You are on page 1of 38

Financial Management

-R.M.Kapadia

1

The objective of a company is to maximize its value to the shareholders.

Value is represented by market price of the ordinary shares of company over a long run, which is reflection of the company’s investment and financing decisions.
Profit maximization, objective is determined in terms of earning per share. Second objective of finance management is wealth maximization. The use of wealth maximization or net present worth maximization has been advocated as an appropriate and operationally feasible criterion to choose among alternative financial actions. According to Ezra Soloman, it provides an unambiguous measure of what financial management should seek to maximize in making investment and financing decisions.

1.

Investment decisions:
1. 2.

Establishing asset management policies Estimating and controlling cash flows and requirements
1. 2. 3. 4. These are dependent upon variables Risk v/s Return External Financing, i.e. Debts v/s Equity Internal Financing, i.e. Payout ratios

2.

Financing decisions:
1. 2.

Deciding upon needs and sources of new outside financing Carrying on negotiations for new outside financing, etc. Determination of the allocation of net profits Checking upon financial performance Financing decisions Investment decisions Dividend decisions

3.

Dividend decisions
1. 2.

4.

Cost of capital depends upon:
1. 2. 3.

 

 

There are two concepts of Working Capital- Gross concept and Net concept. The gross concept is simply called as working capital, refers to investments in Current assets are the assets which can be converted into cash within an accounting year and includes shortterm securities, debtors, bills receivables and inventories. The term Net Working Capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders which are expected to mature for payment within an accounting year and includes creditors, bills payables, bank overdraft and outstanding expenses. Net working capital can be positive or negative. A positive net working capital is when current assets exceeds current liabilities.

   

The need for working capital to run the day-to-day expenses cannot be emphasized any further. We can hardly find any business firm that doesn’t require any amount of working capital. Indeed, funds differ in their requirement of the wealth of share holders. In order to satisfy the above objectives an organization has to run the operation efficiently and uninterruptedly.

The duration of time required to complete the following sequence of events, in case of manufacturing firm, is called the operating cycle:
 Conversion of case into raw materials

Conversion of raw materials into work in process  Conversion of work in process into finished goods  Conversion of finished goods into debtors and bills receivable through sale  Conversion of debtors and bills receivable into cash 

The cycle as shown below will repeat again and again Debitors Cash Goods Raw materials Work in process Sale Finished

  

The firm should maintain a sound working capital position. It should have adequate working capital to run its business operation. Both excessive as well as inadequate working capital positions are dangerous from the firms point of view. Excess working capital means idle funds which earn no profits for the firm. Paucity of working capital not only impairs firms profitability but also result in production interruption. The dangers of excessive working capital are as below:
1. 2. 3. 4.

It results in unnecessary accumulation of inventories. Thus the chances of inventory mishandling waste, theft and losses increase. It is an indication of defective credit policy and slack collection period. Consequently, higher incidence of bad debts results, which adversely affect profits. Excessive working capital makes management complacement which degenerates into managerial inefficiency. Tendencies of accumulating inventories to make speculative profits grow. This may tend to make dividend policy liberal and difficult to cope with in future when the firm is unable to make speculative profits.

Inadequate working capital is also bad and has the following:
1. 2. 3. 4. 5. 6.

It stagnates growth. It becomes difficult for the firm to undertake profitability projects for unavailability of the working capital funds. It becomes difficult to implement operating plans and achieve the firms profit target. Operating inefficiencies creep in when it becomes difficult even to meet day-to-day commitments. Fixed assets are not efficiently utilized for the lack of working capital funds. Thus, the rate of return on investment slumps. Paucity of working capital funds renders the firm unable to avail attractive credit opportunity, etc. The firm losses its reputation when it is not in a position to honour its short-term obligations. As a result, the firm faces tight credit terms.

There are no set rules or formulas to determine the working capital requirements of the firm. A large number of factors influence the working capital needs of the firms. All factors are of different importance. Also the importance of the factors changes for a firm over time. Therefore, an analysis of the relevant factors should be made in order to determine the total investment in working capital. The following are the factors which generally influence the working capital requirements of the firm:
1. 2. 3. 4. 5. 6. 7. 8.

Nature and size of business Production cycles, production policies Manufacturing process Turnover of circulating capital Growth and expansion of business Business cycles fluctuations Terms of purchase and sale Dividend policy

(1) Turnover of working capital = sales Average working capital (2) Current ratios = current assets current liabilities (3) Current debts to tangible net worth = current liabilities tangible net worth

It means:
i.

ii.

A comprehensive system of inventory control covers a wide range of functions like production planning, purchasing, receipt, inspection of materials and stores organization, etc. The main objective of inventory control are:
1. 2. 3. 4. 5. 6. 7.

Providing of raw materials to production and services departments, as and when required by them as per specified quality at the lowest available price, so that production is not held up and funds in inventory is not blocked up Providing of finished goods by production debts to marketing department as and when required by them as per specified quality at the lowest production cost so that marketing department is not out of stock and funds in finished goods is not blocked up.

To reduce capital blocked up To increase turnover rate To minimize inventory carrying cost To increase profit To ensure steady flow of materials to production To ensure better consumer services and prompt delivery of goods to the market To ensure coordination between departments

Some of the techniques adopted in inventory management are stated below:
1. 2. 3. 4. 5.

ABC analysis Economic Ordering Quantity Level Setting Perpetual Inventory System Stock turnover ratio

1. 2. 3. 4. 5. 6.

7. 8.

It eliminates waste in the use of raw materials and supplies. It reduces the risk of loss from fraud, theft and pilferages. It facilitates the preparation of accurate monthly financial statements. It reduces to minimum capital tide up in inventories by fixing minimum and maximum levels It affects a reduction in investments in storage It prevents production delays due to lack of materials by supplying the proper quantities at the right time It provides for accountability on the part of those in responsible position. It brings slow moving materials or non moving materials to the notice of responsible officers.

Example 1
A company has current sales of Rs. 250 lacs. The company has unutilised capacity. In order to boost its sales, it is considering relaxation in its credit policy. The proposed terms of credit will be 60 days credit against the present policy of 45 days. As a result the bad debts will increase from 1.5% to 2% of sales.
The companies sales expected to increase by 10%. The variable operating costs are 75% of sales. The corporate tax rate is 30% and it requires an after tax return of 15% on investment.

Solution to example 1
1. Investment in debtors if credit period is 60 days 275 x (60/360) = 45,83,333. = 31,25,000. Investment in debtors if credit period is 45 days 250 x (45/360) Therefore, increase investment in debtors= 14,58,333. 2. Current bad debts 250 x (1.5/100)= 3,75,000. Expected bad debts 275 x (2/100)= 5,50,000.

Increase in bad debts

= 1,75,000.

3. Calculation of incremental profit on incremental sales of Rs. 25 lacs at 25% = 6,25,000 Less: increase in bad debt = 1,75,000 __________ 4,50,000 Tax 30% 1,35,000

___________
Net increase in profit 3,15,000

Return on investment = 3,15,000/1458333 =21.60% which is more than 15%

Example 2
X ltd want to relax its credit on sales from the current level 1 month to 2 months. Due to this, sales would increase to Rs. 90 lacs from the present level of Rs. 60 lacs per annum, but % of bad debts losses likely to go up by 2% from present level of 3% on sales. The companies variable cost is 75% of sales and fixed expenses are Rs. 10 lacs per annum.

Advise the company on implementation of revising credit policy.

Solution to example 2
Particulars Credit Period Sales Less: Variable cost Contribution Less: Fixed Cost Present Policy 1 month 60 45 15 10 5 Proposed Policy 2 month 90 67.50 22.50 10 12.50

Continue solution
Particulars Present Policy Proposed Policy

Cost of sales i.e Variable cost + Fixed Cost
Debtors : Cost of sales x (credit period/12) Op. Profit Cost of funds invested in debtors at 10 % Bad debts cost Profit

55
4.58

77.50
12.91

5 0.46 1.80 2.26 2.74

12.50 1.29 4.50 5.79 6.71

Example 3
A company ltd is considering relaxing its present credit policy and is in the process of evaluating 2 proposed policies. Current sales of company is Rs. 50 lacs. Current level of Bad debts is Rs. 1,50,000. Company is required to give return of 25% on the investment of new accounts receivable. Companies variable cost is 70% of selling Price. From the following data which is better option?
Particulars Annual credit sales Present Policy 50,00,000 Option 1 60,00,000 3 months 3,00,000 Option 2 67,50,000 4 months 4,50,000

Avg Collection 2 months period Bad debt losses 1,50,000

Solution to example 3
Particulars Credit sales Avg. Collection Period Avg. level of receivables Marginal Increase in investment in receivables Less: Profit Margin Marginal increase in sales Present Policy 50,00,000 2 months 8,33,334 Option 1 60,00,000 3 months 15,00,000 Option 2 67,50,000 4 months 22,50,000

4,66,662

9,91,666

10,00,000

17,50,000

Profit on marginal increase on sales
Marginal increase in bad debt Required return on marginal investment

3,00,000
1,50,000 1,50,000 1,16,665

5,25,000
3,00,000 2,25,000 2,47,916

Capital Structure and leverage analysis

Operating Leverage
Meaning:

The operating leverage may be defined as the tendency of the operating profit to vary disproportionately with sales. It is said to exist when a firm has to pay fixed cost regardless of volume of output or sales. The firm is said to have a high degree of Operating leverage if it employs a greater amount of fixed costs and a small amount of variable costs.
Operating Leverage = Contribution/Operating Profit.

Financial Leverage
Meaning:

The financial leverage may be defined as the tendency of the residual net income to vary disproportionately with operating profit. It indicates the change that takes place in the taxable income as a result of change in operating income. It signifies the existence of fixed interest/ fixed dividend bearing securities in total capital structure of the company.
Financial Leverage = operating Leverage/PBT

Composite Leverage
Operating Leverage measures percentage change in operating profit due to percentage change in sales. It explains the degree of operating risk. Financial leverage measures percentage change in taxable profit ( or EPS ) on account of percentage change in operating profit ( i.e. EBIT ). Thus, it explains the degree of financial risk. Both these leverage are closely concerned with the firm’s capacity to meet its fixed costs (both operating and financial). In case both the leverages are combined, the result obtained will disclose the effect of change in sales over change in taxable profit.
Composite leverage= Operating Leverage x Financial leverage

Example 1
The capital structure of the Progressive corporation consists of an ordinary share capital of Rs. 10,00,000 and Rs. 10,00,000 of 10% debenture. Sales increased by 20% from 1,00,000 units to 1,20,000 units the selling price is Rs. 10 per unit: variable costs amounts to Rs. 6 per unit and fixed expenses amount to Rs. 2,00,000. The income tax rate is assumed to be 50%. You are required to calculate the following: 1. The % increase in EPS.

2. The degree of financial leverage at 1,00,000 & 1,20,000 units.
3. The degree of operating leverage at 1,00,000 & 1,20,000 units

Solution to example 1
Particulars Sales @ Rs. 10 per unit 1,00,000 units 10,00,000 1,20,000 Units 12,00,000

Less: variable cost Contribution ( C )
Less: Fixed expenses Operating Profit ( OP ) Less: Interest Profit before tax ( PBT ) Less: Tax @ 50% Profit after tax EPS= PAT/ No. Of shares % increase in EPS

6,00,000 4,00,000
2,00,000 2,00,000 1,00,000 1,00,000 50,000 50,000 50000/10000= 5

7,20,000 4,80,000
2,00,000 2,80,000 1,00,000 1,80,000 90,000 90,000 90000/10000 =9 80% 4,80,000/2,80,000= 1.71 2,80,000/1,80,000= 1.55

Operating leverage= C / OP 4,00,000/2,00,000= 2 Financial leverage= OP/PBT 2,00,000/1,00,000= 2

Example 2
The share capital of a company is Rs. 10,00,000 with shares of face value of Rs. 10. The company has debt capital of Rs. 6,00,000 at 10% rate of interest. The sales of a company are 3,00,000 units per annum at a selling price of Rs. 5 per unit and variable cost is Rs. 3 per unit. The fixed cost amounts to Rs. 2,00,000. The company pays tax @ 35 %.

If sales increase by 10 %, calculate
1. % increase in EPS 2. degree of operating leverage at two levels. 3. degree of financial leverage at two levels.

Solution to example 2
Particulars Sales units Sales @ Rs. 5 Less: variable cost Contribution ( C ) Less: Fixed expenses Operating Profit ( OP ) Less: Interest Profit before tax ( PBT ) Less: Tax @ 35% Profit after tax EPS= PAT/ No. Of shares % increase in EPS Operating leverage= C / OP 1.5 Existing Level 3,00,000 15,00,000 9,00,000 6,00,000 2,00,000 4,00,000 60,000 3,40,000 1,19,000 2,21,000 2.21 Revised level 3,30,000 16,50,000 9,90,000 6,60,000 2,00,000 4,60,000 60,000 4,00,000 1,40,000 2,60,000 2.60 (0.39/2.21) x 100=17.65 1.43

Financial leverage= OP/PBT

1.176

1.15

Example 3
A company has sales of Rs. 10,00,000, variable cost of Rs. 700,00,000. Fixed cost of Rs. 2,00,000 and debt of Rs. 5,00,000 at 10% rate of interest. What are operating, financial and combined leverages? If the company wants to double its EBIT. How much rise in sales would be needed on a % basis?

Solution to example 3
Operating Leverage Financial Leverage Combined Leverage Contribution/operating profit 300000/100000= 3 Operating profit/PBT 100000/50000=2 Operating lev x financial lev 3 x 2 = 6

Comments
Operating leverage 3 times;

It means if sales increase by 100% operating profit will rise by 300%. If firm wants to double its earnings, then 1/3rd or 33.33% rise in sales is required.
Particulars
10,00,000 x 1/3rd rise Less: Variable cost

Amount
13,33,333 9,33,333 4,00,000

Less: Fixed Cost
Operating Profit

2,00,000
2,00,000

Operating Leverage:

Utility

It indicates the impact of change in sales on operating income. If a company has a high degree of operating leverage a small change in sales will have a large effect on operating income. In other words, the operating profit of such a company will increase at a faster rate than the increase in sales Financial leverage: It helps considerably the finance manager while devising the capital structure of the company. A high financial leverage means high fixed financial cost and high financial risk. Finance manager must plan capital structure in such a way that the company is in a position to meet its fixed financial costs. Increase in fixed financial cost requires necessary increase in EBIT level. In the event of failure to do so the company may go into liquidation.

Example 4
X ltd has equity capital of Rs. 5,00,000 divided into shares of Rs. 10 each. It wishes to raise Rs. 3,00,000 for expansion scheme. The company plans the following financing alternatives.
1. By issuing equity shares only. 2. 3. 4. Rs. 1,00,000 by issuing equity shares and 2,00,000 through debenture or term loan at 10% p.a By raising term loan at 10% p.a. Rs. 1,00,000 by issuing equity shares at Rs. 2,00,000 by issuing 8% preference shares.

You are required to suggest best alternative giving your comment assuming the estimates. EBIT after expansion is Rs. 1,50,000 and tax rate is 35%.

Solution to example 4
Particulars Equity existing New equity 1 5,00,000 3,00,000 2 5,00,000 1,00,000 3 5,00,000 4 5,00,000 1,00,000

8% Preference shares
10% term loan Total Investment 8,00,000 2,00,000 8,00,000 3,00,000 8,00,000

2,00,000

8,00,000

Preference Dividend
Interest On term loan No of equity shares EBIT Less; interest 1,50,000 80000 1,50,000 20000 60000 1,50,000 20000 1,30,000 30000 50000 1,50,000 30000 1,20,000

16000

60000 1,50,000 `1,50,000

Less tax @ 35%
EAT

52,500
97500

45,500
84500

42000
78000

52500
97500

Continue
Less preference dividend
Eat EPS 97500 1.22 84500 1.41 78000 1.56

16000

81500 1.36

Example 5 X ltd considers three financial plans for which the following
information is available. 1. Total investment to be raised Rs. 4,00,000 2. Plans for financing proportion. PLANS A B EQUITY 100% 50% 50% DEBT PREF CAPITAL

C

50%

50%

3. Cost of debt is 8% and cost of pref capital is 8%. 4. Tax rate is 35% 5. Equity shares of face value of Rs. 10 each issued at premium of Rs. 10 per share. 6. Expected earnings before interest and tax is Rs. 1,80,000

Solution to example 5
Particulars
EBIT Less interest @ 8% EBT Less tax @ 35% Less pref dividend 117000 No of equity shares EPS 20000 5.85 106600 10000 10.66 1,80,000 63000

A
1,80,000

B
1,80,000 16000 1,64,000 57400

C
1,80,000 1,80,000 63000 16000 101000 10000 10.10