth and there fore it is
desirable. A financial action resulting in negative NPV
should be rejected. Between a number of desirable

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5 Financial Management

UNIT 2.

SOURCE OF FINANCE

Business is concerned with the production and of the enterprise. The funds required in fixed assets
distribution of goods and services for the satisfaction of remain invested in the business for a long period of
needs of society. For carrying out various activities, time.
business requires money. Finance, therefore, is called
the life blood of any business. The financial needs of a (b)Working Capital requirements: No matter how
business can be categorised as follows: small or large a business is, it needs funds for its day-to-
day operations. This is known as working capital of an
(a) Fixed capital requirements: In order to start enterprise, which is used for holding current assets such
business, funds are required to purchase fixed assets like as stock of material, bills receivables and for meeting
land and building, plant and machinery, and furniture current expenses like salaries, wages, taxes and rent. For
and fixtures. This is known as fixed capital requirements financing such requirements short-term funds are
needed.

CLASSIFICATION OF SOURCE OF FUNDS. Where the funds are required for a period of more than
one year but less than five years, medium-term sources
A. Period Basis. of finance are used. These sources include borrowings
from commercial banks, public deposits, lease financing
On the basis of period, the different sources of and loans from financial institutions.
funds can be categorized into three parts. These are
long-term sources, medium-term sources and short-term Short-term funds are those which are required
sources. The long-term sources fulfill the financial for a period not exceeding one year. Trade credit, loans
requirements of an enterprise for a period exceeding 5 from commercial banks and commercial papers are
years and include sources such as shares and debentures, some of the examples of the sources that provide funds
long-term borrowings and loans from financial for short duration. Short-term financing is most
institutions. Such financing is generally required for the common for financing of current assets such as accounts
acquisition of fixed assets such as equipment, plant, etc. receivable and inventories.

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6 Financial Management
(iv) It may lead to increase in the market price of the
equity shares of a company.
B. Ownership Basis.
2. Trade Credit.
On the basis of ownership, the sources can be
classified into ‘owner’s funds’ and ‘borrowed funds’. Trade credit is the credit extended by one trader to
Owner’s funds means funds that are provided by the another for the purchase of goods and services. Trade
owners of an enterprise, which may be a sole trader or credit facilitates the purchase of supplies without
partners or shareholders of a company. Apart from immediate payment. Such credit appears in the records
capital, it also includes profits reinvested in the business. of the buyer of goods as ‘sundry creditors’ or ‘accounts
The owner’s capital remains invested in the business for payable’. Trade credit is commonly used by business
a longer duration and is not required to be refunded organisations as a source of short-term financing. It is
during the life period of the business. Such capital forms granted to those customers who have reasonable amount
the basis on which owners acquire their right of control of financial standing and goodwill. The volume and
of management. Issue of equity shares and retained period of credit extended depends on factors such as
earnings are the two important sources from where reputation of the purchasing firm, financial position of
owner’s funds can be obtained. the seller, volume of purchases, past record of payment
and degree of competition in the market. Terms of trade
‘Borrowed funds’ on the other hand, refer to the funds credit may vary from one industry to another and from
raised through loans or borrowings. The sources for one person to another. A firm may also offer different
raising borrowed funds include loans from commercial credit terms to different customers.
banks, loans from financial institutions, issue of
debentures, public deposits and trade credit. Such 3. Factoring.
sources provide funds for a specified period, on certain
terms and conditions and have to be repaid after the Factoring is a financial service under which the
expiry of that period. A fixed rate of interest is paid by ‘factor’ renders various services which includes: (a)
the borrowers on such funds. At times it puts a lot of Discounting of bills (with or without recourse) and
burden on the business as payment of interest is to be collection of the client’s debts. Under this, the
made even when the earnings are low or when loss is receivables on account of sale of goods or services are
incurred. Generally, borrowed funds are provided on the sold to the factor at a certain discount. The factor
security of some fixed assets. becomes responsible for all credit control and debt
collection from the buyer and provides protection
against any bad debt losses to the firm. There are two
LONG TERM FUNDS methods of factoring —recourse and non-recourse.
Under recourse factoring, the client is not protected
1. Retained Earnings. against the risk of bad debts. On the other hand, the
factor assumes the entire credit risk under non-recourse
A company generally does not distribute all its factoring i.e., full amount of invoice is paid to the client
earnings amongst the shareholders as dividends. A in the event of the debt becoming bad. The
portion of the net earnings may be retained in the organizations, that provide such services include SBI
business for use in the future. This is known as retained Factors and Commercial Services Ltd., Canbank Factors
earnings. It is a source of internal financing or self Ltd., Foremost Factors Ltd.etc.
financing or ‘ploughing back of profits’. The profit
available for ploughing back in an organisation depends 4. Lease Financing.
on many factors like net profits, dividend policy and age
of the organisation. A lease is a contractual agreement whereby one
party i.e., the owner of an asset grants the other party the
Merits. right to use the asset in return for a periodic payment. In
other words it is a renting of an asset for some specified
The merits of retained earning as a source of finance are period. The owner of the assets is called the ‘lessor’
as follows: while the party that uses the assets is known as the
‘lessee’ (see Box A). The lessee pays a fixed periodic
(i) Retained earnings is a permanent source of funds amount called lease rental to the lessor for the use of the
available to an organisation; asset. The terms and conditions regulating the lease
(ii) It does not involve any explicit cost in the form of arrangements are given in the lease contract. At the end
interest, dividend or floatation cost; of the lease period, the asset goes back to the lessor.
(iii) As the funds are generated internally, there is a Lease finance provides an important means of
greater degree of operational freedom and flexibility; modernization and diversification to the firm. Such type

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7 Financial Management
of financing is more prevalent in the acquisition of represent the ownership of a company and thus the
such assets as computers and electronic equipment capital raised by issue of such shares is known as
which become obsolete quicker because of the fast ownership capital or owner’s funds. Equity share capital
changing technological developments. While making the is a prerequisite to the creation of a company. Equity
leasing decision, the cost of leasing an asset must be shareholders do not get a fixed dividend but are paid on
compared with the cost of owning the same. the basis of earnings by the company. They are referred
to as ‘residual owners’ since they receive what is left
after all other claims on the company’s income and
5. Public Deposits. assets have been settled. They enjoy the reward as well
as bear the risk of ownership. Their liability, however, is
The deposits that are raised by organisations directly limited to the extent of capital contributed by them in
from the public are known as public deposits. Rates of the company. Further, through their right to vote, these
interest offered on public deposits are usually higher shareholders have a right to participate in the
than that offered on bank deposits. Any person who is management of the company.
interested in depositing money in an organisation can do
so by filling up a prescribed form. The organisation in Merits.
return issues a deposit receipt as acknowledgment of the
debt. Public deposits can take care of both medium and The important merits of raising funds through
short-term financial requirements of a business. The issuing equity shares are given as below:
deposits are beneficial to both the depositor as well as to (i) Equity shares are suitable for investors who are
the organisation. While the depositors get higher interest willing to assume risk for higher returns;
rate than that offered by banks, the cost of deposits to (ii) Payment of dividend to the equity shareholders is
the company is less than the cost of borrowings from not compulsory. Therefore, there is no burden on
banks. Companies generally invite public deposits for a the company in this respect;
period up to three years. The acceptance of public (iii) Equity capital serves as permanent capital as it is to
deposits is regulated by the Reserve Bank of India. be repaid only at the time of liquidation of a company.
As it stands last in the list of claims, it provides a
6. Commercial Paper (CP). cushion for creditors, in the event of winding up of a
company;
Commercial Paper emerged as a source of short (iv) Equity capital provides credit worthiness to the
term finance in our country in the early nineties. company and confidence to prospective loan providers;
Commercial paper is an unsecured promissory note (v) Funds can be raised through equity issue without
issued by a firm to raise funds for a short period, varying creating any charge on the assets of the company. The
from 90 days to 364 days. It is issued by one firm to assets of a company are, therefore, free to be mortgaged
other business firms, insurance companies, pension for the purpose of borrowings, if the need be;
funds and banks. The amount raised by CP is generally (vi) Democratic control over management of the
very large. As the debt is totally unsecured, the firms company is assured due to voting rights of equity
having good credit rating can issue the CP. Its regulation shareholders.
comes under the purview of the Reserve Bank of India.
Limitations.
7. Issue of Shares.
The major limitations of raising funds through
The capital obtained by issue of shares is known as issue of equity shares are as follows:
share capital. The capital of a company is divided into (i) Investors who want steady income may not prefer
small units called shares. Each share has its nominal equity shares as equity shares get fluctuating returns;
value. For example, a company can issue 1,00,000 (ii) The cost of equity shares is generally more as
shares of Rs. 10 each for a total value of Rs. 10,00,000. compared to the cost of raising funds through other
The person holding the share is known as shareholder. sources;
There are two types of shares normally issued by a (iii) Issue of additional equity shares dilutes the voting
company. These are equity shares and preference shares. power, and earnings of existing equity shareholders;
The money raised by issue of equity shares is called (iv) More formalities and procedural delays are involved
equity share capital, while the money raised by issue of while raising funds through issue of equity share.
preference shares is called preference share capital.
(b) Preference Shares.
(a) Equity Shares.
The capital raised by issue of preference shares
Equity shares is the most important source of is called preference share capital. The preference
raising long term capital by a company. Equity shares shareholders enjoy a preferential position over equity

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8 Financial Management
shareholders in two ways: (i) receiving a fixed rate of (v) Preference shareholders have a preferential right of
dividend, out of the net profits of the company, before repayment over equity shareholders in the event of
any dividend is declared for equity shareholders; and (ii) liquidation of a company;
receiving their capital after the claims of the company’s (vi) Preference capital does not create any sort of charge
creditors have been settled, at the time of liquidation. In against the assets of a company.
other words, as compared to the equity shareholders, the
preference shareholders have a preferential claim over 8. Debentures.
dividend and repayment of capital. Preference shares
resemble debentures as they bear fixed rate of return. Debentures are an important instrument for raising
Also as the dividend is payable only at the discretion of long term debt capital. A company can raise funds
the directors and only out of profit after tax, to that through issue of debentures, which bear a fixed rate of
extent, these resemble equity shares. Thus, preference interest. The debenture issued by a company is an
shares have some characteristics of both equity shares acknowledgment that the company has borrowed a
and debentures. Preference shareholders generally do certain amount of money, which it promises to repay at a
not enjoy any voting rights. A company can issue future date. Debenture holders are, therefore, termed as
different types of preference shares. creditors of the company. Debenture holders are paid a
fixed stated amount of interest at specified intervals.
Public issue of debentures requires that the issue be
Types of Preference Shares ; rated by a credit rating agency like CRISIL (Credit
Rating and Information Services of India Ltd.) on
1. Cumulative and Non-Cumulative: The preference aspects like track record of the company, its
shares which enjoy the right to accumulate unpaid profitability, debt servicing capacity, credit worthiness
dividends in the future years, in case the same is not and the perceived risk of lending.
paid during a year are known as cumulative preference
shares. On the other hand, on non-cumulative shares, A company can issue different types of
dividend is not accumulated if it is not paid in a debentures . Issue of Zero Interest Debentures (ZID)
particular year. which do not carry any explicit rate of interest has also
become popular in recent years. The difference between
2. Participating and Non-Participating: Preference the face value of the debenture and its purchase price is
shares which have a right to participate in the further the return to the investor.
surplus of a company shares which after dividend at a
certain rate has been paid on equity shares are called Types of Debentures.
participating preference shares. The non-participating
preference are such which do not enjoy such rights of 1. Secured and Unsecured: Secured debentures are
participation in the profits of the company. such which create a charge on the assets of the company,
thereby mortgaging the assets of the company.
3. Convertible and Non-Convertible: Preference Unsecured debentures on the other hand do not carry
shares that can be converted into equity shares within a any charge or security on the assets of the company.
specified period of time are known as convertible 2. Registered and Bearer: Registered debentures are
preference shares. On the other hand, non-convertible those which are duly recorded in the register of
shares are such that cannot be converted into equity debenture holders maintained by the company. These
shares. can be transferred only through a regular instrument of
transfer. In contrast, the debentures which are
Merits. transferable by mere delivery are called bearer
debentures.
The merits of preference shares are given as follows: 3. Convertible and Non-Convertible: Convertible
(i) Preference shares provide reasonably steady income debentures are those debentures that can be converted
in the form of fixed rate of return and safety of into equity shares after the expiry of a specified period.
investment; On the other hand, non-convertible debentures are those
(ii) Preference shares are useful for those investors who which cannot be converted into equity shares.
want fixed low risk; 4. First and Second: Debentures that are repaid before
(iii) It does not affect the control of equity shareholders other debentures are repaid are known as first
over the management as preference shareholders don’t debentures. The second debentures are those which are
have voting rights; paid after the first debentures have been paid back.
(iv) Payment of fixed rate of dividend to preference
shares may enable a company to declare higher rates of Merits.
dividend for the equity shareholders in good times;
The merits of raising funds through debentures are given
as follows:
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9 Financial Management
(i) It is preferred by investors who want fixed income (ICICT), Industrial Development Bank of India (IDBI),
at lesser risk; and Industrial Reconstruction Corporation of India
(ii) Debentures are fixed charge funds and do not (IRCI). They mainly provide long-term finance for large
participate in profits of the company; companies. On the other hand, at the state level there are
(iii) The issue of debentures is suitable in the situation State Financial Corporations (SFCs) and Industrial
when the sales and earnings are relatively stable; Development Corporations (SIDCs). These state level
(iv) As debentures do not carry voting rights, financing institutions mainly provide long-term finance to
through debentures does not dilute control of equity relatively smaller companies.
shareholders on management;
(v) Financing through debentures is less costly as These institutions (both national level and state
compared to cost of preference or equity capital as the level) are known as 'Development Banks' because their
interest payment on debentures is tax deductible. main objective is to provide financial assistance to
industrial enterprises for investment projects, expansion
9. Commercial Banks. or modernisation of plants in accordance with the
priorities laid down in the Five Year Plans.
Commercial banks occupy a vital position as they
provide funds for different purposes as well as for Besides the development banks, there are several
different time periods. Banks extend loans to firms of all other institutions known as investment companies or
sizes and in many ways, like, cash credits, overdrafts, investment trusts which subscribe to the shares and
term loans, purchase/discounting of bills, and issue of debentures offered to the public by companies. For
letter of credit. The rate of interest charged by banks example, the Life Insurance Corporation of India (LIC),
depends on various factors such as the characteristics of General Insurance Corporation of India (GIC), the Unit
the firm and the level of interest rates in the economy. Trust of India (UTI), etc., come under this category.
The loan is repaid either in lump sum or in installments.
Bank credit is not a permanent source of funds. Though
banks have started extending loans for longer periods, Merits.
generally such loans are used for medium to short
periods. The borrower is required to provide some The merits of raising funds through financial institutions
security or create a charge on the assets of the firm are as follows:
before a loan is sanctioned by a commercial bank. (i) Financial institutions provide long term finance,
which are not provided by commercial banks;
Merits (ii) Besides providing funds, many of these institutions
The merits of raising funds from a commercial bank are provide financial, managerial and technical advice and
as follows: consultancy to business firms;
(i) Banks provide timely assistance to business by (iii) Obtaining loan from financial institutions increases
providing funds as and when needed by it. the goodwill of the borrowing company in the capital
(ii) Secrecy of business can be maintained as the market. Consequently, such a company can raise funds
information supplied to the bank by the borrowers is easily from other sources as well;
kept confidential; (iv) As repayment of loan can be made in easy
(iii) Formalities such as issue of prospectus and installments, it does not prove to be much of a burden on
underwriting are not required for raising loans from a the business;
bank. This, therefore, is an easier source of funds; (v) The funds are made available even during periods of
(iv) Loan from a bank is a flexible source of finance as depression, when other sources of finance are not
the loan amount can be increased according to business available.
needs and can be repaid in advance when funds are not
needed. 11. International Financing.

10. Special Financial Institutions. In addition to the sources discussed above, there are
various avenues for organisations to raise funds
After independence a large number of financial internationally. With the opening up of an economy and
institutions have been established in India with the the operations of the business organisations becoming
primary objective of providing long-term financial global, Indian companies have an access to funds in
assistance to industrial enterprises. Some of these global capital market. Various international sources
institutions have been set up on the initiative of the from where funds may be generated include:
Central Government, while others have been set up in
different states on the initiative of the concerned State (i) Commercial Banks ( Foreign): Commercial
Governments. Thus there are all-India institutions like banks all over the world extend foreign currency loans
Industrial Finance Corporation of India (IFCI), for business purposes. They are an important source of
Industrial Credit and Investment Corporation of India financing non-trade international operations. The types
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10 Financial Management
of loans and services provided by banks vary from raw materials must be purchased at regular intervals,
country to country. For example, Standard Chartered workers must be paid wages regularly, water and power
emerged as a major source of foreign currency loans to charges have to be paid regularly. Thus there is a
the Indian industry. continuous necessity of liquid cash to be available for
meeting these expenses. For financing such
(ii) International Agencies and Development requirements short-term funds are needed. There are a
Banks: A number of international agencies and number of sources of short-term finance which are listed
development banks have emerged over the years to below:
finance international trade and business. These bodies
provide long and medium term loans and grants to 1. Trade credit
promote the development of economically backward 2. Bank credit
areas in the world. These bodies were set up by the – Loans and advances
Governments of developed countries of the world at – Cash credit
national, regional and international levels for funding – Overdraft
various projects. The more notable among them include – Discounting of bills
International Finance Corporation (IFC), EXIM Bank 3. Customers’ advances
and Asian Development Bank. 4.. Loans from co-operatives.
5. Indigenous bankers.
(iii) International Capital Markets: Modern
organisations including multinational companies depend 1. Trade Credit.
upon sizeable borrowings in rupees as well as in foreign
currency. Prominent financial instruments used for this Trade credit refers to credit granted to
purpose are: manufactures and traders by the suppliers of raw
material, finished goods, components, etc. Usually
(a) Global Depository Receipts (GDR’s): The local business enterprises buy supplies on a 30 to 90 days
currency shares of a company are delivered to the credit. This means that the goods are delivered but
depository bank. The depository bank issues depository payments are not made until the expiry of period of
receipts against these shares. Such depository receipts credit. This type of credit does not make the funds
denominated in US dollars are known as Global available in cash but it facilitates purchases without
Depository Receipts (GDR). GDR is a negotiable making immediate payment. This is quite a popular
instrument and can be traded freely like any other source of finance.
security. In the Indian context, a GDR is an instrument
issued abroad by an Indian company to raise funds in 2. Bank Credit.
some foreign currency and is listed and traded on a
foreign stock exchange. A holder of GDR can at any Commercial banks grant short-term finance to
time convert it into the number of shares it represents. business firms which is known as bank credit. When
The holders of GDRs do not carry any voting rights but bank credit is granted, the borrower gets a right to draw
only dividends and capital appreciation. Many Indian the amount of credit at one time or in installments as and
companies such as Infosys, Reliance, Wipro and ICICI when needed. Bank credit may be granted by way of
have raised money through issue of GDRs. loans, cash credit, overdraft and discounted bills.

(b) Foreign Currency Convertible Bonds (FCCB’s): (i) Loans


Foreign currency convertible bonds are equity linked When a certain amount is advanced by a bank
debt securities that are to be converted into equity or repayable after a specified period, it is known as bank
depository receipts after a specific period. Thus, a holder loan. Such advance is credited to a separate loan account
of FCCB has the option of either converting them into and the borrower has to pay interest on the whole
equity shares at a predetermined price or exchange rate, amount of loan irrespective of the amount of loan
or retaining the bonds. The FCCB’s are issued in a actually drawn. Usually loans are granted against
foreign currency and carry a fixed interest rate which is security of assets.
lower than the rate of any other similar nonconvertible
debt instrument. FCCB’s are listed and traded in foreign (ii) Cash Credit
stock exchanges. FCCB’s are very similar to the It is an arrangement whereby banks allow the
convertible debentures issued in India. borrower to withdraw money upto a specified limit. This
limit is known as cash credit limit. Initially this limit is
granted for one year. This limit can be extended after
SHORT TERM FUNDS. review for another year. However, if the borrower still
desires to continue the limit, it must be renewed after
After establishment of a business, funds are three years. Rate of interest varies depending upon the
required to meet its day to day expenses. For example
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11 Financial Management
amount of limit. Banks ask for collateral security for of these banks are largely comparable to the functions of
the grant of cash credit. In this arrangement, the commercial banks.
borrower can draw, repay and again draw the amount
within the sanctioned limit. Interest is charged only on 5. Indigenous Bankers.
the amount actually withdrawn and not on the amount of
entire limit. They are private individuals engaged in the
business of financing small and local business units.
(iii) Overdraft They provide short term and medium term loans.
However they charge very high rates of interest and are,
When a bank allows its depositors or account therefore, considered only as a last resort of finance.
holders to withdraw money in excess of the balance in
his account upto a specified limit, it is known as
overdraft facility. This limit is granted purely on the
basis of credit-worthiness of the borrower. Banks
generally give the limit upto Rs.20,000. In this system,
the borrower has to show a positive balance in his
account on the last friday of every month. Interest is
charged only on the overdrawn money. Rate of interest
in case of overdraft is less than the rate charged under
cash credit.

(iv) Discounting of Bill

Banks also advance money by discounting bills


of exchange and promissory notes.. When these
documents are presented before the bank for
discounting, banks credit the amount to cutomer’s
account after deducting discount. The amount of
discount is equal to the amount of interest for the period
of bill.

3. Customers’ Advances.

Sometimes businessmen insist on their


customers to make some advance payment. It is
generally asked when the value of order is quite large or
things ordered are very costly. Customers’ advance
represents a part of the payment towards price on the
product which will be delivered at a later date.
Customers generally agree to make advances when such
goods are not easily available in the market or there is
an urgent need of goods. A firm can meet its short-term
requirements with the help of customers’ advances.

4. Loans from Co-operative Banks

Co-operative banks are a good source to procure


short-term finance. Such banks have been established at
local, district and state levels. District Cooperative
Banks are the federation of primary credit societies. The
State Cooperative Bank finances and controls the
District Cooperative Banks in the state. They are also
governed by Reserve Bank of India regulations. Some of
these banks like the Vaish Co-operative Bank was
initially established as a co-operative society and later
converted into a bank. These banks grant loans for
personal as well as business purposes. Membership is
the primary condition for securing loan. The functions

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12 Financial Management
.

Unit 3. Sometimes, working capital is divided into two varieties


WORKING CAPITAL MANAGEMENT as:
i) Permanent working capital
Introduction ii) Variable working capital

Capital required for a business can be classified Permanent Working Capital: (Fixed working
under two main heads: capital):- Though working capital has a limited life and
usually not exceeding a year, in actual practice some
i. Fixed Capital
part of the investment in that is always permanent. Since
ii. Working Capital firms have relatively longer life and production does not
Fixed capital / Long term funds is required to stop at the end of a particular accounting period some
meet long term obligations namely purchase of fixed investment is always locked up in the form of raw
assets such as plant & machinery, land, building, materials, work-in-progress, finished stocks, book debts
furniture etc. Any business requires funds to meet short- and cash. The investment in these components of
term purposes such as purchase of raw materials, working capital is simply carried forward to the next
payment of wages and other day-to-day expenses. These year. This minimum level of investment in current assets
funds are called Working capital. In short, Working that is required to continue the business without
Capital is the funds required to meet day-to-day interruption is referred to as permanent working capital.
operations of a business firm. And hence study of
Working capital is considered to be very significant.
An inefficient management of working capital leads
to not only loss of profits but also to the closure of
the business firm.
There are two concepts of Working capital namely,
1. Gross Working Capital (GWC)
2. Net Working Capital.
Generally working capital refers to the gross
working capital and represents funds invested in total
current assets of the firm. That means according to
this concept working capital means Total Current
Assets.
Net Working Capital is often referred to as
circulating capital and represents the excess of current
assets over current liabilities. Current liabilities are
short-term obligations which are to be paid in the
ordinary course of the business within a short period of Fluctuating (Variable Working Capital): This is also
one accounting year. Net working capital is positive known as the circulating or transitory working capital.
when current assets exceed current liabilities. It is This is the amount of investment required to take care of
negative when current liabilities exceed current assets. the fluctuations in the business activity. While
Working capital management is concerned with permanent working capital is meant to take care of the
the problems that arise in attempting to manage the minimum investment in various current assets, variable
current assets, current liabilities and the inter working capital is expected to care for the peaks in the
relationship that exist between them. The goal of business activity.
working capital management is to manage firms current
assets and current liabilities in such a way that a NEED FOR WORKING CAPITAL - OPERATING
satisfactory level of working capital is maintained. This CYCLE.
is so because, if the firm can’t maintain a satisfactory The basic aim of Financial management is to
level of working capital, it is likely to become insolvent. maximize the wealth of the share holders and in order to
achieve this; it is necessary to generate sufficient sales
TYPES OF WORKING CAPITAL and profit. However sales do not convert in to cash
instantly. The time between purchase of inventory items
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13 Financial Management
(raw material or merchandise) for the production and cash. The cycle, of course, takes some time to complete.
their conversion into cash is known as operating cycle The longer the period of this conversion the longer is the
or working capital cycle.. operating cycle. A standard operating cycle may be for
A study of the operating cycle would reveal that any time period but does not generally exceed a
the funds invested in operations are re-cycled back into financial year.

If it were possible to complete the sequence capital. At the other extreme are trading and financial
instantly, there would be no need for current enterprises. The nature of their business is such that they
assets( working capital). But since it is not possible, the have to maintain a sufficient amount of cash, inventories
firm is forced to have current assets. Since cash inflows and book debts. They have necessarily to invest
and outflows do not match, the firm has to keep cash for proportionately large amount in working capital.
meeting short term obligations. 2. Production Cycle.
Another factor which affects is production cycle. The
FACTORS DETERMINING THE WORKING term production cycle refers to the time involved in the
CAPITAL REQUIREMENTS. manufacture of goods. It covers the time span between the
purchase of raw materials and the completion of the
manufacturing process leading to the production of finished
The total working capital requirement of a firm is
goods. Funds will have to be necessarily tied up during the
determined by a wide variety of factors. These factors
process of manufacture, necessitating enhanced working
affect different organisations differently and they also vary
capital. The longer the time span (production cycle), the larger
from time to time. In general the following factors are
will be the funds tied up and there fore, the larger the working
involved in a proper assessment of the amount of working
capital needed and vice versa. Further even within the same
capital needed.
group of industries, the operating cycle may be different due to
technological considerations. For economy in working
1. General nature of business. capital, that process should be selected which has a shorter
The working capital requirements of an enterprise manufacturing process. Appropriate policies concerning terms
are basically related to the conduct of those business. of credit for raw materials and other supplies and advance
Enterprises fall in to some broad categories depending on the payment from customers can help in reducing working capital
nature of their business. For instance, public utilities have requirement.
certain features which have a bearing on their walking capital
needs. The two relevant features are Cash nature of 3. Business cycle.
business; and Sale of services than commodities. In view of
The working capital requirements are also determined
these features they do not maintain big inventories and have
by the nature of the business cycle. During the boom period the
there fore, probably little or least requirement of working
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14 Financial Management
need for working capital is likely to grow to cover the lag Higher profit margin of a Co would generate more
between increased sales and receipt of cash as well as to internal funds.. Net profit is a source of working capital to the
finance purchases of additional material to face the expansion of extent that it has been earned in cash. The availability of
the level of activity. The decline stage in the business cycle such funds for working capital would depend upon level
will have exactly an opposite effect on the level of working of tax, dividend and reserves, and depreciations.
capital requirement. The decline in the economy is associated a. Level of Tax:- The amount of tax to be paid is
with a fall in the volume of sales, which will lead to a fall in determined by the prevailing tax regulations and very often
the level of inventories and book debts. The need for taxes have to be paid in advance. An adequate provision
working capital in recessionary condition is bound to for tax is an important aspect of working capital planning. If tax
decline. liability increases, it will lead to an increase in the level of
working capital and vice versa.
b. Dividend Policy:- The payment of dividend
4. Production policy. consumes cash resource and affects working capital. If the
firm does not pay dividend and but retains the profit, working
The quantum of working capital is also
capital will increase.
determined by production policy. In the case of certain lines of
business, the demand for the product is seasonal ie they will c. Depreciation Policy. :- as depreciation charges do not
be purchased during certain months of the year. Such involve any cash out flow, the amount so retained can be used as
companies may either confine their production only to working capital.
periods when goods are purchased or they follow a steady
production policy through out the year. In the former case 9 Price Level Changes.
there will be serious production problems. During slack season
Changes in the price level also affect the
the firm will have to maintain its working force and physical
requirement of working capital. Rising prices would
facilities with out adequate production and sales. A steady
necessitate the use of more funds for maintaining an
production through out the year will cause large
existing level of activity. For the same level of materials
accumulation of finished goods. This will require additional
and assets higher cash out flows are required. The effect of
working capital.
rising prices will be that a higher level of working capital is
needed.
5. Credit Policy.
The level of walking capital is also determined by the MANAGEMENT OF CASH.
credit policy which relates to sales and purchase. The credit
sales will result in higher amount of debtors and more
working capital. On the other hand if liberal credit terms Cash is an important current asset for the
are available from the suppliers of goods the need for working operations of business. Cash is the basic input that keeps
capital will be less. The walking capital requirements of a business running continuously and smoothly. Too much
business are, thus, affected by the terms of purchase and sales. cash and too little cash will have a negative impact on
the overall profitability of the firm as too much cash
would mean cash remaining idle and too less cash would
6. Growth and Expansion. hamper the smooth running of the operations of the firm.
As a Co grows it is logical to expect that a larger Therefore, there is need for the proper management of
amount of working capital will be required. It is difficult cash to ensure high levels of profitability. It is a usual
to determine the relationship between the growth in the practice to include near cash items such as marketable
volume of business of a Co and the increase in the working securities and bank term deposits in cash. The basic
capital. Other things being equal, growing Go's need more characteristics of near cash items is that, they can be
working capital than those that are static. quickly and easily converted into cash without any
transaction cost or negligible transaction cost.
7. Availability of Raw Material.
The availability of Raw material without interruption Motives for Holding Cash. The firm’s need to
would some times affect working capital. There may be some hold cash may be attributed to the three motives given
material which cant be procured easily either because their below:
sources are few or irregular. To sustain smooth production  The transaction motive.
the firm might be compelled to purchase and stock them
 The precautionary motive.
in large quantities. This will result in excessive inventory of
such materials.  The speculative motive.
 The Compensation motive.
8 Profit level.

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15 Financial Management
1.Transaction Motive: The transaction motive In the normal course of business, (inns
requires a firm to hold cash to conduct its business in the have to make payment of cash on a regular and
ordinary course and pay for operating activities like continuous basis to suppliers of goods, employees, and
purchases, wages and salaries, other operating expenses, so on. At the same time there is a constant inflow of
taxes, dividends, payments for utilities etc. The basic cash through collections from debtors. A basic objective
reason for holding cash is non-synchronization between of cash management is to meet the payment schedule,
cash inflows and cash outflows. Firms usually do not that is to have sufficient cash to meet the cash
hold large amounts of cash, instead the cash is invested disbursement needs of a firm It prevents insolvency or
in market securities whose maturity corresponds with bankruptcy arising out of the in ability of a firm to meet
some anticipated payments. Transaction motive mainly its obligations. It also helps in keeping good relation
refers to holding cash to meet anticipated payments with banks and creditors. Cash discount can be availed
whose timing is not perfectly matched with cash of, if the payment is made within the due date.
inflows. B. Minimising Funds Locked up as Cash
2.Precautionary Motive: The precautionary Balance.
motive is the need to hold cash to meet uncertainties and In minimising the cash balance, two conflicting
emergencies. The quantum of cash held for aspects have to be reconciled. A higher cash balance
precautionary objective is influenced by the degree of ensures proper payment with all its advantages. But
predictability of cash flows. In case cash flows can be this will result in a large balance of cash remaining
accurately estimated the cash held for precautionary idle. Low level of cash balance may result in failure of
motive would be fairly low. Another factor which the firm to meet the payment schedule. The finance
influences the quantum of cash to be maintained for this manager should, there fore, try to have an optimum
motive is, the firm’s ability to borrow at short notice. amount of cash balance, keeping in view the above factors.
Precautionary balances are usually kept in the form of
cash and marketable securities. The cash kept for
precautionary motive does not earn any return, CASH MANAGEMENT TECHNIQUES / PROCESS.
therefore, the firms should invest this cash in highly
liquid and low risk marketable securities in order to earn The strategic aspect of an efficient cash management are: -
some returns. 1. Preparation of cash budget
3. Speculative Motive. A firm also keeps cash 2. Efficient Inventory Management
balance to take advantage of un expected opportunities,
typically outside the normal course of business. Such 3. Speedy Cash collection
motive is, there fore, of purely speculative nature. For 4. Delaying Payments.
e.g., a firm may like to take advantage of an opportunity of
purchase raw materials at the reduced price on payment of SPEEDY CASH COLLECTION.
immediate cash. Similarly it may like to keep some cash
balance to make profit by buying securities in times when
their prices fall. In managing cash efficiently, the cash inflow
4. Compensation Motive. Another motive process can be accelerated through systematic planning and
to hold cash balance is to compensate banks for refined techniques. There are two broad approaches to do
providing certain services and loans. Banks provide a this. In the first place the customers should be encouraged
variety of services to business firms such as clearance of to pay as quickly as possible. Secondly the payment from
cheque, supply of credit information, transfer of funds the customers should be converted in to cash with out any
and so on. While for some of these services banks delay.
charge a commission or fees, for others they seek
indirect compensation. Usually clients are required to A. Prompt payment by customers.
maintain a minimum balance of cash at the bank. Since One way to ensure prompt payment by customers is
this balance cant be utilised by the firms for transaction prompt billing. What the customer has to pay and the dale
purpose, the bank themselves can use the amount to earn and period of payment should be notified accurately and in
a return. Such balances are called as compensating advance. The use of mechanical devises for billing along
balances. with a self addressed return envelope will speed up the
payment.
OBJECTIVES OF CASH MANAGEMENT. Another technique is offering cash discount.
The basic objectives of cash management are The availability of discount implies savings to customers.
two fold. Meeting payment schedule and minimising To avail these facility, customers would be eager to make
funds locked up as cash balance. payment early.

A. Meeting Payment Schedule. B. Early conversion of payment in to cash.


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16 Financial Management
A firm can conserve cash and reduce its 1. Avoidance of early payment
requirements for cash balance, if it can speed up its cash 2. Centralised disbursement
collections. Cash collection can be accelerated by
3. Floats
reducing the time gap between the time the customer
pays the bill and the time the cheque is collected and funds 4. Accruals
become available for the firms use.
Three steps are involved in this time interval. 1.Avoidance of early payments.
1 Transit or Mailing time :- This is the lime taken by One way to delay payments is to avoid early
the post office too transfer the cheque from the payments. According to the terms of credit, a firm is
customers to the firm. This delay is referred to as Postal required to make payment within a stipulated period. If
Float. the firm pays it accounts payable before the due date, it
2. Time taken in processing the cheque within the firm has no special advantage. Thus a firm would be well
before they are deposited in the Bank. advised not to make payments early, i.e. not before the
due date.
3. Collection time within the bank called Bank Float.
2.Centralised Disbursements.
The early conversion of payment in to cash, as a
technique to speed up collection , is done to reduce the
time lag between depositing of the cheque by the customer All the payments should be made by the head
and the realisation of money by the firm. The collection of office from a centralised disbursement account. Such an
account receivable can be accelerated, by reducing arrangement would delay payments, because it involves
transit, processing and collection time. An important cash increase in the transit time. The remittance from the
management technique adopted for this is Decentralised head office to the customers in distant places would
Collection. The principal methods of establishing a involve more mailing time.
decentralised collection network are;
3. Floats
A. Concentration Banking . It refers to the amount of money tied up in cheques
This is a system of operating through a number of that have been written, but not yet en cashed It is due to
collection centres, instead of a single collection centre at transit and payment delays. There is a time lag between the
the head office. Under this arrangement, the customers are issue of a cheque and its presentation. So although the
required to send their payments (cheques) to the collection cheque has been issued, cash would be required later,
centres covering their region. It reduces the mailing time, & when the cheque is presented for encashment. There fore a
time involved in sending the bill to the customers. firm can send remittance, although it does not have cash in
its Bank A/C at the time of issue of cheque. There are two
ways of doing it.
B. Lock Box System.
1. Paying from a distant Bank: The firm may issue a
Under this system, a firm arranges a Post office Lock Box
cheque on banks away from the creditor's bank. This
at important collection centres. The customers are required
would involve relatively longer transit time for the
to remit payments to the Post office lock box. The firms
creditor's bank to gel payment and thus enable the firm
local bank is given the authority to pick up the remittances
to use its funds longer.
directly from the Box. The bank pick ups the mail several
times a day and deposits the cheques in the firms A/C. 2. Cheque Encashment Analysis : Another way is to
after crediting the A/C, the bank sends a deposit slip along analyse on the basis of past experience, the time lag in
with the list of payments and other enclosures if any. the issue of cheques and their encashment. For E.g.:
Cheques issued to pay wages and salary may not be
Although the use of concentration banking and
cashed immediately, it may be spread over a few days,
lock box system accelerates the collection of cash, they
say 25% on first day, 50% on the second day and
involve a cost, (cost in terms of maintenance of collection
balance 3r day. It would mean that the firm should keep
centres, compensation to the bank for services etc.). If the
in the bank, not the entire amount of a pay roll, but only
income exceeds the cost, the system is profitable.
a fraction represented by actual withdrawal each day.
This would enable to save operating cash.
DELAYING PAYMENTS. 3. Accruals: - These are liabilities, that represent a
service/goods received by a firm, but not yet paid for. For
Apart from speedy collection of cash , the e.g.: Salary to employees who render service in advance
operating cash requirements can be reduced by slow and receive payment later. They extend a credit to the
disbursement of A/C Payable. Slow disbursement firm for a period at the end of which they are paid (a
represent a source of fund requiring no interest week or a month). The longer the period, the greater is
payment. There are several techniques to delay payment the amount of free financing and the smaller is the
of A/C payable, namely amount of cash balance required.
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17 Financial Management
not prepared or not in a position to pay cash when they
MANAGEMENT OF RECEIVABLES. purchase goods . the firm can sell goods to such customers ,
in case it gives credit.
An efficient control of stocks and liquid
resources in conjunction with credit facility is an 2. Increasing Profits.
essential part of management control. Credit and Increase in sales results in higher profits for the firm, not
collection policies significantly influence working only because of increase in the volume of sales but also
capital requirements. With proper credit terms, the flow of because of the firm charging a higher margin of profit on
cash from receivables is synchronised to liquidate current credit sales as compared to cash sales.
expenses with out requiring additional funds from short
term sources.
3. Meeting Competition.
Accounts receivables constitute a
A firm may have give credit facilities to its customers
significant portion of the total current assets of the
because of similar facilities being granted by the
business. They are a direct result of 'trade credit' which
competing firms to avoid the loss of sales from customers
has become an essential marketing tool in modern
who would buy else where if they did not receive the
business. When a firm sells goods for cash, payments are
expected credit.
received immediately and there fore, no receivables are
created How ever when a firm sells goods or services on The over all objective of committing funds to A/C
credit, the payments are postponed to future dates and receivable is to generate a large flow of operating
receivables are created. revenue and hence profit than what would be achieved
in the absence of no such commitment.

Meaning of Receivables.
Cost of maintaining receivables.
The term receivables is defined as "debt owed to
the firm by customers arising from sale of goods or The costs with respect to maintenance of receivables can be
service in the ordinary course of business." Account identified as follows.
receivables represents an extension of credit to customers, 1. Capital Costs
allowing them a reasonable period of time to pay for the Maintenance of A/C receivables results in blocking
goods purchased. Receivables are a direct result of credit of the firms financial resources in them. This is because
sales. Credit sale is resorted to, by a firm to push up its there is a time lag between the sale of goods to
sales which ultimately results in pushing up the customers and the payments by them. The firm has,
profits earned by the firm. At the same time, selling there fore, to arrange for additional funds to meet its
goods on credit result in blocking of funds in Accounts own obligations, such as payment to employees,
Receivables. suppliers of raw materials, etc while awaiting for
Additional funds are, there fore, payments from its customers. Additional funds may
necessary for the operational needs of the business, either be raised from outside or out of profits retained in
which involve extra cost in terms of interest. Moreover the business. In both cases the firm incurs a cost. In the
increase in receivables also increases the chance of bad former case, the firm has to pay the interest to the
debts. Thus creation of account receivable is beneficial outsider, while in the second case there is an opportunity
as well as dangerous. Management of account cost to the firm. - i.e. the money the firm could have
receivables may, there fore, be defined as the process of earned otherwise by investing the funds else where.
making decisions relating to the investment of funds in
this asset which will result in maximising the over all 2 Administrative Cost.
return of the investment of the firm.
The firm has to incur additional administrative cost for
Thus the objective of receivables management is to maintaining Account Receivables in the form of salaries
promote sales and profits until that point is reached , to the staff kept for maintaining accounting records
where the return on investment in further funding of relating to customers, cost of conducting investigation
receivables is less than the cost of funds raised to finance regarding customers credit worthiness etc.
that additional credit.

3. Collecting Cost.
Objectives of credit sales.
The firm has to incur costs for collecting payments
The major objectives of credit sales are, from its credit customers. Some times additional steps
1. Achieving growth in sales: may have to be taken to recover money from defaulting
If a firm sells goods on credit, it will generally be in a customers.
position to sell more goods than if it insisted on immediate 4. Defaulting Cost.
cash payment. This is because many customers are either
NSS College. Rajakumari.
18 Financial Management
Some times after making all serious efforts to volume of receivables will also be large. If the firm supplies
collect money from defaulting customers, the firm may goods on installment basis its balance in receivables will be
not be able to recover the over dues because of the in high.
ability of the customers. Such debts are treated as bad
debts and have to be written off since they cant be
SYSTEM OF CONTROL OF RECEIVABLES.
realised.
It is in the interest of the enterprise to keep the
investment in receivables in a controllable limit. The
FACTORS AFFECTING THE SIZE OF financial management should consider the following four
RECEIVABLES. factors which control the receivables management cost at a
The size of Account Receivables is determined by a minimum point.
number of factors. Some are:
1. Deciding acceptable level of Risk.
1. Level of sales. The first consideration in this regard is to decide
This is the most important factor in determining the to whom goods are to be sold bearing in mind the risk
size of receivables. Generally in the same industry, a involved. Because every credit transaction involves risk
firm having a largo volume of sales will be having u element, the financial management should consider the
larger level of receivables as computed to a firm with a credit capacity of every customer before allowing any credit
small volume of sales. to him. Capacity of a customer can be judged by
understanding his Character, Capacity^ Capital, Collateral
Security offered and Conditions of sales.
2. Credit Policies.
The term credit policy refers to those decision
variables that influence the amount of trade credit, i.e. 2. Terms of Credit Sales.
investment in receivables. These include total amount of The next thing the company has to decide is the Credit
credit to be accepted, the length of the credit period to be Terms and the Level of Discount. The extension of credit
extended, and the cash discount to be given. A firms credit represents an investment having some cost of capital. It will
policy determines the amount of risk the firm is willing to increase the sale of the organisation resulting in larger
under take in sales activities. If a firm has a liberal credit profits. In deciding upon the credit terms the firm should
policy, it will experience a higher level of receivables as think over certain basic issues involved in it - such as cost
compared to a firm with rigid policy. of capital, cash discount, volume of sales, period of credit
sales, and so on. By considering all these factors, — i.e.
the Cost and the Benefits— the financial manager should
3. Terms of Trade.
fix the most desirable credit terms.
The size of receivables is also affected by the terms
of trade (or credit terms) offered by the firm, the two
important components are credit period and cash discount. 3. Credit Collection Policy.
A. Credit Period - After granting the credit sale, the Co. should try to get
the amount collected from its customers as early as
The term credit period refers to the time duration for which
possible. It needs a sound and strict collection policy to
credit is extended to the customers. It is generally expressed
keep bad debts and losses at the minimum. The must also
in terms of "net date". For eg, if a firms credit terms are 'net
provide a certain amount as reserve for bad debt. The
15' it means the customers are expected to pay within 15
company should follow a collection procedure in a clear
days from the date of credit sale.
cut sequence. — i.e. polite letter, strong worded reminders,
B. Cash Discount. personal visits and then legal action.
Most of the firms offer cash discounts to their
customers for encouraging them to pay their dues before
4. Analysing the Investments in Receivables.
the expiry of the credit period. Allowing cash discounts
results in a loss to the firm because of recovery of less The last step is to analyse the amount of receivables
amount than what is due from the customer, but it reduces from time to time with the help of certain ratios such as
the volume of receivables and puts extra funds at the calculation of average collection period, debtors turn over
disposal of the firm for alternative investment. The amount ratio, ratio of receivables to current assets etc. A proper
of loss thus suffered is, there fore, compensated by the analysis of receivables will help the management in keeping
income otherwise earned by the firm.' the amount of receivables within reasonable limits.

4 Stability of sales.
In the business of seasonal character, total sales and
the credit sales will go up in the season and there fore
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19 Financial Management

Broadly the term is applied to almost any kind of


detailed enquiry in to financial data. A financial
Unit 4 manager has to evaluate the past performance, present
FINANCIAL STATEMENT ANALYSIS. financial position, liquidity situation, enquire in to
profitability of the firm and to plan for future operations.
The financial statements are prepared for the For all this, they have to study the relationship among
purpose of presenting a periodical review or report of various financial variables in a business as disclosed in
the progress made by the concern. It shows the 'status of various financial statements.
the investment' in the business, and 'results achieved' USERS OF FINANCIAL STATEMENT
during the accounting period. ANALYSIS.

Financial statements refer to at least two Analysis of financial statement is an attempt to


statements which are prepared at the end of a given measure the enterprises liquidity, profitability, solvency
period. These statements are Income Statement (P'&L and other indicators to assess its efficiency and
Account ) and Position Statement, (i.e. Balance Sheet). performance. Analysis of financial statements is linked
The purpose of' Income statement' is to ascertain the net with the objective and interest of the individual / agency
result of trading activities. Position statement is prepared involved. Some of the agencies interested include
to find out the financial position of the business as on a Management, investors, creditors, bankers, workers,
particular date. Government, and public at large.

According to John. N .Myer, " the financial 1 MANAGEMENT.


statements provide a summary of the accounts of a Management is interested in the financial
business enterprise, the balance sheet reflecting the performance and financial condition of the enterprise. It
assets and liabilities and the income statement showing would like to know about its viability as an on going
the results of operations during a certain period. concern, management of cash, debtors, inventory and
fixed asset and adequacy of capital structure.
In addition to P&L A/C and Balance sheet, Management would also be interested in the overall
Statement of Retained Earnings, Fund Flow Statement financial position and profitability of the enterprise as a
and cash flow Statements are also considered as whole and its various departments and divisions.
important financial statements.
2. INVESTORS
The financial statements are of much interest to An investor is interested in the profitability and
a number of groups of persons. These groups are very safety of his investment and would like to know whether
much interested in the analysis of financial statements. the business is profitable, has growth potential and is
The process of critical evaluation of the financial progressing on sound lines. The present investors want
information contained in the financial statements in to decide whether they should hold the securities of the
order to understand and make decisions regarding the company or sell them. Potential investors, on the other
operations of the firm is called ‘Financial Statement hand, want to know whether they should invest in the
Analysis’. It is basically a study of relationship among shares of the company or not. Investors (Shareholders or
various financial facts and figures as given in a set of owners) and potential investors, thus, make use of the
financial statements, and the interpretation thereof to financial statements to judge the present and future
gain an insight into the profitability and operational earning capacity of the business, to judge the operational
efficiency of the firm to assess its financial health and efficiency of the business and to know the safety of
future prospects. investment and growth prospects.

Analysis means to put the meaning of a 3. BANKERS AND LENDERS


statement in to simple terms for the benefit of a person. Bankers and lenders are interested in serving of
Analysis comprises resolving the statements by breaking their loans by the enterprise, i.e. regular payment of
them in to simpler statements by a process of re interest and repayment of principal amount on schedule
arranging, regrouping, and collection of information
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20 Financial Management
dates. They also like to know the safety of their 1 External analysis
investment and reliability of returns. Analysis of financial statements may be carried
out on the basis of published information. i.e
4. SUPPLIERS/ CREDITORS. information made available in the Annual Report of the
Creditors dealing with the enterprise are enterprise. Such analysis are usually carried out by those
interested in receiving their payments as and when fall who do not have access to the detailed accounting
due and would like to know its ability to honor its short- records of the Co. ie Banks, Creditors etc.
term commitments.
2 Internal Analysis.
5. EMPLOYEES Analysis may also be based on detailed
Employees interested in better emoluments, information available within the Co, which is not
bonus and continuance of the business, would like to available to the outsiders. Such analysis is called
know its financial performance and profitability. internal analysis. This type of analysis is of a detailed
one and is carried out on behalf of the management for
6. GOVERNMENT the purpose of providing necessary information for
Government and regulatory authorities would decision-making. Such analysis emphasizes on the
like to ensure that the financial statements prepared are performance appraisal and assessing the profitability of
as per the specified laws and rules, and are to safe guard different activities.
the interest of various concerned agencies. E.g.:
Taxation authorities would be interested in ensuring B. According to objectives of analysis.
proper assessment of tax liability of the enterprise as per
the laws. 1. Short Term Analysis
Stock exchange uses the financial statements to Short term analysis is mainly concerned with the
analyze and thereafter, inform its members about the working capital analysis. In the short run, a Co must
performance, financial health, etc. of the company. have ample funds readily available to meet its current
needs and sufficient borrowing capacity to meet the
7. CUSTOMERS contingencies. In short term analysis the current assets
Customers are interested to ascertain and current liabilities are analyzed and liquidity is
continuance of an enterprise. For example, an enterprise determined.
may be supplier of a particular type of consumer goods
and in case it appears that the enterprise may not 2. Long Term Analysis.
continue for a long time, the customer has to find an In the long term a Co: must earn a minimum
alternate source. amount sufficient to maintain a reasonable rate of return
on the investment to provide for the necessary growth
8.. PUBLIC and development of the Co; and to meet the cost of
Enterprises affect members of the public in a capital. Financial planning is also desirable for the
variety of ways. For example, enterprises may make a continued success of a Co. Thus in the long term
substantial contribution to the local economy in many analysis the stability and the earning potentiality of the
ways including the number of people, they employ and Co is analyzed, i.e fixed assets, long term debt structure
their patronage of local suppliers. Financial statements and the ownership interest is analyzed.
may assist the public by providing information about
trends and recent developments in the prosperity of the C. According to the Modus Operandi of analysis.
enterprise and the range of its activities.
1. Horizontal Analysis.
Different agencies thus look at the enterprise Analysis of financial statements involves
from their respective viewpoint and are interested in making comparisons and establishing relationships
knowing about its profitability and financial condition. among related items. Such comparison or establishing of
In short a detailed cause and effect study of profitability relationship may be based on financial statements of a
and financial condition is the over all objective of Co for a number of years and the financial statements of
financial statement analysis. different Co's for the same year. Such analysis is called
Horizontal Analysis. It may take the following two
forms.
TYPES OF FINANCIAL ANALYSIS A. Comparative Financial Statement Analysis
B. Trend Analysis.
Following are the various types of financial
analysis.
2. Vertical Analysis.
A. On the basis of material used. Analysis of financial data based on relationship
among items in a single period of financial statement is
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21 Financial Management
called vertical analysis. From a single Balance Sheet be of two types. Comparative Balance Sheet and
or P&L A/C, relationships of various items may be Comparative P&L A/C.
established. E.g., various assets can be expressed as
percentage of total assets. Statements containing such
analysis are also called as common size statements. The
common size P&L A/C is more useful in analyzing the
operating results and costs during the year. It shows
each element of cost as a percentage of sales. Similarly
common size Balance Sheet shows fixed assets as a
percentage to total assets.

TOOLS OF FINANCIAL ANALYSIS


(METHODS).
The following steps may be followed to prepare the
The analysis of financial statements consist of a comparative statements:
study of relationship and trends to determine whether or
not the financial position of the concern and its Step 1 : List out absolute figures in rupees relating to
operating efficiency have been satisfactory. In the two points of time (as shown in columns 2 and 3)
process of this analysis various tools or methods are Step 2 : Find out change in absolute figures by
used by financial analyst. These tools are, subtracting the first year (Col.2)from the second year
1. Comparative statements (Col.3) and indicate the change as increase (+) or
2. Common size statements decrease (–) and put it in column 4.
3. Trend Analysis Step 3 : Preferably, also calculate the percentage
4. Average Analysis change as follows and put it in Column 5.
5. Statement of changes in working capital
6. Fund Flow Analysis Change in absolute figure x 100
7 Cash Flow analysis & First year figure
8. Ratio Analysis.
Advantages
COMPARATIVE FINANCIAL STATEMENTS. 1. These statements indicate trends in sales, cost of
production, profits, etc., helping the analyst to evaluate
The preparation of comparative financial the performance, efficiency and financial condition of
statement is an important device of horizontal analysis. the undertaking. For example, if the sales are increasing
Financial data becomes more meaningful when coupled with the same or better profit margins, it
compared with similar data for a previous period or a indicates healthy growth.
number of periods. Statements prepared in a form that
reflect financial data for two or more periods are known 2. Comparative statements can also be used to compare
as comparative statements. Annual data can be the position of the firm with the average performance of
compared with similar data for prior years. Such the industry or with other firms. Such a comparison
statements are very helpful in measuring the effects of facilitates the identification or weaknesses and
the conduct of a business during the period under remedying the situation.
consideration.

Financial statements of two or more firms may


also be compared for drawing inferences. This is known
as inter-firm comparison. Comparative statements can

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22 Financial Management

Illustration 1.
Convert the following Income Statement into a comparative income statement of BCR Co. Ltd and interpret
the changes in 2005 in the light of the conditions in 2004.

Interpretation.

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23 Financial Management
1. The Company has
made efforts to
reduce the cost
which is evident
from the fact that
the cost of goods
sold has not
increased in the
same ratio as the
amount sales.

2. The gross profit has


increased in 2005
as compared to
2004 considerably,
33.64% with an
increase 20% in
sales.

3. The company has


also concentrated
on reducing the
operating cost;
hence the
percentage of
operating profit has also considerably increased, i.e 106.07%.

Thus the overall performance of the Co has immensely improved in the year 2005.

Illustration 2.

From the following income statement of Madhu Co Ltd, prepare comparative income statement for the year
ended 31st march, 2005 and 2006 and interpret the same.

Particulars 2005 2006


Sales 4 00 000 6 50 000
Purchases 2 00 000 2 50 000
Opening stock 20 600 32 675
Closing stock 32 675 20 000
Salaries 16 18 000
Rent 010 6 000
Postage and stationary 5 4 100
Advertising 100 4 600
Commission on sales 3 200 3 500
Depreciation 2 600 500
Loss on sale of plant 3 160 2 000
Profit on sale of investments 200 4 500
4 000
3 000

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24 Financial Management

Interpretation.
1. The comparative balance sheet of the company reveals that there has been an
increase in sales by Rs 2 500 000, ie 62.5% where as cost of goods sold has increased
only by Rs 74 750. Ie 39.78%. This reveals that the company has made efforts to
reduce the cost of goods sold thereby the gross profit of the company has increased by
Rs 1 75 250. Ie 82.64%.

2. The expenses of the Co have increased by R s 6430 ie 21.24% only, and the operating
profit has increased by Rs 1 68 820, ie 92.86%.

3. The net profit of the Co has increased by 95.31%

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25 Financial Management
4. The overall performance of the Co is good.

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26 Financial Management

Interpretation.

1. The comparative balance sheet of the company reveals that during the year 2006, there has been an increase in
fixed assets by Rs.1,10,000, i.e. 13.5% while long-term liabilities have relatively increased by Rs.1,50,000 and equity
share capital has increased by Rs.2 lakhs. This fact depicts that the policy of the company is to purchase fixed assets
from long-term source of finance, thereby not affecting the working capital.

2. The current assets have increased by Rs.1,52,000, i.e. 24.52%. The current liabilities have increased only by
Rs.20,000, i.e. 12.9%. This shows an improvement in the liquid position of the Company.

3. Shareholder’s funds (share capital plus reserves) have shown an increase of Rs. 92,000.
4. The overall financial position of the company is satisfactory.

Illustration 4

From the following information, prepare a comparative Balance Sheet of Deepti Ltd. :

Particulars 31.3.2003 31,3.2002


(Rs.) (Ks.)

Equity share capital 50,00,000 50,00,000

Fixed assets 72,00,000 60,00,000

Reserves and surplus 1 2,00,000 1 0,00,000

Investments 1 0,00,000 10,00.000

Long-term loans 30,00,000 30,00,000

Current assets 21,00,000 30,00,000

Current liabilities 11 ,00,000 10,00,000

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27 Financial Management

Solution :
Comparative Balance Sheet
as on 31.3.2002 and 31.3.2003
2002 Rs. 2003 Rs. Absolute Change Percentage
Rs. Change (%)

Assets
Fixed assets 60,00,000 72,00,000 12.00,000 20
Investments 10,00,000 10,00,000 - —
Current assets 30,00,000 21,00,000 (9,00,000) - 30

Total assets 1,00,00,000 1.03,00,000 3,00,000 3

Liabilities and Capital 50,00,000 50,00,000 - -


Equity share capital 10,00,000 12.00,000 2,00,000 20
Reserves and surplus Long-term loans 30,00,000 30,00,000 - -
Current liabilities 10,00,000 1 1 ,00,000 1,00,000 10

1 ,00,00,000 1,03,00,000 3,00,000 1

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28 Financial Management

Debentures 2,00,000 3,00,000 + 1,00.000 +50


Long-term loans on Mortgage 1 .50,000 2.00,000 +50.000 +33

6,75,000 + 1.70.000 +33.66


Total Liabilities 5,05000

Equity Share Capital 6,00,000 8.00,000 +2.00.000 +33


Reserve & Surpluses 3,30.000 2.22.000 - 1 08,000 -32.73

Total 14.35,000 1 6,97.000 +2.62.000 + 1K.26

Interpretation
(1) The comparative balance sheet of" the company reveals that during 2002 there has been an increase in fixed assets of 1,10,000
i.e 13.49% while long-term liabilities to outsiders have relatively increased by Rs. 1,50,000 and equity share capital has increased
by Rs. 2 lakhs. This fact depicts that the policy of the company is to purchase fixed assets from the long-term sources of finance
thereby not affecting the working capital.
(2) The current assets have increased by Rs. 1,52,000 i.e.24.52% and cash has increased by Rs.60.000. On the other hand, there
has been an increase in inventories amounting to Rs, 1 lakh. The current liabilities have increased only by Rs.20,000.
i.e. 12.9%. This further confirms that the company has raised long-term finances even for the current assets resulting into an
improvement in the liquidity position of the company.
(3) Reserves and surpluses have decreased from Rs.3,30,000 to Rs.2,22,000 i.e.,32 73% which shows that the company has
utilised reserves and surpluses for the payment of dividends to shareholders either in cash or by the issue of bonus shares.
(4) The overall financial position of the company is satisfactory.

Illustration 6.
The income statements of a concern are given for the year ending on 31st Dec., 200 8and 2007.
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29 Financial Management
Re-arrange the figures in a comparative form and study the profitability position of the concern.

200 7 2008
Rs.(OOO) Rs.(OOO)

Net sales 785 900

Cost of goods sold 450 500

Operating Expenses:

General and administrative expenses 70 72

Selling expenses 80 90

Non-operating Expenses :

Interest paid 25 30

Income -tax 70 80

Solution :
Comparative Income Statement
for the year ended 3 1st Dec. 2007 and 2008

31 December Increase(+) Increase(+)


Decrease (-) Decrease (-)
2007 2008 Rs. ('000) (Percentages)
Rs. ('000) (Rs. ('000)

785 900 + 115 + 14.65


Net Sales +50 + 11.0
Less : Cost of goods sold 450 500

335 400 +65 + 19.40


Gross Profit

Operating Expenses:
General & Administrative Expenses 70 72 +2 +2.8
Selling Expenses 80 90 + 10 + 12.5

Total Operating Expenses 150 162 + 12 +8.0

Operating Profit 185 238 +53 +28.65


Less : Other deductions Interest paid 25 30 +5 +20

Net profit before tax 160 208 +48 +30.0


Less : Income tax 70 80 + 10 + 14.3

90 128 +38 +42.22


Net Profit after tax

Interpretation
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30 Financial Management
The comparative income statement given above reveals that there has been an increase in net sales of 14.65%
while the cost of goods sold has increased nearly by 11 % thereby resulting in an increase in the gross profit of 19.4%.
Although the operating expenses have increased by 8% the increase in gross profit is sufficient to compensate for the
increase in operating expenses and hence there has been an overall increase in operational profits amounting to Rs.53,000
i.e. 28.65% in spite of an increase in financial expenses of Rs.5,000 for interest and Rs. 10,000 for income -tax. There in an
increase in net profits after tax amounting to Rs.38,000 i.e. 42.22%. It may be concluded that there is sufficient progress in
the company and the overall profitability of the company is good.
…………………………………………………………………………………………………………………………………
…….
Balance sheet. This statement establishes relation
between each asset and total value of asset and each
liability against total liabilities.
COMMON SIZE STATEMENTS. Common Size Income Statement. A Common Size
Income statement is a statement in which each item of
Comparative statements that give only the expense is shown as a percentage of net sale. A
vertical percentage ratio for financial data with out significant relationship can be established between
giving Rupee values are known as common size items of income statement and volume of sales.
statements For example, if the Balance sheet items
are expressed as the ratio of each asset to total assets The following procedure may be adopted for preparing
and the ratio of each liability to total liabilities, it will be the common size statements.
called a common size balance sheet. Thus a common
size statement shows the relation of each component 1. List out absolute figures in rupees at two points of
to the whole. It is useful in vertical financial analysis time, say year 1, and year 2 (Column 2 & 4 of Exhibit
and comparison of two business enterprises at a 2)
certain date.Common size statements include :
Common size Balance Sheet and Common size 2. Choose a common base (as 100). For example,
Income Statement. Sales revenue total may be taken as base (100) in
case of income statement, and total assets or total
Common size Balance Sheet - A statement in which liabilities (100) in case of balance sheet.
Balance Sheet items are expressed as percentage of 3. For all items of Col. 2 and 4 work out the
each asset to total asset and percentage of each percentage of that total. Column 3 and 5 show these
liability to total liabilities is called Common Size percentages.

Illustration 1.

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31 Financial Management

Interpretation :

1. In 2005, both current assets and current liabilities decreased as compared to 2004, but the decrease in current
assets is more than the decrease in the current liabilities. As a result, the firm may face liquidity problem.
2. In 2005 both fixed assets and the long-term liabilities increased, but the increase in the fixed assets is more than
the increase in long-term liabilities. The firm sold some investments to acquire fixed assets and used short-term funds
to purchase fixed assets.
3. The firm has undertaken expansion programme reflected in addition to land and buildings.
The overall financial position of the firm is satisfactory. It should improve its liquidity.

Illustration 2.

From the following financial statements, prepare Common Size Statements for the year ended March 31, 2004 and
2005.

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33 Financial Management

Interpretation :

1. On comparison of the percentage of the cost of goods sold, it is observed that the company has tried to reduce its cost to
improve its profit margin.

2. The profitability of the company has improved as compared to the previous year as the profit after tax percentage has gone up
by 13.28%.

3. The company has issued share capital in order to finance the purchase of fixed assets like furniture and land and buildings.

4. The company has improved its liquidity position as reflected in the increase of its current assets.

Thus, there is an improvement in the working of the company.

Illustration 3.

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34 Financial Management
Prepare Common Size Statement from the following income statement of Karan Ltd. for the year ended March 31,
2006.

Illustration 4.
From the profit and loss accounts of Dharmasa Ltd for the years ended on 31st December, 2006, 2007, and 20089
prepare common size statement and interpret.

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35 Financial Management
DHARMASA LTD
PROFIT AND LOSS ACCOUNTS. For the years ended December31.

Interpretation. The absolute figures in rupees show that sales, cost of goods sold and gross profit all have
continuously increased since 2007. But common-size statement reveals that cost of goods sold in relation to sales
decreased in 2008 and again increased in 2009. Consequently rate of gross profit in 2008 over 2007 increased but in
2009 over 2008 decreased. Similarly, net profit after tax, in absolute figures, shows an increasing trend since 2007 but
the rate of net profit on sales in 2009 is 4.4 in contrast to 6.2 in 2008 and 5.4 in 2007.

FUND FLOW ANALYSIS static summary of assets and liabilities on a particular


date. It doesn’t highlight the factors that were
The technique of fund flow has been responsible for changes in balance sheet figures
developed to account for changes in assets and relating to two periods. Certain important transactions
liabilities that take place in the course of the which might take place during the accounting year
accounting year. Financial accounting has a very may not find any place in the balance sheet. To
limited role to perform in this regard. Financial highlight changes in assets and liabilities, a statement
accounting provides essential basic accounting is prepared which is called a fund flow statement.
information. But its utility is very much limited for
analysis and interpretation. The balance sheet is a
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36 Financial Management
Fund flow analysis is the second tool of is treated as application of fund and decrease in
analysis of financial statement. (Ratio analysis working capital is termed as source of fund.
occupies the first position.). If we look at the balance
sheets of a Company on two different days, we notice This statement or schedule is prepared in such
differences in the figures of assets and liabilities. A a way as to indicate the amount of working capital at
fund flow statement attempts to account for this the end of two years as well as increase or decrease in
difference. In fact Fund Flow analysis measures the the individual items of current assets and current
changes in the assets and liabilities of a Company. liabilities. The difference in the amount of working
capital at the end of two years will depict either
The changes in Current Assets and Current increase or decrease in net working capital.
Liabilities are shown in the Schedule of changes in the
Working Capital and the changes in non current assets While ascertaining the increase or decrease in
and non current liabilities are shown in Fund Flow individual items of current assets and current liabilities
Statement. and its impact on working capital, the following rules
should be taken in to account.
Fund Flow statement is also known as statement of Increase in the items of current asset will increase the
sources and applications of funds. working capital
2. Decrease in the items of current asset will
MEANING OF FUND FLOW. decrease the working capital.
3. Increase in items of current liabilities will
The term “Fund” has been used to convey a decrease working capital.
variety of meanings. To many writers the term fund 4. Decrease in items of current liabilities will
means cash. To others the term fund means working increase working capital.
capital. These are the two extreme opinions. There are
also two concepts of working capital- Gross Concept The following points should be taken in to
and Net Concept. consideration, while preparing a fund flow statement.
1. All changes in Current Assets and Current
Gross working capital refers to firms Liabilities are shown in the Schedule.
investments in total current assets. Net working 2. The schedule should be prepared exclusively
capital refers to the excess of current assets over from the items given in the Balance Sheet.
current liabilities. The most widely acceptable view of The items given in the adjustments do not
fund is the Net Working capital, which is the excess of affect the preparation of this schedule.
Current Assets over Current Liabilities. Thus the term 3. Current Assets or Current Liabilities, once
fund means Net Working Capital. taken in the schedule, will not require any
further treatment else where.
The term Flow means movement or change.
There fore, fund flow means change in funds. In other Treatment of Provision for Bad debt.
words, fund flow means flaw of funds in and out of the Some times it is shown as reserve for bad debt.
area of net working capital. Thus fund flow statement This item should be shown along with current
broadly measures the flow of fund in and out of the liabilities, in the schedule of changes in working
area of net working capital. capital.

There are many transactions which result in Provision for Tax.


the flow of fund, while there are transactions which do
not result in the flow of fund. Any external transaction 1. If the problem itself classifies the provision for
which increases net working capital would be taken as tax under current liabilities, then treat it as a
a source of fund and any such transaction which current liability. Once it is taken in the
decreases net working capital will be considered as schedule, it will not find any place in the fund
application of fund. flow statement.
2. If this item is not specifically classified as a
1. Schedule of Changes in Working Capital. current liability, but is merely shown as one of
the items on the liability side, then this item
Many expert have opined that only the net may be taken as a non current liability. Thus it
change in working capital should be shown in the fund goes to the fund flow statement.
flow statement in place of individual changes in all
current assets and current liabilities. For this purpose, a Proposed dividend.
separate statement or schedule of working capital is
being prepared in which net change in the working
capital is ascertained. The increase in working capital
NSS College. Rajakumari.
37 Financial Management
The same procedure is followed in respect of
proposed dividend as has been given for provision for Application (Uses) of fund.
tax. 1. Redemption of Preference shares.
2. Redemption of debentures
3. Repayment of Loan
4. Purchase of Fixed Assets
5. Dividend Paid
6. Income Tax paid etc
2. Fund Flow statement
3. Calculation of FUND FROM OPERATION.
This is second, but most important part of fund
flow analysis. It is prepared on the basis of changes in P&L A/C closing balance xxx
fixed assets, long term liabilities and share capital on Less: P&L A/C opening balance xxx
the basis of values of these items shown in the balance ---------
sheet. Of course additional information must also be Current year profit. xxx
considered.
Add:
Increase in fixed assets is application of fund Depreciation xx
and decrease in fixed asset on account of sale is a Provision for tax xx
source of fund. Increase in long term liabilities is Proposed Dividend xx
source of fund and decrease in long term liabilities is Interim dividend paid xx
application. Thus the preparation of fund flow Loss on sale of asset xx
statement involves the ascertainment of increase or Amortisation of goodwill xx
decrease in the various items of fixed assets, long term Preliminary expenses-
liabilities, and share capital, in the light of additional written off xx
information given. Transfer to reserve xx
---------------
Sources of Fund. xxxx
1. Issue of shares Less:
2. issue of debentures Dividend received xx
3. Raising of new loans Profit on sale of asset xx
4. Sale of fixed assets -----------------
5. Fund from operation Fund from Operation. xxxx
6. Non trading income like dividend received, -----------------
interest on deposit etc.

CASH FLOW ANALYSIS

Cash flow analysis is another important technique of financial analysis. It involves preparation of cash flow
statement for identifying sources and application of cash. The term cash here stands for cash and bank balance. A
cash flow statement is a statement depicting changes in cash position from one period to another. It explains the
reasons for such inflows or out flows of cash .
A cash flow statement can be prepared on the same pattern on which a fund flow statement is prepared. The
changes in cash position from one period to another is computed by taking in to account ‘Sources and Applications’ of
cash.

Format of cash flow statement.

Source Rs Application Rs
Opening balance: Decrease in liabilities XXX
Cash XXX Increase in asset XXX
Bank XXX Redemption of preference XXX
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38 Financial Management
shares XXX
Sources of cash. Repayment of loan XXX
Purchase of fixed asset XXX
Increase in liabilities XXX Tax paid XXX
Decrease in current assets XXX Dividend paid
Issue of shares XXX
Raising of long term loans XXX
Sale of fixed assets XXX
Short term borrowings. XXX
Closing balance XXX
Cash from operations. XXX Cash XXX
Bank
XXXX XXXX
Calculation of cash from operation

(Refer calculation of fund from operation.)

RATIO ANALYSIS. Ratios can be grouped into various classes


according to financial activity or function to be
A companies financial information is evaluated. In view of the requirements of the various
contained in 3 basic financial statements- the Balance users of ratios, we can classify them into the following
Sheet, the Trading and P&L Account and the P&L categories.
Appropriation Account. These statements are very • Liquidity ratios.
useful to different partiers concerned such as • Profitability Ratios
management, creditors, investors and so on. These • Solvency ratios.
statements may be more fruitfully used if they are
analysed and interpreted to have an insight into the Liquidity Ratios.
strengths and weakness of the firm. Analysis of
statements means such a treatment of the information Liquidity ratios measure the firms ability to
contained in the two statements as to afford a diagnosis meet current obligations; ie the ability to pay its
of the profitability and financial position of the firm obligations as and when they become due. They show
concerned. In the analysis of financial statements, the whether the firm can pay its short term obligations out
analyst has a variety of tools available from which he of short term resources or not. They establish a
can choose those best suited to his specific purpose. relationship between cash and other current assets to
The most important tools used now a days are Ratio current liabilities. If a firm has sufficient net working
analysis, Fund flow analysis and Comparative and capital it is assumed to have enough liquidity. The
common size statements. most common ratios which indicate the extent of
liquidity are current ratio and quick ratio.
Ratio Analysis.
Current Ratio.
Ratios are well known and most widely used It is calculated by dividing the Current Assets
tools of financial analysis. A ratio gives the by Current Liabilities.
mathematical relationship between one variable and
another. Accounting ratios are relationships, expressed Current Asset
in quantitative terms, between figures which have a Current ratio = --------------------------
cause and effect relationship or which are connected Current Liabilities.
with each other in some manner or the other. The
analysis of a ratio can disclose the relationships as well Current assets include cash, securities, debtors
as bass of comparison that reveal conditions and trends B/R, stock etc and current liabilities include creditors,
that cant be detected by going through the individual B/P, accrued expense, short term loan etc. Current
components of the ratio. The usefulness of ratios is ratio is a measure of the firms short term solvency. It
ultimately dependent on their intelligent and skillful indicates the availability of a current asset in rupees for
interpretation. every one rupee of current liability . a ratio greater
than 1 means that the firm has more current assets than
Classification of Ratios. current claims against them.

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As a conventional rule, a Current ratio of Cost of goods sold means sales – gross profit.
2:1 or more is considered satisfactory. This rule is Average inventory refers to the simple average of the
based on the logic that in a worse situation even the opening and closing sock. The ratio indicates how fast
value of CA’s(current assets) becomes half, the firm inventory is sold. A high ratio is good from the view
will be able to meet its obligations. The higher the point of liquidity. A low ratio would signify that
current ratio, the more will be the firms ability to meet inventory does not sell fast.
its current obligations. In inter firm comparison, the
firm with the higher current ratio has better Debtors Turn over Ratio.
liquidity or short term solvency.
It is determined by dividing the net credit sales
by average debtors outstanding during the year.
Quick Ratio. (Acid Test Ratio) Net credit sales
This ratio establishes a relationship between Debtors turnover Ratio = ------------------------
quick or liquid assets and current liabilities. An asset is Average Debtors.
liquid, if it can be converted in to cash immediately or
reasonably soon without a loss of value. Cash is the Net credit sales consists of gross sales – sales returns if
most liquid asset. QA also include debtors, B/R and any from debtors. Average debtors is the simple
securities. Inventories are considered less liquid. They average of opening balance of debtors and closing
normally require some time for realising in to cash. balance.

Quick assets Average debt collection period in days


Quick Ratio = -------------------------- Debtors + B/R
Current Liabilities. =------------------------- X 365
Net credit sales
Quick assets = Current Assets – Inventories or stock Average debt collection period in months

Generally a QR of 1:1 is considered to Debtors + B/R


represent satisfactory current financial position. =------------------------ X 12
Net credit sales
Cash Ratio (Absolute Liquid Ratio).
Since cash is the most liquid asset, a financial 12 months
analyst may examine the ratio of cash and its Or Debt collection period = --------------------------
equivalent to current liabilities. Trade investments or Debtors turnover.
marketable securities are equivalents to cash.
Debtors turnover measures how rapidly debts
Cash / Bank + Marketable securities are collected. A high ratio is indicative of shorter
Cash Ratio = ----------------------------------- time lag between credit sales and cash collection.
Current Liabilities. A low ratio shows that debts are not being collected
rapidly.

Creditors Turnover Ratio.


Turn Over Ratio.
It’s the ratio between net credit purchases and
The liquidity ratios discussed so far relate to average amount of creditors outstanding during the
the liquidity of a firm as a whole. Another way of year. It is calculated as follows.
examining the liquidity is to determine how quickly
certain current assets are converted in to cash. The Net credit purchase
ratios to measure these are referred to as turnover CTR = -------------------------------------------
ratios. Average Creditors.

Inventory Turnover Ratio. Net credit purchase = Gross credit purchase – returns
It is computed by dividing the cost of goods to suppliers.
sold by the average inventory.
Average creditors is the simple average of creditors at
Cost of goods sold the beginning and at the end.
Inventory turnover Ratio = --------------------------
Average inventory. Average debt Payment period in days
Creditors + B/P
= --------------------------------- x 365
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Net credit purchases. Or Net profit ratio = -------------------------X
100
Creditors + B/P Sales
= --------------------------------- x 12
Net credit purchases The net profit margin is indicative of
12 months managements ability to operate the business with
Or Credit payment period = ------------------------ sufficient success not only to recover from revenues,
Creditors turnover. but also to leave a reasonable margin to the owners. A
high net profit margin would ensure adequate return to
the owners as well as enable a firm to face adverse
A low turnover reflects liberal credit terms economic conditions.
granted by suppliers, while a high ratio shows that
accounts are to be settled rapidly. The creditors Expenses ratio.
turnover ratio is an important tool of analysis as a firm
can reduce its requirements of current assets by relying Another profitability ratio related to sales is
on the suppliers credit. expense ratio. It is computed by dividing expenses by
sales.
Profitability Ratios.
Cost of goods sold Ratio
A measure of profitability is the over all
measure of efficiency. The management of the firm is Cost of goods sold
naturally eager to measure its operating efficiency. = --------------------------------------X100
Similarly is the share holders or owners who invest Net sales
their funds in the expectation of reasonable returns.
The profitability of a firm can be measured by its
profitability ratios. Profitability ratios can be Administrative expense
determined on the basis of either sales or investments.
Administrative expense ratio
Gross profit margin. = ---------------------------------------X 100
The gross profit margin ratio is calculated as Net sales

Gross profit
--------------------------------- X 100. Operating expense
Sales
This ratio shows the profit relative to sales. A Operating expense Ratio
high ratio of gross profits to sales is a sign of good = -------------------------------------- X 100
management as it implies that the cost of production of Net sales
the firm is relatively low.
Selling expense Ratio.
Net Profit margin. Selling expense.
This measures the relationship between net =--------------------------------------X 100
profit and sales of a firm. Depending on the concepts Net sales
of the net profit employed, this ratio can be computed
in two ways. The expense ratio is closely related to the
profit margin, gross as well as net. The cost of goods
Operating profit Ratio sold ratio shows what percentage share of sales is
consumed by cost of goods sold and what proportion is
Earning Before interest and Tax (EBIT) available for meeting expenses such as selling and
= ---------------------------------------------------X general distribution expense as well as financial
100 expenses consisting of taxes, interest, dividends and so
Sales on. The expense ratio is very important for analysing
the profitability of a firm. It should be compared over a
period of time with the industry average as well as
Earning after Interest and tax (EAIT) firms of similar type. A low ratio is favourable and a
Net profit Ratio = --------------------------------------X high ratio is unfavourable.
100
Sales Profitability ratios related to Investments.

Net profit
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41 Financial Management
The profitability ratios can be computed by Net profit after tax- Preference dividend
relating the profits of a firm to its investments. Such = ----------------------------------------------------------
ratios are popularly known as Return On Investments Average ordinary shareholders equity.
(ROI). There are 3 different concepts of investments
and based on each of them, there are 3 broad This is probably the single most important
categories of ROI’s. ratio to judge whether the firm has earned a
satisfactory return for its equity share holders or not.

Return on Asset. Earning Per Share.


Here the profitability ratio is measured in terms of the
relationship between net profits and assets. It is also EPS measures the profit available to the equity
called profit – to –asset ratio. shareholders on a per share basis. – ie the amount that
Net profit after tax they can get on every share held. The profits available
Return on Asset = --------------------------------- X100 to the ordinary shareholders are represented by the net
Average total assets. profits after taxes and preference dividend.

Return on capital employed. Net profit available to equity shareholders


Here the profits are related to total capital EPS =
employed. The term capital employed refers to long ------------------------------------------------------------
term funds supplied by the creditors and owners of the Number of ordinary shares outstanding.
firm. A comparison of those with similar firms, and
with the industry average would provide sufficient Dividend Per Share.
insight in to how efficiently the long term funds of
owners and creditors are being used. The higher the This is the dividend paid to the shareholders
ratio, the more efficient is the use of capital. on a ‘per share’ basis. It is net distributed profit
belonging to the shareholders dividend by the number
Return on capital employed = of ordinary shares.
Net profit after tax /EBIT
--------------------------------------------- X 100 Dividend paid to equity shareholders
Average total capital employed. DPS = --------------------------------------------------
Number of equity shares.
Return on Total shareholders equity.
According to this ratio, profitability is Dividend Pay –Out Ratio.
measured by dividing the net profits after tax by the
average total shareholders equity. The term share This is also known as pay out ratio. It
holders equity includes (1) preference share capital, (2) measures the relationship between the earnings
ordinary share holder’s equity consisting of equity belonging to the ordinary shareholders and the
share capital, share premium, and reserves and surplus dividend paid to them. It can be calculated by dividing
less accumulated losses. the total dividend paid to the owners by the total
Return on total shareholders equity profits available to them.
Net profit after tax
= ------------------------------------------------ X 100. Total dividend to equity shareholders
Average total shareholders equity. DPR =---------------------------------------------- X 100.
Net profit belonging to equity shareholders
The ratio reveals how profitably the owner’s
funds have been utilised by the firm. A comparison of
this ratio with that of similar firms will show the
performance of the firm. Or DPS
------------------ X 100
Return on ordinary shareholders equity.(Net worth) EPS

The real owners of the business are the Price Earning Ratio
ordinary share holders who bear all the risk,
participate in management and are entitled to profit This ratio gives the relationship between the
remaining after all outside claims, including preference market price of the stock and its earnings by revealing
dividends are met in full. how earnings affect the market price of the firms
stock.
Return on Equity Fund

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Market price of share the proportion between fixed income bearing securities
P E Ratio = -------------------------------- and non fixed income bearing securities. The former
EPS. includes preference share capital and debentures and
the later includes equity share capital and reserves and
Other important Ratios. surplus.
Capital gearing Ratio =
Debt Equity Ratio.
Fixed interest bearing funds
The relationship between borrowed funds and ---------------------------------------------------
owners capital is a popular measure of the long term Equity share capital + Reserves and Surplus.
financial solvency of the firm. This relationship is
shown by the debt equity ratio. It indicates the relative Working Capital Turnover
proportion of debt and equity in financing the assets of This reflects the turnover of the firm’s net working
a firm. capital in the course of the year.

Net sales
Debt Outsiders fund Working capital turnover Ratio =
Debt Equity Ratio = --------- or ------------------- ---------------------------
Equity. Share holders fund. Net working capital.
The term debt refers to the total outside liabilities. It
includes all current liabilities and other outside
liabilities like loan debenture etc. The term equity Operating Ratio.
refers to networth or shareholders fund. It shows the proportion that the cost of sales
bears to sales. Cost of sales includes direct cost of
Proprietary ratio. goods sold as well as other operating expenses. It is
calculated by dividing the total operating cost by net
This ratio shows the long term solvency of the sales. Total operating expenses include all costs like
business. It is calculated by dividing shareholders administration, selling and distribution expenses etc,
funds by total assets. but do not include financing cost and income tax.
Lower the ratio, the more profitable are the operations
Share holders fund indicating an efficient control over costs and
Proprietary ratio = ------------------------------- appropriate selling price.
Total assets.
Operating Ratio =
Capital gearing ratio.
(Cost of goods sold + Operating expense)
This is also known as Leverage ratio. This is --------------------------------------------------x
mainly used to analyse the capital structure of a 100
company. The term capital gearing normally refers to Net sales

Illustration : 1
From the following compute current ratio:
Rs. Rs.
Stock 36,500 Prepaid expenses 1,000
Sundry Debtors 63,500 Bank overdraft 20,000
Cash in hand & bank 10,000 Sundry creditors 25,000
Bills receivable 9,000 Bills payable 16,000
Short term investments 30,000 Outstanding expenses 14,000

Solution:
Current Assets
Current Ratio = ————————
Current Liabilities
Current Assets = Stock + Sundry debtors + Cash in hand and bank + Bills receivable + Short term
investments + Prepaid expenses
= 36,500 + 63,500 + 10,000 + 9,000 + 30,000 + 1,000

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= Rs. 1,50,000
Current Liabilities = Bank overdraft + Sundry creditors + Bills payable + Outstanding expenses
= 20,000 + 25,000 + 16,000 + 14,000 = Rs. 75,000.
1,50,000
Current Ratio = —————
75,000
=2:1

Illustration :2
Calculate Debt Equity Ratio from the following information.
Rs.
Debentures 2,00,000
Loan from Banks 1,00,000
Equity share capital 1,25,000
Reserves 25,000

Solution:
Total Long Term Debt
Debt - Equity Ratio = ———————————
Shareholders funds
Total long term debt = Debentures + Loans from Bank
= 2,00,000 + 1,00,000 = Rs. 3,00,000
Shareholders funds = Equity Share Capital + Reserves.

= 1,25,000 + 25,000 = Rs. 1,50,000

3,00,000
Debt-Equity Ratio = ————— = 2:1
1,50,000

From the following particulars ascertain gross profit ratio


Rs. Rs.
Cash sales 40,000 Sales return 5,000
Credit sales 65,000 Gross profit 40,000

Solution:
Gross Profit
Gross Profit Ratio = —————— x 100
Sales
Sales = Total Sales –– Sales Returns
= 40,000 + 65,000 –– 5,000 = Rs. 1,00,000
40,000
= ————— x 100 = 40%
1,00,000

Problem 3

The following is the Balance sheet of ABC ltd as on 31st December 2005.
Balance Sheet
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44 Financial Management
Liabilities Rs Assets Rs
Share capital 2 00 Fixed assets 1 60 000
Reserves and surplus 000 Stock 50 000
Creditors 30 000 Debtors 20 000
Bills payable 20 000 Bills receivable 15 000
Bank overdraft 5 000 Prepaid expense 5 000
Outstanding expense 17 000 Cash at bank 30 000
Provision for tax 8 000 Cash in hand 20 000
20 000 3 00 000
3 00
000

Calculate 1) Current ratio, 2) Quick ratio, 3) Absolute liquid ratio.


Answer.

Current asset 1 40 000


Current ratio = -------------------------- = -------------------= 2:1
Current Liability 70 000

Quick asset 85 000


Quick ratio = -------------------- = ----------------- = 1.21 :1
Current Liability 70 000

cash and bank balance 50 000


Absolute liquid asset. = --------------------------------------- = --------------------- = 0.71 :1
Current liabilities 70 000

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Calculate profitability ratios.

Solution:
Gross Profit
1. Gross Profit Ratio = —————— x 100
Sales
1,80,000
= —————— x 100
4,00,000
= 45%

Net Profit
2. Net Profit Ratio = —————— x 100
Sales
1,55,000
= —————— x 100
4,00,000
= 38.75%

Operating Profit
3. Operating Profit Ratio = —————— x 100
Sales
Operating Profit = Net Profit + Non-operating expenses – Non-operating income
= Net Profit + Interest + Loss on sale of machinery – Dividend
= 1,55,000 + 2,000 + 5,000 – 2,000 = Rs. 1,60,000

1,60,000
Operating Profit Ratio = -------------------- x 100
4,00,000

Cost of goods + Operating Expenses


4. Operating Ratio = ————————
Sales
Cost of goods sold = Sales – Gross Profit = 4,00,000 – 1,80,000 = Rs. 2,20,000

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Operating Expenses = Administration + Selling Expenses
= 10,000 + 10,000 = Rs. 20,000
2,20,000 + 20,000
Operating Ratio = ———————— x 100 = 60%*
4,00,000

* Note : Operating ratio = 100% –– Operating profit ratio = 100% –– 40% = 60%

Illustration 5

Calculate the current ratio from the following information :


Working capital Rs. 9,60,000; Total debts Rs.20,80,000; Long-term Liabilities Rs.16,00,000; Stock
Rs. 4,00,000; prepaid expenses Rs. 80,000.

Solution
Current Liabilities = Total debt- Long term debt
= 20,80,000 – 16,00,000
= 4,80,000

Working capital = Current Assets – Current liability


9,60,000 = Current Assets – 4,80,000
Current Assets = 14,40,000

Quick Assets = Current Assets – (stock + prepaid expenses)


= 14,40,000 – (4,00,000 + 80,000)
= 9,60,000

Current ratio = Current Assets / Current liabilities


= 14,40,000/4,80,000
= 3:1
Quick ratio = Quick Assets / Current liabilities
= 9,60,000/4,80,000
= 2:1
Illustration 6

From the following information, calculate Debt Equity Ratio, Debt Ratio,Proprietary Ratio and Ratio of
Total Assets to Debt.

Balance Sheet as on December 31, 2006

Equity share Capital 3,00,000 Fixed Assets 4,50,000


Preference Share Capital 1,00,000 Current Assets 3,50,000
Reserves 50,000 Preliminary Expenses 15,000
Profit & loss A/C 65,000
11 % Mortgage Loan 1,80,000
Current liabilities 1,20,000
8,15,000 8,15,000

Solution

Shareholders Funds = Equity Shares capital + Preference Shares capital +


Reserves + profit % loss A/C - Preliminary Expenses

= Rs. 3,00,000 + Rs. 1,00,000 + Rs.50,000 + Rs. 65,000- Rs. 15,000


= Rs. 5,00,000

Debt Equity Ratio = Debt / Equity


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

Proprietary Ratio = Proprietary funds / Total Assets


= Rs. 5,00,000/Rs. 8,00,000
= 0.625:1

Total Assets to Debt Ratio = Total Assets / Debt


= Rs. 8,00,000/Rs. 1,80,000
= 4.44:1

Illustration 7
Calculate the Gross profit Ratio, Net Profit Ratio and Operating Ratio from the given the following
information:

Sales Rs. 4,00,000


Cost of Goods Sold Rs. 2,20,000
Selling expenses Rs. 20,000
Administrative Expenses Rs. 60,000

Solution

Gross Profit = Sales – Cost of goods sold


= Rs. 4,00,000 – Rs. 2,20,000
= Rs. 1,80,000

Gross Profit Ratio = Gross s Profit X 100


Sales
= Rs. 1 ,80,000 X 100
Rs 4 ,00,000
= 45 %

Net Profit = Gross Profit – Indirect expenses


= Rs. 1,80,000 – (Rs. 20,000 + Rs. 60,000)
= Rs. 1,00,000

Net Profit Ratio = Net profit / Sales × 100


= Rs.(1,00,000/ 4,00,000) X 100
= 25 %

Operating Expenses = Selling Expenses + Administrative Expenses


= Rs. 20,000 + 60,000
= Rs. 80,000

Operating Ratio = Cost of goods + Operating Expenses X 100


Net Sa les
= Rs. 2 ,20,000 + Rs. 80,000 X 100
Rs4, 00,000
= 75 %

Illustration 8

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Problem

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Problem 2.

The following is the Balance sheet of XYZ ltd, as on 31st March 2005.

Liabilities Rs Assets Rs

Equity share capital 2 00 Land and buildings 1 50 000


Preference share 000 Plant and machine 2 50 000
capital 2 00 Furniture 50 000
General reserve 000 Stock 1 50 000
Profit and loss account 80 000 Debtors 70 000
12 % debentures 40 000 Bills receivable 80 000
Creditors 2 20 Cash at bank 1 00 000
Bills payable 000 Cash in hand 40 000
1 00 8 90 000
000
50 000

8 90
000

Calculate 1). Current Ratio. 2) Quick ratio, 3) debt Equity ratio, 4) Proprietary ratio, 5)Fixed asset to net worth, 6)
Capital gearing ratio.

Answer.
Current assets 4 40 000
Current ratio = ------------------------ = ---------------------- = 2.93 :1
Current liabilities 1 50 000

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Quick assets 2 90 000
Quick ratio = -------------------------- = ----------------- = 1.93 : 1
Current liabilities 1 50 000

Debt
Debt equity ratio = ------------------
Equity
(Debt = debenture + creditors + bills payable
Equity = Equity share capital + Pref share + General reserve + P& L account )

Shareholders fund 5 20 000


Proprietary ratio = ---------------------------------- = ---------------------- = 0.58 : 1
Total assets. 8 90 000

(Where, share holders fund = 2 00 000+ 2 00 000+ 80 000+ 40 000 = 5 20 000).

Fixed asset 4 50 000


Fixed asset to net worth ratio = -------------------- = -------------------- = .86 :1.
Net worth.(share holders fund) 5 20 000

Preference share capital + debentures


Capital gearing ratio = Equity share capital + Reserves and surplus.

= 2 00 000 + 2 20 000 = 1.31:1


2 00 000 + 80 000+ 40 000

Problem 3

From the following, work out 1) Gross profit ratio, 2)Net profit ratio, 3)Operating profit ratio, and 4)Operating ratio.

Trading and P&L Account.


particulars Rs Particulars Rs
To Opening stock 40 000 By Sales 5 00 000
Purchases 4 00 Closing stock 1 00 000
Direct expenses 000
Gross profit c/d 60 000
1 00 6 00 000
000
To operating expense 6 00 By gross profit b/d 1 00 000
Administration 000
exp
Selling expense
Finance expense 20 000
Income tax 10 000
Net profit 20 000 1 00 000
10 000
40 000
1 00
000
Gross profit ratio = gross profit x 100 = 1 00 000 x 100
Sales 5 00 000

Net profit ratio = Net profit after interest and tax x 100 = 40 000 x 100 = 8 %.
Net sales 5 00 000

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Operating ratio = cost of goods sold + operating expense x 100
Net sales

Cost of goods sold = sales – gross profit


( ie opening stock + purchases + direct expense ) – Closing stock
ie 5 00 000 – 1 00 000 = 4 00 000.

Operating ratio = 4 00 000 + 30 000 x 100 = 86 %.


5 00 000

Operating profit ratio = 100 – Operating ratio.


= 100 – 86 = 14 %.

Illustration : 5
From the following calculate Proprietory Ratio
Rs. Rs.
Equity share capital 1,00,000 Furniture 10,000
Preference share capital 75,000 Bank 20,000
Reserves & surplus 25,000 Cash 25,000
Machinery 30,000 Stock 15,000
Goodwill 5,000

Solution :
Shareholders funds
Proprietory Ratio = —————————
Total tangible assets.

Shareholders fund = Equity capital + Preference Share Capital + Reserve & Surplus
= 1,00,000 + 75,000 + 25,000 = Rs. 2,00,000
Total tangible assets= Machinery + Furniture + Bank + Cash + Stock
= 30,000 + 10,000 + 20,000 + 25,000 + 15,000 = Rs. 1,00,000
2,00,000
= ————— = 2:1
1,00,000

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From thew following, Calculate Stock Turnover.


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Problem

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66 Financial Management

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67 Financial Management

Problem. 4

The following are the final accounts of Tata consultancy limited for the years ended 31st March
2005 and 2006.
BALANCE SHEET
LIABILITIES 2004 2005 ASSSETS 2004 2005

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68 Financial Management
Share capital Property, plant and
Equity shares of 10 each 2 39 150 2 32 570 equipment 6 08 060 3 67 730
14% Preference shares 32 650 0 Less depreciation 2 00 830 1 02 810
4 07 230 2 64 920
P&L Account 82 050 62 280
General Reserve 2 13 430 1 61 560 Patent etc 0 2 490
Other fixed assets 4 290 800
12 % debentures of Current assets
Rs100 3 20 000 92 500 Stock 2 32 820 68 690
Book debts 2 90 530 1 92 500
Sundry creditors 1 03 680 53 370 Prepaid expense 6 640 4 150
Outstanding expense 13 090 6960 Bank 1 18 430 1 04 360
Other current liabilities 55 890 28 670
10 59 940 6 37 910 10 59 940 6 37 910

REVENUE STATEMENT
2005 2004 2005 2004
Cost of sales 12 84 340 6 07 760 Sales 19 32 130 9 19 540
Gross profit 6 47 790 3 11 780
19 32 130 9 19 540 19 32 130 9 19 540

Administration and 2 63 690 1 38 440 Gross profit . 6 47 790 3 11 780


selling expense .
Bonus paid 98 310 41 670 Other income 9 560 2 730
Interest paid 38 400 11 100
Provision for taxation 1 47 120 69 340
Transfer to reserve 37 200 36 300
Net income 72 630 17 660
6 57 350 3 14 510 6 57 350 3 14 510

From the above,

1) Work out various ratios for the management.

2) With the help of ratios, give a clear account of the profitability and financial condition of the Co in 2004 – 05 , on
a comparative scale.

Solution:

Ratios 2005 2004


Profitability Ratios.

Return on capital employed based on 2 85 790 1 31 670


operating profit, before interest and tax. --------------x 100 = 32.21 % ------------ x 100 = 23.99%
8 87 280 5 48 910

Net profit Ratio 2 85 790 1 31 670


------------ x 100 = 14.79 % ------------ x 100 = 14.32 %
19 32 130 9 19 540

Gross profit ratio 6 47 790 3 11 780


-------------- x 100 = 33. 53 % --------------- x 100 = 33.91%
19 32 130 9 19 540

12 84 340 6 07 760
Cost of sales ratio(cost of sales / sales) -------------- x 100 = 66. 47 % -------------- x 100 = 66.09%
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19 32 130 9 19 540

Operating Ratio. 16 46 340 7 87 870


(cost of sales + operating exp) --------------- x 100 = 85. ---------------- x 100 = 85.68%
------------------------------------ x 100 21% 9 19 540
Sales 19 32 130

Turnover Ratios.
9 19 540
General turn over ratio 19 32 130 ---------------- =1. 68
(sales / capital employed) -------------- = 2.18 5 48 910
8 87 280
9 19 540
Turn over of fixed capital 19 32 130 ---------------- = 3.44
--------------- = 4. 74 2 67 410
4 07 230
9 19 540
Turnover of net working capital 19 32 130 ------------------ = 3. 28
-------------- = 4. 06 2 80 700
4 75 760
Stock turnover ratio 6 07 760
(cost of sales/ closing stock.) 12 84 340 ----------------- = 8.85
-------------- = 5.52 68 690
2 32 820
1 92 500
Average debt collection period 2 90 530 ------------x 12 = 2.51months
------------ x 12 = 1.8 months 9 19 540
19 32 130
Financial Position Ratios.
3 69 700
Current ratio 6 48 420 ------------- = 4.15 : 1
--------------- = 3.76 : 1 89 000
1 72 660
2 96 860
Liquidity ratio 4 08 960 ---------------- = 3.3.4 :1
-------------- = 2.37 : 1 89 000
1 72 660
92 500
Debt equity ratio 3 20 000 --------------- = 0.17
-------------- = 0.36 5 48 910
8 87 280
2 67 410
Fixed asset ratio 4 07 230 --------------= 0.55 :1
---------------- = 0.51 :1 4 86 630
8 05 230
53 960
EPS 1 09 830 --------------- = Rs 2.32
-------------- = Rs 4. 59 23 257
23 915

ASSESSMENT.

The activity of the company (derived from sales figures) during 2005 as compared to 2004 has more than
doubled. Correspondingly, the gross profit has also more than doubled.
He overall profitability ( return on capital employed) has shown a rise. It means in the year 2005 the profit has
increased not only in volume corresponding to the increase in sales, but more than proportionate to the increase in
sales.
Though the net profit and gross profit ratio were almost maintained, still the return on capital employed has
increased. This is mainly due to the increase in turnover of the capital employed. On the whole the performance is
satisfactory.
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On the financial side there have been some setbacks. The liquidity position has worsened and so has debt
equity ratio. Though the situation is not serious yet a close watch should be kept.
Ther have been very heavy long term borrowings. During the year money has been raised from preference
shares and debentures from long term assets. This has pushed the debt equity ratio to a level beyond which probably it
cannot go. It may be better for the company to broaden the equity base by reducing outstanding debentures and raising
additional funds from equity shares.

Problem 5
The ratios relating to Cosmos Limited are given below as follows.
Gross profit ratio : 15 %
Stock velocity : 6 months
Debtors velocity : 3 months
Creditors velocity : 3 months
Gross profit for the year ending 31 st December amounts to Rs 6 00 000. Closing stock is equal to opening stock.

Find out 1) sales, 2) Closing stock, 3 ) Sundry debtors, 4 ) Sundry creditors.

Solution.

Gross profit ratio = Gross profit x 100


Sales

15% = Rs 6 00 000
Sales
Sales = 6 00 000 x 100 = 4 00 000.
15

Closing Stock.

Stock velocity = Cost of goods sold


Average stock

Cost of goods sold = Sales – Gross profit = 4 00 000 – 60 000 = 3 40 000.


12 = 3 40 000 x 6 = Rs 1 70 000.
6 12
Since opening and closing stock are the same ; closing stock is Rs 1 70 000.
Sundry Debtors
Debtors velocity = Total debtors x No of months
Sales

3= Total debtors x 12
4 00 000
Total debtors = 4 00 000 x 3 = 1 00 000.
12

Sundry Creditors
For calculating sundry creditors, the figure for credit purchases will be required.
Cost of goods sold = Opening stock + Purchases – Closing stock
Rs 3 400 000 = Rs 1 70 000 + Purchases – Rs 1 70 000

Purchases = Rs 3 40 000.

Creditors velocity = Total creditors x No of months


Purchases
3= Total creditors x 12
3 40 000

Total creditors = 3 40 000 x 3 = Rs 85 000.


12
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Problem 6

Prepare a Balance sheet in the given format, with the help of the following ratios.
Total assets / Net worth : 3.5
Sales / Fixed assets :6
Sales / current assets :8
Sales / Inventory : 15
Sales / debtors :18
Current ratio : 2.5
Annual sales : Rs 25 00 000.

Balance sheet
Liabilities Rs Assets Rs
Net worth ------ Fixed assets -----
Long term debt ----- Inventory -----
Current ----- Debtors -----
liabilities Liquid -----
------ assets -------
-

Solution.

1. Sales / Fixed assets = 6 :1


Sales = Rs 25 00 000 ( ie 6)
Fixed assets = 25 00 000 x 1 = Rs 4 16 667.
6

2. Sales / Current assets = 8 :1


Sales = Rs 25 00 000 ( ie 8)
Current assets = 25 00 000 x 1 = Rs 3 12 500.
8

3. Sales / Inventory = 15 times.


Inventory = 25 00 000 x 1 = Rs 1 66 667.
15

4. Sales / Debtors = 18 times.


Debtors = 25 00 000 x 1 = Rs 1 38 889.
18

5. Current assets = Inventory + Debtors+ Liquid assets


There fore, liquid assets = current assets – (inventory + debtors)

Liquid assets = 3 12 500 – (1 66 667 + 1 38 889)


Liquid assets = Rs 6 944.

6. Current Ratio = Current assets = 2.5


Current liabilities
Current assets = 3 12 500 (ie 2.5)

Current liabilities = 3 12 500 x 1 = Rs 1 25 000.


2.5

7. Total assets / Networth = Total assets = 3.5 :1


Networth
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Where total assets = Fixed assets +Inventory +Debtors +Liquid assets.
Total assets = 4 16 667 + 1 66 667 + 1 38 889 + 6 944 = Rs 7 29 167.

Networth = 7 29 167 x 1 = Rs 2 08 333.


3.5

8. Long term debt = Total liabilities – (current liabilities + net worth)

Long tem debt = 7 29 167 - ( 1 25 000 + 2 08 333) = Rs 3 95 834.

Balance sheet
Liabilities Rs Assets Rs
Net worth 2 08 Fixed assets 4 16 667
Long term debt 333 Inventory 1 66 667
Current 3 95 Debtors 1 38 889
liabilities 834 Liquid 6 944
1 25 assets
000 7 29 167

7 29
167

Problem 7

You are given the following figures.

Current ratio -2.5 Liquidity ratio- 1.5 Net working capital-Rs 300 000
Stock turnover - 6 times Gross profit ratio 20 % Fixed asset turnover ratio
Average debt collection period Fixed asset / shareholders net (on cost of asset)- 2 times
- 2 months. worth 0.08 Reserves and surplus to capital
Gross profit ratio 20 % 0.50

Draw up the Balance Sheet of the company.

Solution.

Working capital:-
If current liabilities are 1, current assets are 2.5.
It means the difference or working capital 1.5.
Working capital Rs 3 00 000.

There for current assets = 3 00 000 X 2.5 = 5 00 000.


1. 5

Current liabilities = 3 00 000 X 1 = 2 00 000.


1.5

As liquidity ratio = 1.5 and current liabilities 2 00 000,


Liquid assets are = 2 00 000 x 1.5 = 3 00 000.
Stock ( 5 00 000 – 3 00 000, ie current assets – liquid assets ) Rs 2 00 000.
Cost of sales ( as stock turnover ratio is 6) = 12 00 000.
Sales ( as gross profit ratio is 20 % 12 00 000 + 20 x 12 00 000 = 15 00 000.
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Fixed assets are ( since fixed assets turnover ratio is 2 ) Rs 12 00 000 = 6 00 000.
2
Debtors are ( since debt collection period is 2 months )15 00 000 = 2 50 000.
6
Shareholders Net worth 6 00 000 = 7 50 000
0.80
Out of shareholders net worth reserves and surplus = 2 50 000
There fore share capital = 5 00 000.

Liabilities Rs Assets . Rs
Share capital 5 00 000 Fixed assets 6 00 000
Reserves and surplus 2 50 000 Stock 2 00 000
Long term 1 50 000 Debtors 2 50 000
borrowings 2 00 000 bank 50 000
( balancing figure )
Current liabilities 11 00 11 00 000
000
Income Statement – Model form.

Rs Rs

Sales X XXX
Less sales returns XX

Net sales. X XXX

Less. Cost of goods sold

Opening stock of material XXX


Add: Purchases of material XXX
Add: Direct expense XXX
Manufacturing expense XXX
X XXX
Less: Closing stock of material XXX

Cost of production X XXX


Add: Opening stock of finished product XXX
XXX X
XXX
Less :Closing stock of finished product

(Cost of goods sold) XXXX

Gross profit XXX

Less. Operating expense


Administration exp Xxx
Selling and distribution exp Xxx

Operating exp Xxx


Xxxx
Add: Non trading income Xxx
Xxxx
Less: Non trading expense Xxx

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EBIT ( Earning before Interest and Tax) XXXX

Less. Interest on debenture Xxx


Xxxx
Net income
Xxx
Less. Tax

Net profit after tax. / EAIT. XXX


(Earning After Interest and Tax)

Problem 8

Following is the P&L Account and Balance Sheet of Jai hind Ltd. Re draft them for the purpose of analysis
and calculate the following ratio.
1) Gross Profit Ratio 2) Overall profitability Ratio 3) Current Ratio 4) Debt Equity Ratio 5) Stock
Turnover Ratio 6) Liquidity Ratio.

P&L Account
Particulars Rs Particulars Rs
Opening stock of finished 1 00 000 Sales 10 00 000
goods 50 000 Closing stock of materials 1 50 000
Opening stock of materials 3 00 000 Closing stock of finished 1 00 000
Purchases of materials 2 00 000 goods 50 000
Direct wages 1 00 000 Profit on sale of shares
Manufacturing expense 50 000
Administration expense 50 000
Selling and distribution expense 55 000
Loss on sale of plant 10 000
Interest on debentures
3 85 000
Net profit 13 00 13 00 000
000

Balance sheet
Liabilities Rs Assets Rs
Equity share capital 1 00 Fixed assets 2 50 000
Preference share 000 Stock of raw 1 50 000
capital . 1 00 materials . 1 00 000
Reserves 000 Stock of finished stock 1 00 000
Debentures 1 00 Sundry debtors 50 000
Sundry debtors 000 Bank balance
Bills payable 2 00
000 6 50 000
1 00
000
50 000

6 50
000

Solution

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75 Financial Management
Income Statement
Sales 10 00 000
Less: Cost of sales:
Raw material consumed
(Opening stock + Purchases – closing 2 00
stock) . 000
Direct wages 2 00
Manufacturing expense 000
Cost of production 1 00
Add : Opening stock of finished goods 000
5 00
Less : Closing stock of finished goods 000
1 00 5 00 000
Cost of goods sold. 000
6 00 5 00 000
Gross Profit. 000
1 00
Less : Operating expense: 1 00 000
000
Administration expense
4 00 000
Selling and distribution expense
Net operating profit
Add : Non trading income: 50 000
Profit on sale of shares 4 50 000

Less : Non trading expense or loss. 50 000 55 000


Loss on sale of plant 50 000 3 95 000
Income before interest and tax 10 000
Less : Interest on debentures
3 85 000
Net profit before tax.
Solution

1) Gross profit Ratio = Gross profit x 100 = 5 00 000 x 100 = 50 %


Sales 10 00 000

2) Overall profitability Ratio = Operating profit x 100 = 4 00 000 x 100 = 80 %


Capital employed 5 00 000

3) Current Ratio = Current assets x 100 = 4 00 000 = 2 .67


Current liabilities 1 50 000

4) Debt equity Ratio = External equities x 100 = 3 50 000 = 1.17


Internal equities 3 00 000
Or

Total long term debt = 2 00 000 = 0.67


Share holders fund 3 00 000

5) Stock turnover ratio = Cost of goods sold = 5 00 000 = 2.5


Average Inventory 2 00 000

6) Liquid Ratio = Liquid Assets = 1 50 000 =1


Current Liabilities 1 50 000

COST OF CAPITAL

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The cost of capital of a firm is the minimum rate of return expected by its investors. It is the weighted
average cost of various sources of finance used by a firm. The capital used by a firm may be in the form of debt,
preference capital, retained earnings and equity shares. The concept of cost of capital is very important in the financial
management. A decision to invest in a particular project depends upon the cost of capital of the firm or the cut off rate
which is the minimum rate of return expected by the investors. In case a firm is not able to achieve even the cut off
rate, the market value of its shares will fall. In fact, cost of capital is the minimum rate of return expected by its
investors which will maintain the market value of shares at its present level. Hence, to achieve the objective of wealth
maximisation, a firm must earn a rate of return more than its cost of capital.

Further, optimal capital structure maximises the value of a firm and hence the wealth of its owners and
minimises the firm's cost of capital. The cost of capital of a firm or the minimum rate of return expected by its
investors has a direct relation with the risk involved in the firm. Generally, higher the risk involved in a firm, higher is
the cost of capital.
Cost of capital for a firm may be defined as the cost of obtaining funds, i.e., the average rate of return that the
investors in a firm would expect for supplying funds to the firm.
In the words of Hunt, William and Donaldson, "Cost of capital may be defined as the rate that must be earned
on the net proceeds lo provide the cost elements of the burden at the time they are due".
James C. Van Home defines cost of capital as, "a cut-off rate for the allocation of capital to investments of
projects. It is the rate of return on a project that will leave unchanged the market price of the stock."
Hampton, John J. defines cost of capital as, "the rate of return the firm requires from its investments, in order
to increase the value of the firm in the market place".
Thus, we can say that cost of capital is that minimum rate of return which a firm, must and, is expected to earn
on its investments so as to maintain the market value of its shares.

SIGNIFICANCE OF THE COST OF CAPITAL

The concept of cost of capital is very important in the financial management. It plays a crucial role in both
capital budgeting as well as decisions relating to planning of capital structure. Cost of capital concept can also be used
as a basis for evaluating the performance of a firm and it further helps management in taking so many other financial
decisions.

1. As an Acceptance Criterion in Capital budgeting. In the words of James T.S. Posterfield 'the concept of cost of
capital has assumed growing importance largely because of the need to devise a rational mechanism for making the
investment decisions of the firm'. Capital budgeting decisions can be made by considering the cost of capital.
According to the present value method of capital budgeting, if the present value of expected returns from investment
is greater than or equal to the cost of investment, the project may be accepted; otherwise; the project may be rejected.
The present value of expected returns is calculated by discounting the expected cash inflows at cut-off rate (which is
the cost of capital). Hence, the concept of cost of capital is very useful in capital budgeting decision.

2. As a Determinant of Capital Mix in Capital Structure Decisions. Financing the firm's assets is a very crucial
problem in every business and as a general rule there should be a proper mix of debt and equity capital in financing a
firm's assets. While designing an optimal capital structure, the management has to keep in mind the objective of
maximising the value of the firm and minimising the cost of capital. Measurement of cost of capital from various
sources is very essential in planning the capital structure of any firm.

3. As a Basis for Evaluating the Financial Performance. In the words of S .K. Bhattachary the concept of cost of
capital can be used to 'evaluate the financial performance of top management'. The actual profitability of the project is
compared to the projected overall cost of capital; and the actual cost of capital of funds raised to finance the project. If
the actual profitability of the project is more than the projected and the actual cost of capital, the performance may be
said to be satisfactory.

4. As a Basis for taking other Financial Decisions. The cost of capital is also used in making other financial
decisions such as dividend policy, capitalisation of profits, making the rights issue and working capital.

Computation of cost of capital

Computation of cost of capital involves (1) Computation of cost of each specific source of finance and (2)
Computation of composite cost termed as weighted average cost.

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1. Cost of Debt / Debenture.

Debt may be issued at par, at premium or at discount.

Debt issued at par.


Cost of debt = Kd = (1 – T) R
Where; Kd = Cost of debt
T = Tax Rate
R = Debenture interest rate.
For example if a company has issued 9 % Debentures and the tax rate is 50 %, the cost will be
Kd = (1-T) R
= (1 - .5) 9 = 4.5 %.

Debt issued at premium or discount.


In case the debentures are issued at premium or discount, the cost of debt should be calculated on the basis of
net proceeds realized on account of issue of such debentures or bonds.

Kd = I . (1 –T)
NP
Where; Kd = Cost of debt after tax
I = Annual interest payable
NP = Net proceeds of loans or debentures
T = Tax rate.

2. Cost of Redeemable Debt.

If debentures are redeemable after a fixed period,

( P- NP)
I+ ----------------
n
Kd ( before tax) = ------------------------------------------- x 100
( P + NP )
----------------
2
Where, I = Annual interest payable
P = Par value of debentures.
NP = Net proceeds of debentures
.n = number of years to maturity.

Kd ( after tax) = Kd (before tax) x ( 1 – T)

3. Cost of Preference Capital.

DP
KP = ---------- x 100.
NP
Where Kp = Cost of preference capital.
DP = Preference dividend.
NP = Net proceeds.

4. Cost of Redeemable Preference shares.

( P- NP)
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D+ ----------------
n
KP ( before tax) = ------------------------------------------- x 100
( P + NP )
----------------
2
Where, D = Dividend
P = Par value of debentures.
NP = Net proceeds of debentures
.n = number of years to maturity.

5. Cost of Equity Share Capital.

A. Dividend Price Method. ( DP Approach).

New Equity Share Capital.

D
Ke = --------- x 100
NP

Where, D = Dividend
NP = Net proceeds.

Existing shares.

D
Ke = -------- x 100.
MP
Where, MP = Market Price.

B. Earning Price Method.

E
Ke = ------------- x 100
NP

Or
E
Ke = ---------------------x 100
MP
Where, E = Earning per share
NP = Net proceeds
MP = Market price.

6. Weighted Average Cost of Capital.

After calculating the cost of each component of capital, the average cost of capital is generally calculated on the basis
of weighted average method. This may also be termed as overall cost of capital. Weighted average cost of capital is the
average cost of the costs of various sources of financing. Weighted average cost of capital is also known as composite cost
of capital, overall cost of capital or average cost of capital. Once the specific cost of individual sources of finance is
determined, we can compute the weighted average cost of capital by putting weights to the specific costs of capital in
proportion of the various sources of funds to the total.

The computation of the weighted average cost of capital involves the following steps.

1. Calculation of the cost of each specific source of funds.


This involves the determination of the cost of debt, equity capital, preference capital etc. This can be done
either on before tax basis or after tax basis.
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2. Assigning weights to specific costs.
This involves determination of the proportion of each source of funds in the total capital structure of the
company. This may be done according to marginal weight method, or Historical weights method.

3. Adding of the weighted cost of all sources of funds to get an over all weighted average cost of capital.

CAPITAL SRTUCTURE.

In order to run and manage a company, funds are needed. Right from the promotional stage up to end,
finances play an important role in a company's life. If funds are inadequate, or not properly managed, the entire
organisation suffers. It is, therefore, necessary that correct estimate of the current and future need of capital be made to
have an optimum capital structure which shall help the organisation to run its work smoothly and without any stress.

Capital structure of a company refers to the make up of its capitalisation. A company procures funds by
issuing various types of securities i.e. ordinary shares, preference shares, bonds and debentures. According to
Gerestenbeg, "Capital structure of a company refers to the composition or make-up of its capitalisation and it includes
all long-term capital resources viz : loans, reserves, shares and bonds." The capital structure is made up of debt and
equity securities and refers to permanent financing of a firm. It is composed of long-term debt, preference share
capital and shareholder's funds.For example, a company has equity shares of Rs. 1,00,000, debentures Rs. 1,00,000,
preference shares of Rs. 1,00,000 and retained earnings of Rs. 50,000. The term capitalisation is used for total long-
term funds. In this case it is of Rs. 3,50,000. The term capital structure is used for the mix of capitalisation. In this
case it will be said that the capital structure of the company consists of Rs. 1,00,000 in equity shares, Rs. 1,00,000 in
preference shares, Rs. 1,00,000 in debentures and Rs. 50,000 in retained earnings

Before issuing any of these securities, a company should decide about the kinds of securities to be issued. In
what proportion will the various kinds of securities be issued, should also be considered.

CAPITALISATION, CAPITAL STRUCTURE AND FINANCIAL STRUCTURE.

The terms, capitalisation, capital structure and financial structure, do not mean the same. Capitalisation refers
to the total amount of securities issued by a company while capital structure refers to the kinds of securities and the
proportionate amounts that make up capitalisation. For raising long-term finances, a company can issue three types of
securities viz. Equity shares, Preference Shares and Debentures. A decision about the proportion among these types of
securities refers to the capital structure of an enterprise.

Some authors on financial management define capital structure in a broad sense so as to include even the proportion of
short-term debt. In fact, they refer to capital structure as financial structure. Financial structure means the entire
liabilities side of the balance sheet.

OPTIMUM CAPITAL STRUCTURE; and FACTORS DETERMINING CAPITAL STRUCTURE

The optimum or balanced capital structure means an ideal combination of borrowed and owned capital that
may attain the marginal goal, ie maximizing of market value per share or minimization of cost of capital. The market
value will be maximised or the cost of capital will be minimised when the real cost of each source of fund is the same.

The capital structure of a company is to be determined initially at the time the company is floated. Great
caution is required at this stage, since the initial capital structure will have long-term implications. Of course, it is not
possible to have an ideal capital structure but the management should set a target capital structure and the initial
capital structure should be framed and subsequent changes in the capital structure should be done keeping in view the
target capital structure. Thus, the capital structure decision is a continuous one and has to be taken whenever a firm
needs additional finances.

Following are the factors which should be kept in view while determining the capital structure of a company:
(1) Trading on Equity.

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A company may raise funds either by issue of shares or by debentures. Debentures carry a fixed rate of interest and
this interest has to be paid irrespective of profits. Of course, preference shares are also entitled to a fixed rate of
dividend but payment of dividend depends upon the profitability of the company. In case the rate of return (ROI) on
the total capital employed (shareholders' funds plus long-term borrowed funds) is more than the rate of interest on
debentures or rate of dividend on preference shares, it is said that the company is trading on equity. For example, the
total capital employed in a company is a sum of Rs. 2 lakhs. The capital employed consists of equity shares of Rs. 10
each. The company makes a profit of Rs. 30,000 every year. In such a case the company cannot pay a dividend of
more than 15% on the equity share capital. However, if the funds are raised in the following manner, and other things
remain the same, the company may be in a position to pay a higher rate of return on equity shareholders' funds:

(2) Retaining Control.


The capital structure of a company is also affected by the extent to which the promoter/existing management of
the company desire to maintain control over the affairs of the company. The preference shareholders and
debentureholders have not much say in the management of the company. It is the equity shareholders who
select the team of managerial personnel. It is necessary, therefore, for the promoters to own majority of the equity
share capital in order to exercise effective control over the affairs of the company. The promoters or the
existing management are not interested in losing their grip over the affairs of the company and at the same time,
they need extra funds. They will, therefore, prefer preference shares or debentures over equity shares so long they
help them in retaining control over the company.
(3) Nature of Enterprise
The nature of enterprise also to a great extent affects the capital structure of the company. Business enterprises which
have stability in their earnings or which enjoy monopoly regarding their products may go for debentures or preference
shares since they will have adequate profits to meet the recurring cost of interest/fixed dividend. This is true in case of
public utility concemes. On the other hand, companies which do not have this advantage should rely on equity share
capital to a greater extent for raising their funds. This is, particularly, true in case of manufacturing enterprises.
(4) Legal Requirements
The promoters of the company have also to keep in view the legal requirements while deciding about the capital
structure of the company. This is particularly true in case of banking companies which are not allowed to issue any
other type of security for raising funds except equity share capital on account of the Banking Regulation Act.
(5) Purpose of Financing
The purpose of financing also to some extent affects the capital structure of the company. In case funds are required
for some directly productive purposes, for example, purchase of new machinery, the company can afford to raise 4he
funds by issue of debentures. This is because the company will have the capacity to pay interest on debentures
out of the profits so earned. On the other hand, if the funds are required for non-productive purposes, providing
more welfare facilities to the employees such as construction of school or hospital building for company's employees,
the company should raise the funds by issue of equity shares.
(6) Period of Finance
The period for which finance is required also affects the determination of capital structure of companies. In case,
funds are required, say for 3 to 10 years, it will be appropriate to raise them by issue of debentures rather than by issue
of shares. This is because in case the funds are raised by issue of shares, their repayment after 8 to 10 years (when
they are not required) will be subject to legal complications. Even if such funds are raised by issue of redeemable
preference shares, their redemption is also subject to certain legal restrictions. However, if the funds are required more
or less permanently, it will be appropriate to raise them by issue of equity shares.
(7) Market Sentiments
The market sentiments also decide the capital structure of the company. There are periods when people want to have
absolute safety. In such cases, it will be appropriate to raise funds by issue of debentures. At other periods, people may
be interested in earning high speculative incomes; at such times, it will be appropriate to raise funds, by issue of equity
shares. Thus, if a company wants to raise sufficient funds, it must take into account market sentiments; otherwise its
issue may not be successful.
(8) Requirement of Investors
Different types of securities are to be issued for different classes of investors. Equity shares are best suited for bold or
venturesome investors. Debentures are suited for investors who are very cautious while preference shares are suitable
for investors who are not very cautious. In order to collect funds from different categories of investors, it will be
appropriate for the companies to issue different categories of securities. This is particularly true when a company
needs heavy funds.
(9) Size of the Company
Companies which are of small size have to rely considerably upon the owners' funds for financing. Such companies
find it difficult to obtain long-term debt. Large companies are generally considered to be less risky by the investors

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81 Financial Management
and, therefore, they can issue different types of securities and collect their funds from different sources. They are in
a better bargaining position and can get funds form the sources of their choice.
(10) Government Policy
Government policy is also an important factor in planning the company's capital structure. For example, a change in
the lending policy of financial institutions may mean a complete change in the financial pattern. Similarly, by virtue of
the Securities & Exchange Board of India Act, 1992 and the Rules made there under, the Securities & Exchange
Board of India can also considerably affect the capital issue policies of various companies. Besides this, the monetary
and fiscal policies of the Government also affect the capital structure decision.
(11) Provision for the Future
While planning capital structure the provision for future should, also be kept in view. It will always be safe to keep the
best security to be issued in the last instead of issuing all types of securities in one installment. In the words of
Gerestenberg, "Manager of corporate financing operations must always think of rainy days or the emergencies. The
general rule is to keep your best security or some of your best securities till the last".

DU-PONT CONTROL CHART.

A system of management control designed by an American company named Du-Pont paint Company is popularly
called Du-Pont Control Chart., This system uses the ratio inter-relationship to provide charts for managerial attention. The
standard ratios of the company are compared to present ratios and changes in performance are judged.
The chart is based on two elements i.e., Net profit and capital employed. Net profit is related to operating expenses.
If the expenses are under control then profit margin will increase. The earnings as a percentage of sales or earnings divided
by sales give us percentage of profitability. Earnings can be calculated by deducting cost of sales from sales. Cost of sales
includes cost of goods sold plus office and administrative expenses and selling and distributive expenses. Capital employed,
on the other hand, consists of current assets and net fixed assets. Current assets include debtors, stock, bills receivables,
cash, etc. Fixed assets are taken after deducting depreciation. So profit margin is divided by capital employed and is
multiplied by 100.

So ratio will be Profit margin x 100


capital employed .

DU PONT CHART

Net profit ratio Investment Turnover

Sales / Investments
Operating profit / Sales

Investments
Sales Operating Expense Fixed assets + Working capital

Cost of goods sold + Selling


administrative and others.

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

NSS College. Rajakumari.