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. Establishing asset management policies
2. Estimating and controlling cash flows and requirements
1. These are dependent upon variables
2. Risk v/s Return
3. External Financing, i.e. Debts v/s Equity
4. Internal Financing, i.e. Payout ratios
2. Financing decisions:
1. Deciding upon needs and sources of new outside financing
2. Carrying on negotiations for new outside financing, etc.
3. Dividend decisions
1. Determination of the allocation of net profits
2. Checking upon financial performance
4. Cost of capital depends upon:
1. Financing decisions
2. Investment decisions
3. Dividend decisions
 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 short-
term 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 Sale

Cash Finished
Goods

Raw materials Work in process

 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. It results in unnecessary accumulation of inventories. Thus the chances of inventory
mishandling waste, theft and losses increase.
2. It is an indication of defective credit policy and slack collection period. Consequently,
higher incidence of bad debts results, which adversely affect profits.
3. Excessive working capital makes management complacement which degenerates
into managerial inefficiency.
4. 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. It stagnates growth. It becomes difficult for the firm to undertake profitability
projects for unavailability of the working capital funds.
2. It becomes difficult to implement operating plans and achieve the firms profit target.
3. Operating inefficiencies creep in when it becomes difficult even to meet day-to-day
commitments.
4. Fixed assets are not efficiently utilized for the lack of working capital funds. Thus, the
rate of return on investment slumps.
5. Paucity of working capital funds renders the firm unable to avail attractive credit
opportunity, etc.
6. 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. Nature and size of business
2. Production cycles, production policies
3. Manufacturing process
4. Turnover of circulating capital
5. Growth and expansion of business
6. Business cycles fluctuations
7. Terms of purchase and sale
8. 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. 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
ii. 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.
 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. To reduce capital blocked up
2. To increase turnover rate
3. To minimize inventory carrying cost
4. To increase profit
5. To ensure steady flow of materials to production
6. To ensure better consumer services and prompt delivery of goods to the market
7. To ensure coordination between departments
 Some of the techniques adopted in inventory management are stated
below:
1. ABC analysis
2. Economic Ordering Quantity
3. Level Setting
4. Perpetual Inventory System
5. Stock turnover ratio
1. It eliminates waste in the use of raw materials and supplies.
2. It reduces the risk of loss from fraud, theft and pilferages.
3. It facilitates the preparation of accurate monthly financial statements.
4. It reduces to minimum capital tide up in inventories by fixing minimum and
maximum levels
5. It affects a reduction in investments in storage
6. It prevents production delays due to lack of materials by supplying the
proper quantities at the right time
7. It provides for accountability on the part of those in responsible position.
8. 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.
1.
Solution to example 1
Investment in debtors if credit period is 60 days 275 x (60/360) = 45,83,333.

Investment in debtors if credit period is 45 days 250 x (45/360) = 31,25,000.

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 Present Policy Proposed Policy
Credit Period 1 month 2 month
Sales 60 90
Less: Variable cost 45 67.50
Contribution 15 22.50
Less: Fixed Cost 10 10
5 12.50
 Continue solution
Particulars Present Policy Proposed Policy
Cost of sales i.e Variable 55 77.50
cost + Fixed Cost
Debtors : Cost of sales x 4.58 12.91
(credit period/12)

Op. Profit 5 12.50

Cost of funds invested in 0.46 1.29
debtors at 10 %
Bad debts 1.80 4.50
cost 2.26 5.79
Profit 2.74 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 Present Option 1 Option 2
Policy
Annual credit 50,00,000 60,00,000 67,50,000
sales
Avg Collection 2 months 3 months 4 months
period
Bad debt 1,50,000 3,00,000 4,50,000
losses
Particulars
Solution to example 3
Present Policy Option 1 Option 2
Credit sales 50,00,000 60,00,000 67,50,000
Avg. Collection 2 months 3 months 4 months
Period
Avg. level of 8,33,334 15,00,000 22,50,000
receivables

Marginal Increase in 4,66,662 9,91,666

investment in
receivables Less:
Profit Margin
Marginal increase in 10,00,000 17,50,000
sales
Profit on marginal 3,00,000 5,25,000
increase on sales
Marginal increase in 1,50,000 3,00,000
bad debt
1,50,000 2,25,000
Required return on 1,16,665 2,47,916
marginal investment
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 1,00,000 units 1,20,000 Units
Sales @ Rs. 10 per unit 10,00,000 12,00,000
Less: variable cost 6,00,000 7,20,000
Contribution ( C ) 4,00,000 4,80,000
Less: Fixed expenses 2,00,000 2,00,000
Operating Profit ( OP ) 2,00,000 2,80,000
Less: Interest 1,00,000 1,00,000
Profit before tax ( PBT ) 1,00,000 1,80,000
Less: Tax @ 50% 50,000 90,000
Profit after tax 50,000 90,000

EPS= PAT/ No. Of shares 50000/10000= 5 90000/10000 =9

% increase in EPS 80%
Operating leverage= C / OP 4,00,000/2,00,000= 2 4,80,000/2,80,000= 1.71
Financial leverage= 2,00,000/1,00,000= 2 2,80,000/1,80,000= 1.55
OP/PBT
 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 Existing Level Revised level
Sales units 3,00,000 3,30,000
Sales @ Rs. 5 15,00,000 16,50,000
Less: variable cost 9,00,000 9,90,000
Contribution ( C ) 6,00,000 6,60,000
Less: Fixed expenses 2,00,000 2,00,000
Operating Profit ( OP ) 4,00,000 4,60,000
Less: Interest 60,000 60,000
Profit before tax ( PBT ) 3,40,000 4,00,000
Less: Tax @ 35% 1,19,000 1,40,000
Profit after tax 2,21,000 2,60,000

EPS= PAT/ No. Of shares 2.21 2.60

% increase in EPS (0.39/2.21) x 100=17.65
Operating leverage= C / OP 1.5 1.43
Financial leverage= 1.176 1.15
OP/PBT
 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 Contribution/operating profit 300000/100000= 3

Financial Leverage Operating profit/PBT 100000/50000=2
Combined Leverage 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 Amount
10,00,000 x 1/3rd rise 13,33,333
Less: Variable cost 9,33,333
4,00,000
Less: Fixed Cost 2,00,000
Operating Profit 2,00,000
 Utility
Operating Leverage:
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. Rs. 1,00,000 by issuing equity shares and 2,00,000 through
debenture or term loan at 10% p.a
3. By raising term loan at 10% p.a.
4. 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 1 2 3 4
Equity existing 5,00,000 5,00,000 5,00,000 5,00,000
New equity 3,00,000 1,00,000 1,00,000
8% Preference 2,00,000
shares
10% term loan 2,00,000 3,00,000
Total 8,00,000 8,00,000 8,00,000 8,00,000
Investment
Preference 16000
Dividend
Interest On - 20000 30000
term loan
No of equity 80000 60000 50000 60000
shares
EBIT 1,50,000 1,50,000 1,50,000 1,50,000
Less; interest 20000 30000
1,50,000 1,30,000 1,20,000 `1,50,000
Less tax @ 52,500 45,500 42000 52500
35%
EAT 97500 84500 78000 97500
 Continue

Less 16000
preference
dividend
Eat 97500 84500 78000 81500
EPS 1.22 1.41 1.56 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 EQUITY DEBT PREF CAPITAL
A 100%
B 50% 50%
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 A B C
EBIT 1,80,000 1,80,000 1,80,000
Less interest @ 8% 16000
EBT 1,80,000 1,64,000 1,80,000
Less tax @ 35% 63000 57400 63000
Less pref dividend 16000
117000 106600 101000
No of equity shares 20000 10000 10000
EPS 5.85 10.66 10.10