(EEA)

Unit-111

Cash flows and Capital Budgeting

1) Examine the nature and Scope of capital budgeting?

Every organization, irrespective of its nature whether it is

getting profit or loss or big or small, in the course of its functioning, usually
acquires the assets such as land and building, plant and machinery and
soon. For each of these, there exist two or more alternatives, which need to
be understanding of the principles and practices of capital budgeting is
essential.

Nature of capital budgeting:

Author namely T Horngren defines capital budgeting as ‘the long-
term planning to make and finance proposed capital outlays. The capital
budgeting decisions involve long-term planning for selection and also
finance-investment proposals. Capital budgeting is the process of
evaluating the relative growth of long-term investment proposals on the
basis of their respective profitability.
Capital budgets are different from operating budgets from time
frame point of view. Operating budgets such as sales budget, purchase
budget or overheads etc. which show the firm’s planned operations or
resource allocation for a given period in future, normally one year. On the
other hand, capital budgets are made for long-term period say three years
or beyond.
Long-term investment proposals involve larger cash outlays. This
requires a careful analysis of cash outflows and inflows associated with
each of these proposals. While evaluating capital budgeting proposals, the
following steps are considered.
• Estimating cash flows for the proposals.
• Generating investment proposals.
• Evaluating cash flows.
• Selection of projects based on an acceptance criterion.
• Monitoring and revaluating, the investment projects.

Why is capital budgeting necessary:

It is necessary to reduce costs or increase revenues to maximize
profits. The company is said to be efficient in its operations when it can
maximize profits. In other words, capital budgeting decisions are made to
keep the business vibrant, competitive, profitable and this efficient. Capital
budgeting decisions can be classified into the following types:

• Projects that reduce costs.

• Projects that increase revues.
Of these two, the capital budgeting decisions that reduce costs
are relatively easier to be bundled as full information about their
presents costs and revenues is available. What is to be decided here is:
how to reduce the costs further before a capital budgeting proposal is
selected.
Regarding the projects which increase the revenues, it may be
difficult to select one from the given alternatives. It is so because the
available data about the future cash flows has its own limitations, such
as uncertainty in future, inaccurate estimate of life of the asset and so
on.
Capital budgeting decisions:
The following are examples of certain investment or capital
budgeting decisions:
• Building a bridge.
• Construction of a new building
• Making a new product.
• Starting a new business.
 • Purchasing of technology from a foreign country.
• Expansion of business.

Complementary vs mutually exclusive projects:

The investment decisions can also be classified as
complementary projects and mutually exclusive projects. Two or more
projects are said to be complementary to each other when any one of
these projects canot be taken up independently without the others. For
example, a firm may be proposing the construction of factory building
and a canteen. A canteen and factory building are complementary to
each other, as a factory cannot function effectively without a canteen
for its employees. \these are also called contingent projects as one is
based on the other. If there is no proposal for a factory there is no need
for a canteen. So the proposal for a canteen is contingent on the main
proposal, that is, factory construction. Computer and related software
also constitute another example for complementary projects.
Mutually exclusive projects are these projects when one cannot
be taken up simultaneously with the other. If one is taken up, the other
project has to be abandoned. For instance, if a company has a budget of
Rs 1,00,000 to invest either in new product development or introducing
automation in the production department. If one is taken up, there is no
money left for the other. In such a case, the projects are said to be
mutually exclusive. Where the projects are listed on the basis of their
profitability, it is relatively easier to identify the best profitable project.
It is also difficult to select one under this category, if more than one
project gets cleared for final decision.

2) Examine the cash inflow and outflow analysis?

Cash inflows refer to cash receipts. It does not refer to future

income. It may be calculated for a particular project or asset or for the
whole business for one year or series of years.
 Estimation of amount and the timing of the cash flows are very
crucial stages. The cash inflows are determined on an after-tax, that is ,
form the gross inflows, deduct the cash expenses and depreciation and
lastly, taxes.
Example: 1.
Suppose an asset costing Rs 25,000 has 5 years of life and is
expected to yields Rs 20,000; 30,000;35,000;30,000; and 25,000. Its
operating cash expenses are 40 percent of the estimated revenues of
each year. The asset is subject to 20 percent depreciation. The company
is subject to 30 percent of income tax. Estimate the cash inflows for
years 1 to 5.

Depreciation is calculated as = ( Cost of the asset + Installation costs) –

scrap / No of life in years.
There is no information about the installation cost or scrap value. Hence
these are ignored here.
In this example, the depreciation per year is = 25,000 / 5 = Rs 5000.
Estimation of cash inflows.
Table.

year Cash revenue Cash Cash flow

expenses- before taxes.
40%
a b c d = (b-c)
1 20,000 8,000 12,000
2 30,000 12,000 18,000
3 35,000 14,000 21,000
4 30,000 12,000 18,000
5 25,000 10,000 15,000
Continue------
Depreciation Taxable Taxes@30% Cash flow Cash inflows.
income after tastes.
e F= (d-e) g h- (f-g) I= (h+e)
5,000 7,000 2,100 4,900 9,900
5,000 13,000 3,900 9,700 14,700
5,000 16,000 6,400 9,600 14,600
5,000 13.000 3,900 9,700 14,700
5,000 10,000 3,000 7,000 12,000

In the process of estimation of cash inflows, the

important factors are the operating cash expenses, depreciation
and taxes. With any change in any of these variables, the cash
flows also vary.
Example:2- Estimation of cash flows.
Suresh industries are considering the purchase of a new
machine which will mechanize the presently carried out manual
operations. The following is the data about the two alternative
models. Estimate the net cash inflows. The firm is subject to a tax
of 30 percent per annum.
Table.
Particulars. Machine’ A’ Machine ‘B’
Cost (Rs) 1,00,000 1,50,000
Life ( in Year) 5 7
Cost of indirect
material p.a. (Rs) 2000 3000
Savings in scrap .p.a 15,000 18,000
(Rs)
Savings in direct 20,000 30,000
wages;
Employees required 5 6
(no)
Wages per 4000 5,000
employee(|Rs)
Additional cost of 5000 6,000
maintenance p.a (Rs)
Additional cost of 3000 6,000
supervision p.a.(Rs)

Profitability statement.
Machine ‘A’ Machine ‘B’
Savings per annum:
Scrap 15,000 18,000
Wages 30,000 30,000
----------- ------------
35,000 48,000
Less; Estimated additional costs:
Indirect material 2,000 3,000
Maintenance 5,000 6,000
Supervision 3,000 6,000
----------- 10,000 --------------- 15,000
----------- ---------
Profits before tax. 25,000 33,000
Less taxes (30 % p.a) 7,000 9,900
------------- -----------
Cash flows after taxes (CFAT) 17,000 23,100
----------- -------------
-
Capital budgeting proposal illustrated:
A business needs a new machine and has to make a
choice between machine Y and machine Z. The initial cost and the
net cash flow over five years ( income less running expenses but
not depreciation) to the business have been calculated for each
machine as follows.
Table.
Initial cost Machine Y (Rs) Machine Z (Rs)
Net cash flow. 20,000 28,000
1 8,000 10,000
2 12,000 12,000
3 9,000 12,000
4 7,000 9,000
5 6,000 9,000

Only one machine is needed, and at the end of five

years, the machine will have no value and will be crapped. To
finance the project the business can borrow money at 10 percent
per annum. Which machine should be chosen?
This is a real situation confronting business with two
alternatives. Sometimes the alternatives could be more. Which
one is to be preferred?
These decisions are to be analyzed based on their
profitability. To understand this, let us see the different methods
of investment appraisal.
 3) Differentiate Payback period method from accounting rate of
return method?

Capital budgeting decisions are made under different criteria.

How are these criteria determined? These criteria differ in concepts.
Some use thumb rules and some use logic and scientific approach. So,
based on these criteria, the methods of capital budgeting can be classified
as:
a) Payback Method:

Under payback method, the decision to accept or reject a

proposal is based in the payback period. Payback period refers to the period
within which the original cost of the project is recovered. It is calculated by
dividing the cost of the project by the annual cash inflows.

Payback period = cost of the project / annual cash inflows.

The shorter the length of the payback period, the better is the
project in terms of paying back the original investment. Particularly where the
future is uncertain, the companies favor this method. The earlier the original
investment is recovered, the better it is, in terms of safety and liquidity. |Where
the cash flows are uniform throughout, they are said to even. Consider this
example.

Where the cash inflows are even:

Example:

The cost of a project is Rs 50,000 the annual cash inflows for the next 4 years
are Rs 25,000. What is the buyback period for the project?

Payback period= Cost of the project / annual cash inflows.

= 50,000 / 25,000

= 2 years.
 If another project has 3 years, for example, it is better to choose the above
project because it has less payback period.

Where the cash flows are not uniform, they are said to be uneven. In
such a case take the cumulative cash inflows and see how much time it takes to
get back the original investment. Consider the following example.

Example:-2

The cost of project is Rs 50,000 which has an expected life of 5 years. The
cash inflows for next 5 years are Rs 24,000, Rs 26,000. Rs 20,000 Rs/ 17,000 and
Rss 16,000 respectively. Determine the payback period.

Table.

Cash inflows and cumulative cash inflows for the project.

Year Cash inflows (Rs) Cumulative cash inflows

(Rs)
1 24,000 24,000
2 26,000 50,000
3 20,000 70,000
4 17,000 87,000
5 16,000 1,03,000

Table shows that the original investment can be recovered by the end
of the second year and hence the project has 2 years of payback period.

So the payback period is 2 years.

Where the cash inflows are same, but timing is different:

At times, the cash inflows may be different each year, but the total cash
inflows over the life of the project may be the dame. Sometimes, the buyback
period may be similar. In such a case, observe the timing of the cash inflows.
Choose the project which has higher cash inflows in the initial years. Check the
following example.
Example-3:

Two projects, costing Rs 20,000 each, have the following cash inflows. Both have
the same payback period. Which one do you choose and why?

Table.

Same total cash inflows with a difference in size and timing.

year Project ‘A’ Project’B’

1 8,000 12,000
2 12,000 8,000
3 10,000 12,000
4 9,000 7,000
5 7,000 7,000
Total 46,000 46,000

Solution:

Table shows equal cash inflows and also the equal playback of two years. But
the timing of cash inflows is different. Project B yields Rs 12,000 as against Rs
8,000 by A. This has more value for next for years. Besides this, earlier cash
inflows are likely to prove more accurate estimates than later cash flows.

b) Accounting rate of Return ( ARR) Method:

Accounting rate of return refers to the ratio of annual profits after taxes to the
average investment. The average investment is equal to half of the original
investment. Accounting rate of return is also called average rate of return.

It is assumed that the asset is depreciated as per straight line

method. Usually it is expressed in terms of percentage. The higher the ARR is, the
better is the profitability and hence the projects with higher accounting rate of
return are short listed for implementation.

The above formula can be changed as per the meeds of the

appraised. Average profits can be considered before or after deplreciation,
interest or taxes. At times, ARR is determined considering the original cost of the
project as the denominator.

Example: Accounting rate of return:

A firm is considering two projects each with an initial investment of Rs 20,000

and a life of 4 years. The A firm is considering two projects each with an initial
investment of Rs 20,000 and a life 4 years. The following is the list of estimated
cash inflows after taxes.

Table.

Estimated cash inflows proposals for three projects.

Year Proposal-1 Proposal--2 Proposal-3

1 12,500 11,750 13,500
2 12,500 12,250 12,500
3 12,500 12,500 12,500
4 12,500 13,500 11,750
Total 50,000 50,000 50,000

Determine accounting rate of return on (a) average capital (b) original capital
employed.

(a) ARR on average capital: Proposa-1 Proposal-2 PLroposa-3

ARR = Average annual = 12,500/10,000 = 12,500/10,000 12,500/ 10,000

Profits after taxes/

Average investment.

(b) On original investment: Proposal-1 Proposal-2 Proposal-3.

ARR- Average annual = 12,000/20,000 = 12,500/20,000 = 12,500/20,000

Profits after taxes/
Original investment.
 It is clear that the ARR gives equal priority to all the proposals
though the timing of the cash inflows is different.

If there is working capital and scrap. How is ARR computed?

Where there is scrap resulting from the sale of the old assets and
there is working capitol, these two are added to the average investment.
These are shown in the following formula:
Example-1 Computation of ARR:
Find out the average rate of return from the following data relating to CNC
Machines 1 and 2.
Cost Rs 30,0000 each
Estimated life 3 years each
Estimated scrap 60,000 each
Income tax rate 50%
Additional
Working capital
Required. 2, 50,000 for cash machine.
The estimated cash inflows after tases for each machine are so given
below.
Table.
year CNC Machine - Rs CNC Machine-2 RS
1 1,50,000 2,00,000
2 3.00,000 3,00,000
3 1,50,000 2,50,000
4 -- 1,50,000
Total 6,00,000 9,00,000

Solution:
The average cash inflows after taxes for CNC Machine-1 = 2,00,000 tjat os.
(6,00,000/3)
The average cash inflows after taxes for CNC Machine-2 = 2,25,000 that is (
9,00,000/4)
Average capital = ( Cost – Scrap) /2 + working capital + scrap
 = ( 3,00,000 – 60,000) / 2 + 2,50,000 + 60,000
=1,20,000 + 2,50,000 + 60,000
= Rs 4,30,000

ARR for Machine-1 = Average annual profits after taxes / Average investment

= 2,00,000/ 4,30,000 = 45.5%

ARR for Machine -2 = 2,25,000 / 4,30,000 = 52.32%

Based on the accounting rate of return, the machine-2 is profitable.

4) Differentiate internal rate of return method from net present

value method?
Discounted cash flow methods are improved methods over the traditional
techniques. These consider the time value of money. They consider the whole
earnings of the proposal and the cost of the project because of these reasons,
these methods are also called modern methods of investment appraisal.
Disconted cash flow methods can be (a) Internal rate of return (IRR) method (b)
Net present value (NPV) methods

What is discounted cash flows?

Discounted cash flows are the future cash inflows reduced to their present
value based on a discounting factor. The process of reducing the future cash
inflows to their present value based on a discounting factor or cut-off return is
called discounting. Discounting is the obverse of compounding. To understand
this, let us see the following example.

Example: Time value of money.

Suppose your friend asks you to lend him Rs 1000 today and offers to
repay the same after one day or one year, do you lend him? What terms do you
put forth?

Solution:
 Naturally, you would like to have the money as quickly as possible. You
may not ask any interest, if the money is repaid after one day. But, if the money
were to be repaid, after say one year, You would like to make it clear how much
interest is the to be paid along with the principal amount or Rs 1000. In case the
friend does not agree, you may not lend him at all.

The above example shows that money earns interest at a given rate which
is otherwise called time value. In other words, if you invest the same money in
any bank, your will get interest, at a a given rate, accursed on this Rs 1000. You do
not want to be deprived of this interest. Yes, why should you? If the friend is very
close, that is different. You may not ask any interest at all that is different thing.

Using the above example, if it is invested with a bank or a building society at

an interest rate of 10 percent per annum, it will increase as follows.

Table.

Origianal investment Rs 1000

Interest at 10% on Rs 1000 for the first 100
ear
Value at the end of first year. 1,100
Interest at 10% on \rs 1100 for the 110
second year.
Value at the end of 2 year. 1,210

In other words, it a principle of Rs 1000 will multiply to Rs 1210 at the end of

second year @ 10 percent per annum. The growth of Rs210 is because of time
value of money. The higher the rate of interest, the higher is the growth.

The same can be looked at from a different point of view. We are going to
receive Ts 1,110 at the end of 2 year. What is its present value if it is growing at
10 percent per annum?

The answer is Rs 1000. The future value of Rs 1000 at the end of two years at
a rate of return of 10 percent per annum is Rs 1,210,
 The present value of Rs 1210 received at the end of two years from now
discounted at 10 percent pre annum is Rs 1000.

The present value of future income can be obtained by discounting rate if

interest which can be understood from the following equation.

V = R1 /(1+i) + R2 / (1+i) --------Rn/ (1+I)

V = Present value.

R1,R2 and R3 = prospective income.

I = current rate of interest.

For example R1= 1100

R2 = 1210

I = 10%

V = 1100/ (1,10) + 1210 / (1.10)2

V = 1000 + 1000 = 2000.

Then, the present value of Rs 2310/- (1100+1210) is Rs 2000/-. This

discount is used in calculating the marginal efficiency of capital.

It can be expressed in another form as follows.

Where K = supply price.

R= annual income.

( r) = MEC or rate of interest.

Suppose, K = Rs24,000/-

R1 = Rs 6600 /-

R2 + Rs8680/-

R3 = 13,500/-
 K = 6600 / (1.10) + 8680/ (1.10)2 + 13,500 / (1.10)3

K = 6000 + 8000 + 10,000

K =Rs 24,000/-

In the above illustration the present value become Rs 24,000 which is equal to
the supply price. If the ‘r’ is taken as 10%, the percent value of the total income Rs
29780/- is greater than the supply price of Rs 24,000/-

From this, it is understood that when MEC is greater than rate of interest,
investment will increase, when interest is greater than MEC investment will
decreases. If both are equal investment becomes optimum.

Internal Rate of Return (IRR) Method:

Internal rate of return is that rate of return at which the present value of
expected cash flows of a project exactly equals the original investment. In other
words, it equates the present value of a given project with its outlay. This is the
cut –of point at which the income equals the expenditure or the investment
breaks even.

The net present value refers to the excess of the present value of future
cash flows over and above the original investment. IRR is denoted by’r’ . It is
computed as shown below.

C = CF1 / (1+r) + CF2 / (1+r)2-------CFr/ (1+r) n

Where C is the capital outlay, r is the internal rate of return and CFn is the cash
inflow at different time periods.

If we have scrap value and working capital adjustments, the above formula will
change to:

The shows IRR are that rate at which the different between the present value of
cash inflows and the original cost is equal to zero.

Evaluation of IRR:
 The internal rate of retune is compared with the cost of the capital. If the
IRR, is more than the cost of capital, the project is profitable, otherwise it is not.
Where /there are two projects with different IRRs, sclect the project with higher
IRR.

IRR and Even Cash Flows:

Where cash inflows are eve, it is relatively easy to compute IRR based on a
factor located from the cumulative present value or Rs 1. It is explained as given
below.

Example:

A project costs Rs 1,44,000. The average annual cash inflows are likely to be Rs
45,000 for a period of 5 years. Calculate the IRR for the project.

Factor = Project cost / annual cash inflows

= 1,44,000 /45,000

= 3.2

From the table, it is understood that the cumulative present value of Rs 1

received annually for a N years, find out between which rates of return, the factor
3.2 is lying. It can be seen that 3.2 is lying between 3.274 and 3.127 the
corresponding rates of return are 16 percent and 18 percent respectively. Since
3.2 is close to 16 percent, the IRR can be considered as close to 16 percent and 18
percent respectively. Since 3.2 is close to 16 percent, the IRR can be considered as
close to 16 percent. However, the exact percentage can be determined by
interpolation method as given below

IRR (r) = Rl + { PV cfat – PVc / d PV } X d R

= 16 + { 1,47,330 – 1,44,000 / 1,47,330 – 1,40,715} x2

= 16 + { 3,330 / 6,615} x 2

= 16 + ( 0.5) x 2
 = 16 + 1.0

= 17 %.

-------------------

Net present value method:

Net present value refers to the excess of present value of future cash inflows
over and above the cost of original investmet.

NPV = ( PV cfat) minus ( PV c)

Where PV cfat refers to the present value of future cash inflows after taxes.

PVc refers to present value of original investment or capital.

The conceplt of NPV is a logical extension to the concept of present value. Here
the decision is based on the size of net present value. The projects wich higher
NPVs are selected. If the NPV is negative, that means the project is not profitable.
In other words, the NPV should always be positive and should be maximum. The
present value factor tables are used here to determine the present value of the
future cash inflows.

How is NPV calculated?

The following are the stages in the determination of NPV

• From the PV factor table, identify the PV factors of Rs 1 for the given
discount rate ( PV)
• Multiply the cash flows ( both outflows and inflows) with the
corresponding PV factor to find the products DCF -= (PV) x ( CFAT).
• Find the sum of the products.
• If the sum is positive, that means, the project is profitable. In case of
projects with different NPVS, choose the project with the highest NPV
because, the higher the NPV, the higher is the profitability.

Interpretation:
NPV > 1. it means that the project earns more than the discount rate.
NPV = 1. It means that the project earns the same as the discount rate.
NPV < 1. It means that the project earns less than the discount rate.

Example: - NPV determination in cause of even cash inflows:

Given that a project costing Rs 40,000 has annual cash inflows of Rs
20,000 after taxes for a period of 6 years. How much is the net present
value. If the firm expects, 15 percent per annum, what is result?

Net present value + ( Pv cfat) minus (PVc)

P\v (annuity) factor@ 15 percent for six years = 3,784
NPV cfat = 20,000 x 3,784
NPV = 75,680 – 40,000
= Rs 35,680.
------------------------------------------------------------------------------------------------
 Unit-111

Borrowings on Investment.
1) Examine the capital structure ratios or leverage ratios?

Capital structure or leverage ratio is defined as ‘ the financial ratio,

which focuses on the long-term solvency of the firm. The long –term
solvency of the firms is always reflected in its ability to meet its long-term
commitments such as payment of interest periodically without fail,
repayment of principal as and when due.
All the financial institutions offering long-term finances are interested in
these ratios
A) Debt-Equity ( D / E) Ratio:

Debt-ratio is the ratio between outsiders’ funds (debt) and

insider’s funds (equity). This is used to measure the firm’s obligations to
creditors in relation to the owners finds. It is a measure of solvency. The
yardstick for this ratio is1:1. In other words, for every rupee of debt,
there should be one rupee worth internal funds.
This is also industry/ sector specific ratio. Depending upon the
industry, the standard for the debt-equity ratio differs. For instance, in
case of capital intensive industries such as shipping companies or steel
manufacturing companies, the DV ratio can be as high as 20.1. So this
ratio has to be interpreted considering the nature of industry and
competitors D/E ratios.
A high D/E ratio implies that the creditor’s stake is more as
compared to that of owners. In other words, if the project fails
financially, there is greater risk for the creditors. This may further mean
that the creditors have higher degree of control in the management of
the company.
On the other hand, a low D/E ratio is desirable which means
less risk to the creditors leaving higher margin of safety for the creditors.
 From the firms’ point of view, this is also good in terms of lower
commitment to pay fixed interest charges. This will deprive the
company to take advantage of borrowed funds to enhance the
profitability.
Debt- equity ratio is calculated as follows:
Debt-Equity Ratio = ( Debt / Equity ) or
(Outsiders funds / insiders or shareholders’ funds)
Debt or outsiders funds include debentures, bonds, long-
term loans, and so on. Shareholders’ funds or equity here includes share
capital (both preference and equity) reserves (both general and specific)
retained earnings and such other. Equity does not only means equity
share capital. Equity here is interpreted as insider’s funds. Debt here
means only long-term debt.
Example: Calculate Debt-Equity ratio from the data given in
The following are the outsider’s funds.
Outsider’s funds + debentures Rs. 4, 00,000 + long-term loans 2, 00,000
= Rs6, 00,000
Insiders funds = RS 6, 00,000
( preference share capital Rs 1,00,000 + equity share capital Rs 1,50,000
+ General Reserve RS 2,50,000 + profit and loss account Rs 1,00,00)
Debt equity ratio + 6, 00,000 / 6,00,000/-
= 1:1
Debt equity ratio of 1:1 means that for every |Rs 1.0 of debt, there is
an equity fund of Rs 1, which meets the standard yardstick of 1:1. This is
quite satisfactory.

B) Interest Coverage Ratio:

Interest coverage ratio is calculated to judge the firms capacity to
pay the interest on debt it borrows. It gives an idea of the extent the firms
earnings may contract before it is unable to pay interest payment out of
current earnings. It is a very important ratio for the financial institutions to
judge the ability of the borrower to service the loan from the current year’s
profits. The higher the ratio, better it is ,. In other words, a higher ratio
implies that the company has no problems in paying interest.

Interest coverage ratio is calculated as follows.

Interest coverage ratio =( Net profit before interest and taxes / fixed
interest Charges)

The more the number of times of coverage. the better is the solvency
position of the borrower.

Example:

The earnings before interest and taxes (EBIT) of a company is Rs 5,

60,000. It’s subject to tax of 30 percent per annum.

Calculate interest coverage ratio:

Net profit before interest and taxes = Rs 5,60,000

Fixed interest charges on the debentures = ( 7000 x 100) x10 percent

= 70,000.

Interest coverage ration= ( 5, 60,000 / 70,000)

= 8 times.

Interest coverage ratio of 8 times means that the net profit earnings are 8
times to the fixed interest charges payable during the year.

C) Ratio of proprietors Funds to total assets:

This establishes the relationship between proprietor’s funds and

the total assets. Here, the total assets include the tangible fixed assets
plus current assets. As a guideline a ratio of around 0.5:1 or 50 percent
is considered as the minimum desirable. In other words, half of the
tangible assets are owned by the ordinary shareholders of owners and
half by contributors of other types of share and loan capital and by
creditors. Intangible assets such as goodwill are not considered here
because, if the business has to be sold off forcible, goodwill may not be
of any worth. This shows that the proprietors have solid stake in the
organization.
Ratio of proprietors funds to total assets = (proprietors fund total
assets) x 100
Example: Compute ratio of proprietors funds to ttotal assets from the
data given below of example.
Solution:
The ratio of proprietors funds to total assets can be computed as
follows. ( proprietors funds = Rs 7,00,000 ( preference share capital Rs
1,00,000 + Equity share capital Rs 1,50,000 + General reserve Rs
2,50,000 + Employee provident fund Rs 1,00,000 + profit and loss Rs
1,20,000 + general reserve Rs 2,50,000 + employee provident fund Rs
1,0,000 + profit and loss account Rs 1,00,000)
Total assets = Rs 15, 00,000
Ratio of proprietors funds to total assets = (7,00,00 / 15,00,000 ) x100
= 46.66%
This revels that 45.66 percent of the total assets are financed by
proprietors funds. In other words, the balance ( 553.34 %) is financed by
outsides funds. This ratio is further explained in a finer whay by
considering the volume of fixed assets and current assets to the
proprietor’s funds separately.

a) Ratio of Fixed assets to proprietors funds:

This ratio explains whether the fixed assets have been bought
from the proprietors funds or not. By matching the long –term
investment with the long-term finance, it is possible to determine
whether the borrowing has been made to finance fixed assets. It is
 not safe to use short term finance to buy long-term assets because
when the borrowing is to be repaid, there may be a problem as the
fixed assets cannot be readily converted into cash. The long-term
sources of finance can be used for buying current assets but no
short-term sources of finance can be utilized to acquire fixed assets.
This ratio shows the percentage of proprietors funds locked up
in fixed assets. Normally, for industrial establishments this can be 65
percent of the proprietor’s funds.
Ratio of Fixed assets to proprietors funds = (fixed assets /
proprietors funds ) x 100.
Example:
Compute ratio of fixed assets to proprietor’s fnds from the data
given in example.
From example: Fixed assets are = Rs 5, 75,000 and proprietors
funds are Rs 7, 00,000
Ratio of fixed assets to proprietors funds = ( 5,75,000 / 7,00,000 x
= 82.14%
Considering that this is industrial establishment,82 percent is on
very high side. A large portion of proprietor’s finds is blocked in fixed
assets. This is not desirable.

b) Ratio of current assets to proprietors funds:

A higher ratio of current assets to proprietors funds is

considered as financial strength to the business. It is necessary to
hold adequate funds in working capital to generate profits.
This is calculated as follows:
Ratio of current assets to proprietors funds = (Current assets /
proprietors funds) x 100
Example:
Compute ratio of current assets to proprietor’s funds from the
data given in example.
 Ratio of current assets to proprietors funds = (Current assets /
proprietors funds) x100
=( 9,00,000 / 7,00,00) x 100
= 132%.
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