Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the financial activities such as procurement
and utilization of funds of the enterprise. It means applying general management principles to financial resources of the
enterprise.

Scope/Elements
1. Investment decisions includes investment in fixed assets (called as capital budgeting). Investment in
current assets are also a part of investment decisions called as working capital decisions.
2. Financial decisions - They relate to the raising of finance from various resources which will depend upon
decision on type of source, period of financing, cost of financing and the returns thereby.
3. Dividend decision - The finance manager has to take decision with regards to the net profit distribution.
Net profits are generally divided into two:
a. Dividend for shareholders- Dividend and the rate of it has to be decided.
b. Retained profits- Amount of retained profits has to be finalized which will depend upon expansion
and diversification plans of the enterprise.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of financial resources
of a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the earning capacity, market
price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum
possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that adequate rate of
return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of capital so that a balance
is maintained between debt and equity capital.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation with regards to capital
requirements of the company. This will depend upon expected costs and profits and future programmes
and policies of a concern. Estimations have to be made in an adequate manner which increases earning
capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the capital structure have
to be decided. This involves short- term and long- term debt equity analysis. This will depend upon the
proportion of equity capital a company is possessing and additional funds which have to be raised from
outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has many choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period of financing.
 4. Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so that
there is safety on investment and regular returns is possible.
5. Disposal of surplus: The net profits decision have to be made by the finance manager. This can be done in
two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon expansional,
innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash management. Cash is
required for many purposes like payment of wages and salaries, payment of electricity and water bills,
payment to creditors, meeting current liabilities, maintainance of enough stock, purchase of raw
materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize the funds but he also has
to exercise control over finances. This can be done through many techniques like ratio analysis, financial
forecasting, cost and profit control, etc.

Definition of Financial Planning

Financial Planning is the process of estimating the capital required and determining it’s competition. It is the
process of framing financial policies in relation to procurement, investment and administration of funds of an
enterprise.

Objectives of Financial Planning

Financial Planning has got many objectives to look forward to:

a. Determining capital requirements- This will depend upon factors like cost of current and fixed assets,
promotional expenses and long- range planning. Capital requirements have to be looked with both
aspects: short- term and long- term requirements.
b. Determining capital structure- The capital structure is the composition of capital, i.e., the relative kind
and proportion of capital required in the business. This includes decisions of debt- equity ratio- both
short-term and long- term.
c. Framing financial policies with regards to cash control, lending, borrowings, etc.
d. A finance manager ensures that the scarce financial resources are maximally utilized in the best possible
mannerat least cost in order to get maximum returns on investment.

Importance of Financial Planning

Financial Planning is process of framing objectives, policies, procedures, programmes and budgets regarding the
financial activities of a concern. This ensures effective and adequate financial and investment policies. The
importance can be outlined as-

1. Adequate funds have to be ensured.

2. Financial Planning helps in ensuring a reasonable balance between outflow and inflow of funds so that
stability is maintained.
3. Financial Planning ensures that the suppliers of funds are easily investing in companies which exercise
financial planning.
4. Financial Planning helps in making growth and expansion programmes which helps in long-run survival of
the company.
5. Financial Planning reduces uncertainties with regards to changing market trends which can be faced easily
through enough funds.
6. Financial Planning helps in reducing the uncertainties which can be a hindrance to growth of the
company. This helps in ensuring stability an d profitability in concern.
Finance function
The following explanation will help in understanding each finance function in detail

Investment Decision
One of the most important finance functions is to intelligently allocate capital to long term assets. This activity is
also known as capital budgeting. It is important to allocate capital in those long term assets so as to get maximum
yield in future. Following are the two aspects of investment decision

a. Evaluation of new investment in terms of profitability

b. Comparison of cut off rate against new investment and prevailing investment.

Since the future is uncertain therefore there are difficulties in calculation of expected return. Along with
uncertainty comes the risk factor which has to be taken into consideration. This risk factor plays a very significant
role in calculating the expected return of the prospective investment. Therefore while considering investment
proposal it is important to take into consideration both expected return and the risk involved.

Investment decision not only involves allocating capital to long term assets but also involves decisions of using
funds which are obtained by selling those assets which become less profitable and less productive. It wise
decisions to decompose depreciated assets which are not adding value and utilize those funds in securing other
beneficial assets. An opportunity cost of capital needs to be calculating while dissolving such assets. The correct
cut off rate is calculated by using this opportunity cost of the required rate of return (RRR)

Financial Decision
Financial decision is yet another important function which a financial manger must perform. It is important to
make wise decisions about when, where and how should a business acquire funds. Funds can be acquired through
many ways and channels. Broadly speaking a correct ratio of an equity and debt has to be maintained. This mix of
equity capital and debt is known as a firm’s capital structure.

A firm tends to benefit most when the market value of a company’s share maximizes this not only is a sign of
growth for the firm but also maximizes shareholders wealth. On the other hand the use of debt affects the risk
and return of a shareholder. It is more risky though it may increase the return on equity funds.

A sound financial structure is said to be one which aims at maximizing shareholders return with minimum risk. In
such a scenario the market value of the firm will maximize and hence an optimum capital structure would be
achieved. Other than equity and debt there are several other tools which are used in deciding a firm capital
structure.

Dividend Decision
Earning profit or a positive return is a common aim of all the businesses. But the key function a financial manger
performs in case of profitability is to decide whether to distribute all the profits to the shareholder or retain all
the profits or distribute part of the profits to the shareholder and retain the other half in the business.

It’s the financial manager’s responsibility to decide a optimum dividend policy which maximizes the market value
of the firm. Hence an optimum dividend payout ratio is calculated. It is a common practice to pay regular
dividends in case of profitability Another way is to issue bonus shares to existing shareholders.

Liquidity Decision
It is very important to maintain a liquidity position of a firm to avoid insolvency. Firm’s profitability, liquidity and
risk all are associated with the investment in current assets. In order to maintain a tradeoff between profitability
and liquidity it is important to invest sufficient funds in current assets. But since current assets do not earn
anything for business therefore a proper calculation must be done before investing in current assets.
Current assets should properly be valued and disposed of from time to time once they become non profitable.
Currents assets must be used in times of liquidity problems and times of insolvency.

Financial activities of a firm is one of the most important and complex activities of a firm. Therefore in order to
take care of these activities a financial manager performs all the requisite financial activities.

A financial manger is a person who takes care of all the important financial functions of an organization. The
person in charge should maintain a far sightedness in order to ensure that the funds are utilized in the most
efficient manner. His actions directly affect the Profitability, growth and goodwill of the firm.

Following are the main functions of a Financial Manager:

1. Raising of Funds
In order to meet the obligation of the business it is important to have enough cash and liquidity. A firm
can raise funds by the way of equity and debt. It is the responsibility of a financial manager to decide the
ratio between debt and equity. It is important to maintain a good balance between equity and debt.

2. Allocation of Funds
Once the funds are raised through different channels the next important function is to allocate the funds.
The funds should be allocated in such a manner that they are optimally used. In order to allocate funds in
the best possible manner the following point must be considered

▪ The size of the firm and its growth capability

▪ Status of assets whether they are long-term or short-term
▪ Mode by which the funds are raised

These financial decisions directly and indirectly influence other managerial activities. Hence formation of
a good asset mix and proper allocation of funds is one of the most important activity

3. Profit Planning
Profit earning is one of the prime functions of any business organization. Profit earning is important for
survival and sustenance of any organization. Profit planning refers to proper usage of the profit generated
by the firm.

Profit arises due to many factors such as pricing, industry competition, state of the economy, mechanism
of demand and supply, cost and output. A healthy mix of variable and fixed factors of production can lead
to an increase in the profitability of the firm.

Fixed costs are incurred by the use of fixed factors of production such as land and machinery. In order to
maintain a tandem it is important to continuously value the depreciation cost of fixed cost of production.
An opportunity cost must be calculated in order to replace those factors of production which has gone
thrown wear and tear. If this is not noted then these fixed cost can cause huge fluctuations in profit.

4. Understanding Capital Markets

Shares of a company are traded on stock exchange and there is a continuous sale and purchase of
securities. Hence a clear understanding of capital market is an important function of a financial manager.
When securities are traded on stock market there involves a huge amount of risk involved. Therefore a
financial manger understands and calculates the risk involved in this trading of shares and debentures.
 Its on the discretion of a financial manager as to how to distribute the profits. Many investors do not like
the firm to distribute the profits amongst share holders as dividend instead invest in the business itself to
enhance growth. The practices of a financial manager directly impact the operation in capital market.

Meaning of Capital Structure

Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as long-term finance.
The capital structure involves two decisions-

a. Type of securities to be issued are equity shares, preference shares and long term borrowings
(Debentures).
b. Relative ratio of securities can be determined by process of capital gearing. On this basis, the companies
are divided into two-
i. Highly geared companies - Those companies whose proportion of equity capitalization is small.
ii. Low geared companies - Those companies whose equity capital dominates total capitalization.

For instance - There are two companies A and B. Total capitalization amounts to be USD 200,000 in each
case. The ratio of equity capital to total capitalization in company A is USD 50,000, while in company B,
ratio of equity capital is USD 150,000 to total capitalization, i.e, in Company A, proportion is 25% and in
company B, proportion is 75%. In such cases, company A is considered to be a highly geared company and
company B is low geared company.

Factors Determining Capital Structure

1. Trading on Equity- The word “equity” denotes the ownership of the company. Trading on equity means
taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to additional
profits that equity shareholders earn because of issuance of debentures and preference shares. It is based
on the thought that if the rate of dividend on preference capital and the rate of interest on borrowed
capital is lower than the general rate of company’s earnings, equity shareholders are at advantage which
means a company should go for a judicious blend of preference shares, equity shares as well as
debentures. Trading on equity becomes more important when expectations of shareholders are high.
2. Degree of control- In a company, it is the directors who are so called elected representatives of equity
shareholders. These members have got maximum voting rights in a concern as compared to the
preference shareholders and debenture holders. Preference shareholders have reasonably less voting
rights while debenture holders have no voting rights. If the company’s management policies are such that
they want to retain their voting rights in their hands, the capital structure consists of debenture holders
and loans rather than equity shares.
3. Flexibility of financial plan- In an enterprise, the capital structure should be such that there is both
contractions as well as relaxation in plans. Debentures and loans can be refunded back as the time
requires. While equity capital cannot be refunded at any point which provides rigidity to plans. Therefore,
in order to make the capital structure possible, the company should go for issue of debentures and other
loans.
4. Choice of investors- The company’s policy generally is to have different categories of investors for
securities. Therefore, a capital structure should give enough choice to all kind of investors to invest. Bold
and adventurous investors generally go for equity shares and loans and debentures are generally raised
keeping into mind conscious investors.
5. Capital market condition- In the lifetime of the company, the market price of the shares has got an
important influence. During the depression period, the company’s capital structure generally consists of
debentures and loans. While in period of boons and inflation, the company’s capital should consist of
share capital generally equity shares.
6. Period of financing- When company wants to raise finance for short period, it goes for loans from banks
and other institutions; while for long period it goes for issue of shares and debentures.
 7. Cost of financing- In a capital structure, the company has to look to the factor of cost when securities are
raised. It is seen that debentures at the time of profit earning of company prove to be a cheaper source of
finance as compared to equity shares where equity shareholders demand an extra share in profits.
8. Stability of sales- An established business which has a growing market and high sales turnover, the
company is in position to meet fixed commitments. Interest on debentures has to be paid regardless of
profit. Therefore, when sales are high, thereby the profits are high and company is in better position to
meet such fixed commitments like interest on debentures and dividends on preference shares. If
company is having unstable sales, then the company is not in position to meet fixed obligations. So,
equity capital proves to be safe in such cases.
9. Sizes of a company- Small size business firms capital structure generally consists of loans from banks and
retained profits. While on the other hand, big companies having goodwill, stability and an established
profit can easily go for issuance of shares and debentures as well as loans and borrowings from financial
institutions. The bigger the size, the wider is total capitalization.

Ratio analysis
Ratio analysis is one of the oldest methods of financial statements analysis. It was developed by banks and
other lenders to help them chose amongst competing companies asking for their credit. Two sets of financial
statements can be difficult to compare. The effect of time, of being in different industries and having different
styles of conducting business can make it almost impossible to come up with a conclusion as to which company is
a better investment. Ratio analysis helps creditors solve these issues. Here is how:

What are Financial Ratios ?

▪ Shortcut: Financial ratios provide a sort of heuristic or thumb rule that investors can apply to understand
the true financial position of a company. There are recommended values that specific ratios must fall
within. Whereas in other cases, the values for comparison are derived from other companies or the same
companies own previous records. However, instead of undertaking a complete tedious analysis, financial
ratios helps investors shortlist companies that meet their criteria.
▪ Sneak-Peek: Investors have limited data to make their decisions with. They do not know what the state of
affairs of the company truly is. The financial statements provide the window for them to look at the
internal operations of the company. Financial ratios make financial analysis simpler. They also help
investors compare the relationships between various income statement and balance sheet items,
providing them with a sneak peek of what truly is happening behind the scenes in the company.
▪ Connecting the Dots: Over the years investors have realized that financial ratios have incredible power in
revealing the true state of affairs of a company. Analyses like the DuPont Analysis have brought to the
forefront the inter-relationship between ratios and how they help a company become more profitable.

Sources of Data
Here is where the investors get the data they require for ratio analysis:

▪ Financial Statements: The financial data published by the company and its competitors is the prime
source of information for ratio analysis.
▪ Best Practices Reports: There are a wide range of consulting firms that collate and publish data about
various companies. This data is used for operational benchmarking and can also be used for financial data
analysis.
▪ Market: The data generated by all the activity on the stock exchange is also important from ratio analysis
point of view. There is a whole class of ratios where the stock price is compared with earnings, cash flow
and such other metrics to check if it is fairly priced.
Techniques used in ratio analysis
Ratio, as the name suggests, is nothing more than one number divided by the other. However, they become
useful when they are put in some sort of context. This means that when an analysts looks at the number resulting
out of a ratio calculation he/she must have a reasonable basis to compare it with. Only when the analyst looks at
the number and compares it what the ideal state of affairs should be like, do the numbers become powerful tool
of management and financial analysis.

Dividing numbers and obtaining ratios is therefore not the main skill. In fact this part can be automated and
done by the computer. Companies wouldn’t want to pay analysts for doing simple division, would they?. The real
skill lies in being able to interpret these numbers. Here are some common techniques used in the interpretation
of these numbers.

Horizontal Analysis
Horizontal analysis is an industry jargon for comparison of the same ratio over time. Once a ratio is calculated, it is
compared with what the value was in the previous quarter, the previous years, or many years in case the analyst
is trying to make a trend. This provides more information of two grounds. They are:

▪ Horizontal analysis clarifies whether the company has a stable track record or is the value of the ratio
influenced by one time special circumstances.
▪ Horizontal analysis helps to unveil trends which help analysts unveil trends in the performance of the
business. This helps them make more accurate future projections and value the share correctly.

Cross-Sectional Analysis
Cross sectional ratio analysis is the industry jargon used to denote comparison of ratios with other companies.
The other companies may or may not belong to the same industry. Cross sectional analysis helps an analyst
understand how well a company is performing relative to its peers. In a way this removes the effect of business
cycles. There are many variations of cross sectional analysis. They are as follows:

▪ Industry Average: The most popular method is to take the industry average and compare it with the
ratios of the firm. This provides a measure of how the company is performing in comparison to an
average firm.
▪ Industry Leader: Many companies and analysts are not satisfied with being average. They want to be the
industry leader and therefore benchmark against them.
▪ Best Practice: In case, the company is the industrial leader, then it usually crosses the industry border and
seeks inspiration from anyone anywhere in the world. They benchmark with the best practices across the
globe.

Limitations of ratio analysis

Ratio analysis, without a doubt, is amongst the most powerful tools of financial analysis. Any investor, who wants
to be more efficient at their job, must devote more time towards understanding ratios and ratio analysis.
However, this does not mean that it is free of limitations. Like all techniques, financial ratios have their
limitations too. Understanding the limitations will help investors understand the possible shortcomings with
ratios and avoid them. Here are the shortcomings:

▪ Misleading Financial Statements

The first and foremost threat to ratio analysis is deliberate misleading statements issued by the
management. The management of most companies is aware that investors look at certain numbers like
sales, earnings, cash flow etc very seriously. Other numbers on the financial statements do not get such
attention. They therefore manipulate the numbers within the legal framework to make important metrics
look good. This is a common practice amongst publically listed companies and is called “Window
 Dressing”. Investors need to be aware of such window dressing and must be careful in calculating and
interpreting ratios based on these numbers.

▪ Incomparability
Comparison is the crux of ratio analysis. Once ratios have been calculated, they need to be compared with
other companies or over time. However, many times companies have accounting policies that do not
match with each other. This makes it impossible to have any meaningful ratio analysis. Regulators all over
the world are striving to make financial statements standardized. However in many cases, companies can
still choose accounting policies which will make their statements incomparable.

▪ Qualitative Factors
Comparison over time is another important technique used in ratio analysis. It is called horizontal
analysis. However, many times comparison over time is meaningless because of inflation. Two companies
may be using the same machine with the same efficiency but one will have a better ratio because it
bought the machine earlier at a low price. Also, since the machine was purchased earlier, it may be closer
to impairment. But the ratio does not reflect this.

▪ Subjective Interpretation
Financial ratios are established “thumb of rules” about the way a business should operate. However some
of these rules of thumb have become obsolete. Therefore when companies come with a new kind of
business model, ratios show that the company is not a good investment. In reality the company is just
“unconventional”. Many may even call these companies innovative. Ratio analysis of such companies
does not provide meaningful information. Investors must look further to make their decisions.

Problem 1. From the data calculate :

(i) Gross Profit Ratio (ii) Net Profit Ratio (iii) Return on Total Assets
(iv) Inventory Turnover (v) Working Capital Turnover (vi) Net worth to Debt
Sales 25,20,000 Other Current Assets 7,60,000
Cost of sale 19,20,000 Fixed Assets 14, 40,000
Net profit 3,60,000 Net worth 15,00,000
Inventory 8,00,000 Debt. 9,00,000
Current Liabilities 6,00,000
Solution:
1. Gross Profit Ratio = (GP/ Sales) * 100 = 6
Sales – Cost of Sales Gross Profit
25,20,000 – 19,20,000 = 6,00,000
2. Net Profit Ratio = (NP / Sales)* 100 = 3
3. Inventory Turnover Ratio = Turnover / Total Assets) * 100= 1920000/800000=
2.4 times
Turnover Refers Cost of Sales
4. Return on Total Assets = NP/ Total Assets = (360000/3000000)*100 = 12%
FA+ CA +inventory [14,40,000 + 7,60,000 + 8,00,000] = 30,00,000
5. Net worth to Debt = Net worth/ Debt= (1500000/900000)* 100 = 1.66 times
6. Working Capital Turnover = Turnover/Working capital
Working Capital = Current Assets – Current Liabilities
= 8,00,000 + 7,60,000 – 6,00,000
15,60,000 – 6,00,000= 9,60,000
Working Capital Turnover Ratio = 19,20,000 = 2 times.

Problem 4. The Balance sheet of Naronath & Co. as on 31.12.2000 shows as follows:
Liabilities $ Assets $
Equity capital 1,00,000 Fixed Assets 1,80,000
15% Preference shares 50,000 Stores 25,000
12% Debentures 50,000 Debtors 55,000
Retained Earnings 20,000 Bills Receivable 3,000
Creditors 45,000 Bank 2,000
2,65,000 2,65,000
Comment on the financial position of the Company i. e., Debt – Equity Ratio, Fixed Assets
Ratio, Current Ratio, and Liquidity.
Solution:
Debt – Equity Ratio = Debt – Equity Ratio / Long – Term Debt
Long-term Debt = Debentures
= 50,000
Shareholder’s Fund = Equity + Preference + Retained Earnings
= 1,00,000 + 50,000 + 20,000
= 50,000
= 1,70,000
= ·29
Fixed Assets Ratio= Fixed Assets / Proprietor’s Fund= -1,80,000
Proprietor’s Fund=Equity Share Capital + Preference Share Capital+ Retained Earnings
=1,00,000 + 50,000 + 20,000 = 1,70,000
Fixed Assets Ratio = 1,80,000 / 1,70,000= 1.05
Current Ratio = Current Assets / Current Liabilities
Current Assets = Stores + Debtors + BR + Bank= 25,000 + 55,000 + 3,000 + 2,000 = 85,000
Liquid Ratio=45,000 / 85,000= 1.88
Liquid Assets = 45,000
Liquid Liabilities = Debtors + Bill Receivable + Cash=55,000 + 3,000 + 2,000 = 60,000
Liquid Ratio = 60,000 / 45,000 = 1.33

Problem 6. From the following details of a trader you are required to calculate :
(i) Purchase for the year.
(ii) Rate of stock turnover
(iii) Percentage of Gross profit to turnover
Sales $ 33,984 Stock at the close at cost price 1814
Sales Returns 380 G.P. for the year 8068
Stock at the beginning
at cost price 1378
Solution :
Trading Account
To Opening stock 1378 By Sales 33984
To Purchase (BD 25972 Sales Return 380
To gross profit 8068 33604
By closing Stock 1814
35418 35418
(i) Purchase for the year $ 25,972
(ii) Stock Turnover = Cost of Goods Sold
Cost of Goods Sold = Cost of Goods Sold / Average Stock
Average Stock = (Opening Stock + Closing Stock)/ 2
= (1372 + 1814 )/2
= 25916/1596
=16.23 times
(iii) Percentage of Gross Profit to Turnover = Gross Profit / Sales *100
= 8068 / 33 ,984 * 100
= 23.74%.

Problem 7. Calculate stock turnover ratio from the following information :

Opening stock 5 8,000
Purchases 4,84,000
Sales 6,40,000
Gross Profit Rate – 25% on Sales.
Solution :
Stock Turnover Ratio = Cost of Goods Sold / Average Stock
Cost of Goods Sold = Sales- G.P
= 6,40,000 – 1,60,000 = 4,80,000
Stock Turnover Ratio= 4,80,000 /58000
= 8.27 times
Here, there is no closing stock. So there is no need to calculate the average stock.

Problem 8. Calculate the operating Ratio from the following figures.

Items ($ in Lakhs)
Sales 17874
Sales Returns 4
Other Incomes 53
Cost of Sales 15440
Administration and Selling Exp. 1843
Depreciation 63
Interest Expenses (Non- operating 456
Solution:
Operating Ratio = (Cost of Goods Sold + Operating Expenses * 100) / Sales
= ((15,440 + 1,843)/ 17,870)*100
= 97%

Types of Budgets: 6 Important Types of

Budgets

Some of types of Budgets are: (i) Sales Budget (ii) Production budget (iii) Financial budget
(iv) Overheads budget (v) Personnel budget and (vi) Master budget!

(i) Sales Budget:

A sales budget is an estimate of expected total sales revenue and selling expenses of the
firm. It is known as a nerve centre or backbone of the enterprise. It is the starting point
on which other budgets are also based. It is a forecasting of sales for the period both in
quantity and value. It shows what product will be sold, in what quantities, and at what
prices.
Some of these factors are:
(i) Past sales figures and trend ;
(ii) Estimates and reports by salesmen ;
(iii) General economic conditions ;
(iv) Orders in hand ;
(v) Seasonal fluctuations ;
(vi) Competition ; and
(vii) Government’s control.

(ii) Production budget:

Production budget is prepared on the basis of the sales budget. But it also takes into
account the stock levels required to be maintained. It contains the manufacturing
programmes of the enterprise. It is helpful in anticipating the cost of production.

The nature of production budget will differ from enterprise to enterprise. For practical
purposes, the overall budget should be divided into production per article per month,
looking into the estimate of the likely quantity of demand. It is the responsibility of
production department to adjust its production according to sales forecast.

It is made by the production manager keeping in mind the following

important factors:
(i) The sales budget ;

(ii) Plant capacity ;

(iii) Inventory policy ; and

(iv) Availability of raw-materials, labour, power, etc.

The production budget is often divided into several budgets:

(i) Material Budget- which fixes the quantity, quality and cost of raw materials needed for
uninterrupted production ;

(ii) Labour Budget-which specifies the requirements of labour in terms of the number and
type of workers for various jobs ;
(iii) Plant and equipment Budget- which lays down the needs of machines, equipment
and tools including their repairs and maintenance ; and

(iv) Research and Development Budget-which specifies the estimated cost on research
and development for developing new products and for improving existing ones.

(iii) Financial budget:

This budget shows the requirement of capital for both long-term and short-term needs of
the enterprise at various points of time in future. Its objective is to ensure regular supply
of adequate funds at the right time. An important part of the financial budget is the cash
budget.

Cash budget contains estimated receipts and payments of cash over the specified future
period. It serves as an effective device for control and coordination of activities that
involves receipt and payment of cash. It helps to detect possible shortage or excess of
cash in business. The financial budget also contains estimates of the firm’s profits and
expenditure i.e., the operating budget.

(iv) Overheads budget:

It includes the estimated costs of indirect materials, indirect labour and indirect factory
expenses needed during the budget period for the attainment of budgeted production
targets. In other words, an estimate of factory overheads, distribution overheads and
administrative overheads is known as the overheads budget. The capital expenditure
budget contains a forecast of the capital investment.

This budget is prepared on departmental basis for effective control over costs. The
factory or manufacturing overheads can be divided into three categories: (i) fixed, (ii)
variable, (iii) semi-variable. This classification helps in the formulation of overhead
budgets for each department.

(V) Personnel budget:

It lays down manpower requirements of all departments for the budget period. It shows
labour requirements in terms of labour hours, cost and grade of workers. It facilitates the
personnel managers in providing required number of workers to the departments either
by transfers or by new appointments.

(Vi) Master budget:

The Institute of Cost and Management Accountants, England defines master budget as
the summary budget incorporating all the functional budgets, which is finally approved,
adopted and applied. Thus, master budget is prepared by consolidating departmental or
functional budgets.

It is a summarised budget incorporating all functional budgets. It projects a

comprehensive picture of the proposed activities and anticipated results during the
budget period. It must be approved by the top management of the enterprise. Though
practices differ, a master budget generally includes, sales, production, costs-materials,
labour, factory overhead, profit, appropriation of profit and major financial ratios.

The following points highlight the three types of budgets Prepared in budgetary control,
i.e, (A) Classification According to Time, (B) Classification on the Basis of Functions, and
(C) Classification on the Basis of Flexibility.

(A) Classification According to Time:

1. Long Term Budget:

The budgets are prepared to depict long term planning of the business. The period of
long term budgets varies between five to ten years. The long term planning is done by
the top level management; it is not generally known to lower levels of management.
Long time budgets are prepared for some sectors of the concern such as capital
expenditure, research and development, long term finances, etc. These budgets are
useful for those industries where gestation period is long i.e., machinery, electricity,
engineering, etc.

2. Short-Term Budget:

These budgets are generally for one or two years and are in the form of monetary terms.
The consumers goods industries like sugar, cotton, textile, etc. use short-term budgets.

3. Current Budget:

ADVERTISEMENTS:

The period of current budgets is generally of months and weeks. These budgets relate to
the current activities of the business. According to I.C.W.A. London, “Current budget is a
budget which is established for use over a short period of time and is related to current
conditions.”

(B) Classification on the Basis of Functions:

1. Operating Budget:
These budgets relate to the different activities or operations of a firm. The number of
such budgets depends upon the size and nature of business.

The commonly used operating budgets are:

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(a) Sales Budget

(b) Production Budget

(c) Production Cost Budget

(d) Purchase Budget

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(e) Raw Material Budget

(f) Labour Budget

(g) Plant Utilization Budget

(h) Manufacturing Expenses or Works Overhead Budget

ADVERTISEMENTS:

(i) Administrative and Selling Expenses, Budget, etc.

The operating budget for a firm may be constructed in terms of programmes or

responsibility areas, and hence may consist of:

(i) Programme Budget, and

(ii) Responsibility Budget.

ADVERTISEMENTS:

(i) Programme Budget:

It consists of expected revenues and costs of various products or projects that are termed
as the major programmes of the firm. Such a budget can be prepared for each product
line or project showing revenues, costs and the relative profitability of the various
programmes. Programme budgets are, thus, useful in locating areas where efforts may
be required to reduce costs and increase revenues. They are also useful in determining
imbalances and inadequacies in programmes so that corrective action may be taken in
future.

(ii) Responsibility Budget:

When the operating budget of a firm is constructed in terms of responsibility areas it is

called the responsibility budget. Such a budget shows the plan in terms of persons
responsible for achieving them. It is used by the management as a control device to
evaluate the performance of executives who are in charge of various cost centres. Their
performance is compared to the targets (budgets), set for them and proper action is
taken for adverse results, if any. The kinds of responsibility areas depend upon the size
and nature of business activities and the organisational structure.

However, responsibility areas may be classified under three broad categories:

(a) Cost/Expense Centre

(b) Profit Centre

(c) Investment Centre.

We have discussed the concept and technique of responsibility budgeting in detail under
a separate chapter on ‘Responsibility Accounting’ latter in this book.

2. Financial Budget:

Financial budgets are concerned with cash receipts and disbursements, working capital,
capital expenditure, financial position and results of business operations.

The commonly used financial budgets are:

(a) Cash Budget

(b) Working Capital Budget

(c) Capital Expenditure Budget

ADVERTISEMENTS:

(d) Income Statement Budget

(e) Statement of Retained Earnings Budget

(f) Budgeted Balance Sheet or Position Statement Budget.

3. Master Budget:

Various functional budgets are integrated into master budget. This budget is prepared by
the ultimate integration of separate functional budgets. According to I.C.W.A. London,
“The Master Budget is the summary budget incorporating its functional budgets”. Master
budget is prepared by the budget officer and it remains with the top level management.
This budget is used to co-ordinate the activities of various functional departments and
also to help as a control device.

(C) Classification on the Basis of Flexibility:

1. Fixed Budget:

ADVERTISEMENTS:

The fixed budgets are prepared for a given level of activity, the budget is prepared before
the beginning of the financial year. If the financial year starts in January then the budget
will be prepared a month or two earlier, i.e., November or December. The changes in
expenditure arising out of the anticipated changes will not be adjusted in the budget.

There is a difference of about twelve months in the budgeted and actual figures.
According to I.C.W.A. London, “Fixed budget is a budget which is designed to remain
unchanged irrespective of the level of activity actually attained.” Fixed budgets are
suitable under static conditions. If sales, expenses and costs can be forecasted with
greater accuracy then this budget can be advantageously used.

2. Flexible Budget:

A flexible budget consists of a series of budgets for different level of activity. It, therefore,
varies with the level of activity attained. A flexible budget is prepared after taking into
consideration unforeseen changes in the conditions of the business. A flexible budget is
defined as a budget which by recognizing the difference between fixed, semi-fixed and
variable cost is designed to change in relation to the level of activity.

The flexible budgets will be useful where level of activity changes from time to time.
When the forecasting of demand is uncertain and the undertaking operates under
conditions of shortage of materials, labour etc., then this budget will be more suited.
Illustration 1:
The expenses for the production of 5,000 units in a factory are given
as follows:
Illustration 2:
The following information at 50% capacity is given. Prepare a
flexible budget and forecast the profit or loss at 60%, 70% and 90%
capacity.

Illustration 3:
The following information relates to a flexible budget at 60%
capacity. Find out the overhead costs at 50% and 70% capacity and
also determine the overhead rates:
 DIFFERENCE BETWEEN BALANCE SHEET AND PROFIT AND LOSS ACCOUNT

BASIS FOR PROFIT AND LOSS

BALANCE SHEET
COMPARISON ACCOUNT
Meaning A statement that shows Account that shows
company's assets, liabilities the company's
and equity at a specific revenue and
date. expenses over a
period of time.
What is it? Statement Account

Represents Financial position of the Profit earned or

business on a particular loss suffered by
date. business for the
accounting period
Preparation Prepared on the last day of Prepared for the
financial year. financial year.
Information Assets, liabilities, and Income, expenses,
Disclosed capital of shareholders. gains and losses.
Accounts Accounts shown in the Accounts
Balance Sheet do not lose transferred to
their identity, rather their Profit and Loss
balance is carry forward to account are closed
next year as opening and cease to exist.
balance.
Sequence It is prepared after the It is prepared
preparation of Profit & Loss before the
Account. preparation of
Balance Sheet.
Meaning of Working Capital
Capital required for a business can be classified under two main categories viz.
(i) Fixed capital
(ii) Working capital.
Every business needs funds for two purposes for its establishment and to carry out its
day-to-day operations. Long-term funds are required to create production facilities
through purchase of fixed assets such as plant and machinery, land, Building etc.
Investments in these assets represent that part of firm’s capital which is blocked on
permanent basis and is called fixed capital. Funds are also needed for short-term purposes
for purchase of raw materials, payment of wages and other day-to-day expenses etc. These
funds are known as working capital which is also known as Revolving or circulating capital
or short term capital. According to Shubin, “Working capital is amount of funds necessary
to cover the cost of operating the enterprise”.
Concept of Working Capital
There are two concepts of working capital:
(i) Gross working capital
(ii) Net working capital.
Gross working capital is the capital invested in total current assets of the enterprise.
Examples of current assets are : cash in hand and bank balances, Bills Receivable, Short
term loans and advances, prepaid expenses, Accrued Incomes etc. The gross working
capital is financial or going concern concept. Net working capital is excess of Current
Assets over Current liabilities.
Net Working Capital = Current Assets – Current Liabilities
When current assets exceed the current liabilities the working capital is positive and
negative working capital results when current liabilities are more than current assets.
Examples of current liabilities are Bills Payable, Sunday debtors, accrued expenses, Bank
Overdraft, Provision for taxation etc. Net working capital is an accounting concept of
working capital.
Classification or Kinds of Working Capital
Working capital may be classified in two ways:
(a) On the basis of concept
(b) On the basis of time
On the basis of concept working capital is classified as gross working capital and net
working capital. On the basis of time working capital may be classifies as Permanent or
fixed working capital and Temporary or variable working capital.
Permanent or Fixed working capital
It is the minimum amount which is required to ensure effective utilisation of fixed
facilities and for maintaining the circulation of current assets. There is always a minimum
level of current assets which its continuously required by enterprise to carry out its normal
business operations. As the business grows, the requirements of permanent working
capital also increase due to increase in current assets. The permanent working capital can
further be classified as regular working capital and reserve working capital required to
ensure circulation of current assets from cash to inventories, from inventories to
receivables and from receivables to cash and so on. Reserve working capital is the excess
mount over the requirement for regular working capital which may be provided for
contingencies that may arise at unstated periods such as strikes, rise in prices, depression
etc.
Temporary or Variable working capital
It is the amount of working capital which is required to meet the seasonal demands
and some special exigencies. Variable working capital is further classified as seasonal
working capital and special working capital. The capital required to meet seasonal needs
of the enterprise is called seasonal working capital. Special working capital is that part of
working capital which is required to meet special exigencies such as launching of extensive
marketing campaigns for conducting research etc.
Importance or Advantages of Adequate Working Capital : Working capital is the life
blood and nerve centre of a business. Hence, it is very essential to maintain smooth running
of a business. No business can run successfully without an adequate amount of working
capital. The main advantages of maintaining adequate amount of working capital are as
follows:
1. Solvency of the Business: Adequate working capital helps in maintaining solvency
of business by providing uninterrupted flow of production.
2. Goodwill: Sufficient working capital enables a business concern to make prompt
payments and hence helps in creating and maintaining goodwill.
3. Easy Loans: A concern having adequate working capital, high solvency and good
credit standing can arrange loans from banks and others on easy and favourable
terms.
4. Cash Discounts: Adequate working capital also enables a concern to avail cash
discounts on purchases and hence it reduces cost.
5. Regular Supply of Raw Material: Sufficient working capital ensure regular supply
of raw materials and continuous production.
6. Regular payment of salaries, wages and other day to day commitments: A
company which has ample working capital can make regular payment of salaries,
wages and other day to day commitments which raises morale of its employees,
increases their efficiency, reduces costs and wastages.
7. Ability to face crisis: Adequate working capital enables a concern to face business
crisis in emergencies such as depression.
8. Quick and regular return on investments: Every investor wants a quick and
regular return on his investments. Sufficiency of working capital enables a concern to
pay quick and regular dividends to is investor as there may not be much pressure to
plough back profits which gains the confidence of investors and creates a favourable
market to raise additional funds in future.
9. Exploitation of Favourable market conditions: Only concerns with adequate
working capital can exploit favourable market conditions such as purchasing its
requirements in bulk when the prices are lower and by holding its inventories for
higher prices.
10. High Morale: Adequacy of working capital creates an environment of security,
confidence, high morale and creates overall efficiency in a business.
Excess or Inadequate Working Capital
Every business concern should have adequate working capital to run its business
operations. It should have neither excess working capital nor inadequate working capital.
Both excess as well as short working capital positions are bad for any business.
Disadvantages of Excessive Working Capital

1. Excessive working capital means idle funds which earn no profits for business and hence
business cannot earn a proper rate of return.
2. When there is a redundant working capital it may lead to unnecessary purchasing and
accumulation of inventories causing more chances of theft, waste and losses.
3. It may result into overall inefficiency in organization.
4. Due to low rate of return on investments, the value of shares may also fall.
5. The redundant working capital gives rise to speculative transaction.
6. When there is excessive working capital, relations with banks and other financial
institutions may not be maintained.
Disadvantages of Inadequate working capital
1. A concern which has inadequate working capital cannot pay its short-term liabilities in
time. Thus, it will lose its reputation and shall not be able to get good credit facilities.
2. It cannot buy its requirements in bulk and cannot avail of discounts.
3. It becomes difficult for firm to exploit favourable market conditions and undertake
profitable projects due to lack of working capital.
4. The rate of return on investments also falls with shortage of working capital.
5. The firm cannot pay day-to-day expenses of its operations and it created inefficiencies,
increases costs and reduces the profits of business.

The Need or Objects or Working Capital

The need for working capital arises due to time gap between production and realisation
of cash from sales. There is an operating cycle involved in sales and realisation of cash.
There are time gaps in purchase of raw materials and production, production and sales,
and sales and realisation of cash. Thus, working capital is needed for following purposes.
1. For purchase of raw materials, components and spares.
2. To pay wages and salaries.
3. To incur day-to-day expenses and overhead costs such as fuel, power etc.
4. To meet selling costs as packing, advertisement
5. To provide credit facilities to customers.
6. To maintain inventories of raw materials, work in progress, stores and spares and
finished stock.
Greater size of business unit large will be requirements of working capital. The amount
of working capital needed goes on increasing with growth and expansion of business till it
attains maturity. At maturity the amount of working capital needed is called normal
working capital.
Factors Determing the Working Capital Requirements
The following are important factors which influence working capital requirements:
1. Nature or Character of Business: The working capital requirements of firm
depend upon nature of its business. Public utility undertakings like electricity,
water supply need very limited working capital because they offer cash sales only
and supply services, not products, and such no funds are tied up in inventories
and receivables whereas trading and financial firms require less investment in
fixed assets but have to invest large amounts in current assets and as such they
need large amount of working capital. Manufacturing undertaking require
sizeable working capital between these two.
2. Size of Business/Scale of Operations: Greater the size of a business unit, larger
will be requirement of working capital and vice-versa.
3. Production Policy: The requirements of working capital depend upon
production policy. If the policy is to keep production steady by accumulating
 inventories it will require higher working capital. The production could be kept
either steady by accumulating inventories during slack periods with view to meet
high demand during peak season or production could be curtailed during slack
season and increased during peak season.
4. Manufacturing process / Length of Production cycle: Longer the process
period of manufacture, larger is the amount of working capital required. The
longer the manufacturing time, the raw materials and other supplies have to be
carried for longer period in the process with progressive increment of labour and
service costs before finished product is finally obtained. Therefore, if there are
alternative processes of production, the process with the shortest production
period should be chosen.
5. Credit Policy: A concern that purchases its requirements on credit and sell its
products/services on cash requires lesser amount of working capital. On other
hand a concern buying its requirements for cash and allowing credit to its
customers, shall need larger amount of working capital as very huge amount of
funds are bound to be tied up in debtors or bills receivables.
6. Business Cycles: In period of boom i.e. when business is prosperous, there is
need for larger amount of working capital due to increase in sales, rise in prices
etc. On contrary in times of depression the business contracts, sales decline,
difficulties are faced in collections from debtors and firms may have large amount
of working capital lying idle.
7. Rate of Growth of Business: The working capital requirements of a concern
increase with growth and expansion of its business activities. In fast growing
concerns large amount of working capital is required whereas in normal rate of
expansion in the volume of business the firm may have retained profits to provide
for more working capital.
8. Earning Capacity and Dividend Policy. The firms with high earning capacity
generate cash profits from operations and contribute to working capital. The
dividend policy of concern also influences the requirements of its working capital.
A firm that maintains a steady high rate of cash dividend irrespective of its
generation of profits need more working capital than firm that retains larger part
of its profits and does not pay so high rate of cash dividend.
9. Price Level Changes: Changes in price level affect the working capital
requirements. Generally, the rising prices will require the firm to maintain large
amount of working capital as more funds will be required to maintain the same
current assets. The effect of rising prices may be different for different firms.
10. Working Capital Cycle: In a manufacturing concern, the working capital cycle
starts with the purchase of raw material and ends with realisation of cash from
the sale of finished products. This cycle involves purchase of raw materials and
stores, its conversion into stocks of finished goods through work in progress with
progressive increment of labour and service costs, conversion of finished stock
 into sales, debtors and receivables and ultimately realisation of cash and this cycle
again from cash to purchase of raw material and so on. The speed with which the
working capital completes one cycle determines the requirements of working
capital longer the period of cycle larger is requirement of working capital.
Managemant of Working Capital
Working capital refers to excess of current assets over current liabilities. Management
of working capital therefore is concerned with the problems that arise in attempting to
manage current assets, current liabilities and inter relationship that exists between them.
The basic goal of working capital management is to manage the current assets and current
of a firm in such a way that satisfactory level of working capital is maintained i.e. it is
neither inadequate nor excessive. This is so because both inadequate as well as excessive
working capital positions are bad for any business. Inadequacy of working capital may lead
the firm to insolvency and excessive working capital implies idle funds which earns no
profits for the business.
Working capital Management policies of a firm have a great effect on its profitability,
liquidity and structural health of organization. In this context, evolving capital management
is three dimensional in nature.
1. Dimension I is concerned with formulation of policies with regard to profitability, risk
and liquidity.
2. Dimension II is concerned with decisions about composition and level of current assets.
3. Dimension III is concerned with decisions about composition and level of current
liabilities.

Principles of Working Capital Management

1. Principle of Risk Variation: Risk refers to inability of firm to meet its obligation as and
when they become due for payment. Larger investment in current assets with less
dependence on short-term borrowings increases liquidity, reduces risk and thereby
decreases opportunity for gain or loss. On other hand less investment in current assets
with greater dependence on short-term borrowings increases risk, reduces liquidity and
increases profitability.
There is definite direct relationship between degree of risk and profitability. A conservative
management prefers to minimize risk by maintaining higher level of current assets while
liberal management assumes greater risk by reducing working capital. However, the goal
of management should be to establish suitable trade off between profitability and risk. The
various working capital policies indicating relationship between current assets and sales
are depicted below:-
 2. Principle of Cost of Capital: The various sources of raising working capital finance
have different cost of capital and degree of risk involved. Generally, higher the risk lower
is cost and lower the risk higher is the cost. A sound working capital management should
always try to achieve proper balance between these two.
3. Principle of Equity Position: This principle is concerned with planning the total
investment in current assets. According to this principle, the amount of working capital
invested in each component should be adequately justified by firm’s equity position. Every
rupee invested in current assets should contribute to the net worth of firm. The level of
current assets may be measured with help of two ratios.
(i) Current assets as a percentage of total assets and
(ii) Current assets as a percentage of total sales.

4. Principle of Maturity of Payment: This principle is concerned with planning the

sources of finance for working capital. According to this principle, a firm should make every
effort to relate maturities of payment to its flow of internally generated funds. Generally,
shorter the maturity schedule of current liabilities in relation to expected cash inflows, the
greater inability to meet its obligations in time.

(1) The Hedging or Matching Approach: The term ‘hedging’ refers to two off-selling
transactions of a simultaneous but opposite nature which counterbalance effect of each
other. With reference to financing mix, the term hedging refers to ‘process of matching
of maturities of debt with maturities of financial needs’. According to this approach the
maturity of sources of funds should match the nature of assets to be financed. This
approach is also known as ‘matching approach’ which classifies the requirements of total
working capital into permanent and temporary working capital.

The hedging approach suggests that permanent working capital requirements should
be financed with funds from long-term sources while temporary working capital
requirements should be financed with short-term funds.

(2) The Conservative Approach: This approach suggests that the entire estimated
investments in current assets should be financed from long-term sources and short-term
sources should be used only for emergency requirements. The distinct features of this
approach are:
(ii) Liquidity is greater
(iii) Risk is minimised
 (iv) The cost of financing is relatively more as interest has to be paid even
on seasonal requirements for entire period.

Trade off Between the Hedging and Conservative Approaches

The hedging approach implies low cost, high profit and high risk while the conservative
approach leads to high cost, low profits and low risk. Both the approaches are the two
extremes and neither of them serves the purpose of efficient working capital management.
A trade off between the two will then be an acceptable approach. The level of trade off
may differ from case to case depending upon the perception of risk by the persons involved
in financial decision making. However, one way of determining the trade off is by finding
the average of maximum and the minimum requirements of current assets. The average
requirements so calculated may be financed out of long-term funds and excess over the
average from short-term funds.

(3). Aggressive Approach: The aggressive approach suggests that entire estimated
requirements of current asset should be financed from short-term sources even a part of
fixed assets investments be financed from short-term sources. This approach makes the
finance – mix more risky, less costly and more profitable.
Hedging Vs Conservative Approach
Hedging Approach Conservative Approach
1. The cost of financing is 1. The cost of financing is higher
reduced.
2. The investment in net working 2. Large Investment is blocked in
capital is nil. temporary working capital.
3. Frequent efforts are required 3. The firm does not face
to arrange funds. frequent financing problems.

4. The risk is increased as firm is 4. It is less risky and firm is able

vulnerable to sudden shocks. to absorb shocks.