Method of bifurcating total risk: Systematic and unsystematic

Measurement of Beta
Characteristic line is used for bifurcating total Risk into
and unsystematic risk of the stocks. As beta of the stoc
volatility of the stock relative to the movement of the m
also be computed using the following formula:
𝐶𝑜𝑣𝑎𝑟𝑖𝑛𝑐𝑒 ( 𝑆𝑡𝑜𝑐𝑘,𝑀𝑎𝑟𝑘𝑒𝑡)
Beta of Stock =
𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑀𝑎𝑟𝑘𝑒𝑡

𝐶𝑜𝑣𝑎𝑟𝑖𝑛𝑐𝑒 ( 𝑆,𝑀)
Beta of Stock =
(σ𝑚) 𝟐
 Covariance =
σ(𝐷𝑒𝑣 𝑓𝑟𝑜𝑚 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑖𝑛 𝑠𝑡𝑜𝑐𝑘 𝑋 𝐷𝑒𝑣 𝑓𝑟𝑜𝑚 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑖𝑛 𝑚𝑎𝑟𝑘𝑒𝑡)
𝑁𝑜 𝑜𝑓 𝑜𝑏𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛𝑠

2
σ 𝐷𝑒𝑣 𝑓𝑟𝑜𝑚 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑖𝑛 𝑚𝑎𝑟𝑘𝑒𝑡
Variance of Market = 𝑁𝑜 𝑜𝑓 𝑜𝑏𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛𝑠
Significance of 𝛼 and 𝛽 of stocks
Example:-4 consider the following data relating to
return on stock and market index: Compute the beta
of the stock.
Period Return on Stock % Return on Market %

1 10 15

2 18 12

3 14 18

4 20 16

5 11 19
 Solution:-

riod Return on Return on Dvs X Dvm

Stock % Market %

1 10 15 -4.6 -1 4.6 1

2 18 12 3.4 -4 -13.6 16

3 14 18 -0.6 2 -1.2 4

4 20 16 5.4 0 0 0

5 11 19 -3.6 3 -10.8 9

otal 73 80 -21 30

erage 14.60 16 -4.2 6

Covariance =
σ(𝐷𝑒𝑣 𝑓𝑟𝑜𝑚 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑖𝑛 𝑠𝑡𝑜𝑐𝑘 𝑋 𝐷𝑒𝑣 𝑓𝑟𝑜𝑚 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑡𝑢𝑟
𝑁𝑜 𝑜𝑓 𝑜𝑏𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛𝑠

−21
Covariance = = - 4.2
5
σ 𝐷𝑒𝑣 𝑓𝑟𝑜𝑚 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑖𝑛 𝑚𝑎𝑟𝑘𝑒𝑡
Variance of Market =
𝑁𝑜 𝑜𝑓 𝑜𝑏𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛𝑠
30
Variance of Market= = 6
5
𝐶𝑜𝑣𝑎𝑟𝑖𝑛𝑐𝑒 ( 𝑆𝑡𝑜𝑐𝑘,𝑀𝑎𝑟𝑘𝑒𝑡)
Beta of Stock =
𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑀𝑎𝑟𝑘𝑒𝑡
−4.2
= = -0.7
6
Long Term Sources of Finance
 Long Term Sources of Finance
Broadly Speaking, Long term sources of finance can be classified into debt and equity. Although,
the distinction between debt and equity is often made in terms of bonds and shares, its roots
lie in the nature of cash flow claims of each type of financing.
Comparison of debt and Equity as a source of long term finance
Characteristics Debt Equity

Claim on profit and Asset Fixed Claim Residual Claim

Tax Treatment Tax deductible Not Tax deductible

Priority in repayment High Priority Lowest Priority

Maturity Fixed Maturity Infinite life

Voice in management No management control Management Control

 Different Sources of Long term Finance

Equity share capital:

Equity shares represents the ownership capital of a company. Due to their
fluctuating earnings, equity shareholders are called risk bearers of the
company. These shareholders enjoy higher returns during prosperity and have a
say in the management of a company, through exercising their voting rights.
Some of its basic features are:
• Voting rights
• Right to sell or transfer equity shares
• Residual claim on assets.
• Pre-emptive rights.
• Right to receive the annual report
 Other Considerations
• Equity shares does not have a maturity date.
• Equity share does not saddle the issuing company with a legal requirement to pay dividends.

• Equity shares forms the basis of the support of all types of debt issued by the company.
• Equity financing tend to free the company from certain restrictions imposed on management
by creditors and preference shareholders.
• Dividends paid to equity shareholders are not taxable in their hands, but the company paying
such dividend pays the dividend distribution tax.
 Limitations of Equity share financing
• The equity share capital has the highest specific cost of capital
among all other sources. This necessitates that the investment
proposals should also have equally high rate of return.
• Dividend distribution tax is an additional burden on the
company.
• At times, new issue of equity share may reduce the EPS and
thus may have an adverse effect on the market price of the
equity share.
 Preference Share Capital

These shares provide a preferential right to the shareholders with

respect to payment of earnings and the repayment of capital.
Investors who prefer steady income without undertaking higher
risks prefer these shares. A company can issue different types of
preference shares.
Some of its basic features include:
• Preference shares are a part of ownership of the company.
• No collateral or mortgage is required as it is not a debt.
• Fixed rate of dividend is payable. Preference dividend is an
approximation of profit and hence no compulsory payment.
• Priority in income distribution as well as asset distribution as
compared to equity shareholders.
• Unless otherwise stated in terms of issue, the preference shares are cumulative and the
dividends on these shares, and the unpaid dividend on these shares gets accumulated and are
paid in future whenever company wants to pay equity dividend.

• The voice of the preference shareholders in management of the company is quite limited.
Advantages of preference share financing
• The preference shares carry limited voting right though they are a part of the capital. Thus,
these do not present a major control or ownership problem as long as the dividends are paid
to them.
• As an instrument of financing, the cost of capital of preference shares is less than that of
equity shares.
• As there is no legal compulsion to pay preference dividend, a company does not face
liquidation or any legal proceedings if it fails to pay preference dividend.
 Limitations of Preference Share Financing
• The cost of capital of preference share is higher than cost of debt.
• Though, there is no compulsion to pay preference dividend, yet non-
payment of such dividend may adversely affect the market position of the
company.
• The compulsory redemption of preference shares after 20 years will entails a
substantial cashflow from the company.
 Debt Financing

Besides share capital, the other long term source of financing available to a company is
debt financing, which refers to the funds obtained by a firm on credit from a lender under
specified terms and conditions with respect to income and return of this credit.

The debt financing may be procured broadly in two ways:

i) By issue of different types of debt instruments to investors ( both individuals as well as
institutions)
ii) In terms of term loans from term lending institutions.
A bond or a debenture is the basic debt instrument which may be issued by a borrowing
company for a price which may be less than, equal to or more than the face value.

A debenture also carries a promise by the company to make interest payment to the debenture
holders of specified amount, at specified time and to repay the principal amount at the end of a
specified period.
Since debt instruments are issued keeping in view the need and cash flow profile of the company
as well as the investor, there have been a variety of debt instruments being issued by companies
in practice.

In all these instruments, the basic features of being in nature of a loan is not dispensed with and
therefore, these instruments have some or the other common features as follows:
• Credit Instrument
• Interest Rates
• Collateral
• Maturity Date
• Voting Rights
• Face Value
• Priority in Liquidation
 Advantages of Debentures
• The after tax cost of capital of debentures as a source of long-term is lower, at least up
to some level of leverage, than the other sources.

• The shareholders also benefit from debenture financing because the latter do not
participate in extra-ordinary profits and do not enjoy any voting rights.
• The debentures do not pose any ownership problem to shareholders.
• Long term borrowing in the form of debenture issue is preferable to repeated short
term borrowings as the debenture issue avoids the extra commitment fees etc. In
addition the short term borrowing rates may fluctuate and the availability of short
term financing may not be guaranteed after the end of a particular short term lending.

• Another advantage of debenture issue is that it provides a hedge against inflation

because the interest payment as well as the principal repayment is fixed in monetary
terms.
 Disadvantages of Debentures
• The debt financing increases the financing risk of the company. The periodic fixed financial
commitment in the form of interest payment must be met otherwise the firm will be
default.

• The firm must retire the bonds and debentures at maturity. This fixed repayment
commitment should also be met regardless of the liquidity position of the company. This
provides greater safety to the debenture holders but also implies a greater risk to the
shareholders.
• A debt issue is also subject to the condition prevailing in the capital market, particularly
when the required rate of return on new debt instruments is too high. This may also the
company to delay the debt financing and/or to resort to the equity financing.
 Debt Financing

Besides share capital, the other long term source of financing available to a company is
debt financing, which refers to the funds obtained by a firm on credit from a lender under
specified terms and conditions with respect to income and return of this credit.

The debt financing may be procured broadly in two ways:

i) By issue of different types of debt instruments to investors ( both individuals as well as
institutions)
ii) In terms of term loans from term lending institutions.
A bond or a debenture is the basic debt instrument which may be issued by a borrowing
company for a price which may be less than, equal to or more than the face value.

A debenture also carries a promise by the company to make interest payment to the debenture
holders of specified amount, at specified time and to repay the principal amount at the end of a
specified period.
Since debt instruments are issued keeping in view the need and cash flow profile of the company
as well as the investor, there have been a variety of debt instruments being issued by companies
in practice.

In all these instruments, the basic features of being in nature of a loan is not dispensed with and
therefore, these instruments have some or the other common features as follows:
• Credit Instrument
• Interest Rates
• Collateral
• Maturity Date
• Voting Rights
• Face Value
• Priority in Liquidation
 Advantages of Debentures
• The after tax cost of capital of debentures as a source of long-term is lower, at least up
to some level of leverage, than the other sources.

• The shareholders also benefit from debenture financing because the latter do not
participate in extra-ordinary profits and do not enjoy any voting rights.
• The debentures do not pose any ownership problem to shareholders.
• Long term borrowing in the form of debenture issue is preferable to repeated short
term borrowings as the debenture issue avoids the extra commitment fees etc. In
addition the short term borrowing rates may fluctuate and the availability of short
term financing may not be guaranteed after the end of a particular short term lending.

• Another advantage of debenture issue is that it provides a hedge against inflation

because the interest payment as well as the principal repayment is fixed in monetary
terms.
 Disadvantages of Debentures
• The debt financing increases the financing risk of the company. The periodic fixed financial
commitment in the form of interest payment must be met otherwise the firm will be
default.

• The firm must retire the bonds and debentures at maturity. This fixed repayment
commitment should also be met regardless of the liquidity position of the company. This
provides greater safety to the debenture holders but also implies a greater risk to the
shareholders.
• A debt issue is also subject to the condition prevailing in the capital market, particularly
when the required rate of return on new debt instruments is too high. This may also the
company to delay the debt financing and/or to resort to the equity financing.
 Types of Debentures

From the Point of view of Security

Secured Debentures: Secured debentures are that kind of debentures where a charge is
being established on the properties or assets of the enterprise for the purpose of any
payment. The charge might be either floating or fixed. The fixed charge is established
against those assets which come under the enterprise’s possession for the purpose to use
in activities not meant for sale whereas floating charge comprises of all assets excluding
those accredited to the secured creditors. A fixed charge is established on a particular
asset whereas a floating charge is on the general assets of the enterprise.

Unsecured Debentures: They do not have a particular charge on the assets of the
enterprise. However, a floating charge may be established on these debentures by
default. Usually, these types of debentures are not circulated.
From the Point of view of Tenure
Redeemable Debentures: These debentures are those debentures that are
due on the cessation of the time frame either in a lump-sum or in instalments
during the lifetime of the enterprise. Debentures can be reclaimed either at a
premium or at par.
Irredeemable Debentures: These debentures are also called as Perpetual
Debentures as the company doesn’t give any attempt for the repayment of
money acquired or borrowed by circulating such debentures. These
debentures are repayable on the closing up of an enterprise or on the expiry
(cessation) of a long period.
 From the Point of view of Convertibility

Convertible Debentures: Debentures which are changeable to equity shares or

in any other security either at the choice of the enterprise or the debenture
holders are called convertible debentures. These debentures are either entirely
convertible or partly changeable.

Non-Convertible Debentures: The debentures which can’t be changed into

shares or in other securities are called Non-Convertible Debentures. Most
debentures circulated by enterprises fall in this class.
From Coupon Rate Point of view

Specific Coupon Rate Debentures: Such debentures are circulated with a

mentioned rate of interest, and it is known as the coupon rate.

Zero-Coupon Rate Debentures: These debentures don’t normally carry a

particular rate of interest. In order to restore the investors’ confidence, such
type of debentures are circulated at a considerable discount and the difference
between the nominal value and the circulated price is treated as the amount of
interest associated to the duration of the debentures.
From the viewpoint of Registration

Registered Debentures: These debentures are such debentures within

which all details comprising addresses, names and particulars of holding of
the debenture holders are filed in a register kept by the enterprise. Such
debentures can be moved only by performing a normal transfer deed.

Bearer Debentures: These debentures are debentures which can be

transferred by way of delivery and the company does not keep any record
of the debenture holders Interest on debentures is paid to a person who
produces the interest coupon attached to such debentures.
 Deep-discount bonds

• A deep-discount bond (DDB) is also a type of zero interest bond. But it is not convertible. It has
got a face value but the issue price of the DDB is a discounted value. The DDB is redeemed at
the expiry of a specified period at the face value. The return to the DDB holder is available in the
form of the difference between the issue price and the realizable maturity amount.
• The is no coupon rate and no interest rate is payable during the life of the DDB.

• The Industrial Development Bank of India (IDBI) first issued DDB in 1992 of the face value of
₹100,000 redeemable in 25 years. The issue price was however ₹ 2700 and the investor were
given option to get redemption at the end of 5th, 10th, 15th and 20th year at different values. If
investors holds the DDB for full 25 years, then the rate of return comes to around 15.5%.

• Since then SIDBI, ICICI and IFCI have issued DDB of different denominations and maturity.

• Thus, it can be said that a deep-discount bond is a bond that sells at a significantly lesser value
than its par value. In particular, these bonds sell at a discount of 20% or more to par and has a
yield that is significantly higher than the prevailing rates of fixed-income securities with a similar
profiles.
 Term loan

Term loan is a medium-term source financed primarily by banks and

financial institutions. Such a type of loan is generally used for financing of
expansion, diversification and modernization of projects—so this type of
financing is also known as project financing. Term loans are repayable in
periodic installments.
Features of Term Loans:

Term loan is a part of debt financing obtained from banks and financial institutions.

The basic features of term loan have been discussed below:

1. Security:
Term loans are secured loans. Assets which are financed through term loans serve as primary
security and the other assets of the company serve as collateral security.
2. Obligation:
Interest payment and repayment of principal on term loans is obligatory on the part of the
borrower. Whether the firm is earning a profit or not, term loans are generally repayable over a
period of 5 to 10 years in installments.
3. Interest:
Term loans carry a fixed rate of interest, but this rate is negotiated between the borrowers and
lenders at the time of dispersing of loan.
4. Maturity:
As it is a source of medium-term financing, its maturity period lies between 5 to 10 years and
repayment is made in installments.
5. Restrictive Covenants:
Besides asset security, the lender of the term loans imposes other restrictive
covenants to the firm. Lenders ask the borrowers to maintain a minimum asset
base, not to raise additional loans or to repay existing loans, etc.

6. Convertibility:
Term loans may be converted into equity at the option and according to the
terms and conditions laid down by the financial institutions.
 Advantages of Term Loans
Term loans are one of the important sources of project financing.
The advantages of term loans are as follows;
i. From Point of View of the Borrower:
• Cheap: It is a cheaper source of medium-term financing.
• Tax Benefit: Interest payable on term loan is a tax deductible expenditure
and thus taxation benefit is available on interest.
• Flexible: Term loans are negotiable loans between the borrowers and
lenders. So terms and conditions of such type of loans are not rigid and this
provides some sort of flexibility.
 Advantages from the point of view of lender
Secured:
Term loans are provided by banks and other financial institutions against
security—so term loans are secured.

Regular Income:
It is obligatory on the part of the borrower to pay the interest and repayment
of principal irrespective of its financial position—hence the lender has a
regular and steady income.

Conversion:
Financial institutions may insist the borrower to convert the term loans into
equity. Therefore, they can get the right to control the affairs of the company.
 Disadvantages of Term Loans:

Term loans have several disadvantages which are discussed below.

i. From Point of View of the Borrower:
Obligation:
Yearly interest payment and repayment of principal is obligatory on the part of
borrower. Failure to meet these payments raises a question on the liquidity
position of the borrower and its existence will be at stake.
Risk:
Like any other form of debt financing term loans also increases the financial risk
of the company. Debt financing is beneficial only if the internal rate of return of
the concern is greater than its cost of capital; otherwise it adversely affects the
benefit of shareholders.
Interference:
In addition to collateral security, restrictive covenants are also imposed by the lenders which
lead to unnecessary interference in the functioning of the concern.
ii. From Point of View of the Lender:
Negotiability:
Terms and conditions of term loans are negotiable between borrower and lenders and thus it
sometimes can affect the interest of lenders.
Control:
Like other sources of debt financing, the lenders of term loans do not have any right to
control the affairs of the company.
 Venture capital
• Venture Capital financing can be explained in terms of the meaning of the terms venture
and capital.
• A venture refers to an undertaking involving more than normal business risk.
• Venture capital therefore refers to investment of capital in relatively high risk enterprises.
• There are many business opportunities where the risk involved is more than the normal
risk a firm has..
• In such cases, the funds are not easily available as a common investor may not be willing
to participate in a high risk situation.
Venture capital as a source of financing has emerged as a necessity for the potentially growth
undertakings of the new entrepreneurs.
 Venture capital

Venture capital (VC) is a form of private equity and a type of financing that investors
provide to startup companies and small businesses that are believed to have long-term
growth potential. Venture capital generally comes from well-off investors, investment
banks, and any other financial institutions.

However, it does not always take a monetary form; it can also be provided in the form of
technical or managerial expertise. Venture capital is typically allocated to small companies
with exceptional growth potential, or to companies that have grown quickly and appear
poised to continue to expand.
Though it can be risky for investors who put up funds, the potential for
above-average returns is an attractive payoff. For new companies or ventures
that have a limited operating history (under two years), venture capital is
increasingly becoming a popular—even essential—source for raising money,
especially if they lack access to capital markets, bank loans, or other debt
instruments. The main downside is that the investors usually get equity in the
company, and, thus, a say in company decisions.

Venture Capital Undertakings: Under the SEBI (Venture Capital Funds)

Regulations, 1996, a venture capital undertakings means a company whose
shares are not listed on stock exchange and which is not engaged in the
production or service of real estate, gold financing or others as specified in
the negative list by the SEBI.
 Features

Entrepreneurial Promoter: The Promoter of venture capital undertakings are generally

technically or professionally qualified but not having funds to invest. The promoters are
fresh, competent and capable, but are not able to start the business due to lack of
funds. These promoters require some outside assistance in the form of capital funds to
undertake new processes, products etc.

Innovative Technology: Generally, VC undertakings has a project to start with a new

process, or to introduce a new technology or new product in the market.. There is high
risk involved as the new product or process may not be acceptable to the market. But
there is expectedly high return as the new process or product may offer better margin.
Longer Gestation Period: The venture capital undertaking generally involves a longer
gestation period. This includes not only the period before the start of the production but also
the period required after the product/process has been introduced in the market. Initially,
there may be some resistance for which a venture capital undertaking require funds for longer
period.
 Types of Venture Capital Financing
Some common Methods of Venture Capital Financing are:
Equity Financing: Since Venture Capital Undertakings (VCUs) are high risk unit involving
long gestation period and hence they require funds for a longer period but may not be
able to provide returns to the investors during the initial stages. Therefore, VC is
generally provided in the form of equity capital. The capital providing firm may not get
return in the form of dividends, but once the VCU becomes profitable, the returns can
be realized in the form of capital gain by selling these shares. The equity capital
contribution does not exceed 49% of the total equity capital of the VCUs so that the
effective control and ownership remains with entrepreneur.

Debt Financing: Some special debt arrangement can be made to suit the requirement of
the VCU. The ordinary debt instruments may not serve the purpose as the VCU does not
have incomes in the initial stages, hence may find problems to pay the debt interest . So,
debt financing in case of VCU must be arranged in such a way that it does not over-
burden the VCU by the interest charge.
 Continuation
In such case, a condition loan may be preferred. This loan is repayable in the form of royalty
after VCU is able to generable revenue. No interest may be payable on the loan.

Income Notes: In case of income notes, the features of conventional loans as well as
conditional loans are brought together. The VCU may be required to pay interest as well as
the royalty on the basis of production/turnover. The rate of interest in case of income notes
is generally substantially low.
 Five Stages in Venture Capital Financing
There are five stages in venture capital financing, and they include:
Seed Stage
At the seed stage, the company is only an idea for a product or service, and the entrepreneur
must convince the venture capitalist that their idea is a viable investment opportunity. If the
business shows potential for growth, the investor will provide funding to finance early
product or service development, market research, business plan development, and setting up
a management team. Seed-stage venture capitalists participate in other investment rounds
alongside other investors.

Startup Stage
The startup stage requires a significant cash infusion to help in advertising and marketing of
new products or services to new customers. At this stage, the company has completed
market research, has a business plan in place, and has a prototype of its products to show
investors. The company brings in other investors at this stage to provide additional financing.
3 First Stage
The company is now ready to go into actual manufacturing and sales, and this requires a
higher amount of capital than the previous stages. Most first-stage businesses are
generally young and have a commercially-viable product or service.

4 Expansion Stage
The business has already started selling its products or services and needs additional
capital to support the demand. It requires this funding to support market expansion or
start another line of business. The funding may also be used for product improvement and
plant expansion.
5 Bridge Stage
The bridge stage represents the transition to a public company. The business has reached
maturity, and it requires financing to support acquisitions, mergers, and IPOs. The
venture capitalist can exit the company at this stage, sell off his shares, and earn a huge
return on his investments in the company. The exit of the venture capitalist allows other
investors to come in, hoping to gain from the IPO.
 Criteria for Investment in Venture Capital

The VCU is a risky proposition and therefore the VC firm should be very careful, analytical
and selective in financing the VCU. Each case of financing must be evaluated not only from
the point of view of profitability but also for its technology, marketing and managerial skills.
The following are the criteria which may be applied to find out the eligibility of an
undertaking for venture capital financing.

1. The venture must be a technically feasible propostion.

2. It should be commercially viable.
3. The entrepreneurs must be technically competent and should have managerial skill.
4. The VCU must have a long run competitive advantage over other units.
 Venture Capital in India
Venture capitalism in India began in 1986 with the start of the economic liberalisation. In
1988, the Indian government formalised venture capital by issuing a set of guidelines.
Initially, venture capital or VC was limited to subsidiaries set up IDBI, ICICI and the IFC, and
focused on large industrial concerns.

But the turning point came when the well-established start-ups by Indians in the Silicon
Valley convinced foreign investors that India had the talent and the scope for economic
development and growth. Over the years, more and more private investors from India and
abroad have entered the Indian venture capital market.
 Five Stages in Venture Capital Financing
There are five stages in venture capital financing, and they include:
Seed Stage
At the seed stage, the company is only an idea for a product or service, and the entrepreneur
must convince the venture capitalist that their idea is a viable investment opportunity. If the
business shows potential for growth, the investor will provide funding to finance early
product or service development, market research, business plan development, and setting up
a management team. Seed-stage venture capitalists participate in other investment rounds
alongside other investors.

Startup Stage
The startup stage requires a significant cash infusion to help in advertising and marketing of
new products or services to new customers. At this stage, the company has completed
market research, has a business plan in place, and has a prototype of its products to show
investors. The company brings in other investors at this stage to provide additional financing.
3 First Stage
The company is now ready to go into actual manufacturing and sales, and this requires a
higher amount of capital than the previous stages. Most first-stage businesses are
generally young and have a commercially-viable product or service.

4 Expansion Stage
The business has already started selling its products or services and needs additional
capital to support the demand. It requires this funding to support market expansion or
start another line of business. The funding may also be used for product improvement and
plant expansion.
5 Bridge Stage
The bridge stage represents the transition to a public company. The business has reached
maturity, and it requires financing to support acquisitions, mergers, and IPOs. The
venture capitalist can exit the company at this stage, sell off his shares, and earn a huge
return on his investments in the company. The exit of the venture capitalist allows other
investors to come in, hoping to gain from the IPO.
 Criteria for Investment in Venture Capital

The VCU is a risky proposition and therefore the VC firm should be very careful, analytical
and selective in financing the VCU. Each case of financing must be evaluated not only from
the point of view of profitability but also for its technology, marketing and managerial skills.
The following are the criteria which may be applied to find out the eligibility of an
undertaking for venture capital financing.

1. The venture must be a technically feasible propostion.

2. It should be commercially viable.
3. The entrepreneurs must be technically competent and should have managerial skill.
4. The VCU must have a long run competitive advantage over other units.
 Venture Capital in India
Venture capitalism in India began in 1986 with the start of the economic liberalisation. In
1988, the Indian government formalised venture capital by issuing a set of guidelines.
Initially, venture capital or VC was limited to subsidiaries set up IDBI, ICICI and the IFC, and
focused on large industrial concerns.

But the turning point came when the well-established start-ups by Indians in the Silicon
Valley convinced foreign investors that India had the talent and the scope for economic
development and growth. Over the years, more and more private investors from India and
abroad have entered the Indian venture capital market.
 Continuation
In the early stages, venture capital investments were mainly in the manufacturing
sector. However, with changing trends and increased liberalisation, companies in
consumer services and consumer retail space emerged as top contenders for VC
funding, attracting almost 50% of total VC investments. Other key industries
included IT and IT-related services, software development, telecommunications,
electronics, biotechnology and pharmaceuticals, banking and finance/insurance,
public sector disinvestment, media and entertainment, and education.

A completely new field that is attracting venture capital is agriculture. This has been
fuelled by the realisation that food security is a vital, long-term necessity.
 Private Equity
Private Equity refers to contribution in equity capital of a company on private basis. In
broader sense, private equity refers to investment in a company in a way that the equity is
not transferable or tradable in the market. The investee company is not a listed company
and the shares are bought by the private equity firm on a private basis from the promoter
of the unlisted company.

Private equity provides long term equity funds to help the unquoted companies to grow.
Suppose, a company wants to expand, buy-out another company or to re-vitalize the
company by infusing new funds, it may get funds for these purposes from private equity
firms.

Obtaining funds from private equity is different from raising debt. In case of debt, lenders
have a legal right to receive interest and principal irrespective of the result of operations
of the investee company.
However, return on investment of private equity depends on the growth of business of the
investee company.

Sometimes private equity firms provide a combination of capital and expertise and thus
helps the investee company in achieving its target. Private equity firms may also provide a
funding package to the company.
 Types of Private Equity Funds
Private equity funds generally fall into two categories:
1. Venture Capital and
2. Buyout or Leveraged Buyout.

1. Venture Capital (VC)

Venture capital funds are pools of capital that typically invest in small, early stage and
emerging businesses that are expected to have high growth potential but have limited access
to other forms of capital. From the point of view of small start-ups with ambitious value
propositions and innovations, VC funds are an essential source to raise capital as they lack
access to large amounts of debt. From the point of view of an investor, although venture
capital funds carry risks from investing in unconfirmed emerging businesses, they can
generate extraordinary returns.
 Continuation
2. Buyout or Leveraged Buyout (LBO)
• Contrary to VC funds, leveraged buyout funds invest in more mature businesses, usually
taking a controlling interest. LBO funds use extensive amounts of leverage to enhance the
rate of return. Buyout funds tend to be significantly larger in size than VC funds.
How Does a Leveraged Buyout Work?
• A leveraged buyout (LBO) is when one company attempts to buy another company,
borrowing a large amount of money in order to finance the acquisition. The acquiring
company issues bonds against the combined assets of the two companies, meaning that
the assets of the acquired company can actually be used as collateral against it. Although
often viewed as a predatory or hostile action, large-scale LBOs experienced a resurgence
in the early 2020s.
• In a leveraged buyout (LBO), there is usually a ratio of 90% debt to 10% equity. Because of
this high debt/equity ratio, the bonds issued in the buyout are usually not investment
grade and are referred to as junk bonds.
 Continuation
LBOs are conducted for three main reasons:
• To take a public company private
• To spin off a portion of an existing business by selling it
• To transfer private property, as is the case with a change in small business
ownership

However, it is usually a requirement that the acquired company or entity, in each scenario, is
profitable and growing.

• Leveraged buyouts have had a notorious history, especially in the 1980s, when several
prominent buyouts led to the eventual bankruptcy of the acquired companies. This was
mainly due to the fact that the leverage ratio was nearly 100% and the interest payments
were so large that the company's operating cash flows were unable to meet the
obligation.
 What Type of Companies Are Attractive for LBOs?

Equity firms will typically target companies in established industries and mature for
leveraged buyouts, rather than fledgeling or more speculative industries. The best
candidates for LBOs typically have strong, dependable operating cash flows, well-
established product lines, strong management teams, and viable exit strategies so that
the acquirer can realize gains.
 Private Equity
Private Equity refers to contribution in equity capital of a company on private basis. In
broader sense, private equity refers to investment in a company in a way that the equity is
not transferable or tradable in the market. The investee company is not a listed company
and the shares are bought by the private equity firm on a private basis from the promoter
of the unlisted company.

Private equity provides long term equity funds to help the unquoted companies to grow.
Suppose, a company wants to expand, buy-out another company or to re-vitalize the
company by infusing new funds, it may get funds for these purposes from private equity
firms.

Obtaining funds from private equity is different from raising debt. In case of debt, lenders
have a legal right to receive interest and principal irrespective of the result of operations
of the investee company.
However, return on investment of private equity depends on the growth of business of the
investee company.

Sometimes private equity firms provide a combination of capital and expertise and thus
helps the investee company in achieving its target. Private equity firms may also provide a
funding package to the company.
 Types of Private Equity Funds
Private equity funds generally fall into two categories:
1. Venture Capital and
2. Buyout or Leveraged Buyout.

1. Venture Capital (VC)

Venture capital funds are pools of capital that typically invest in small, early stage and
emerging businesses that are expected to have high growth potential but have limited access
to other forms of capital. From the point of view of small start-ups with ambitious value
propositions and innovations, VC funds are an essential source to raise capital as they lack
access to large amounts of debt. From the point of view of an investor, although venture
capital funds carry risks from investing in unconfirmed emerging businesses, they can
generate extraordinary returns.
 Continuation
2. Buyout or Leveraged Buyout (LBO)
• Contrary to VC funds, leveraged buyout funds invest in more mature businesses, usually
taking a controlling interest. LBO funds use extensive amounts of leverage to enhance the
rate of return. Buyout firms tend to be significantly larger in size than VC funds.
How Does a Leveraged Buyout Work?
• A leveraged buyout (LBO) is when one company attempts to buy another company,
borrowing a large amount of money in order to finance the acquisition. The acquiring
company issues bonds against the combined assets of the two companies, meaning that
the assets of the acquired company can actually be used as collateral against it. Although
often viewed as a predatory or hostile action, large-scale LBOs experienced a resurgence
in the early 2020s.
• In a leveraged buyout (LBO), there is usually a ratio of 90% debt to 10% equity. Because of
this high debt/equity ratio, the bonds issued in the buyout are usually not investment
grade and are referred to as junk bonds.
 Continuation
LBOs are conducted for three main reasons:
• To take a public company private
• To spin off a portion of an existing business by selling it
• To transfer private property, as is the case with a change in small business
ownership

However, it is usually a requirement that the acquired company or entity, in each scenario, is
profitable and growing.

• Leveraged buyouts have had a notorious history, especially in the 1980s, when several
prominent buyouts led to the eventual bankruptcy of the acquired companies. This was
mainly due to the fact that the leverage ratio was nearly 100% and the interest payments
were so large that the company's operating cash flows were unable to meet the
obligation.
 What Type of Companies Are Attractive for LBOs?

Equity firms will typically target companies in established industries and mature for
leveraged buyouts, rather than fledgeling or more speculative industries. The best
candidates for LBOs typically have strong, dependable operating cash flows, well-
established product lines, strong management teams, and viable exit strategies so that
the acquirer can realize gains.
IPO Process
“If you can get an IPO, don’t buy it, only buy IPOs you can’t get”

- Vahan Janjigian
 Initial Public Offer
• Initial public offer is the process by which a private company can go public by sale of its
stocks to the general public. It could be a young company or an old company that decides
to be listed on an exchange and hence goes public.
• Companies can raise equity capital with the help of an IPO by issuing new shares to the
public or the existing shareholders can sell their shares to the public without raising any
fresh capital. In other words, a company that was privately owned until then becomes a
publicly-traded company.
• Before the IPO, a company has very few shareholders. This includes the founders, angel
investors, and venture capitalists. But during an IPO, the company opens its shares for
sale to the public. As an investor, one can buy shares directly from the company and
become a shareholder.
 Why IPOs?
For Funding Needs
•Funding Capital Requirements for Organic Growth
•Expansion through Projects
•Diversification
•Funding Global Requirements
•Funding Joint Venture and Collaborations needs
•Funding Infrastructure Requirements, Marketing Initiatives and Distribution
Channels
•Financing Working Capital Requirements
•Funding General Corporate Purposes
•Repaying debt to strengthen the Balance Sheet
For Non-funding Needs
•Enhancing Corporate Stature
•Provide liquidity to the shareholders
 Steps in IPO

• Assembling of IPO Team and Selection of Underwriter/Investment banker

• Filling Registration Statement
• Preparation of draft prospectus or draft red herring prospectus
• Regulators’ Review and Comments
• The Roadshow
• Valuation and Pricing
• Allotment of Shares
 Continuation
Assembling of IPO Team and Selection of Underwriter/Investment banker:
The IPO team of the company generally consists of its Chief Financial Officer, Company
Secretary, Compliance Officer and support staff. Once the internal term of IPO becomes ready,
company opts for selection of an underwriter or group of underwriters, as they are the lead
managers responsible for selling the securities. The selection of underwriters is influenced by their
reputation, experience, distribution and market-making capabilities, fees, research coverage and
after offering services.
Likewise, underwriters holds a due diligence meeting with members of the IPO team to gather and
authenticate matters such as articles of incorporation, bylaws, patents and verification of corporate
existence. Due diligence meetings are held to ensure that all the material facts about are fully and
fairly disclosed to the lead managers.
If both the parties are satisfied, the investment banker issues the letter of intent to formalize the
arrangement, which later lead to underwriting agreement.
IPO Process
“If you can get an IPO, don’t buy it, only buy IPOs you can’t get”

- Vahan Janjigian
 Initial Public Offer
• Initial public offer is the process by which a private company can go public by sale of its
stocks to the general public. It could be a young company or an old company that decides
to be listed on an exchange and hence goes public.
• Companies can raise equity capital with the help of an IPO by issuing new shares to the
public or the existing shareholders can sell their shares to the public without raising any
fresh capital. In other words, a company that was privately owned until then becomes a
publicly-traded company.
• Before the IPO, a company has very few shareholders. This includes the founders, angel
investors, and venture capitalists. But during an IPO, the company opens its shares for
sale to the public. As an investor, one can buy shares directly from the company and
become a shareholder.
 Why IPOs?
For Funding Needs
•Funding Capital Requirements for Organic Growth
•Expansion through Projects
•Diversification
•Funding Global Requirements
•Funding Joint Venture and Collaboration needs
•Funding Infrastructure Requirements, Marketing Initiatives and Distribution
Channels
•Financing Working Capital Requirements
•Funding General Corporate Purposes
•Repaying debt to strengthen the Balance Sheet
For Non-funding Needs
•Enhancing Corporate Stature
•Provide liquidity to the shareholders
 Understanding IPO Process
Steps in IPO:
• Assembling of IPO Team and Selection of Underwriter/Investment banker
• Filling Registration Statement
• Preparation of draft prospectus or draft red herring prospectus
• Regulators’ Review and Comments
• The Roadshow
• Valuation and Pricing
• Allotment of Shares
 Continuation
Assembling of IPO Team and Selection of Underwriter/Investment banker:
The IPO team of the company generally consists of its Chief Financial Officer, Company
Secretary, Compliance Officer and support staff. Once the internal term of IPO becomes ready,
company opts for selection of an underwriter or group of underwriters, as they are the lead
managers responsible for selling the securities. The selection of underwriters is influenced by their
reputation, experience, distribution and market-making capabilities, fees, research coverage and
after offering services.
Likewise, underwriters holds a due diligence meeting with members of the IPO team to gather and
authenticate matters such as articles of incorporation, bylaws, patents and verification of corporate
existence. Due diligence meetings are held to ensure that all the material facts about are fully and
fairly disclosed to the lead managers.
If both the parties are satisfied, the investment banker issues the letter of intent to formalize the
arrangement, which later lead to underwriting agreement.
 Continuation

Underwriting agreements contain the following:

Introduction- Parties to the underwriting syndicate, the size and type of securities to be offered.
Warranties- Guarantee by the company; underwriter’s pledge to buy and pay for the securities,
any option that the underwriter has to buy additional shares at the offering price (called as
green shoe option).
Covenants- rights and obligations of all parties.
Conditions- Completeness and accuracy of the company’s representation.
Indemnification- Excuse the underwriter’s liability for material misstatement or omission by
the company
Cancellation clause- it allows the underwriter to cancel the offering, provided that it can show
valid justification
 Continuation

Filling Registration Statement:

•In this step, the investment banker coordinates with the company’s IPO team in the preparation
of detailed information about the firm called a registration statement to be filed with the
regulator (e.g., SEC in US or SEBI in case of India). The registration statement comprises of all
the financial data and business plans of the company. It will also have to declare how the
Company is going to utilize the funds it will raise from the IPO.
•If the registration statement is compliant with the stringent guidelines set by the particular
regulator, which ensures that the company has disclosed every detail a potential investor should
know, then it gets approval.
•On the contrary, if it fails to meet the set requirements, the registration statement is sent back
to the company with comments. The company should then work on the comments and file for
registration again.
 Continuation
Preparation of the Draft Prospectus and Final Budget
•After successful filling of registration statement, the lead managers prepares a draft
prospectus, which contains preliminary information about the issue such as probable price
estimate per share and other details regarding the IPO. This is the main document that lead
managers uses to gather indication of interest from the prospective investors.
•Along with the preparation of the draft prospectus, the lead managers also prepares the final
budget of the IPO, which states the total cost to be incurred in the entire process of IPO, after
taking into consideration the prevailing regulations relating to such expenditure .
•Subsequently, the lead manager sends the draft prospectus along with the final budget to the
board of directors (BODs) of the company for approval.
•Once BOD approval is obtained, the lead managers file the draft prospectus with the regulator
(i.e, SEBI).
 Regulators Review and Comments:

SEBI

Lead managers will

upload on its website for
SEBI gives its own Upload on its website public comments
suggestion within 30 for public comments
days

Once lead manager submits the draft prospectus to SEBI, it enters into a quiet period.
During this period corporate communications and advertisements are regulated.
 Continuation

After filing the draft prospectus with SEBI, the company has to make listing applications along
with draft prospectus to all the stock exchanges on which they want to list their shares.

Lead
Manager

Stock
SEBI
Exchange

The lead manager will modify the preliminary prospectus by consulting with stock exchanges and SEBI
 Continuation
The lead manager will get the in-principle approval from the stock exchange within 15
days of submission of the draft prospectus to them and will submit it to SEBI.

After all suggestions and modifications, the final document of the draft prospectus again
go to the BODs of company for approval

After the approval of the board, the final prospectus is submitted to SEBI
 Continuation
Company will form a tripartite agreement with registrars and depositories

Company Registrar

Depositories (e.g.
CDSL or NSDL)

The company has to submit the prospectus to the registrar of companies as mentioned in the
prospectus. Once the prospectus is submitted to registrar, the company has to issue shares within
90 days
 Valuation and Pricing:
• The underwriter typically conducts a survey of comparable public companies, which helps to
provide a preliminary valuation. The underwriter also takes into consideration some factors
like- efficiency, leverage, profit margins, use of proceeds, operating history, operating base,
management quality, and product differentiation for valuation.
• Pricing refers to setting the offer price. In this regard, most underwriters follow historical
tradition in pricing that the price should not be too high or low in order to appeal to potential
investors.
• Underwriters price a new issue a certain percentage below what they consider a fair value.
Thus, there is a difference between the price of an IPO and the price when those shares trade
in the secondary market. This creates incentives for investors to put money into the new
issue.
• Timing is also critical. The offering price is adjusted upward when the underwriter has
received a higher oversubscription in indications of interest. The offering price needs to be
lowered or the issue may be postponed if indications of interest are weak.
 Continuation

Price of the Issue:

Company can arrive at share price in two ways

Fixed Book
Price Building
Offer offer

No. of shares and/or price of the shares is

Number of shares and share price is
not mentioned in the draft prospectus
mentioned in the draft prospectus as well as
and that is why it is known as draft red
final prospectus
herring prospectus
 Creating a Buzz By Roadshows

• Before an IPO opens to the public, the lead managers of the company create a buzz in the
market by roadshows. Over a period of two weeks, the lead managers along with executives
of the company will advertise the impending IPO across the country.
• This is basically a marketing and advertising tactic to attract potential investors. The key
highlights of the company are shared with various people, including business analysts and
fund managers, wealthy individuals by way of multimedia presentations, group meetings,
online virtual roadshows, and so on.
• However, all marketing efforts need to comply with the regulatory requirements, and they
should not mislead the public.
• In the case of fixed price offers, road shows are primarily created to generate interest among
investors about the IPO, while in the case of the book-building process road shows help lead
managers to know the demand from the investors’ side for the issue. Subsequently, the
company along with the lead manager decides the price band for the share price within which
the investors will bid. This information is finally incorporated into the draft red herring
prospectus, and it will be submitted to SEBI and stock exchanges.
• Finally, company will give time period for applying to IPO by public [Min. 3 to maximum 10
days]
 Continuation
Fixed Price Offer Book Building Offer

Issue Size 2500 cr. Issue Size 2250-2500 cr.

No. of Shares 10cr. No. of Shares 10cr.
Price 250 Floor Price 225
Lot Size 50 Cap Price 250
Minimum investment 12500 Lot Size 50
Minimum investment 11250-12500

• Higher risk for the issuer and underwriter Tickprice

Bid Size 5 No. of shares
• Price discovered by underwriter based on
formulas 250 4 cr.
• Qualitative factors are not taken into 245 5 cr.
consideration
240 2.5 cr.

235 3 cr.

230 3.5 cr.

225 4 cr.
 Allotment of Shares

Once the bidding process stops, the company along with the underwriters will determine the
basis of allocation of shares to each investor. In the case of over-subscription, partial
allotments will be made. The IPO stocks are usually allotted to the bidders within 10 working
days of the last bidding date.

Closing of Underwriting agreement: The closing date of the underwriting agreement is

generally set after the allotment of shares. The closing meeting includes the IPO team of the
company, BODs of the company, and the lead managers. At the closing date, various IPO
documents as well as the updated comfort letter are exchanged. The company delivers the
registered securities to the underwriter and receives payment for the issue.
 Underwriting Risk and Compensation for Investment Banker
Underwriting Risk:
In underwriting, investment bankers sell risk services to the issuers by assuming at least a part of
the floating risk when they underwrite an offering by firm commitment. Floating risk comprises
of waiting risk, pricing risk, and marketing risk. During the period after filing the registration
statement, but preparation and approval of the draft prospectus, the changes in a market
environment often affect the offering price. Such waiting risks are borne by the issuer. The
pricing risk and marketing risk are exclusively borne by the underwriter.
The pricing risk occurs when the market condition worsens after the underwriting agreement is
signed. Likewise, any adverse impact of marketing activity or violation of the regulator’s rule is
also borne by the underwriter.
 Continuation

Underwriting Compensation:
Underwriting compensation is the spread between the price to the public issue printed on the
prospectus and the price the corporate issuer receives. The amount of the spread is
determined through negotiation between the underwriter and the issuer.
All compensation to the underwriters is paid out of the spread.
The manager’s fee is compensation to the managing underwriter for preparing the offering.
Participating in a thorough due diligence review and putting the deal together is the primary
basis for the compensation.
In addition, the underwriting allowance covers expenses incurred by the investment banker
including advertising, legal expenses, and other out-of-pocket expenses. Finally, a selling
commission is allowed to underwriters based on the securities they accept to sell.
Thus, an underwriter will have all three concessions like manager’s fee, the underwriting
allowance, and the selling commission.
 Conclusion

To conclude, it can be inferred that IPO is a comprehensive as well as a complex process, wherein
investment banker plays a vital role in the entire process.
 Valuation and Pricing:
• The underwriter typically conducts a survey of comparable public companies, which helps to
provide a preliminary valuation. The underwriter also takes into consideration some factors
like- efficiency, leverage, profit margins, use of proceeds, operating history, operating base,
management quality, and product differentiation for valuation.
• Pricing refers to setting the offer price. In this regard, most underwriters follow historical
tradition in pricing that the price should not be too high or low in order to appeal to potential
investors.
• Underwriters price a new issue a certain percentage below what they consider a fair value.
Thus, there is a difference between the price of an IPO and the price when those shares trade
in the secondary market. This creates incentives for investors to put money into the new
issue.
• Timing is also critical. The offering price is adjusted upward when the underwriter has
received a higher oversubscription in indications of interest. The offering price needs to be
lowered or the issue may be postponed if indications of interest are weak.
 Continuation

Price of the Issue:

Company can arrive at share price in two ways

Fixed Book
Price Building
Offer offer

No. of shares and/or price of the shares is

Number of shares and share price is
not mentioned in the draft prospectus
mentioned in the draft prospectus as well as
and that is why it is known as draft red
final prospectus
herring prospectus
 Creating a Buzz By Roadshows

• Before an IPO opens to the public, the lead managers of the company create a buzz in the
market by roadshows. Over a period of two weeks, the lead managers along with executives
of the company will advertise the impending IPO across the country.
• This is basically a marketing and advertising tactic to attract potential investors. The key
highlights of the company are shared with various people, including business analysts and
fund managers, wealthy individuals by way of multimedia presentations, group meetings,
online virtual roadshows, and so on.
• However, all marketing efforts need to comply with the regulatory requirements, and they
should not mislead the public.
• In the case of fixed price offers, road shows are primarily created to generate interest among
investors about the IPO, while in the case of the book-building process road shows help lead
managers to know the demand from the investors’ side for the issue. Subsequently, the
company along with the lead manager decides the price band for the share price within which
the investors will bid. This information is finally incorporated into the draft red herring
prospectus, and it will be submitted to SEBI and stock exchanges.
• Finally, company will give time period for applying to IPO by public [Min. 3 to maximum 10
days]
 Continuation
Fixed Price Offer Book Building Offer

Issue Size 2500 cr. Issue Size 2250-2500 cr.

No. of Shares 10cr. No. of Shares 10cr.
Price 250 Floor Price 225
Lot Size 50 Cap Price 250
Minimum investment 12500 Lot Size 50
Minimum investment 11250-12500

• Higher risk for the issuer and underwriter Tickprice

Bid Size 5 No. of shares
• Price discovered by underwriter based on
formulas 250 4 cr.
• Qualitative factors are not taken into 245 5 cr.
consideration
240 2.5 cr.

235 3 cr.

230 3.5 cr.

225 4 cr.
 Allotment of Shares

Once the bidding process stops, the company along with the underwriters will determine the
basis of allocation of shares to each investor. In the case of over-subscription, partial
allotments will be made. The IPO stocks are usually allotted to the bidders within 10 working
days of the last bidding date.

Closing of Underwriting agreement: The closing date of the underwriting agreement is

generally set after the allotment of shares. The closing meeting includes the IPO team of the
company, BODs of the company, and the lead managers. At the closing date, various IPO
documents as well as the updated comfort letter are exchanged. The company delivers the
registered securities to the underwriter and receives payment for the issue.
 Underwriting Risk and Compensation for Investment Banker
Underwriting Risk:
In underwriting, investment bankers sell risk services to the issuers by assuming at least a part of
the floating risk when they underwrite an offering by firm commitment. Floating risk comprises
of waiting risk, pricing risk, and marketing risk. During the period after filing the registration
statement, but preparation and approval of the draft prospectus, the changes in a market
environment often affect the offering price. Such waiting risks are borne by the issuer. The
pricing risk and marketing risk are exclusively borne by the underwriter.
The pricing risk occurs when the market condition worsens after the underwriting agreement is
signed. Likewise, any adverse impact of marketing activity or violation of the regulator’s rule is
also borne by the underwriter.
 Continuation

Underwriting Compensation:
Underwriting compensation is the spread between the price to the public issue printed on the
prospectus and the price the corporate issuer receives. The amount of the spread is
determined through negotiation between the underwriter and the issuer.
All compensation to the underwriters is paid out of the spread.
The manager’s fee is compensation to the managing underwriter for preparing the offering.
Participating in a thorough due diligence review and putting the deal together is the primary
basis for the compensation.
In addition, the underwriting allowance covers expenses incurred by the investment banker
including advertising, legal expenses, and other out-of-pocket expenses. Finally, a selling
commission is allowed to underwriters based on the securities they accept to sell.
Thus, an underwriter will have all three concessions like manager’s fee, the underwriting
allowance, and the selling commission.
 Conclusion

To conclude, it can be inferred that IPO is a comprehensive as well as a complex process, wherein
investment banker plays a vital role in the entire process.
 Primary vs Secondary Market
• The primary market is where securities are created, while the secondary market
is where those securities are traded by investors.

• In the primary market, companies issue new shares to investors in exchange for cash.
The proceeds from such an offering are used to fund the business, make acquisitions,
and for general corporate purposes.

• In the secondary market, investors buy and sell shares of publicly traded companies
between each other, directly. No new shares are issued by the company, and the
company doesn’t receive any additional capital. The secondary market is basically
the stock market and refers to the New York Stock Exchange, the Bombay Stock
Exchange, the Nasdaq, and other exchanges worldwide.
 Secondary Public Offers

• The term secondary offering refers to the sale of shares owned by an investor to the
general public on the secondary market. These are shares that were already sold by the
company in an initial public offering (IPO). The proceeds from a secondary offering are
paid to the stockholders who sell their shares rather than to the company.

• Some companies may offer follow-on offerings, which may also be called
secondary offerings. These offerings can take on two different forms: Follow-on
offerings can be either dilutive, which results in an increase in shares, or non-
dilutive, where new shares are not created.
 Understanding Secondary Public Offer in Detail

Once the IPO is complete, investors can make secondary offerings to the public on the
secondary market or the stock market. Securities sold in a secondary offering are held by
investors and sold to one or more other investors through a stock exchange. As such, the
proceeds from a secondary offering go directly to the seller—not the company whose
shares change hands.

Sometimes, a company may perform a secondary, follow—on offering. This need may arise
to raise capital to finance its debt, make acquisitions, or fund its research and development
(R&D) pipeline.
 Types of Secondary Offerings
Secondary offerings come in two different forms. The first is a non-dilutive offering while the
other is referred to as a dilutive secondary offering. The differences between each are
outlined below:
Non-Dilutive Secondary Offerings
A non-dilutive secondary offering does not dilute shares held by existing shareholders
because no new shares are created. The issuing company might not benefit at all because the
shares are offered for sale by private shareholders, such as directors or other insiders, such as
company insiders or venture capitalists, who want to diversify their holdings.
 Dilutive Secondary Offerings
A dilutive secondary offering is also known as a subsequent offering or follow-on public
offering (FPO). This offering occurs when a company itself creates and places new shares
onto the market, thus diluting existing shares. This offering happens when a company's
board of directors agrees to increase the share float to sell more equity.

When the number of outstanding shares increases, this causes the dilution of earnings per
share (EPS). The resulting influx of cash helps the company achieve its longer-term goals, or
it can be used to pay off debt or finance expansion. This may not be positive for the
shorter-term horizons of certain shareholders.
 Right Issue

• A rights issue is an offering of rights to the existing shareholders of a company that

gives them an opportunity to buy additional shares directly from the company at a
discounted price rather than buying them in the secondary market. The number of
additional shares that can be bought depends on the existing holdings of the
shareowners.

Features of a Rights Issue

Companies undertake a rights issue when they need cash for various objectives. The
process enables the company to raise money without incurring underwriting fees.
A rights issue gives preferential treatment to existing shareholders, where they are given
the right (not obligation) to purchase shares at a lower price on or before a specified date.
 Continuation

• Existing shareholders also enjoy the right to trade with other interested
market participants until the date at which the new shares can be
purchased. The rights are traded in a similar way as normal equity shares.
• The number of additional shares that can be purchased by the
shareholders is usually in proportion to their existing shareholding.
• Existing shareholders can also choose to ignore the rights; however, if they
do not purchase additional shares, then their existing shareholding will be
diluted post issue of additional shares.
 Reasons for a Rights Issue

• When a company is planning an expansion of its operations, it may require a huge

amount of capital. Instead of opting for debt, they may like to go for equity to avoid
fixed payments of interest. To raise equity capital, a rights issue may be a faster way to
achieve the objective.
• A project where debt/loan funding may not be available/suitable or expensive usually
makes a company raise capital through a rights issue.
• Companies looking to improve their debt-to-equity ratio or looking to buy a new
company may opt for funding via the same route.
• Sometimes troubled companies may issue shares to pay off debt in order to improve
their financial health.
 Example of Right Issue

Let’s say an investor owns 100 shares of ABC Ltd. and the shares are trading at $10 each. The
company announces a rights issue in the ratio of 2 for 5, i.e., each investor holding 5 shares
will be eligible to buy 2 new shares. The company announces a discounted price of, for
example, $6 per share. It means that for every 5 shares (at $10 each) held by an existing
shareholder, the company will offer 2 shares at a discounted price of $6.

Investor’s Portfolio Value (before rights issue) = 100 shares x $10 = $ 1,000
Number of right shares to be received = (100 x 2/5) = 40
Price paid to buy rights shares = 40 shares x $6 = $ 240
Total number of shares after exercising rights issue = 100 + 40 = 140
Revised Value of the portfolio after exercising rights issue = $ 1,000 + $240 = $1,240
Should be price per share post-rights issue = $1,240 / 140 = $8.86
 Continuation
According to theory, the price of the share after the rights issue should be $8.86, but that is
not how the markets behave. An uptrend in the share price will benefit the investor, while if
the price falls below $8.86, the investor will lose money. The decline in share price can be
attributed to several factors. Some of them are:

• It gives a signal to the market that the company may be struggling, which can be the
reason the company issued shares at a discount.
• By issuing more shares, there is dilution in the value of available shares.
Capital Budgeting
“Budgeting has only one rule: Do not go over budget”
-Leslie Tayne
 Overview of Capital Budgeting

Capital budgeting is the process of making investment decisions in capital expenditures.

What is Capital Expenditure?

Capital expenditure may be defined as an expenditure the benefits of which are expected to be
received over a period of time exceeding one year. The main characteristic of is that it is incurred
at one point of time whereas the benefits of such expenditures are realized at different points of
time in the future.
Examples:
• Cost of acquisition of fixed assets like land and building, plant and machinery, goodwill, etc.
• Cost of addition, expansion, improvement, or alteration in the fixed assets.
• Cost of replacement of the fixed asset.
• Research and development expenditure etc.
 Need or Importance of Capital Budgeting

• Large Investments
• Long term Commitment of Funds
• Irreversible decision
• Long term Effect on Profitability
• Difficulties of Investment Decision
• National Importance
 Capital Budgeting Process

• Identification of Investment Proposals

• Screening the proposals.
• Evaluation of various proposals
• Fixing priorities
• Final approval and preparation of capital expenditure budget
• Implementing proposal
• Performance review
 Kinds of Capital Budgeting Decisions

Accept Reject Decisions: It relates to independent projects, which do not compete with one
another. Such decisions are taken on the basis of minimum return on investment. All those
projects which yield a rate of return higher than the minimum required rate of return, or the cost
of capital are accepted, and the rest are rejected.

Mutually Exclusive Project Decisions: Such decisions relate to proposals that compete with
one another in such a way that acceptance of one automatically excludes the acceptance of the
other.

Capital Rationing Decisions: A firm may have several profitable investment proposals but only
limited funds to invest. In such as case, the various investment proposals compete for limited
funds and thus firm has to ration them. The firm selects the combination of proposals that will
yield the greatest profitability by ranking them in descending order of their profitability.
 Methods of Capital Budgeting
Traditional Methods Time-adjusted Or Discounted Or Modern Methods

1. Pay-back Period Method 1. Net Present Value Method

2. Post Pay Back Period Method 2. Internal Rate Of Return Method

Accounting Rate Of Return Method 3. Profitability Index Method

 Traditional Methods
The payback method represents the period in which the total investment in permanent assets
pays back itself. This method is based on the principle that every capital expenditure pays itself
back within a certain period out of additional earnings generated from the capital assets.
The pay-back period can be ascertained in the following manner:
1. Calculate annual net earnings (profits) before depreciation and after taxes; these are called
annual cash inflows.
2. Divide the initial outlay (cost) of the project by the annual cash inflow, where the project
generates constant annual cash inflows.

Pay-Back Period= Cash Outlay of the Project/ annual Cash inflows.

3. Where the annual cash inflows are unequal, the pay-back period can be found by adding up
cash inflows unit the total is equal to the initial cash outlay of the project.
 Examples
1) A project costs Rs. 1,00,000 and yields an annual cash inflow of Rs. 20,000 for 8 years.
Calculate its pay-back period.
Solution:
Pay-back period = Initial outlay of the project/Annual Cash Inflow = Rs. 100,000/20,000 = 5
years
2) Determine the pay-back period for a project which requires a cash outlay of Rs. 100,000 and
generates cash inflows of Rs. 20,000, Rs. 40,000, Rs. 30,000 and Rs. 20,000 in the first, second,
third and fourth year, respectively.
Solution:
Total Cash Outlay = Rs. 100,000
Total cash inflow for first three years = Rs. 20,000 + 40,000 + 30,000 =Rs. 90,000
If cashflow for fourth year is added it becomes 1,10,000, 10,000 more than cost of the project.
So, the payback period is between 3 and 4 years.
Assuming cash flows occur evenly throughout the year, the time required to recover 10,000 will
be (10,000/20,000) 12 = 6 months.
Hence, pay-back period is 3 years and 6 months.
 Continuation
Post pay-back Profitability Method: One of the serious limitations of pay-back period method
is that it does not take into account the cash inflows earned after pay-back period and hence true
profitability of the project cannot be assessed. Hence, an improvement over this method is made
by taking into account the returns receivable beyond the pay-back period. These returns are called
post-pay-back profits.
Post pay-back profitability method = (Post-pay-back profits/Investment) * 100
Accounting Rate of Return Method:
It is known as the accounting rate of return method because the concept of accounting profit rather
than cash inflows are used. In this method various projects are ranked in order of the rate of
return. The project with higher rate of return is selected as compared to the one with lower rate of
return.
Average Accounting rate of return = [Total Profits (after dep. & taxes) / Net Investment in the
project x No. of yrs of profits] x 100
 Example
A project requires an investment of Rs. 5,00,000 and has a scrap value of Rs. 20,000 after five
years. It is expected to yield profits after depreciation and taxes during the five years amounting
to Rs. 40,000, Rs, 60,000, Rs. 70,000, Rs, 50,000 and Rs. 20,000. Calculate the average rate of
return on the investment.

Total Profit = Rs. (40,000 + 60,000 + 70,000 +50,000 +20,000) = Rs. 2,40,000
Average Profit = Rs. 2,40,000/5 = Rs. 48,000
Net Investment in the project = Rs. 5,00,000 – Rs, 20,000 (Scrap value) = Rs. 4,80,000
Average Rate of Return = (Average Annual profit/Net investment in the project) *100
=(48,000/4,80,000)*100 = 10%
 Methods of Capital Budgeting
Traditional Methods Time-adjusted Or Discounted Or Modern Methods

1. Pay-back Period Method 1. Net Present Value Method

2. Post Pay Back Period Method 2. Internal Rate Of Return Method

Accounting Rate Of Return Method 3. Profitability Index Method

 Traditional Methods
The payback method represents the period in which the total investment in permanent assets
pays back itself. This method is based on the principle that every capital expenditure pays itself
back within a certain period out of additional earnings generated from the capital assets.
The pay-back period can be ascertained in the following manner:
1. Calculate annual net earnings (profits) before depreciation and after taxes; these are called
annual cash inflows.
2. Divide the initial outlay (cost) of the project by the annual cash inflow, where the project
generates constant annual cash inflows.

Pay-Back Period= Cash Outlay of the Project/ annual Cash inflows.

3. Where the annual cash inflows are unequal, the pay-back period can be found by adding up
cash inflows unit the total is equal to the initial cash outlay of the project.
 Examples
1) A project costs Rs. 1,00,000 and yields an annual cash inflow of Rs. 20,000 for 8 years.
Calculate its pay-back period.
Solution:
Pay-back period = Initial outlay of the project/Annual Cash Inflow = Rs. 100,000/20,000 = 5
years
2) Determine the pay-back period for a project which requires a cash outlay of Rs. 100,000 and
generates cash inflows of Rs. 20,000, Rs. 40,000, Rs. 30,000 and Rs. 20,000 in the first, second,
third and fourth year, respectively.
Solution:
Total Cash Outlay = Rs. 100,000
Total cash inflow for first three years = Rs. 20,000 + 40,000 + 30,000 =Rs. 90,000
If cashflow for fourth year is added it becomes 1,10,000, 10,000 more than cost of the project.
So, the payback period is between 3 and 4 years.
Assuming cash flows occur evenly throughout the year, the time required to recover 10,000 will
be (10,000/20,000) 12 = 6 months.
Hence, pay-back period is 3 years and 6 months.
 Continuation
Post pay-back Profitability Method: One of the serious limitations of pay-back period method
is that it does not take into account the cash inflows earned after pay-back period and hence true
profitability of the project cannot be assessed. Hence, an improvement over this method is made
by taking into account the returns receivable beyond the pay-back period. These returns are called
post-pay-back profits.
Post pay-back profitability method = (Post-pay-back profits/Investment) * 100
Accounting Rate of Return Method:
It is known as the accounting rate of return method because the concept of accounting profit rather
than cash inflows are used. In this method various projects are ranked in order of the rate of
return. The project with higher rate of return is selected as compared to the one with lower rate of
return.
Average Accounting rate of return = [Total Profits (after dep. & taxes) / Net Investment in the
project x No. of yrs of profits] x 100
 Example
A project requires an investment of Rs. 5,00,000 and has a scrap value of Rs. 20,000 after five
years. It is expected to yield profits after depreciation and taxes during the five years amounting
to Rs. 40,000, Rs, 60,000, Rs. 70,000, Rs, 50,000 and Rs. 20,000. Calculate the average rate of
return on the investment.

Total Profit = Rs. (40,000 + 60,000 + 70,000 +50,000 +20,000) = Rs. 2,40,000
Average Profit = Rs. 2,40,000/5 = Rs. 48,000
Net Investment in the project = Rs. 5,00,000 – Rs, 20,000 (Scrap value) = Rs. 4,80,000
Average Rate of Return = (Average Annual profit/Net investment in the project) *100
=(48,000/4,80,000)*100 = 10%
 Time-adjusted or Discounted cash flow or Modern Methods
Why Modern Methods?
• Traditional methods suffer from serious limitations of considering present income as well as
future income as equal.
• Does not takes into consideration the time value of money, the fact that a rupee earned today
has more value than the same rupee earned tomorrow.
Time time-adjusted methods consider the profitability and also the time value of money.

Following are the modern Methods of Capital Budgeting:

• Net Present Value Method
• Profitability Index Method
• Internal Rate of Return Method
 Net Present Value Method
This method takes into consideration the time value of money and attempts to calculate the
return on investments by introducing the factor of the time element. The net present values
of all inflows and outflows of cash occurring during the entire life of the project are
determined separately for each year by discounting these flows by the firm’s cost of capital or
a pre-determined rate.
Steps Involved:
• Determine an appropriate rate of interest that should be selected as the minimum required
rate of return called the discount rate.
• Compute the present value of the total investment outlay at the determined discount rate.
• Compute the present values of the total investment proceeds i.e, cash inflow (profit before
depreciation and after-tax) at the above-determined discount rate.
• Calculate the net present value (NPV) of the project by subtracting the present value of
cash inflows from the present value of cash outflows of each project
 If the NPV is positive i.e, when the PV of inflow is greater than PV of outflow, the proposal may
be accepted. But in case the PV of inflow is less than the PV of outflows, the proposal should be
rejected.
To select between mutually exclusive projects, projects should be ranked in order of their NPV in
descending order.
The PV of Re. 1 due in any number of years can be computed with the help of the following
formula:
PV= 1/(1 + 𝑟)𝑛
PV = Present Value
R= rate of interest/discount rate
n= number of years
 Example
From the following information, calculate the NPV of two projects and suggests which of the
projects should be accepted assuming a discount rate of 10%.

Project X Project Y
Initial Investment Rs. 20,000 Rs. 30,000
Estimated Life 5 years 5 years
Scrap Value Rs. 1000 Rs. 2,000

The profits before depreciation and after taxes (cash flows) are as follows:

Year 1 Year 2 Year 3 Year 4 Year 5

Project X 5,000 10,000 10,000 3,000 2,000
Project Y 20,000 10,000 5,000 3,000 2,000
Profitability Index (P.I.) Method or Benefit Cost Ratio: P.I. is the relationship between the
present value of cash inflows and the present value of cash outflows.

P.I. =PV of Cash Inflows/PV of Cash Outflows

P.I. (Net) = NPV/PV of Outflow

This method is a slight modification of the Net present value method. The NPV has one major
drawback it is not easy to rank projects, particularly when the costs of the projects vary
significantly. To evaluate such projects, P.I. is most suitable.
Internal rate of return method:
• In this method, the cash flows of a project are discounted at a suitable rate by hit and trial
method, which equates to the present value of cash inflow so calculated to the amount of
investment.
• Under this method, since the discount rate is internally determined, this method is called as the
internal rate of return method.
• The internal rate of return can be defined as the rate of discount at which the present value of
cash inflows is equal to the present value of cash outflows.
Determination of Internal Rate of Return (IRR)
a) When the annual net cash flows are equal over the life of the project:
i) Find out the PV factor by dividing the initial outlay by the annual cash inflow.
ii) Then consult the PV annuity table with the number of years equal to the life of the asset and
find out the rate at which the calculated PVF is equal to the present value given in the table.
b) When the annual cash flows are unequal over the life of the asset: In this case, IRR is
calculated by the hit and trial method as mentioned below:
i. Discount the cash inflows by using an arbitrary discount rate
ii) Find out the NPV by deducting the PV of the total of cash inflows calculated in (i) from the
initial cost of investment.
iii) If the NPV is positive apply a higher discount rate.
iv) If the higher discount rate still gives a positive NPV, further increase the discount rate until the
NPV becomes negative.
v) If the NPV is negative at this higher rate of discount, the internal rate of return must be between
these two rates.

IRR= Lower rate of discount + (NPV at a lower rate of the discount/(NPV at a lower rate of
discount + NPV at a higher rate of discount) x (Higher rate of discount – Lower rate of
discount)
 Example
From the following information, calculate the NPV of two projects and suggests which of the
projects should be accepted assuming a discount rate of 10%.

Project X Project Y
Initial Investment Rs. 20,000 Rs. 30,000
Estimated Life 5 years 5 years
Scrap Value Rs. 1000 Rs. 2,000

The profits before depreciation and after taxes (cash flows) are as follows:

Year 1 Year 2 Year 3 Year 4 Year 5

Project X 5,000 10,000 10,000 3,000 2,000
Project Y 20,000 10,000 5,000 3,000 2,000
Profitability Index (P.I.) Method or Benefit Cost Ratio: P.I. is the relationship between the
present value of cash inflows and the present value of cash outflows.

P.I. =PV of Cash Inflows/PV of Cash Outflows

P.I. (Net) = NPV/PV of Outflow

This method is a slight modification of the Net present value method. The NPV has one major
drawback it is not easy to rank projects, particularly when the costs of the projects vary
significantly. To evaluate such projects, P.I. is most suitable.
Internal rate of return method:
• In this method, the cash flows of a project are discounted at a suitable rate by hit and trial
method, which equates to the present value of cash inflow so calculated to the amount of
investment.
• Under this method, since the discount rate is internally determined, this method is called as the
internal rate of return method.
• The internal rate of return can be defined as the rate of discount at which the present value of
cash inflows is equal to the present value of cash outflows.
Determination of Internal Rate of Return (IRR)
a) When the annual net cash flows are equal over the life of the project:
i) Find out the PV factor by dividing the initial outlay by the annual cash inflow.
ii) Then consult the PV annuity table with the number of years equal to the life of the asset and
find out the rate at which the calculated PVF is equal to the present value given in the table.
b) When the annual cash flows are unequal over the life of the asset: In this case, IRR is
calculated by the hit and trial method as mentioned below:
i. Discount the cash inflows by using an arbitrary discount rate
ii) Find out the NPV by deducting the PV of the total of cash inflows calculated in (i) from the
initial cost of investment.
iii) If the NPV is positive apply a higher discount rate.
iv) If the higher discount rate still gives a positive NPV, further increase the discount rate until the
NPV becomes negative.
v) If the NPV is negative at this higher rate of discount, the internal rate of return must be between
these two rates.

IRR= Lower rate of discount + (NPV at a lower rate of the discount/(NPV at a lower rate of
discount + NPV at a higher rate of discount) x (Higher rate of discount – Lower rate of
discount)
Initial Outlay Rs. 50,000
Life of the asset 5 years
Estimated Annual cash flow 12,500

Calculate IRR
Initial Investment Rs. 60,000

Life of the Asset 4 years

Estimated Net Annual Cash Flows:

1st year 15,000

2nd year 20,000

3rd year 30,000

4th year 20,000

Calculate IRR
A company is considering an investment proposal to purchase a machine costing Rs.
2,50,000. The machine has a life expectancy of 5 years and no salvage value. The company’s
tax rate is 40%. The firm uses straight line method of providing depreciation. The estimated
cash flows before tax after depreciation from the machine are as follows:
Year CFBT
1 60,000
2 70,000
3 90,000
4 1,00,000
5 1,50,000

Calculate: a) Pay-back period b) Average rate of return c) Net present value and d) profitability index at 10% discount
rate.
A company is considering an investment proposal to purchase a machine costing Rs.
2,50,000. The machine has a life expectancy of 5 years and no salvage value. The company’s
tax rate is 40%. The firm uses straight line method of providing depreciation. The estimated
cash flows before tax after depreciation from the machine are as follows:
Year CFBT
1 60,000
2 70,000
3 90,000
4 1,00,000
5 1,50,000

Calculate: a) Pay-back period b) Average rate of return c) Net present value and d) profitability index at 10% discount
rate.
A company has an investment opportunity costing Rs. 40,000 with the following expected
net cash flow after taxes and before depreciation.
YEAR NET CASH FLOW
1 7000
2 7000
3 7000
4 7000
5 7000
6 8000
7 10000
8 15000
9 10000
10 4000
Using 10% as the cost of capital, determine the following:
a) Payback period
b) Net present value at 10% discount factor
c) Profitability index at 10% discount factor
CASH AND LIQUIDITY MANAGEMENT
“Revenue is vanity, profit is sanity, but cash is king”
 Introduction to Cash Management

• Management of cash is one of the most important areas of overall working capital
management due to the fact that cash is the most liquid type of current assets. As
such it is the responsibility of the finance function to see that the various functional
areas of the business have sufficient cash whenever they require the same.

• At the same time, it has also to be ensured that the funds are not blocked in the
form of idle cash, as the cash remaining idle also involves cost in the form of interest
cost and opportunity cost. As such the management of cash has to find a mean
between these two extremes of shortage of cash as well as idle cash.
 Continuation

In cash management, the term has been used in two senses:

(a)Narrow Sense – Under this cash covers currency and generally accepted equivalents
of cash, viz., cheques, demand drafts and banks demand deposits.

(b)Broad Sense – Here, cash includes not only the above stated but also near cash
assets. They are Bank time deposits and marketable securities.
 Motives for Holding Cash

A company may hold the cash with the various motives as stated below:

(1) Transaction Motive:

The company may be required to make various regular payments like purchases,
wages/salaries, various expenses, interest, taxes, dividends etc. for which the
company may hold the cash. Similarly, the company may receive the cash
basically from its sales operations.

However, receipts of the cash and the payments by cash may not always match
with each other. In such situations, the company will like to hold the cash to
honour the commitments whenever they become due. This requirement of cash
balances to meet routine needs is known as transaction motive.
 Continuation
(2) Precautionary Motive:
In addition to the requirement of cash for routine transactions, the company may also
require the cash for such purchases which cannot be estimated or foreseen. E.g. There may
be a sudden decline in the collection from the customers, there may be a sharp increase in
the prices of the raw materials etc. The company may like to hold the cash balance to take
care of such contingencies and unforeseen circumstances. This need of cash is known as
precautionary motive.
(3) Speculative Motive:
The company may like to hold some reserve kind of cash balance to take the benefit of
favourable market conditions of some specific nature. E.g. Purchases of raw material
available at low prices on the immediate payment of cash, purchase of securities if interest
rates are expected to increase etc. This need to hold the cash for such purposes is known as
speculative motive.
 Continuation
4. Compensating Balances
Compensating balances represent cash at Bank balances which are necessary
to compensate for the services rendered by banks to the business concerns.
For operating and maintaining a Current Account or- Savings Account in any
bank, a minimum balance in the account has to be kept all the time. That is
known as compensating balances to a business concern.

Ordinarily, the compensating balance is fixed by a bank after considering the

income from an account and cost of operation of the same account. Bank
offers a number of services to its clients for whom it compels its clients to
leave a minimum balance in their accounts so that the banker may earn some
interest and thus compensate to some extent its cost-free services to clients.
 Factors Determining Level of Cash

The factors affecting or determining the cash requirements of a business are as follows:

(1) Timing of Cash Flows:

The need for maintaining cash balance arises because cash inflows and cash outflows take
place at different times. If cash inflows perfectly match cash outflows, i.e., if they take place
at same time, there would be no need for keeping cash balance. Need for keeping cash
balance arises when cash outflows exceed cash inflows. Therefore, the need for cash can be
determined by forecasting cash inflows and cash outflows. Forecast is done through a cash
budget.

(2) Cash Shortage Costs:

Cash budget would reveal the quantum as well as periods of cash shortages. Every shortage
of cash involves a cost depending upon the quantum and duration of shortfall. Costs
incurred as a result of shortfall of cash are called cash shortage costs.
 Continuation
(3) Cash Excess Costs:
If a firm keeps cash balance in excess of its requirements, it will miss opportunities to invest
it elsewhere. As a result, it will lose interest which it would otherwise have earned by
investing excess cash elsewhere. This factor should also be considered in determining the
level of cash and therefore the level of cash should not be determined in excess.

(4) Cash Management Costs:

Cash management also involves some costs such as salary, clerical expenses etc. of cash
management staff. Cash need should be determined after considering this factor also.
 Continuation

5) Cash Cycle: The term cash cycle refers to the length of time between the payment for
purchase of raw materials and the receipts of sales revenue. So the cash cycle refers to the
time that passes from the point when firm makes an outlay to purchase raw materials to the
point when cash is collected from the sale of finished goods produced using raw materials.
Different patterns of cash cycles and cash flows may be there depending upon the nature of
the business.
 Continuation
(5) Uncertainty:
Cash flows can never be predicted with complete accuracy and there is always some
uncertainty in their forecast such as unexpected delay in collection from debtors. Firm must
always keep some additional cash to meet these uncertainties.

(6) Firm’s Capacity to Borrow in Emergent Situations:

If a firm is able to borrow quickly in case of emergency, it can keep a low level of cash. Firm’s
ability to borrow depends on many factors such as its credit standing, relation with the banks
and so on.
 Continuation
(7) Attitude of Management:

The attitude of management towards liquidity and profitability affects the level of cash. If
the management attaches more significance to liquidity than profitability, the level of cash
will be high. On the contrary, if it gives more importance to profitability instead of liquidity,
the level of cash will be low.

(8) Efficiency of Management:

If the management can accelerate the collection of cash from customers and slow down
the disbursement of cash, it can keep a low level of cash.
 CASH MANAGEMENT: PLANNING ASPECTS

• In order to maintain an optimum cash balance, what is required is i) a complete and

accurate forecast of net cashflows over the planning horizons and ii) perfect
synchronization of cash receipt and disbursements.
• Thus, implementation of an efficient cash management system starts with the
preparation of a plan of firm’s operation for a period in the future.
• This plan will help in preparation of a statement of receipts and disbursements
expected at different point of time of that period. It will enable the management to pin
point the timing of excess cash or shortage of cash.
• This will also help to find out whether there is any expected surplus cash still unutilized
or shortage of cash yet to be arranged for.
• In order to take care of all these considerations, the firm should prepare a cash budget.
 Cash Budget

Cash budget is a summary of movement of cash during a particular period. There are three
methods of preparation of cash budget. These are: i) Receipt and Payment method; ii)
Adjusted Profit and Loss/Net Income Method and iii) Balance sheet method.

In all these methods, the information with which the final cash budget is constructed is
basically the same. However, they utilize different forecasting technique and therefore, the
information they provide to the financial manager is quite different.
 Continuation
i) Receipts and Payments Method:
Under this method, all actual possible items of cash receipts and payments for the
budgeted period are considered. Sources of information are the various other budgets.
For example, (a) Sales from the sales budget (b) Materials, labor, overhead expenditure and
capital expenditure etc., from the concerned budgets.

Steps to be adopted:
Cash Receipts Forecast:
Cash receipts from sales, debtors, income from sales of assets and investments and.,
probable borrowings should be forecast and brought into cash budget. Any lag in payment
by debtors or by others shall be considered for ascertaining further cash inflows.
 Continuation

Cash requirements forecast:

Total cash outflows are taken out from operating budgets for the elements of cost, and from
capital expenditure budget for the purchase of fixed assets. Adjustments are to be made for
any lag in payments.
Care must be taken to ensure that out-standings or accruals are excluded from the cash
budget since this method is based on the concept of actual cash flows. Moreover, non-cash
items such as depreciation expenses must be ignored.
The cash budget under the receipts and payments method may be prepared on monthly
basis or quarterly basis or half-yearly basis.
 Continuation
ii) Adjusted Profit and Loss Method:

• This method requires that a proforma income statement should be prepared for each interim period of
the budget period. The net income figures for each desired period are then adjusted to a cash basis by
deleting the items that are affecting the income statements but not the cash balance. This adjusted
figure is taken as cash profit (loss) during that period.

• Compared with the previous method, this method is less detailed and more difficult to comprehend; it
is particularly useful for the long-term forecasts, say for a period of over three years. It transforms the
profit and loss account into cash forecast.

• The basic assumption in this method is that any increase or decrease in cash balance is due to profit or
loss of the business. All non-cash items such as depreciation, write-offs or write-ups etc., are mainly
adjusted to the net profit.

• The theory, under this method, is based on the assumption that profit is cash. If there were no credit
transactions or noncash transactions, the balance of profit on the Profit and Loss account should be
equal to the balance of cash in the cash book.
 Continuation
iii) Balance Sheet Method:
This method requires the preparation of proforma balance sheet for different interim period of
cash budget. Each item of the balance sheet except cash is projected for each period and the
cash balance is ascertained in accordance with the accounting equation i.e, Total Asset = Total
Liabilities + Capital. The balancing figure of proforma B/S is taken as the cash balance
If there is excess of liabilities over assets, the balance is ordinary cash balance; if there is excess
of assets over liabilities, the balance is assumed to be bank overdraft.

Of these three methods, the first method is mostly preferred because it is a short-term forecast
and is much more detailed than the other two methods which are normally used as long-term
forecasts.
 Proforma of Cash Budget (Receipt and Payment method, Monthly Basis)
Particulars OtherJanuary
Incomes February --------- November Decembe

Opening balance of Cash

A. CASH INFLOWS:

Cash Sales

Collection from Debtors

Loans and Borrowings

Subsidy

Other Incomes
Total Cash Available (A)
B. CASH OUTFLOWS:

Payment to Creditors

Wages and Salaries

Other expenses

Purchase of Fixed Asset

Investments

Repayment of Debts

Interest, taxes and dividend payment

Total Payments (B)

Closing Balance (A-B)

(+) Cash Surplus

(-) Cash Deficit

 Illustration 1:
The following forecasts have been made for ABC Ltd. For the period January to April 2016

January February March April

Sales 75,000 1,05,000 1,80,000 1,05,000
Raw Materials 70,000 1,00,000 80,000 85,000
Manufacturing Expenses 10,000 20,000 29,000 16,000
Loan Instalment 1,000 11,000 21,000 21,000

Additional Information:
i) All sales made on credit basis. 2/3 of debtors are collected in the same month and balance in the next
month. There is no expected bad debt. The debtors on January 1, 2016 were Rs. 30,000.
ii) The minimum cash balance, that firm must have is estimated to be Rs. 5,000, however, the cash balance on
January 1 was Rs. 6,500.

Prepare the cash budget for the period of 4 months (ignore interest on borrowing).
 Illustration 2:
Prepare cash budget for the period of July-December 2016 from the following information:
Figures in Rs. Lacs
June July Aug. Sept. Oct. Nov. Dec.
Sales 35 40 40 50 50 60 65
Purchases 14 16 17 20 20 25 28
Wages and salaries 13 14 16 18 19 21 22
Expenses 5 6 6 6 7 7 7
Interest Received 2 - - 2 - - 2
Sale of Fixed assets - - 20 - - - -
Additional Information:
i) 20% of the sales are made on cash and balance on credit. 50% of the debtors are collected in the month of sales
and the remaining in the next month.
ii) The time lag in the payment of purchases, expenses, wages and salaries is 1 month.
iii) The company keeps a minimum cash balance of Rs. 5 lacs. The cash balance in excess of Rs. 7 lacs is invested in
government securities. Shortfalls in cash balance if any, are made good by borrowings from banks. The interest
received as well as paid is to be ignored.
 Illustration 3:

Prepare monthly cash forecast for the company XYZ Ltd. For the quarter ending 31st March,
from the following details:
i) Opening balance as on 1st January is Rs. 22,000.
ii) Its estimated sale for the month of January and February Rs. 1,00,000 each and for the
month of March is Rs. 1,20,000. The sale for Nov. and Dec. of the previous year have been
Rs. 1,00,000 each.
iii) Cash and credit sales are estimated 20% and 80% respectively.
iv)The receivables from credit sales are expected to be collected as follows: 50% of the
receivable on an average of one month from the date of sales; and balance 50% after two
months from the date of sale. No bad debts are expected.
v) Other anticipated receipt is Rs. 5,000 from the sale of machine in March.
The forecast of payment is as follows:
a) The purchase of materials worth Rs. 40,000 in Jan. and Feb. and materials worth Rs. 48,000 in
March.
b) The payments for these purchases are made approximately a month after the purchase. The
purchase for Dec. of the previous year have been Rs. 40,000 for which the payment will be
made in January.
c) Miscellaneous cash purchase of Rs. 2,000 per month.
d) The wages payments are expected to be Rs, 15,000 per month.
e) Manufacturing expenses are expected to be Rs. 20,000 per month.
f) General selling expenses are expected to be Rs. 10,000 per month.
g) A machine worth Rs. 50,000 is proposed to be purchased on cash in March.
 Illustration 4:

ABC Ltd. Has given the forecast sales for January 2016 to July 2016 and actual sales of November
and December 2015 as under. With the other given particulars, prepare a cash budget from
January to May 2016.
Sales Rs.
Nov. 2015 1,60,000
Dec. 2015 1,40,000
Jan. 2016 1,60,000
Feb. 2,00,000
March. 1,60,000
April 2,00,000
May 1,80,000
June 2,40,000
July 2,00,000
Additional Information:
•Sales 20% cash and 80% credit, Credit period two months.
•Variable expenses 5% on turnover.
•Commission 5% on credit sales payable in two months.
•Purchases are 60% of the sales. Payment will be made in 3rd month of
purchases.
•Rent Rs. 6,000 paid every month.
•Other payments: Fixed assets purchases- Feb. Rs. 36,000 and March Rs.
1,00,000; Taxes – April, 40,000
•Opening Balance of Cash Rs. 50,000.
 Illustration 1:
The following forecasts have been made for ABC Ltd. For the period January to April 2016

January February March April

Sales 75,000 1,05,000 1,80,000 1,05,000
Raw Materials 70,000 1,00,000 80,000 85,000
Manufacturing Expenses 10,000 20,000 29,000 16,000
Loan Instalment 1,000 11,000 21,000 21,000

Additional Information:
i) All sales made on credit basis. 2/3 of debtors are collected in the same month and balance in the next
month. There is no expected bad debt. The debtors on January 1, 2016 were Rs. 30,000.
ii) The minimum cash balance, that firm must have is estimated to be Rs. 5,000, however, the cash balance on
January 1 was Rs. 6,500.

Prepare the cash budget for the period of 4 months (ignore interest on borrowing).
 Illustration 2:
Prepare cash budget for the period of July-December 2016 from the following information:
Figures in Rs. Lacs
June July Aug. Sept. Oct. Nov. Dec.
Sales 35 40 40 50 50 60 65
Purchases 14 16 17 20 20 25 28
Wages and salaries 13 14 16 18 19 21 22
Expenses 5 6 6 6 7 7 7
Interest Received 2 - - 2 - - 2
Sale of Fixed assets - - 20 - - - -
Additional Information:
i) 20% of the sales are made on cash and balance on credit. 50% of the debtors are collected in the month of sales
and the remaining in the next month.
ii) The time lag in the payment of purchases, expenses, wages and salaries is 1 month.
iii) The company keeps a minimum cash balance of Rs. 5 lacs. The cash balance in excess of Rs. 7 lacs is invested in
government securities. Shortfalls in cash balance if any, are made good by borrowings from banks. The interest
received as well as paid is to be ignored.
Particulars July Solution
Aug. Sept. Oct. Nov. Dec.
Opening balance of Cash 5 7
A. Cash Inflows:
Cash Sales 8 8
Collection from Debtors (Previous Month) 14 16
Collection from Debtors (Current Month) 16 16
Interest Received - -
Sale of Fixed asset - 20
Total of (A) 43 67
B. Cash Outflows:
Purchases 14 16
Expenses 5 6
Wages and Salaries 13 14
Total of (B) 32 36
Cash Balance (A-B) 11 31
Investment in Govt. Securities 4 24
 Illustration 3:

Prepare monthly cash forecast for the company XYZ Ltd. For the quarter ending 31st March,
from the following details:
i) Opening balance as on 1st January is Rs. 22,000.
ii) Its estimated sale for the month of January and February Rs. 1,00,000 each and for the
month of March is Rs. 1,20,000. The sale for Nov. and Dec. of the previous year have been
Rs. 1,00,000 each.
iii) Cash and credit sales are estimated 20% and 80% respectively.
iv)The receivables from credit sales are expected to be collected as follows: 50% of the
receivable on an average of one month from the date of sales; and balance 50% after two
months from the date of sale. No bad debts are expected.
v) Other anticipated receipt is Rs. 5,000 from the sale of machine in March.
The forecast of payment is as follows:
a) The purchase of materials worth Rs. 40,000 in Jan. and Feb. and materials worth Rs. 48,000 in
March.
b) The payments for these purchases are made approximately a month after the purchase. The
purchase for Dec. of the previous year have been Rs. 40,000 for which the payment will be
made in January.
c) Miscellaneous cash purchase of Rs. 2,000 per month.
d) The wages payments are expected to be Rs, 15,000 per month.
e) Manufacturing expenses are expected to be Rs. 20,000 per month.
f) General selling expenses are expected to be Rs. 10,000 per month.
g) A machine worth Rs. 50,000 is proposed to be purchased on cash in March.
 Illustration 4:

ABC Ltd. Has given the forecast sales for January 2016 to July 2016 and actual sales of November
and December 2015 as under. With the other given particulars, prepare a cash budget from
January to May 2016.
Sales Rs.
Nov. 2015 1,60,000
Dec. 2015 1,40,000
Jan. 2016 1,60,000
Feb. 2,00,000
March. 1,60,000
April 2,00,000
May 1,80,000
June 2,40,000
July 2,00,000
Additional Information:
•Sales 20% cash and 80% credit, Credit period two months.
•Variable expenses 5% on turnover.
•Commission 5% on credit sales payable in two months.
•Purchases are 60% of the sales. Payment will be made in 3rd month of
purchases.
•Rent Rs. 6,000 paid every month.
•Other payments: Fixed assets purchases- Feb. Rs. 36,000 and March Rs.
1,00,000; Taxes – April, 40,000
•Opening Balance of Cash Rs. 50,000.
 Illustration 3:

Prepare monthly cash forecast for the company XYZ Ltd. For the quarter ending 31st March,
from the following details:
i) Opening balance as on 1st January is Rs. 22,000.
ii) Its estimated sale for the month of January and February Rs. 1,00,000 each and for the
month of March is Rs. 1,20,000. The sale for Nov. and Dec. of the previous year have been
Rs. 1,00,000 each.
iii) Cash and credit sales are estimated 20% and 80% respectively.
iv)The receivables from credit sales are expected to be collected as follows: 50% of the
receivable on an average of one month from the date of sales; and balance 50% after two
months from the date of sale. No bad debts are expected.
v) Other anticipated receipt is Rs. 5,000 from the sale of machine in March.
The forecast of payment is as follows:
a) The purchase of materials worth Rs. 40,000 in Jan. and Feb. and materials worth Rs. 48,000 in
March.
b) The payments for these purchases are made approximately a month after the purchase. The
purchase for Dec. of the previous year have been Rs. 40,000 for which the payment will be
made in January.
c) Miscellaneous cash purchase of Rs. 2,000 per month.
d) The wages payments are expected to be Rs, 15,000 per month.
e) Manufacturing expenses are expected to be Rs. 20,000 per month.
f) General selling expenses are expected to be Rs. 10,000 per month.
g) A machine worth Rs. 50,000 is proposed to be purchased on cash in March.
 Illustration 4:

ABC Ltd. Has given the forecast sales for January 2016 to July 2016 and actual sales of November
and December 2015 as under. With the other given particulars, prepare a cash budget from
January to May 2016.
Sales Rs.
Nov. 2015 1,60,000
Dec. 2015 1,40,000
Jan. 2016 1,60,000
Feb. 2,00,000
March. 1,60,000
April 2,00,000
May 1,80,000
June 2,40,000
July 2,00,000
Additional Information:
•Sales 20% cash and 80% credit, Credit period two months.
•Variable expenses 5% on turnover.
•Commission 5% on credit sales payable in two months.
•Purchases are 60% of the sales. Payment will be made in 3rd month of
purchases.
•Rent Rs. 6,000 paid every month.
•Other payments: Fixed assets purchases- Feb. Rs. 36,000 and March Rs.
1,00,000; Taxes – April, 40,000
•Opening Balance of Cash Rs. 50,000.
Inventory Management
 Introduction of Inventory Management
⚫ Abusiness can run smoothly its operating activities only when appropriate amount
of inventory is maintained.Inventory affects all operating activities like
manufacturing, warehousing, sales etc.The amount of opening inventory and
closing inventory should be sufficient so that the other business activities are not
adversely affected.Thus, inventoryplays an important role in operations
management.
⚫ It constitutes the largest component of current asset in most business enterprises.
⚫ The turnover of working capital is largely governed bythe turnover of inventory. It
is therefore quite natural that inventory which helps in maximize profit occupies
the most significant place among current assets.
 Meaningand Definition of Inventory
⚫ In dictionary meaning of inventory is a “detailed list of goods, furniture etc.” Many understand
the word inventory, as a stock of goods, but the generally accepted meaning of the word
‘goods’in the accounting language, is the stock of finished goods only. In a manufacturing
organization, however, in addition to the stock of finished goods, there will be stock of partly
finished goods, raw materials and stores.The collective name of these entire items is
‘inventory’.
⚫ In other words, the inventory is used to represent the aggregate of those items of tangible
assets which are –
⚫ Held for sale in ordinary course of the business.
⚫ In process of production for such sale.
⚫ To be currently consumed in the production of goods or services to be available for sale.
 Types of inventories

⚫ Raw material and supplies: It refers to the unfinished items which go in the
production process. Every manufacturing concern hasto carry certain stock of raw
materials in stores.The amount of raw materials to be kept by a firm depends on a
number of factors like the speed with which raw materials can be ordered and procured,
uncertainty in the supply of raw materials.
⚫ Work in Progress: It refers to the semi-finished goods which are not 100% complete
but some work hasbeen done on them.The degree of completion maybe varying for
different units.The value of work in progress includes the raw materials costs, direct
wages and expenses already incurred and overhead, if any.The quantity and the value of
work in progress depends on the length of the production cycle.
 Types of inventories

⚫ Finished goods: It refers to the goods on which 100% work has been done and which
are ready for sale. It also includes the goods purchased firm particularly in case of a
trading organization. Inventory of finished goods arise because of the time involved in the
production process and the need to meet the customer’s needs promptly. If firms do not
maintain sufficient level of finished goods, they run the risk of losing sales as the
customers who are unwilling to wait may turn to competitors.
 Motives for holding inventory:

1.Transaction Motive: Every firm has to maintain certain level of inventory to

meet day to day requirements of sales, production process etc.This motive makes
the firm to keep the inventory of finished goods as well as raw materials.
2.Precautionary motive: Afirm should keep some level of inventory for
unforeseen circumstances. For Example: fresh supply of raw materials maynot
reach to the factory due to strike by transporters or due to natural calamities in a
particular area.
3.Speculative motive: Firm may be tempted to keep some inventory to keep to
reap an opportunity to make some additional profit. For example: sufficient level
of inventory may help the firm to earn extra profit in case of expected shortage in
the market.
 Overview of InventoryManagement
⚫ Inventory management is the practice overseeing and controlling of the ordering, storage and
use of components that a company uses in the production of the items it sells.The objective of
inventory management is to determine the optimum level of inventory i.e, the level at which
interest of all departments are taken care off.
⚫ Inventory control means efficient management of capital invested in raw materials and

supplies, work- in – progress and finished goods.

⚫ The maintenance of inventory means blocking of funds and so it involves the interest and
opportunity cost to the firm.
⚫ In many countries specially in Japan great emphasis is placed on inventory management.
Efforts are made to minimize the stock of inputs and outputs by proper planning and
forecasting of demand of various inputs and producing only that much quantity which can be
sold in the market.
⚫ The inventory cost is not only interest on stocks but also cost of store building for storage,
insurance and obsolesce and movement of inputs from place of storage to the factory where
the materials have to be finally used to convert them into finished goods.
⚫ In japan industries have adopted concept of JIT (Just in Time) inventory management
approach and components, materials are received when required for which detailed
instructions are given to suppliers.
⚫ As against this by and large in India the inventory of raw materials and packing materials is
very high and many items become junk or obsolete causing heavy loss to the enterprise.
⚫ Lack of inventory planning in India hasbeen pointed out byvarious committees due to
uncertainties in supplies, problem of timely receipt of railway wagons, lack of planning and
unreliable suppliers, which leads to quit high amount of investment in inventories.
 Significance of holding inventory
⚫ ForTrading firm:
 Continued sale of goods , even if the procurement of goods is stopped for the time being due
to one reason or the other.
 Moreover, it is not always possible to procure goods whenever there is a sale opportunity as
there is always a time gap between the purchase and sale of goods.
 Thus, a trading organisation should have some amount of inventory to carry out their sales
activity independently, irrespective of the procurement schedule.
 Significance of holding inventory
⚫ For Manufacturing Firms:
Amanufacturing firm must have inventory of not only finished goods, but also of raw materials
and work in progress for some of the obvious reasons:
 Uninterrupted Production Schedule: Every manufacturing firm must have sufficient stock of
raw materials to in order to have regular and uninterrupted production schedule. If there is a
stock-out of raw materials at any stage of production process, then the entire production
process will come to a halt.This may result in customer dissatisfaction as the goods cannot be
delivered in time. Moreover, fixed cost will continue to be incurred even if there is no
production.
 Independent sales activity: The Production Schedule is a time consuming process, and thus
every organisation must maintain a minimum level of finished goods in order to deliver the
goods as soon as the order is received.
 Objectives of Inventory Management
⚫ The objective of inventory management is to maintain inventory at an appropriate level to avoid
excess or shortage of inventory. Inventory management systems reduce the cost of carrying inventory
and ensure that the supply of raw material and finished goods remains continuous throughout the
business operations.The objectives specifically may be divided into two categories mentioned below:
⚫ A. Operating objectives: They are related to the operating activities of the business like purchase,
production, sales etc.
 a. To ensure continuous supply of materials.
 b.To ensure uninterrupted production process.
 c.To minimize the risks and losses incurred due to shortage of inventory.
 d.To ensure better customer services. e.Avoiding of stock out danger.
⚫ B. Financial Objectives:
 a. To minimize the capital investment in the inventory.
 b.To minimize inventory costs.
 c. Economy in purchase.
 Apart from the above objectives, inventory management also emphasize to bring down the
adverse impacts of holding excess inventory. Holding excess inventory lead to the
following consequences:
 Unnecessary investment of funds and reduction in profit.
 Increase in holding costs.
 Loss of liquidity.
 Deterioration in inventory.
The excessive level of inventories consumes the funds of business, which cannot be used for
any other purpose and thus involves an opportunity cost.The carrying cost, such as the cost
of shortage, handling insurance, recording and inspection, are also increased in proportion to
the volume of inventories.This cost will impair the concern profitability further.
 Factors affecting the level of inventory
⚫ The level of inventory should be appropriate.The appropriateness of the amount of inventory depends
upon several factors. Some significant factors affecting the level of inventory are explained as follows:
⚫ 1. Nature of business: The level of inventory will depend upon the nature of business whether it is
a retail business, wholesale business, manufacturing business or trading business.
⚫ 2. Inventory turnover: Inventory turnover refers to the amount of inventory which gets sold and
the frequency of its sale. It has a direct impact on the amount of inventory held by a business concern.
⚫ 3. Nature of type of product: The product sold by the business may be a perishable product or a
durable product.Accordingly, the inventory has to be maintained.
⚫ 4. Economies of production: The scale on which the production is done also affects the amount of
inventory held.Abusiness may work on large scale in order to get the economies of production.
⚫ 5. Inventory costs: More the amount of inventory is held bythe business, more will be the
operating cost of holding inventory.There has to be a trade-off between the inventory held and the
total cost of inventory.
⚫ 6. Financial position: Sometimes, the credit terms of the supplier are rigid and credit
period is very short.Then, according to the financial situation of the business the inventory
has to be held.
⚫ 7. Period of operating cycle: If the operating cycle period is long, then the money
realization from the sale of inventory will also take a long duration.Thus, the inventory
managed should be in line with the working capital requirement and the period of
operating cycle.
⚫ 8. Attitude of management: The attitude and philosophy of top management may
support zero inventory concept or believe in maintaining huge inventory level.Accordingly,
the inventory policy will be designed for the business.
 Cost of inventory
Every firm maintains some stock of raw materials, work-in-progress and finished goods
depending upon the requirements and other features of the firm. Though are many benefits
of holding inventory, yet there are some cost associated with it, which are mentioned below:
1.Carrying cost: this is the cost incurred in the keeping or maintaining an inventory. Two
basic cost are associated with holding a units in inventory.These are:
 cost of storage :This means and includes the cost of storing one unit of raw material or work in
progress or finished goods.This cost may include the rent of the space occupied, cost of the
people employed for security of the stock, cost of infrastructure required eg: cost of insurance,
warehousing cost, handling cost etc.
 Cost of financing:This is the cost of funds invested in the inventories.The fund invested in the
inventories have an opportunity cost. Moreover, if the firm has to pay interest on borrowings
for the purchase of materials, then there is an explicit cost of financing.
 Cost of inventory
2.Cost of ordering: the cost of ordering include the cost of acquisition of inventories. It is the cost
of preparation and execution of an order, including cost of paperwork and communicating with the
suppliers.The total annual cost of ordering is equal to the cost per order multiplied by the number
of orders placed in ayear.The number of order determines the average inventory being held bythe
firm.Therefore, the total ordering cost is inversely related to the average inventory of the firm.
The carrying cost and the cost of ordering are the opposite forces and they collectively determine
the level of inventory of any firm.
The carrying cost considerations require that the firms should maintain the inventories at the lowest
levels and should be replenished as frequently as possible.This will result in lowering carrying cost.
But this will also require frequent orders to be placed, therefore results in increase in the total cost
of ordering.Therefore, afinance manager has to achieve atrade off between carrying cost and the
cost of ordering
3.Cost of stock-out: Astock-out is a situation when the firm is not having units of an items in
store but there is a demand for that.
It refers to the demand for an item whose inventory level has reduced to zero or insufficient level. It
may be noted that the stock out does not appear if the item is not demanded even if the inventory has
fallen to zero.
 Techniques of inventory control
⚫ Inventory control refers to a process of ensuring that appropriate amount of stock are maintained by a
business, so as to be able to meet customer demand without delay while keeping the costs associated with
holding stock to a minimum. Inventory control signifies a planned approach of finding when to shift,what to
shift, how much to shift and how much to stock so that costs in buying and storing are optimally minimum
without interrupting production or affecting sales.To solve these problems of inventory management various
techniques are there.These techniques are divided into two categories – modern techniques and traditional
techniques.
MODERNTECHNIQUES TRADITIONAL TECHNIQUES
(a) Economic Order Quantity (EOQ) (a) Inventory Control Ratios
(b) Re-Order Point (ROP) (b) Two Bin System
(c) Fixing Stock Levels (c) Perpetual Inventory System
(d) Selective Inventory Control: (d) Periodic Order System
• ABC Analysis
• VED Analysis (Vital, Essential, Desirable)
• SDE Analysis (Scarce, Difficult, Easy)
• FSN Analysis (Fast Moving, Slow, Moving and
Non-
 Modern Techniques
⚫ Modern techniques of inventory control refers to those techniques which are evolved
through a scientific process.These techniques involve the use of a formula or a method
which is logically derived to keep control on the inventory levels.
 ECONOMIC ORDER QUANTITY (EOQ)
⚫ The EOQ refers to the order size that will result in the lowest total of order and carrying costs for an
item of inventory. If afirm place unnecessary orders it will incur unneeded order costs. If a firm
places too few order, it must maintain large stocks of goods and will have excessive carrying cost. By
calculating an economic order quantity, the firm identifies the number of units to order that result in
the lowest total of these two costs.
⚫ The limitations of this method are given below:
⚫ 1. Demand is known-- Using past data and future plans a reasonably accurate prediction of
demand can often be made.This is expressed in unit sold in a year.
⚫ 2. Sales occur at a constant rate-- This model may be used for goods that are sold in relatively
constant amount throughout the year. Amore complicated model is needed for firms whose sales
fluctuate in response to there seasonal cyclical factors.
⚫ 3. Cost of running out of goods are ignored-- Cost associated with delays or lost sales are not
considered.These costs are considered in the determination of safety level in the re-order point
subsystem.
⚫ 4. Safety stock level is not considered-- The safety stock level is the minimum level of
inventory that the firm wishes to hold as a protection against running out. Since the firm must always
be above this level the EOQ need not be considered the safety stock level.
⚫ The optimal size of an order for replenishment of inventory is called economic order
quantity.
⚫ Economic order quantity (EOQ) or optimum order quantity is that size of the order where
total inventory costs (ordering costs + carrying costs) are minimized.
⚫ Economic order quantity can be calculated from any of the following two methods:
⚫ 1. Formula Method
⚫ 2. Graphic Method
 ECONOMIC ORDER QUANTITY (EOQ)- Formula Method
⚫ Formula Method: It is also known as‘SQUARE ROOT FORMULA’or ‘WILSON FORMULA’as given
below:
2𝑹𝑶
EOQ=
𝑐
Where,
EOQ = Economic Order Quantity
R = Annual Requirement or consumption in units
O = Ordering Cost per order
C = Carrying Cost per unit per year
𝑅
No. of orders =
𝐸𝑂𝑄
No. of days in a year
Time gap between two orders=
No. of orders

T𝑜𝑡𝑎𝑙𝐶𝑜𝑠𝑡= Purchase Cost + Carrying Cost+ Order Cost

or
= (R x Unit Price) + (EOQ/2 x C) + (R/EOQ x O)
 Cost of inventory
Every firm maintains some stock of raw materials, work-in-progress and finished goods
depending upon the requirements and other features of the firm. Though are many benefits
of holding inventory, yet there are some cost associated with it, which are mentioned below:
1.Carrying cost: this is the cost incurred in the keeping or maintaining an inventory. Two
basic cost are associated with holding a units in inventory.These are:
 cost of storage :This means and includes the cost of storing one unit of raw material or work in
progress or finished goods.This cost may include the rent of the space occupied, cost of the
people employed for security of the stock, cost of infrastructure required eg: cost of insurance,
warehousing cost, handling cost etc.
 Cost of financing:This is the cost of funds invested in the inventories.The fund invested in the
inventories have an opportunity cost. Moreover, if the firm has to pay interest on borrowings
for the purchase of materials, then there is an explicit cost of financing.
 Cost of inventory
2.Cost of ordering: the cost of ordering include the cost of acquisition of inventories. It is the cost
of preparation and execution of an order, including cost of paperwork and communicating with the
suppliers.The total annual cost of ordering is equal to the cost per order multiplied by the number
of orders placed in ayear.The number of order determines the average inventory being held bythe
firm.Therefore, the total ordering cost is inversely related to the average inventory of the firm.
The carrying cost and the cost of ordering are the opposite forces and they collectively determine
the level of inventory of any firm.
The carrying cost considerations require that the firms should maintain the inventories at the lowest
levels and should be replenished as frequently as possible.This will result in lowering carrying cost.
But this will also require frequent orders to be placed, therefore results in increase in the total cost
of ordering.Therefore, afinance manager has to achieve atrade off between carrying cost and the
cost of ordering
3.Cost of stock-out: Astock-out is a situation when the firm is not having units of an items in
store but there is a demand for that.
It refers to the demand for an item whose inventory level has reduced to zero or insufficient level. It
may be noted that the stock out does not appear if the item is not demanded even if the inventory has
fallen to zero.
 Techniques of inventory control
⚫ Inventory control refers to a process of ensuring that appropriate amount of stock are maintained by a
business, so as to be able to meet customer demand without delay while keeping the costs associated with
holding stock to a minimum. Inventory control signifies a planned approach of finding when to shift,what to
shift, how much to shift and how much to stock so that costs in buying and storing are optimally minimum
without interrupting production or affecting sales.To solve these problems of inventory management various
techniques are there.These techniques are divided into two categories – modern techniques and traditional
techniques.
MODERNTECHNIQUES TRADITIONAL TECHNIQUES
(a) Economic Order Quantity (EOQ) (a) Inventory Control Ratios
(b) Re-Order Point (ROP) (b) Two Bin System
(c) Fixing Stock Levels (c) Perpetual Inventory System
(d) Selective Inventory Control: (d) Periodic Order System
• ABC Analysis
• VED Analysis (Vital, Essential, Desirable)
• SDE Analysis (Scarce, Difficult, Easy)
• FSN Analysis (Fast Moving, Slow, Moving and
Non-
 Modern Techniques
⚫ Modern techniques of inventory control refers to those techniques which are evolved
through a scientific process.These techniques involve the use of a formula or a method
which is logically derived to keep control on the inventory levels.
 ECONOMIC ORDER QUANTITY (EOQ)
⚫ The EOQ refers to the order size that will result in the lowest total of order and carrying costs for an
item of inventory. If afirm place unnecessary orders it will incur unneeded order costs. If a firm
places too few order, it must maintain large stocks of goods and will have excessive carrying cost. By
calculating an economic order quantity, the firm identifies the number of units to order that result in
the lowest total of these two costs.
⚫ The limitations of this method are given below:
⚫ 1. Demand is known-- Using past data and future plans a reasonably accurate prediction of
demand can often be made.This is expressed in unit sold in a year.
⚫ 2. Sales occur at a constant rate-- This model may be used for goods that are sold in relatively
constant amount throughout the year. Amore complicated model is needed for firms whose sales
fluctuate in response to there seasonal cyclical factors.
⚫ 3. Cost of running out of goods are ignored-- Cost associated with delays or lost sales are not
considered.These costs are considered in the determination of safety level in the re-order point
subsystem.
⚫ 4. Safety stock level is not considered-- The safety stock level is the minimum level of
inventory that the firm wishes to hold as a protection against running out. Since the firm must always
be above this level the EOQ need not be considered the safety stock level.
⚫ The optimal size of an order for replenishment of inventory is called economic order
quantity.
⚫ Economic order quantity (EOQ) or optimum order quantity is that size of the order where
total inventory costs (ordering costs + carrying costs) are minimized.
⚫ Economic order quantity can be calculated from any of the following two methods:
⚫ 1. Formula Method
⚫ 2. Graphic Method
 ECONOMIC ORDER QUANTITY (EOQ)- Formula Method
⚫ Formula Method: It is also known as‘SQUARE ROOT FORMULA’or ‘WILSON FORMULA’as given
below:
2𝑹𝑶
EOQ=
𝑐
Where,
EOQ = Economic Order Quantity
R = Annual Requirement or consumption in units
O = Ordering Cost per order
C = Carrying Cost per unit per year
𝑅
No. of orders =
𝐸𝑂𝑄
No. of days in a year
Time gap between two orders=
No. of orders

T𝑜𝑡𝑎𝑙𝐶𝑜𝑠𝑡= Purchase Cost + Carrying Cost+ Order Cost

or
= (R x Unit Price) + (EOQ/2 x C) + (R/EOQ x O)
 Practice Problems-1: EOQ
⚫ Q.1. Calculate the economic order quantity from the following particulars:
 Annual requirement =2,000 units
 Cost of materials per unit =Rs. 20
 Cost of placing and receiving one order= Rs. 40
Annual carrying cost of inventory 20% of unit price of inventory.
Solution:
Here, R = 2,000, O = 40, Unit Price = 20, C = 20% of Unit Price = 20% of 20 = 4
2𝑹𝑶
EOQ=
𝑐

2𝑿𝟐𝟎𝟎𝟎𝑿𝟒𝟎
=
𝟒
= 200 units
 Practice Problems-2: EOQ
Q.2-Compute EOQ and the total variable cost from the following information:
⚫ Annual demand = 4,000 units
⚫ Units Price = Rs. 40
⚫ Order Cost = Rs. 20
⚫ Storage Rate = 7% Per annum
⚫ Interest Rate = 3% Per annum
Solution: Here, R = 4,000 O = 20 Unit Price = 40
⚫ C = 10% of Unit Price = 10% of 40 = 4
2𝑿𝟒𝟎𝟎𝟎𝑿𝟐𝟎
=
𝟒
= 200 units
Total Variable Cost = Carrying Cost + Order Cost or
= (EOQ/2 x C) + (R/EOQ x O)
= (200/2 x 4) + (4000/200 x 20) = 400 + 400 = Rs. 800
Practical Problem 3:

⚫ The following information is available in respect of an item:

⚫ Annual Requirement (R) = 20,000 units
⚫ Ordering cost (O) = Rs 1875 per order
⚫ Carrying cost ©= Rs 3 per unit
Find Out the Economic Order Quantity and also verify the results.
Practical Problem 4:
⚫ The finance department of a Corporation provides the following information:
⚫ i)The carrying cost per unit of inventory is Rs. 10
⚫ The fixed cost per order is Rs. 20
⚫ The number of units required is 30,000 per year.

⚫ Determine the Economic Order Quantity (EOQ), total no. of orders in a year and the time
gap between two orders.
Practical Problem 5:
⚫ The following information is available in respect of the inventory costs of a firm:
⚫ Total annual consumption 600 units
⚫ Price per unit Rs. 6
⚫ Order cost Rs. 10 per order
⚫Carrying cost 20% of the unit price
Compute the EOQ.
 STOCK LEVELS
In order to guard against under-stocking and over-stocking, most of the large companies adopt a scientific approach of fixing
stock levels. These levels are: (i) maximum level; (ii) minimum level; (iii) reorder level; and (iv) reorder quantity. By adhering to
these levels, each item of material will automatically be held within appropriate limits of control.

Maximum
Level

Minimum Level

Reorder Level or Ordering Level

Danger Level

Average Stock Level

 Usage Time (re-order period)

Minimum 5 2 days

Normal 10 3 days

Maximum 15 4 days
 Problem:
In a manufacturing company, a material is used as follows:
Maximum Consumption 12,000 units per week
Minimum consumption 4000 units per week
Normal consumption 8000 units per week
Re order Quantity 48,000 units
Time required for delivery- Minimum 4 weeks; Maximum 6 weeks
Calculate a) Re order level b) minimum level c) maximum level and d) average stock level
 Problem:
Medical Aids Company manufactures a special product A. The following particulars were
collected for the year 2022
a) Cost of Placing an order Rs. 100
b) Carrying cost p.u Rs. 15
c) Normal Usage 50 units per week
d) Minimum Usage 25 units per week
e) Maximum Usage 75 units per week
f) Re order period 4 to 6 weeks
From the above information, compute:
1) Re-order quantity 2) Re-order level 3) Minimum level 4) Maximum level and
5) Average stock level
 Problem:
Medical Aids Company manufactures a special product A. The following particulars were
collected for the year 2022
a) Cost of Placing an order Rs. 100
b) Carrying cost p.u Rs. 15
c) Normal Usage 50 units per week
d) Minimum Usage 25 units per week
e) Maximum Usage 75 units per week
f) Re order period 4 to 6 weeks
From the above information, compute:
1) Re-order quantity 2) Re-order level 3) Minimum level 4) Maximum level and
5) Average stock level
Receivable Management
 Receivable Management
 Meaning:-
 Receivables represent amounts owed to the firm as a result of sale of goods or services
in the ordinary course of business. These are claims of the firm against its customers and
form part of its current assets. Receivables are also known as account receivables, trade
receivables, or book debts. The receivables are carried for the customers. The period for
credit and extent of receivables depends upon the credit policy followed by the firm. The
purpose of maintaining or investing in receivables is to meet competition, and to increase
the sales and profits.
 “Receivables management is the process of making decisions relating to an investment
in trade debtors. If you want to increase sales turnover and profits of the firm, you have to
sale goods on credit basis, which includes the risk of bad debts. The objective of receivables
management is “to promote sales and profits until that point is reached where the return
on investment in funding of receivables is less than the cost of funds raised to finance that
additional credit”
 Objectives of Receivable Management
 Monitor and Improve Cash Flow: Receivable management monitors and control all cash
movements of organizations. It maintains a systematic record of all sales transactions.
Receivable management helps business in deciding appropriate investment in trade debtors. It
aims that a sufficient amount of cash needed for day-to-day activities is maintained at business.
Credit facilities are extended by doing proper analysis and planning to ensure optimum cash
flow in a business organization.
 Minimizes bad debt losses: Bad debts are harmful to organizations and may lead to heavy
losses. Receivable management takes all necessary steps to avoid bad debts in business
transactions. It designs and implement schedules for collection of outstanding amount timely
and informs the collection department on due dates. Customers are notified for amount
standing against them and charges interest on delay in payments.
 Avoids invoice disputes: Receivable management has an efficient role in avoiding
any disputes arising in business. Disputes adversely affect the relationship between
customers and business organizations. Complete and fair record of all transactions with
customers are maintained on a daily basis. There is no chance of confusion and dispute
arising as all sales transactions are accurately maintained.
 Boost up sales volume: Receivable management increase the sales and the
profitability of the organization. By extending the credit facilities to their customers
business are able to boost up their sales volume. More and more customers are able to
do transactions with the business by purchasing products on a credit basis. Receivable
management helps business in managing and deciding their investment in credit sales.
This leads to increase in the number of sales and profit level.
 Improve customer satisfaction: Customer satisfaction and retention are key goals
of every business. By lending credit, it supports financially weaken customers who can’t
purchase business products fully on a cash basis. This strengthens the relationship
between customer and organization. Customers are happy with the services of their
business partners. Receivable management help in organizing better credit facilities for
their customers.
 Helps in facing competition: Receivable management helps in facing stiff
competition in the market. Several competitors existing in market offers different
credit options to attract more and more customers. Receivable management process
analysis all information about market and helps the business in farming its credit lending
policies. Customers are provided better services by extending credit at convenient
rates. Appropriate amount and rates of credit transactions can be easily decided through
receivable management process. All credit and payment terms are decided for every
customer as per their needs.
 Cost of Maintaining Receivables.
 The allowing of credit to customers means giving of funds for the customer’s use. The concern incurs
the following costs on maintaining receivables:-
 COST OF FINANCING: The credit sales delay the time of sales realization & therefore the time gap
between incurring the cost & the sales realization is extended. This results in the blocking of funds for
a longer period. The firm, on the other hand, has to arrange funds to meet its own obligations towards
payment to the supplier, employees etc., and these funds are to be procured at some explicit or
implicit cost. This is known as the cost of financing the receivables.
 ADMINISTRATIVE COST: A firm will also be required to incur various costs in order to maintain
the record of credit customers after the credit sales
 DELINQUENCY COST: The firm has to incur additional costs known as delinquency costs if there
is a delay in the payment by a customer. The firm may have to incur costs on reminders, phone calls,
postages, legal notices etc. There is always an opportunity cost of the funds tied up in the receivables
due to delays in payment.
 COST OF DEFAULT BY THE CUSTOMER: If there is a default by the customer & the receivables
become partly or wholly, unrealizable, then this amount is known as bad debt, also becomes a cost to
the firm. This cost does not appear in the case of sales.
 BENEFITS OF RECEIVABLES
 INCREASE IN SALES: Most of the firms sell goods on credit, either because of trade
customs or other conditions. The sales can be further increased by liberalizing the credit
terms. This will attract more customers to the firm resulting in higher sales & growth of the
firm.
 INCREASE IN PROFITS: Increase in sales help the firm to easily increase the operating
profit of the firm.
 EXTRA PROFIT: Sometimes, the firm makes the credit sales higher than the usual cash
selling price. This brings an opportunity to the firm to make extra profit over & above the
normal profit.
 Factors influencing the size of Receivables.
 Size of credit sales.
 Credit policies.
 Terms of trade.
 Expansion plans.
 Relation with profits.
 Credit collection efforts.
 Habits of customers.
 Issues of Receivable Management:
 The management of receivables is a very critical area in the total working capital
management as it can be very costly and time-consuming activity. The efficient receivables
management results ample opportunities for a firm to achieve advantages through
improvements in customer service, cash management and reductions in costs. The
management of receivables can be divided into:
 (i) Credit Policy
 (ii) Credit Analysis
 (iii) Collection Policy
 Credit policy
 Credit policy: It covers the questions concerning terms of credit, credit limits, discounts,
etc. A business firm is not required to accept the credit policies employed by its competitors,
but the optimal credit policy cannot be determined without considering competitors’ credit
policies. A firm’s credit policy has an important influence on its volume of sales, and thus on
its profitability. Therefore, a firm should have a well expressed and written credit policy for
the purpose of attaining the efficiency in cash flow, clarity of objectives, good customers’
relations, etc.
 Types of Credit Policies:
 The credit policy will never be balanced unless managed with all precautions. A rider on horse
if not careful will get slipped. Similarly, if the credit policy is not carefully designed, it will
end- up in losses. The credit policies are different types.
 a) Liberal credit policy: Under this policy, the firm is ready to sell more on credit so as to
maximize the sales. Profits will increase in liberal credit policy as a result of increased sales.
More sales by way of liberal credit policy would also give rise to bad debts and losses there
upon.
 b) Stringent credit policy: The firm is highly careful in extending credit to customers. The
financial manager through rigid standards often sacrifices profitable sales opportunities and
profits in the name of rigid and cautious credit norms. Therefore, the objective of profit
maximization is partially fulfilled.
 c) Optimum credit policy: Optimum Credit policy is one, which maximizes the firm’s
value.
 Optimum Credit Policy
 To achieve this goal the evaluation of an investment in receivables should involve the
estimation of incremental operating profit; investment in receivables; estimation of the rate of
return of investment; comparison of the rate of return with the required rate of return Sales
increase by credit extension is associated with bad debt costs, because of defaulting accounts.
Though return on credit sales increases firm’s returns, simultaneously firm’s liquidity is
affected because of slow recovery of debts and at times no recovery of some of the debts .
 The analysis of the determination of optimum credit policy involves analysis of opportunity
cost of lost contribution and credit administration costs and bad debt losses.
An optimum credit policy covers the following aspects:
i) Investment in receivables: Financial manager has to offer certain sales on credit, which
means the credit sales is financed by the firm. Firms if rich in cash, credit extension is desirable.
If firms are not strong financially, finance has to be obtained from outside which means inviting
interest burden that goes to reduce profitability of the firm. So, financial manager has to reduce
the capital tied up on credit sales.
ii) Terms of credit: If credit terms are not competitive it will affect sales and consequently the
shareholders’ wealth. Here terms refers to what is the price if sold for cash, otherwise, what is
the credit period and cash discount, how much percentage for how many days are the issues. Like
wise the financial manager has to decide as and when situation arises.
 iii) Credit Standards: Credit standards have a bearing on sales of the firm. These standards
refer to minimum requirements for the evaluation of credit worthiness of a customer. The
company may be liberal or strict in defining the requirement in getting credit. The standards
imposed by the company are to assess the credit worthiness of customers. As long as company’s
profitability is higher, it can lower credit standards, which it would adversely, affect the sales.
Following are the effects of lowering the credit standards.
a) Rise in sales
b) Rise in collection period
c) Rise in accounts receivables
d) Rise in bad debts
e) Increase in servicing costs of accounts receivables
 Credit Analysis
 After establishing the credit policy, the firm should conduct the credit analysis for evaluating
the capabilities of the customers.
 The credit analysis would broadly divided into two steps, i.e.,
 obtaining credit information,
 and analysis of credit information.
 It is on the basis of credit analysis that the decision to grant credit to a customer as well as the
quantum of credit would be taken. The credit information may provide some insights about the
creditworthiness of the customer with respect to the character, capacity, capital, condition, cost and
collateral.
Besides establishing a credit policy, a firm should develop procedures for evaluating credit applicants.
The first step in the credit analysis is obtaining the credit information. The sources of information
broadly divided into internal and external. The internal source of information is derived from the
records of the firms contemplating an extension of credit. On the other hand the information available
from external sources are financial statements of the customer, bank references, trade references
credit bureau reports, etc.
 Collection Policy
 The third area involved in receivable management is collection policies. The firm should
follow a well laid down collection policy and procedure to collect dues from its customers.
The collection policies cover two aspects, i.e., the degree of effort to collect the over dues,
and the type of collection efforts. The collection policies may be classified into strict and
liberal. The effects of tightening the collection policy would be to decline in sales, debts,
collection period, interest costs and an increase in collection costs and whereas, the effects
of a lenient policy would be exactly the opposite.
 Firms should be practical in their approach to collecting credit sales through regular
correspondence, personal calls, telephone contacts, etc. The sudden reminders will not
make the collection programs effective unless they take follow-up action and maintain
personal relations. If the collection policy is not effective the company will incur large
expenses and fail to be ‘fund-rich.
 Credit control
The following actions are more helpful to bring the management of accounts receivables under control.
i) Prompt invoicing: Even after delivery, invoicing is made slowly. This will give impression to the
customers that invoice has not yet reached. After receiving the invoice, he starts calculating the
credit period from the day he has received the invoice. So to quicken the collection, the suppliers
should dispatch invoice immediately.
ii) Open item accounts: In many firms, ways of collections are very slow and many invoices are
turning to be bad debts due to lack of information such as which invoice in which stage. All the
amount of each invoice is not collected at one time. Practically amounts are made partially and the
payment is computed over a period of time. So for effective control the financial manager should
have information invoice-wise, product-wise, division-wise, etc. and all these particulars be
collected month-wise so that follow-up action can be initiated.
iii) Personal touch: A credit manager has to be in touch with the customer personally if possible.
Otherwise contact them over-phone at-least, so that the customer will be serious and clear the
pending dues. This kind of follow-up will bring the accounts receivables under control rather than
regular reminders, where the customers act mechanically.