Unit 1 - Finance Function

1.1 Introduction A business is an activity which is carried on with the intention of earning profits

If the operations of a typical manufacturing organization are considered, it involves the purchasing of raw material, processing like labour and machinery , manufacturing the final product and selling the finished product in the market to earn profits Thus production, marketing and finance are the keep operational areas in case of a manufacturing organization out of which fina This is so as the functions of production and marketing are related with the function of finance If the decisions relating to money or funds fail it may result in failure of business organization as a whole Hence it is utmost importance to take a financial decision and that too at a proper point of time.

In practical situations in order to overcome temporary financial problems, the organizations tend to take hasty decisions which m 1.2 Approaches to the term Finance The concept of finance has changed markedly with the change in times and circumstances. The various approaches on finance 1) According to the first approach, the term finance was interpreted to mean the procurement of funds by corporate enterprise was used in broad sense to include the whole gamut of raising funds externally This approach towards finance was criticized on various grounds

a) It is too narrow and restrictive in nature. Procurement of funds is the only one of the functions of finance and other functions a

b) It considers the financial problems only of corporate enterprises. In that sense it ignores the financial problems of non-corpor etc c) It considers only the basic and non-recurring problems relating to the business. Day to day financial problems of a normal com

d) It concentrates only on long term financing. It means that the working capital management is out of purview of finance function

2) The second approach holds that finance is concerned with cash. As all the transactions are ultimately expressed in terms activity of the enterprise Thus according to this approach, the finance function is concerned with all the functional areas of business, for example, pro and development and so on. Obviously this approach is too broad to be meaningful

3) The third approach, which is more balanced one and hence acceptable one to the modern scholars interprets the term finan wise application of funds This approach is supposed to be more acceptable as it gives equal weightage to both procurement of funds as well as utilization This approach is called the managerial approach to the term finance

In light of the above discussions it will be worthwhile to note some of the definitions of finance functions given by some modern s R.C.Osborn: The finance function is the process of acquiring and utilizing funds of a business

Bonneville and Dewey: Financing consists of rising, providing, managing of all the money, capital or funds of any kind to be used

Prather and Wert: Business finance deals primarily with raising, administering and disbursing funds by privately owned business 1.3 Scope of Finance function: According to the modern approach, the function of finance is concerned with the three types of decisions a) Financing Decision b) Investment decision c) dividend policy decision a) financing decision

Financing decisions are the decisions regarding the process of raising of funds. This function of finance is concerned with provid

1) what should be the amount of funds to be raised. In simple words, the amount of funds to be raised by the organization shoul situations involve adverse consequences 2) what are the various sources available to the organization for raising the required amount of funds. For the purpose of raising as well as external sources 3) What should be the proportion in which the internal and external sources should be used by the organization

4) If the organization, particularly the corporate form of organization wants to raise the funds from different sources it is required . Earlier these legal and procedural formalities were prescribed and regulated by Controller of Capital issues(CCI)

Since 1992 after the abolition of CCI, these formalities are prescribed and regulated by Securities and exchange board of India (

Though the intention of this subject is not to consider the SEBI regulations and guidelines in detail, relevant SEBI guidelines are

5) During the last decade of the twentieth century, lots of changes have taken place in the capital market, which refers to the requirement of funds The question arises what is the nature of capital market operations? What kind of changes have taken place recently affecting th b) Investment Decisions

Investment decisions are decisions regarding the application of funds raised by the organization. The investment decisions relat be invested The assets in which the funds can be invested are basically of 2 types 1) Fixed assets

Fixed assets indicate the infrastructural facilities and properties required by the organization. Fixed assets are the assets which of time The investment decision in these type of assets are referred to as Capital budgeting decisions. Capital budgeting decisions are c

a) how the fixed assets or proposals or projects should be selected to make the investment in ? What are the various methods fixed assets b) How the decisions regarding the investment in fixed assets or proposals or projects should be made in situations of risk or un 2) Capital assets

Capital assets are the assets which get generated during the course of operations and are capable of getting converted in th span of one year Current assets keep on changing the form and shape very frequently. The investment decision in these type of assets are referred to as Working Capital management. Working Capital management what is the meaning of working capital management, what are the objectives of Working Capital management why the need for Working Capital arises what are the factors affecting the requirement of Working Capital how to quantify the requirement of Working Capital what are the sources available for financing the requirement for Working Capital

Working Capital management is concerned with the management of current assets on overall basis as well as on individual bas in the form of cash and bank balances, receivables and inventory. Working Capital management is concerned with the manage as well c) dividend policy decisions

Profits earned by the organization belong to the owners of the organization. In case of corporate form of organization, shareh profits in the form of dividend. However there is no specific law or statute which specifies as to how much amount of profits should be distributed by the way retained in the business The alternatives available to the organization to distribute the profits in the form of dividend in one hand and retention of pro other If the dividend paid are higher, retained profits are less and vice versa

If the organization pays higher dividends the shareholders are happy as they get more recurring income and the company may b however the organization can be in problem as payment of dividend results in withdrawal of profits from the business

On the other hand If the organization pays lesser dividends the organization may be in a favourable position. However the share

As such the organization is required to take decisions regarding the payment of dividends in such a way that neither the shareh problems As such dividend policy decisions are the strategic financial decisions and are concerned with the answers to questions like 1. what are the forms in which dividends can be paid to shareholders 2. what are the legal and procedural formalities to be completed while paying dividends in different forms 1.4 Goals / Objects of finance function Profit maximization As a basic principle, any business activity aims at earning profits. According to this principle all the functions of the business will Similarly the finance function will have the profits as the main objective 1. the term profit is an ambiguous concept which isn't having precise connotation for example, profits can be long term or short term. Profits can be before tax or after tax and so on 2 the profits always go hand in hand with risks. The more profitable ventures necessarily involve more amount of risk. The owners of the business will not like to earn more and more profits by accepting more risk if profit maximization is accepted as the goal of the finance function, it totally ignores the risk factor Both proposals A and B involve same amount of profits and hence ideally should be treated on par.

but this was only a traditional belief. Now profit cannot be the sole goal or objective of finance function due to the following probl

if profit maximization is accepted as the goal of the finance function, the next question arises which type of profit should be maxi

3. Profit maximization as the goal of the finance function involves the time pattern of returns. Consider 2 proposals A and B whic

But it will not be proper as proposal A involves higher amount returns in earlier years while proposal B involves returns in the lat

It makes proposal A more profitable ultimately as the returns received earlier are more valuable than the returns receive differentiate between the returns received earlier and the returns received later 4. Profit maximization as the objective doesnt take into consideration the social consideration as well as the obligations to var the ethical trade practices if these factors are ignored the organization cannot survive for long. Profit maximization at the cost of social and moral obligatio

As such Profit maximization cant be a prime objective of a finance function. The objective has to be one having more broad a b and time value of money and which gives consideration to social and ethical elements also. The alternative is the form of wealth wealth maximization

due to the limitation attached with profit maximization as an objective of finance function, it is no more accepted as a basic objec of the business should be to maximize its wealth and value of the shares of the company. This object can also be stated as max the value of an asset is judged not in terms of cost but it terms of benefits it produces Similarly the value of a course of action is judged in terms of benefits it produces less the cost of undertaking it

The benefits can be measured in terms of stream of future expected cash flows but they must take into consideration not only th

thus wealth maximization goal as a decision criteria suggests that any financial action which creates wealth or which has disc desirable and should be accepted and that which does not satisfy this test should be rejected the goal of wealth maximization is supposed to be superior to the goal of profit maximization due to

1. it uses the concept of future expected cash flows rather than the ambiguous term of profits. As such measurement of benefits That is why while computing value of total benefits, the cash flows are discounted at a certain discounting rate At the same time it recognizes the concept of risk also by making necessary adjustments As such cash flows of a project involving higher risks are discounted a higher discounting rate and vice versa

2. it considers time value of money. It recognizes that the cash flow generated earlier are more valuable than those generated la

Thus the discounting rate used to discount future cash inflows reflects the concept of both time and risk however it should be noted that wealth maximization is only an extension of profit maximization goal

Due to the above reasons wealth maximization is considered to be superior to profit maximization as an objective or goal of a fin

if the time period is too short and risk element is minimum both wealth maximization and profit maximization will mean the same 1.5 Organization of finance function one unlike other business functions in fact the proprietor or partners will only be looking after all the functional areas like production, marketing, finance etc

in smaller concerns where the operations are relatively less complicated and simple, there may not be a separate executive to lo

in bigger concerns, the execution of finance becomes a specialized task and maybe handled by an executive who may be in vice-president (finance) and so on he is generally given the charge of credit and collection accounting, investment and audit departments. He is responsible for p president and board of directors secondly it should be noted that generally the organization of finance function is centralized one unlike other business functions

Board of directors takes the main financial decisions .Board of directors may delegate the powers to the executive committe directors and finance officer of the company. The executive committee takes all financial decisions Routine financial matters may be delegated to lower level officers. The reasons for finance function being a highly centralized fu 1. financial decisions are the most crucial ones on which survival or failure of the organization depends 3. the organization may gain economies of centralization in form of reduced cost of raising the funds, acquisition of fixed assets

2. financial decisions affect the solvency position of the organization and a wrong decision in this area may land the organization

Though there is no standard pattern for organization of finance function, in general organization of finance function takes the foll 1.6 Duties and Responsibilities of finance executive 1. Recurring Duties 2. Non-recurring duties Recurring Duties 1. Deciding the financial needs Financial plan decides in advance the quantum of funds required their duration etc

on the basis of scope of finance function which has already been discussed, various duties and responsibilities which a finance e

in case of a newly started or a growing concern the basic duty of the finance executive is to prepare the financial plan for the com

The funds may be needed by the company for initial promotional expenditure, fixed capital, working capital or for dividend di needs of funds properly 2. Raising the funds required the finance executive has to choose the sources of funds to fulfill financial needs. The sources may in the form of debentures, general public, lease financing etc the finance executive has also to decide the proportion in which the various sources should be raised for this he may have to keep in mind three basic principles of cost, risk and control if the company decides to go in for a borrowed capital he has to negotiate with the lenders of the funds 3. Allocation of funds the finance executive has to ensure proper allocation of funds . He can allocate the fund basically for 2 purposes a) fixed assets management

if the company decides to go for an issue of securities say in the form of debentures he has to arrange for an underwriting or list

he has to decide in which fixed assets the company should invest the funds. He has to ensure that the fixed assets acquired or needs of the company

he has to ensure that the funds invested in fixed assets justify the investments in terms of cash flow generated by them in the f investment in fixed assets, the finance executive has to decide in which proposal the company should invest the funds for this purpose he maybe required to take the help of various techniques of capital budgeting to evaluate the various proposals for example, payback period, net present value, internal rate of return, profitability index

if the outright purchases of fixed assets is not useful, the finance executive has to ensure that in order to facilitate the replaceme depreciation policies are formulated the wrong policies in the area of providing for the depreciation may result into over capitalization or under capitalization b) Working capital management non-availability of funds to invest in current asset in the form of cash, receivable, inventory may halt business operations

the finance executive has to ensure that sufficient funds are made available for investing in current assets as it is the life-blood o

at the same time he has to ensure that there is no blocking of funds in the current assets as it may costly in terms of cost of thes

thus the finance manager has to ensure that investment in current assets is minimum without affecting the operations of the com 4. Allocation of income allocation of income of company is the exclusive responsibility of the finance executive.

fir this purpose basically the income may be distributed among the shareholders by way of dividends or it may be retained in bus

decision in this regard may be taken in the light of financial position, present and future cash requirements, preferences of share 5, Control of funds

the finance executive is responsible to the control the use of funds committed in the business so as to ensure that cash is between estimates and plan proper corrective action may be taken in light of financial position of the company for this he may be required to supervise cash receipts and disbursements, ensure the safety of cash balances, expedite results a 6. Evaluation of performance:

the financial executive may be required to evaluate and interpret the financial statements, financial position and operations of the

he may be required to ensure that proper books and records are maintained in a proper way so that whatever data is required of

for the evaluation and interpretation of financial statements, finance executive may use techniques like ratio analysis, funds flow 7 Corporate taxation

as the company is a separate legal entity, it is subjected to various direct and indirect taxes like income tax, wealth tax, excise, c

the finance executive may be expected to deal with the various tax planning and tax saving devices in order to minimize tax liabi 8. Other duties

in addition to all the above duties he financial executive may be required to prepare annual accounts, prepare and present fina audit, get done statutory an tax audit, safeguarding securities and assets of company by properly insuring them Non-recurring duties

the non-recurring duties of the finance executive may involve preparation of financial plan at the time of company promoti valuation of the enterprise at the time of acquisition and merge thereof 1.7 The fields of Finance The distinction arise due to variety problems and variety of objects. The various fields of finance can be stated as below a) Business finance This business finance covers the study of finance function in the area of business which includes both trade as well as industry b) Corporation finance

There can be various fields in which the finance function may operate. In each field finance executives deal with the manageme

The term business and hence business finance is a very broad term. It covers all the activities carried on with the intention of ea

Corporation finance is a part of business finance and deals with the financial practices, policies and problems of corporate enter

The corporation finance studies the financial operations carried on by a corporate enterprise from the stage of its inception to the

c) International finance

International finance is the study of flow of funds between individuals and organization beyond natural boundaries and developin

This study become crucial as it involves exchange of currencies and also the government of either of the nations may have c foreign currencies d) Public finance:

it deals with the financial matters of the government. It becomes crucial as the government deals with huge sums of money whi methods are required to be utilized within the statutory and other limitations further the government does not operate with objectives similar to that of the private organization i.e. earning the profits Is not th operate with the intention of accomplishing social or economic objectives e) Private finance it deals with the financial matters of non-government organizations 1.8 finance function in relation with other functions ether than finance, each business generally operates in three main functional areas Production, Marketing and personnel

all these functions are closely related finance function due to simplest reason that for executing these functions, funds are requir

for example, to produce good quality of finished goods, the business needs good infrastructural facilities like building, machin raw material, work in progress, consumable stores, quality control equipments, good maintenance facilities All these activates need investment to be made either in terms of fixed capital or working capital which is the area of finance fun it may be required to have good distribution systems which may call for investment in terms of fixed assets or labour force

to market the finished goods properly in the market, the business has to have a proper investment in the finishes goods to guara

The personnel function deals with the availability of proper kinds of laborers at proper time, training them properly and fixing thei

to pay salaries, wages and other facilities to workers, funds are needed to provide training facilities to workers, it may be ne equipments To conclude it may be stated that all the functions or activities of the business are ultimately related to finance the success of the business depends on how best all these functions can be coordinated 1.9 Summary A business is an activity which is carried on with the intention of earning profits finance function deals with the activities related to procurement of funds and deployment of funds in business main object of finance function is wealth maximization of shareholders of a company

UNIT 2 : FORMS OF BUSINESS ORGANISATION 2.1 INTRODUCTION The finance function of the organization is greatly affected by the forms of organization. The form of business organization means the basic constitution of the organization in which it is set. It is generally defined by is ownership. The owners are persons who own the business organization and they are a major source of finance for the organization. The various laws applicable to business entities as well as the mode of conducting business depend upon the form of business In practical circumstances, we come across basically three forms of business organizations. a. Proprietary Firms b. Partnership Firms c. Joint Stock Companies

2.2 PROPRIETARY FIRMS

In this case, only one person is the owner of the business who is called as the 'Proprietor' and the same person is the manager All the profits earned by the business belong to the proprietor and he is liable for the losses and liabilities of the business. Advantages : a. Proprietary Firm is the easiest and most economical form of business organization to form and operate. Not many of the government regulations are applicable to the Proprietary Firms.

b. This form of organization is very suitable where the size of the business is small and the complexities involved in the busines However, if the size of the business increases or the complexities in the business operations grow, this from may prove to be in Disadvantages : a. This form of organization does not have any legal status. The proprietary firms exist due to the existence of the proprietor. If the proprietor ceases to be in existence, the firm ceases to be in existence.

b. As only one person is the owner and the manager, the capacity of the business to raise funds and cope up with complex bus

c. Proprietary firms is always an unlimited liability organization. In the sense, if the assets of the firm are insufficient to me always at stake.

d. The income of the proprietary firm is clubbed with the individual income of the proprietor. As such, effective rate of incom likely to be higher.

e. It is not possible to transfer the ownership of the business to somebody else without affecting the basic constitution of the b 2.3 PARTNERSHIP FIRMS

In this case, more than two persons but less than twenty persons come together and form a partnership firm. Each of these p decided among themselves.

Partnership is a contract among the partners and the relationship among the partners is governed on the basis of terms document called as 'partnership deed' or 'partnership agreement'. Advantages : a. This form of organization is also reasonably easy and economical to form and operate.

b. As resources of more than one person are pooled together, capacity of the business to handle more complex business oper is better as compared to the proprietary firms.

c. The tax structure applicable to the partnership firms is fairly reasonable. At present, the profits of partnership firm is taxed at the rate of 30% which is further increased by the surcharge of 10% and as well as surcharge.

The effective rate of tax works out to be 33.66%. While calculating the profit of the partnership firm, following amounts can be

i. The firm can pay interest on capital to the partners on the amount of capital introduced by them in the business but the interest on capital can be paid by the firm to all the partners.

ii. The firm can remunerate the partners in the form of salary, bonus, commission etc. provided that the partners are 'working A working partner is a partner who is capable of participating in the day-to-day affairs of the firm by virtue of experience or qu However, the firm cannot remunerate the partners to any extent it wants. The maximum amount of remuneration which the f is prescribed in Income Tax Act, 1961. Section 44AA of the said Act provides that the maximum amount of remuneration which on the basis of its 'book profits' which means the amount of profits as per its profitability statement after calculating the intere After deciding the amount of book profit, the enumeration is decided as below : If the firm is carrying on a profession : * On the first Rs. 1,00,000 of the book profit or in case of a loss, Rs. 50,000 or 90% of the book profit whichever is more. * On the next Rs. 1,00,000 of the book profit, at the rate of 60%. * On the balance amount of book profit, at the rate of 40%. In case of any other firm : * On the first Rs. 75,000 of the book profit or in case of a loss, Rs. 50,000 or 90% of the book profit whichever is more. * On the next Rs. 75,000 of the book profit, at the rate of 60%. * On the balance amount of book profit, at the rate of 40%.

However, it should be remunerated that the amount of interest on capital paid by the firm and the remuneration paid to the p

After charging the above amounts, the balance amount of profits are transferred to the capital account of the partners whi profit is not taxable in the hands of individual partners. d. Not many of the government regulations are applicable to the partnership firms. Disadvantages :

a. This form of organization also does not have any legal status. The partnership firms exist due to the existence of the part ceases to be in existence. The retirement or death of a partner leads to the dissolution of the partnership firm.

b. The capacity of the business to raise the funds and to cope up with the complex business operations is comparatively limited

c. Partnership firm is also an unlimited liability organization. In the sense, if the assets of the firm are insufficient to meet its li stake.

d. It is not possible to transfer the ownership of the business to somebody else without affecting the basic constitution of the b 2.4 JOINT STOCK COMPANIES

Joint stock companies have become a major form of organization in the recent past. This form of organization can raise large people can be pooled together. In this case, the total requirement of funds of the organization is split into smaller units, each of such units being called as a 'sh Each such share carries a denomination value which is called as 'face value' or 'nominal value'. An individual can particip purchasing the shares of the company and he becomes the part owner of the company to the extent of his shareholding in the Such shareholder can exercise his ownership rights thorough the voting rights offered to him. The joint stock companies have the following characteristic features :

a. All the joint stock companies have a legal entity separate from their owner viz. shareholders. They gain the legal status b governs and regulates the operations of all joint stock companies in India. As legal entities, the joint stock companies can own assets, incur liabilities, enter into contracts, sue and be sued. The share actions of the company.

b. Generally all joint stock companies are limited liability organizations and the liability of the shareholders is limited to the ex For example, if Mr. A undertakes to purchase 100 shares of a company of Rs. 100 each, his liability ceases once he pays Rs. 10,0 His personal property is never in danger despite the losses and liabilities incurred by the company.

c. Segregation of ownership and management is a typical feature of joint stock companies. In case of the companies, sharehol shareholders and their wide geographical spread, it may not be possible for the shareholders to exercise their ownership r company. As such, the shareholders appoint their representatives (viz. directors) to manage the day-to-day affairs of the company. In case of joint stock companies, shareholders are the owners while directors/board of directors are the managers.

d. Transferability of shares is a feature of a joint stock company. A shareholder can transfer his ownership rights in the compan

In case of public limited companies, shares are freely transferable and such transfer can be greatly facilitated if the shares are l

In case of private limited companies, there may be some restrictions on the transfer of shares.

e. Being an artificial legal person, the company enjoys a perpetual existence. The company can die only s legal death, after com

There is a very famous case under the Companies Act, where during the war, all the members of a private company, while survived.

f. A company is an artificial legal person which does not have a body like a natural person and hence it cannot sign any docu only by those documents which bear its signature.

Hence, as the substitute to the signature, the law provides for the use of common seal. Any document having the common sea the company legally. Advantages : a. The capacity of the corporate organizations to raise the funds is comparatively high. As the number of persons contributing large amount of funds.

b. As the company has a separate legal entity, apart from its owners viz. shareholders, the personal property of the shareholde

c. Transferability of shares is a facility available to the shareholders. If the shareholders want to release their investment i person. However, it should be remembered that in case of private limited companies, the shares are not freely transferable. Disadvantages :

The company form of organization is subjected to elaborate legal and procedural formalities to be complied with, not only operation. The basic applicable law in this connection is in the form of Companies Act, 1956. However, it should be noted that in case o rigorous in nature.

As the company form of organization is the most frequently found form of organization, for the future discussion in the follow a 'company'. In practical situations, we come across basically two types of limited liability companies : a. Private Limited Company b. Public Limited Company a. Private Limited Company

In non-technical language, operations of a private limited company affect the fate of a smaller number of people. As such, C limited companies.

Private Limited Company is entitled to many privileges exemptions from the various provisions of the Companies Act, 195 following features : a. Minimum number of shareholders is 2 and the maximum number is 50.

b. A private limited company cannot approach public in general for subscribing the shares/debentures of the company. Simila deposits from public in general other than its shareholders, directors or their relatives. The funds required by the company are required to be collected through the private circulation only. c. In case of private limited company, right of the shareholders to transfer shares is restricted. These restrictions are usually in

i. that the shares to be transferred should be offered to the existing members on priority basis and if the existing memb transferred to anybody else.

ii. That the directors will have the power to refuse to register the transfer of shares provided that such power should be exer of the company.

d. A private limited company needs to have a minimum paid-up share capital of Rs. 1 lakh or any higher amount as may be pre b. Public Limited Company

In non-technical language, a public limited company affects the fate of a larger number of people. As such, operations of publi the form of compliance to the various provisions of Companies Act, 1956. A public limited company is characterized by the following features : a. Minimum number of shareholders is 7 and there is no restriction on the maximum number of shareholders.

b. Public limited company can freely approach public in general for subscribing to the shares and/or debentures of the compan

c. The shareholders of a public limited company can freely transfer their shares to any other person. As such, shares of onl exchange.

d. A public limited company needs to have a minimum paid-up share capital of Rs. 5 Lakhs or any higher amount as may be pre 2.5 SUMMARY

This unit specifies the various types of constitutions under which any business activity can be conducted. A business can be ca firm or as a corporate entity. A proprietary concern is easy to operate however does not have a legal status. One of the major disadvantages of a proprietary

A partnership firm is an entity when two or persons come together to run a business proprietor. A major advantage of partn various partners.

However, a partnership firm also is an unlimited liability organization. A joint stock company is an entity which enjoys a lega 1956.

The drawback of unlimited liability is eliminated in case of a company. A joint stock company can be either a Private Limited Limited Company can approach the general public for funds, it is closely regulated under the companies Act as compared to a P
UNIT -3 Financial Statements 3.1 Introduction

Financial statements of an organization are the basis of data required for financial decision making. The financial statements and their accompanying notes explain a company's financial performance and recent financial history Financial analysts use these statements in several ways such as to evaluate a company's overall performance, identify str problems and ultimately help them decide if the company is a good investment opportunity.

As such, correct understanding of the structure of financial statements and also of the tools available for the interpretation of of the further discussions on financial management.
3.2 Nature of financial statements

Any organization doing the business, whether it is a manufacturing activity or trading activity or service activity, is interested in

a. Where the business stands at any given point of time in financial terms? b. What is the result of operations carried out by the business organization during specific period? In order to answer these questions, the organization carries out the process of recording various transactions in a defined which effectively result into the preparation of what are called as financial statements. These financial statements are basically in two forms.

a. First financial statement is Balance sheet. This is the answer to the first question viz. Where the business stands in financial t Balance sheet informs about the various sources used by the organization to raise the funds which technically result in to sources are used which technically result in to the creation of 'assets'. Sometimes, Balance Sheet is also referred to as " Statement of Sources and Application of Funds". Effectively Balance Sheet is a listing of various assets and liabilities of the organization at any given point of time. Technically, Balance sheet is a position statement in the sense it refers to a particular date. As such, Balance Sheet is referred to as " Balance Sheet as on ---------------" or Balance Sheet as at ---------------".

b. Second Financial statement is Profitability Statement. In technical language it is referred to as "Profit and Loss Account'. This is the answer to the second question viz. What is the result of the operations of the business during the specific period i.e loss by what amount? Technically profitability statement is a period statement in the sense it refers to a particular period. This may be a month, a quarter, a half year or a year depending upon the organization and the purpose for which it is prepared As such, Profitability Statement is referred to as " Profit and Loss Account for the year ending on ---------------".

Basic principles behind the preparation of Financial Statements.

3.3 Basic Concepts in Accounting

The theory and practice of accounting is based upon certain assumptions which are referred to variously as concepts, principle For the convenience purpose, we will term as 'concepts'. The various concepts which form the basis of theory and practice of accounting can be discussed as below:
(1) Business Entity Concept:

According to this concept, the business is assumed to be distinct entity from the persons who own the business e.g. if there where Mr. A and Mr. B are partners, from the accounting point of view, M/s. X is supposed to be a separate entity from Mr. A

The financial statements prepared on the basis of accounting records relate to the business i.e. M/s. X and not to Mr. A or Mr. It should be noted in this connection that the business entity concept has nothing to do with the legal entity of the business. It applies to both corporate organization( which by itself is legal entity separate from the owners) as well as non-corporate org owners.)
(2) Money Measurement Concept:

According to this concept, only those transactions and facts find the place in the process of accounting and hence on fina money. As such, all those transactions and facts which cannot be expressed in terms of money( e.g. morale and motivation of the wo are not within the purview of accounting though they may be having direct and indirect bearing on the business. This principle imposes severe restrictions on the kind of information available from the financial statements. In fact, it is one of the major drawbacks of financial statements.
(3) Cost Concept:

According to this concept, the assets acquired by a business are recorded at their cost of acquisition and this cost is consid charging of depreciation. This concept does not take in to consideration the current market prices of the various assets.
(4) Going Concern Concept:

According to this concept it is assumed that the business entity is going to be in business for an indefinitely long period of shorter period of time. This concept affects the valuation of assets and liabilities. As such the assets are shown on the balance sheet at cost less depreciation and not at the current market price or realizable va If the assets are to be disclosed at the correct value in the balance sheet, the current market price will be most suitable. However, as the business is likely to be a going concern in future, they are disclosed at cost less depreciation.
(5) Conservatism Concept:

This concept is usually expressed as - " Anticipate all the future losses and expenses. However do not anticipate the future inco This principle is applicable to current assets generally and hence the current assets are valued at cost or market price whicheve The valuation of non-current assets is made at cost( as per the cost concept).
(6) Dual Aspect Concept:

According to this concept, every business transactions has two aspects, however the basic relationship between the assets and the same e.g. if Mr. A starts the business by introducing the capital of Rs. 50,000 the assets and liabilities structure will be as be Liabilities Capital Rs 50,000 Assets Cash Rs 50,000

Now, if Mr. A uses the cash to purchase the material worth Rs. 40,000; the asset and liabilities structure will change as below: Liabilities Capital Rs 50,000 50,000 Assets Stock in trade Cash Rs 40,000 10,000 50,000

If Mr. A sells the above material worth Rs. 40,000 for Rs. 45,000 on credit basis the assets and liabilities structure will change a Liabilities Capital Rs 55,000 55,000 Assets Receivables Cash Rs 45,000 10,000 55,000

(7) Accounting Period Concept:

According to this concept, even though a business is likely to be a going concern over a longer period of time, in order periodically the future is divided into shorter segment, each one of them being in the form of accounting period. Income is computed according to this accounting period ( by preparing profitability statement) and financial position is assess a Balance Sheet). It may be noted that the length of the accounting period depend upon various factors like characteristics of the business, tax c

(8) Matching Concept:

According to this concept, in order to calculate the profit for the accounting period in a correct manner, the expenses and c should be matched with the revenues generated during that period.

(9) Materiality Concept:

According to this concept, while accounting for various transactions, only those which are having material impact on profita considered, ignoring the insignificant ones.

E.g. if an organization purchases some postage stamps some of which remained non-used at the end of the accounting period used stamps should not be treated as an item of expenditure.

However, as its impact on profitability is likely to be negligible, the cost of non-used stamps may be ignored treating the cost o Now which transactions should be treated as material ones is a subjective concept and depends upon the judgment and knowl
(10) Consistency Concept:

According to this concept, whatever accounting policies and procedures are adopted they should be adopted consistently f between two different sets of financial statements.

If there is any change in the accounting policies an procedures this fact coupled with its effect on profitability should be disclos

3.4 Structure of Financial Statements

As there is no specific law applicable to the preparation of financial statements of non-corporate organizations like proprieta prepare their financial statements in whatever structure they want. However in case of a corporate organization, in simple language a company form of organization, there is an uniform law app Act 1956. As such a company form of organization is require to prepare and present its financial statements in accordance with the pro per the provisions of schedule VI of the Companies act 1956. The underlying presumptions of schedule VI provisions is that it is through the financial statements that the companies commu As such it is required that the financial statement should be transparent and as informative as possible. Hence, Schedule VI lays down various disclosure requirements which the companies are required to follow while preparing the Schedule VI of the Companies Act, 1956 is subdivided into four parts: Part I deals with the format of the balance sheet. Part II deals with the Profit and Loss Account. Part III deals with notes forming part of the Profit and Loss Account and the Balance Sheet. Part IV deals with Balance sheet abstract and the company's general business profile.

Part I : structure of Balance Sheet :

As stated above, part I of schedule with Balance Sheet. It lays down both the vertical as well as horizontal form of preparing the balance sheet, though in normal circumstances we co Following items appear in the Balance Sheet. Liabilities Assets

a. Share Capital b. Reserves and Surplus c. Secured loans d. Unsecured Loans e. Current Liabilities and Provisions

a. Fixed Assets b. Investments c. Current Assets, Loans and Advances d. Miscellaneous Expenditure to the extent not written off or adjusted. e. Profit and loss account debit balance.

In addition to the above items of assets and liabilities, the various contingent liabilities are required to be disclosed by way of a Liabilities Side
A. Share Capital :

The Share Capital is required to be disclosed under the following headings : a. Authorized : ..shares of Rseach b. Issued : ..shares of Rseach c. Subscribed : ..shares of Rseach d. Called up : ..shares of Rs..each e. Less : Calls unpaid f. Add : Forfeited Shares ( Amount originally paid up) Notes:

a) The details of issued and subscribed capital should be given after distinguishing between the different classes of shares. It should be noted that in Indian circumstances, the company can issue only two types of shares i.e. Equity shares and Preferen In case of preference shares, details of different classes of preference shares should be given. Similarly, in case of redeemed or convertible preference shares the terms of redemption on conversion should be given.

b) If the shares are allotted as fully paid shares pursuant to a contract without payments being received in cash, the details of t c) If the shares are allotted as fully paid bonus shares, details of the same should be given along with the sources from which reserves, share premium etc. Similarly the details of bonus shares held by (i) directors and (ii) others should be given. e) It is provided that any profit on the reissue of forfeited shares should be transferred to capital reserve.

B. Reserves and surplus :

Reserves indicate that portion of the earnings, receipt or other surplus of the company (whether capital or revenue) appro purpose other than provisions for depreciation or for a known liability. The reserves can be primarily of two types : (i) Capital reserve and (ii) Revenue Reserve. Capital reserve is that reserve which cannot be disturbed by way of dividend. Revenue Reserve is any other reserve than the capital reserve.

The Reserves are required to be classified as below: a. Capital reserve b. Capital Redemption Reserve (As per the provisions of Section 80 of the Companies Act 1956, this reserve is created for the r c. Share Premium Account. d. Other reserves specifying the nature of each reserve and the amount in respect thereof. Less : Debit balance in Profit and Loss Account if any.

e. Surplus i.e. balance in profit and loss account after providing for proposed allocations viz. dividend, bonus shares or reserves f. Proposed addition to reserves. g. Sinking fund.
Notes :

a. Additions and deductions since the last balance sheet is required to be given under each head of reserves and surplus. b. In case of the share premium account, the details of the utilization of the balance in share premium account should be given It should be noted that as per the provisions of Section 78 of the Companies Act, 1956, the amount lying to the credit of share 1. For issuing fully paid bonus shares. 2. To write off preliminary expenses. 3. To write off the balance of commission/discount allowed/paid while issuing shares/debentures. 4. To provide for premium on the redemption of preference shares. c. The word 'fund' is generally used interchangeably with the word 'reserve fund'. the word fund indicates that there is a specific investment against such reserves. d. Debit balance in Profit and Loss Account should be deducted from the unspecified reserves. If there are no unspecified reserves, such debit balance should be shown on assets side.
C. Secured Loans :

Loans borrowed by the Company, secured wholly or partly, against the assets of the company are stated as secured loans. Secured loans are classified as below : a. Debentures b. Loans and Advances from banks c. Loans and Advances from Subsidiaries d other Loans and Advances

Notes ; a. In case of debentures, the terms of redemption or conversion if any should be specified together with the earliest date of re b. Nature of security should be specified. c. Interest accrued and due on secured loans should be included under the appropriate sub-head under secured loans. d. Loans taken from directors and managers should be shown separately.

e. If the loans are guaranteed by director or manager it is required to mention the guarantee and amount of loan under each h Unsecured loans : Unsecured loans are those loans which are not secured against the security of any of the assets of the company. Unsecured portion of the partly secured loans should be showed under unsecured loans. unsecured loans are classified as below : a. Fixed Deposits b. Loans and Advances from subsidiaries c. Short term Loans and Advances i) from Subsidiaries ii) from others d. Other loans and advances i) from Subsidiaries ii) from others

Notes : a. Interest accrued and due on secured loans should be included under the appropriate sub-head under unsecured loans. b. Loans taken from directors and managers should be shown separately. c. If the loans are guaranteed by the director or manager, it is required to mention the guarantee and the amount of loan unde d. Short term loans and advances are those which are due for repayment within one year from the date of the balance sheet. e. Inter-corporate unsecured deposits and commercial Papers fall under his head.

Current Liabilities and Provisions :

The guidance note issued by The Institute of chartered accountants of India on terms used in Financial Statements defines 'Cu bank overdraft which falls due for payment in a relatively short time, normally not more than 12months. Current Liabilities and Provisions are classified as below:
A. Current Liabilities :

a. Acceptance ; This include the bills payable including the promissory notes issued by the company. b. Sundry Creditors for goods purchased or services received c. Subsidiary Companies d. Advance received and unexpired discount e. Unclaimed dividend f. Other liabilities, if any g. Interest accrued but not due on loans

B. Provisions ;

a. Provision for taxation b. Proposed Dividend c. Provision for contingencies d. Provision for provident fund scheme e. Provision for insurance, pension and other similar staff benefit schemes f. other provisions

Assets Side Fixed assets :

Schedule VI requires the company to classify the fixed assets as far as possible under the following heads : a, Good will b. Land c. Buildings d. Leaseholds e. Railway Sidings f. Plant and machinery g. Furniture and Fittings h. Development of Property i. Patents, Trade Marks and Designs j. Livestock k. Vehicles etc Under each of the above heads, original cost and the additions there to or the deductions there from during the year and the of the year should be stated.

In the practical circumstances in the vertical form of balance sheet, the fixed assets are presented as below : a. Gross block ( which indicates accumulated original cost) b. less : depreciation ( which indicates accumulated depreciation) c. net Block ( which indicates Gross Block less depreciation) d. Capital Work-in-progress

Note : Capital work-in-progress indicates the fixed assets under construction or under installation. After the construction of fixed assets is complete or the fixed assets are installed, they are capitalized under the suitable head. No depreciation will be provided by the company on capital work-in-progress. Usually details of original cost, additions, deductions, depreciations etc. are shown in a separate schedule.

Investments :

Investments indicate the assets held by a company for earning income by way of dividend, interest etc, or for capital appreciat

Investments are required to be distinguished as below : a. investments in government or Trust securities. b. Investments in shares, debentures or bonds showing separately, shares fully paid up and partly paid up and also distinguishi Similar details should be given in case of investment in subsidiary companies. c. immovable Properties. d. Investment in capital of partnership firm. e. Balance of unutilized monies raised by issue.
Notes :

a. It is necessary to indicate the nature of investment and mode of valuation for example cost or market value. b. It is required to disclose i) Aggregate amount of company's quoted investments and the market value thereof. ii) Aggregate amount of company's unquoted investments. Quoted investment means an investment which is traded on a recognized stock exchange and unquoted investment means oth
Current Assets, Loans and Advances : A. Current Assets

Cash and other assets which are expected to be converted in to cash or consumed in the production of goods or rendering the as current assets. Current Assets are required to be classified as : a. Interest accrued on investments b. Stores and spare parts c. Loose tools d. Stock-in-Trade ( This in turn may consist of stock of raw materials and stock finished goods) e. Work-in -progress f. Sundry debtors i) Debts outstanding for a period exceeding six months ii) Other debts
Less : provision

g. Cash balance on hand h. bank balances i) With scheduled bank ii) With others

Notes :

a. Mode of valuation of stock-in-trade and work-in-progress should be specified. b. Sundry debtors are required to be disclosed based on security in the following manner. i) Debts considered good and in respect of which the company is fully secured. ii) Debts considered good for which the company holds no security other than the debtor's personal security. iii) Debts considered bad or doubtful.

Further following details are also required to be disclosed in case of debtors : i) debts due by directors or other officers of the company or any of them either jointly or severally with any other person. ii) Debts due by firms in which any director is a partner or debts due by a private company in which a director is a director or m iii) Maximum amount due by directors or other officers of the company at any time during the year is required to be shown by iv) Debts due from the company under the sane management as defined in Section 370(1B) of the companies Act, 1956 are r of these companies. c. In case of bank balances, following details are require to be given : i) Balance lying with Scheduled bank in current account, call account or deposit account. It should be noted that a scheduled bank is defined in section 2(e) of the Reserve Bank Act, 1934.

ii) Balances lying with banks, other than Scheduled Banks in current account, call account or deposit account. It is further required to state the names of all such banks and the maximum amount outstanding at any time during the year fr iii) Nature of interest of the directors or the relatives of the directors in the non-scheduled bank is also required to be stated.

B. Loans and Advances :

The loans and advances may not always be in the form of current assets. However for the purpose of schedule VI they are club The loans and advances are classified as : a. Advances and loans to subsidiaries. b. Advances an loans to partnership firms in which the company or any of its subsidiaries is a partner. c. Bills of exchange d. Advances recoverable in cash or in kind or in value to be received e.g. Rates, taxes ,insurance etc. e. Balances with customs, port trust etc. (where payable on demand) Disclose requirements applicable to sundry debtors equally apply to Loans and Advances. a. Loans and Advances are required to be classified as i) Outstanding for a period exceeding six months ii) Other loans and advances.

b. Provision for bad and doubtful advances is required to be reduced from the balance of loans and advances. c. Advances due by directors or other officers of the company or any of them either jointly or severally with any other person a

e. Maximum amount due by directors or other officers of the company at any time during the year is required to be shown by f. Advances due from the companies under the same management as defined in section 370(1B) of the companies act,1956 names of these companies.
Miscellaneous Expenditure :

( To the extent not written of or adjusted) In accounting language this amount arises due to the deferred expenditure incurred by the company. Deferred revenue expenditure is that expenditure which is neither capital expenditure nor revenue expenditure. It is not a capital expenditure as no fixed asset is related due to this expenditure. It is not a revenue expenditure also as the benefits received from such expenditure are staggered benefits. Such expenditure should not be transferred to profit and loss account in the year of incurrence. In practical circumstances, following expenditure may appear under this head. a. Expenditure incurred in connection with drafting and printing of Memorandum of Association and Articles of Association of paid for getting the company registered as per the provisions of Companies Act, 1956 etc. b. Expenditure incurred in connection with the preparation of feasibility report, conducting the market survey etc.

c. Expenditure incurred in connection with the public issue of shares and debentures like underwriting commission, brokerag and legal charges etc.

As per the provisions of Section 35D of the income Tax Act 1961, such expenditure can be written off to Profit and loss account

Contingent Liabilities :

Contingent Liabilities may be defined as the liabilities the crystallization of which depends upon the happening or non-happeni Contingent Liabilities are never a part of main Balance Sheet. They are to be disclosed below the Balance Sheet by way of ' Fo

In practical circumstances contingent liabilities are disclosed in the annexure to the Balance Sheet in the form of ' Notes on Acc

The contingent liabilities referred to in Schedule VI are as below : a. Claims against the company not acknowledged as debts. ( In simple language they are the disputed claims). They are likely to become final liability only if the company loses the suit).

b. Uncalled liability on shares partly paid. ( This liability may arise if the compact has invested some amount in the shares o called.) c. Arrears of dividend on cumulative preference shares. d. estimated amount of contracts remaining to be executed on capital accounts and not provided for.

e. Other money for which the company is contingently liable. ( In practical circumstances it may include the amounts like bills guarantees given by the company on behalf of directors or other officers of the company etc.)

Part II : Structure of Profitability Statement : The profitability statement of a company may be split in to the following components.

a. First component discloses profits earned by the company after the manufacturing function is over. This profit is technically referred to as 'Gross Profit' and is calculated as Sales less cost of Goods Manufactured ( also called as f b. Second component discloses profits earned by the company after all the operating activities are over. This profit is technically referred to as 'Operating Profit' and calculated as Sales less Operating Cost. c. Third component discloses final profit earned by the company after all the activities are over. This profit ids technically referred to as 'profit After Tax' and is calculated as : operating Profit Add : Non-operating incomes Less : Non-operating expenses Less : Taxation

d. Fourth component indicates the profits retained in the business after the profit After Tax is distributed among the owners b Based upon the above discussion, the structure of the profitability statement can be drafted as below : Sales Less : Factory Cost Gross Profit Less : Administrative and selling overheads Operating profits Less : Non-operating expenses Add : Non-operating incomes Profit before tax Less : taxes Profit after tax Less : Dividend Paid Retained Profit

3.5 ROLE PLAYED BY FINANCIAL STATEMENTS

In the present circumstances, the process of financial accounting and hence the preparation of financial statements has been or at least indirectly.

As such, the preparation of financial statements indicates the compliance with the various legal requirements. Moreover, persons dealing with an organization get the information to enable them to take proper decisions e.g. on the basis of financia retain the investment in the company or not.

On the basis of financial statements, the creditors of an organization may decide whether to continue extending the credit or n On the basis of financial statements, the employees may base their demands for additional wages or various benefits i.e. the organization is having good profitability.

It is on the basis of financial statements that the banks and/or financial institutions appraise the applications made by continuance of credit facilities, as the financial statements give a good indication about the performance and financial conditio

The financial statements may be used by the various agencies like Government or Reserve Bank of India, to formulate certain p The financial statements may be used by the various tax authorities to ascertain the tax liability of the organization in various a Last but not least, on the basis of financial statements the management may review the progress of the organization and decid

However, it may be stated that the financial statements may not be really available to the management as a tool for decision same. Thus, it is by way of the financial statements that an organization speaks to the various persons dealing with it and gives the position of itself. It may not be out of place to mention here that if the accounts are required to be audited as per any of the statutory requ Income Tax Act, 1961 ) the financial statements prepared there from may be treated as more credible by the readers. 3.6 LIMITATIONS OF FINANCIAL STATEMENTS

(1) Financial statements are available only after the specific period of time is over e.g. the Balance Sheet as on 31st March, 199

The various legal provisions also provide for sufficient time lag for the preparation of financial statements. Thus, the financial statements give the information about the historic facts which may not be sufficient from decision making p

(2) Financial statements are necessarily interim reports and cannot be final ones. E.g. to understand the correct profitability an and liabilities, it will be necessary to stop the business operations and dispose off all the assets and liquidate all the liabilities w

In order to prepare the financial statements for a specific period, it may be necessary to cut off various transactions involving which may involve personal judgments. Various policies and principles are required to be formulated and followed consistently for such cutting off of incomes and cos

(3) As 'going concern principle' is followed while preparing the Balance Sheet, the various assets and liabilities are shown at current market prices or the liquidation prices. This may affect the profitability statement as well in the form of incorrect provision for depression, This problem maybe more critical during the periods of extreme inflation or depression.

As such, any conclusions drawn on the basis of such financial statements may be misleading ones. (4) Financial statements consider only those transactions which can be expressed in monetary terms. All other transactions or factors which cannot be expressed in terms of money are ignored by the financial statements. E.g. Assuming that the business of a company is such that it is likely to be injurious to the health of local community. As such, for the company's carrying on of business at that location.

This opposition is something which cannot be expressed in terms of money and hence finds no place in the financial statemen company to a very great extent.

(5) The financial statements prepared may be useful for the use of normal users under normal circumstances. If an user want to use the financial statements for some special purposes, the necessary information or details may not be ava E.g. if an user, on the basis of financial statements available wants to value the equity shares of the company with the metho required details may not be available from the financial statements.

Similarly, the financial statements may not give correct indications about the profitability or the financial conditions of the bus E.g. suppose that the production and sales of a company in a particular year are abnormally high due to the prolonged strike i profits in that particular year are abnormally high. Now when both the sales and profits are at normal level, the performance of that year may be treated as bad as compared to a

(6) Financial statements, however carefully and correctly prepared, do not mean anything all by themselves unless the inform interpreted. As such, merely the preparation of financial statements is not sufficient; equally important is the task of their analysis and inte

3.7 ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

As stated earlier, the financial statements are not useful unless they are properly analyzed and interpreted. The process of ana and rearrangement, grouping and regrouping of the financial and operational data appearing on the financial statements, and

The process of interpretation follows that of analysis and involves the attempts to arrive at logical conclusions regarding th organization. Types of Analysis : These can be basically two ways in which the analysis of financial statements can be carried out. (1) Internal Analysis :

This indicates the analysis carried out by those parties who have the access to the books and records of the company. Natura management of the company to enable the decision making process. This may also indicate the analysis carried out in the legal or statutory matters where the parties who are not a part of the ma books and records of the company. (2) External Analysis :

This indicates the analysis carried out by those parties who do not have the access to the books and records of the company. prospective investors and other outsiders.

Naturally, those outsiders are required to depend upon the published financial statements. As such, the depth and correctnes the recent amendments to the statutes like Companies Act, 1956 have made it mandatory for the companies to reveal maximu position, in order to facilitate the correct and proper analysis and interpretation of the financial statements by the readers. Techniques of Analysis and Interpretation :

Though there may be numerous techniques available for the analysis and interpretation of financial statements, we will consid (a) Ratio Analysis (b) Funds Flow/Cash Flow Analysis 3.8 SUMMARY

Financial statements of an organization gives the details of financial performance of the organization as well as the financial sta The organization carries out the process of accounting which effectively results into the preparation the financial statements namely the Balance Sheet and the Profit and Loss Account. Balance Sheet gives details of the various sources used by the organization to raise the funds and the various assets in which th The result of operations of the business during the specific period i.e. whether the operations have resulted into a profit or lo account.

A company is required to prepare and present its financial statements in accordance with the provisions of Schedule VI of the C Schedule VI lays down various disclosure requirements which the companies are required to follow while preparing their finan The financial statements of a company are used by the shareholders, creditors, banks, financial institutions, employees, govern company. It is by way of the financial statements that an organization gives the report about the performance and financial position of its Financial Statements are further analyzed and interpreted to arrive at logical conclusions regarding the performance and finan
Unit 4 Interpretation of Financial Statements (Ratio Analysis)

4.1 Introduction

Generally, an absolute figure conveys no meaning. A figure may become meaningful if it is compared with some appearing on the financial statements, either the profitability statement or the balance sheet, may not give the qualit performance of an organization which may be available if the accounting figures appearing in the financial statements the profitability statement discloses the amount of Rs. 1 Lakh as the net profit, it appears to be a good performance. B the sales turnover during the corresponding period was rs. 1 lakh as the net profit, it appears to be a goo performance the sales turnover during the corresponding period was rs.10 crores, it can be immediately concluded that the perform the net profit as the performance of sales turnover is only 0.1%.. The comparison of profit on one hand and sale indication about the performance of the organization. Here comes into the picture the technique of

Ratio analysis. The term ratio implies arithmetical relationship between two related figures. The technique of Ratio analysis as technique computation of various ratios. By grouping or regrouping the various figures and or information appearing on the financi conclusions there from.

It should be remembered that ratios, depending on the nature of ratio, may be expressed in either of the following ways. a. Percentage for example, net profit as 10% of sales. b. Fractions for example, retained earnings as 1/3rd of share capital. c. Stated comparison between number for example, Current assets as twice the current liabilities. 4.2 INTERPRETATION OF RATIOS

The ratios calculated on the basis of grouping of the figures appearing on either profitability statement or balance anything, unless they can be compared maybe in the following three forms:

1. The ratios of one organization may be compared with the ratios of the same organization for the various years, either the format of intra-firm comparison 2. The ratios of one organization may be compare with the ratios of other organization in the same industry and such compar the same industry may be facing similar kinds of financial problems. This maybe in the form of inter-firm comparison. 3. The ratios of an organization may be compared with some standards which may be supposed to be the thumb rule for th comparison of current assets for one rupee of current assets and actual current liabilities may be compared with this standard

4.3 ROLE OF RATIO ANALYSIS It is true that the technique if ratio analysis is not a creative technique in the sense that it uses the same figures and inf statements. At the same time it is also true that what can be achieve by the technique of ratio analysis cannot be achieved by the mere pre Ratio analysis helps to appraise the firms in terms of their profitability and efficiency of performance, either individually or in r

The process of this appraisal is not complete until the ratios so computed can be compared with something, as the ratios all may be the intra-firm comparison inter-firm comparison, inter-firm comparison with standard ratios. thus proper compa compared with earlier periods or in comparison with other firms in the same industry.

Ratio analysis Is one of the best possible techniques available to the management to impart the basic functions like planning and control. A ratios calculated on the basis of historical financial statements maybe of good assistance to predict the future. Example, on the ratio in the past, the level of inventory and debtors can easily be ascertained for any given amount of sales. Similarly, Ratio ana

May be able to locate and point out the various areas which needs the managements attention in order to improve the situ declining trend may indicate the need for the further introduction of long term finance in order to improve the liquidity positi indicate certain specific aspects of the conduct of business. As such, the importance of various ratios may vary for different bankers, trade creditors and lenders of short term credit are basically interested in the liquidity position of the organization a inventory turnover ratio and average collection period are more important. The financial institutions and lender of long term profitability position of the organization and as such the ratios like debt equity ratio, debt service coverage ratio, interes important. As the ratio analysis is concerned with all the aspects of a firms financial analysis i.e. Liquidity, solvency, profitability and ov know the financial and operational characteristics of an organization and take the suitable decisions.

CLASSIFICATION OF RATIOS The ratios may be classified may be classified under various ways which may use various criterion to do the same. However under the following groups. i. ii.

Liquidity group Turnover group

iii. iv. v. vi.

Solvency group Profitability group Overall profitability group Miscellaneous group

Liquidity group:

The ratios computed under this group indicate the short term position of the organization also indicate the efficien Commercial banks and short term creditors may basically interested in the ratios under this group. Two most importan

1. Current ratio It is calculated as current assets/current liabilities components: current assets include cash in hand or at bank, marketable securities, sundry debtors, bills receivables, inventories, prepaid exp Current liabilities include sundry creditors, bills payable, outstanding expenses and bank overdraft or cash credit.
Following propositions should be considered:

i.

Disagreement may be there for inclusion of bank overdraft or cash credit in current liabilities, strictly speakin are the demand facilities i.e. banks can ask for repayment at any time. However in practice those facilities are usually they should be considered as non current liabilities. However, considering the legal implications of the same, it is bett
ii.

If bills receivables raised by the organization are discounted with the bank, they cease to appear as the rece note to the same. At the same time, they indicate the working capital facility granted by the bank to that extent, for th the amount of bills discounted with banks should be added to both current assets as well as current liabilities.

Indication/Precautions: Current ratios indicate the backing available to current liabilities in the form of current assets. In other words, a higher c available with the organization which can be converted in the form of cash, without any reduction in value, in a short span of are to be paid off in a short span of time i.e. current liabilities.

As such, higher the current ratio better will be the situation. A current ratio of 2:1 is supposed to be standard and ideal. A blin current ratio may lead to unrealistic conclusions. As such, before drawing the conclusion that higher current ratio indicates s mind:

1. It should be ensured that the valuation of current assets and current liabilities is made on a consistent basis and as p

2. It should be ensured that the current assets do not include the inventories which are obsolete or non moving and the rece long time and are not provided for which may be almost non recoverable. If the current assets include these types of assets, excluded fro the current assets.

3. If current ratio is computed on the basis of balance sheet figures, abnormal purchases of inventories or abnormal creation should be considered in the right perspective. 4. A higher current ratio indicates unnecessarily high investment in current assets in the form of inventories or receivables or b 2) Liquid ratio or acid test ratio or quick ratio It is an improved version of current ratio. It is calculated as: liquid assets / liquid liabilities
Components:

Liquid Assets include all current assets except inventories and prepaid expenses. Liquid liabilities include all current liabilities except bank overdraft or cash credit. Indications/precautions:

Liquid ratio indicates the backing available to liquid liabilities in the form of liquid assets. The term liquid assets indi without any reduction in value, almost immediately whereas, the term liquid liabilities indicates the liabilities which ar words, a higher liquid ratio indicates that there are sufficient assets available with the organization which can be conve off those liabilities which are to be paid off almost immediately. As such, higher the liquid ratio better will be the situat and ideal.

Before drawing any conclusions regarding the indications given by the liquid ratio, following propositions should be kept in min

1. Liquid assets exclude the current assets in the form of inventories and prepaid expenses, but include the current assets prepaid expenses cannot be argued upon as they indicate the assets which cannot be converted in cash, the exclusion of inven There may be some kinds of inventories which can be disposed off almost immediately, due to their specific nature, and this m may be some receivables outstanding for a very long time and provided for, which may be almost non-recoverable and this ide 2. Non consideration of bank overdraft or cash credit as liquid liability can hardly be challenged as by its practical nature, it immediately. b) Turnover Group

The ratios computed under this group indicate the efficiency of the organization to use the various kinds of assets by conve basically categorized as Fixed Assets and Current Assets and as the current assets may further be classified according to the and receivables (debtors) or as net current assets i.e., current assets less liabilities viz., working capital, under this grou computed: 1) Fixed Assets Turnover Ratio: It is calculated as: Net Sales/Fixed Assets Components: Net sales include sales after returns, if any, both cash as well as credit. Fixed assets include net fixed assets i.e., fixed assets after providing for depreciation. Indications/Precautions

A high fixed assets turnover indicates the capability of the organization t achieve maximum sales with the minimum investme turned over in the form of sales more number of times. As such, higher the fixed assets turnover ratio better will be the situati 2) Current Assets Turnover Ratio: It is calculated as: Net Sales/ Current Assets Components: Net sales include sales after returns, if any, both cash as well as credit.

Current Assets include the assets like inventories, sundry debtors, bills receivables, cash in hand or at bank, marketable securit

Indications\Precautions:

A high current assets turnover ratio indicates the capability of the organization to achieve maximum sales with the minimu current assets are turned over in the form of sales more number of times. As such, higher the current assets turnover ratio, be 3. Working capital ratio:
Calculated as net sales/working capital

Components: Net sales include sales after returns, if any, both cash as well as credit. Working capital includes difference between current assets and current liabilities. Indications/precautions: A high working capital turnover ratio indicates the capability of the organization to achieve maximum sales with the minim working capital is turned over in the form of sales more number of times. as such higher this ratio, better will be the situation. 4. Inventory / stock turnover ratio:
Calculated as

a. cost of goods sold/average inventory or b. net sales / average inventory or c. cost of goods sold / closing inventory or
d. net sales/closing inventory

It can be seen from the above that the inventory turnover ratio may be expressed in either of the four ways as stated above t express inventory turnover ratio. It is specifically due to the fact that other alternatives have certain flaws as stated below. i.

alternatives b and d consider the amount of sales as the numerator which includes the amount of profi average or closing inventory is normally valued at costs. ii. Alternatives c and d consider closing inventory which ignores the possibility of certain seasonal or abn which may increase the closing inventory. Alternative a does not have both the above stated limitations. As numera consider profit. As denominator is in the form of average inventory, it considers possibility of seasonal or abnorm Ideally, average inventory should be the average of monthly inventory specifically when the size of inventories average inventory may be computed as :
Opening inventory + inventory at the end of every month / 13

However, in many cases, for convenience purposes, inventory may be computed as the average of opening and closing invento

Indications/Precautions: A high inventory turnover ratio indicates that maximum sales turnover is achieved with the minimum investment in inventory desirable. However, the high inventory turnover ratio should be viewed from some more angles. Firstly, it may indicate that t organization may lose customer patronage if it is unable to maintain the delivery schedule. Secondly, high inventory turnover As organization, in order to achieve a large sales volume, may sometimes sacrifices on profits, whereby a high inventory ratio m

On the other hand, a low inventory turnover ratio may indicate over investment in inventory, existence of excessive or management, accumulation of inventories at the year end in anticipation of increased prices or sales volume in near future and

There can be no standard inventory turnover ratio which may be considered to be ideal may depend on nature of industry and 5. Debtors turnover ratio :
It is calculated as net credit sales / closing sundry debtors

This ratio indicates the speed at which the sundry debtors are converted in the form of cash. However, this intention is not cor As such, this ratio is normally supported by the calculations of average collection period, which is calculated as below:

a. calculation of daily sales : net credit sales / no. of working days b. calculation of average collection period: closing sundry debtors / daily sales following propositions should be kept in mind: 1. As the concept of sundry debtors does not come into the picture in case of cash sales, while computing average colle However, in practice, break up of cash sales and credit sales may not be available from the published statement of accou computation of this ratio.

2. while considering the total amount of debtors, the bill receivables should be considered along with the debtors. Further should be excluded as far as possible. For example, debtors for the sales of fixed assets.

3. in some cases, while computing this ratio, average sundry debtors instead of only closing sundry debtors may be considered 66 For the calculation of daily sales, it is customary to consider 360 days in a year instead of 365 days in a year. In some cases, i holidays also when there are no business transactions. Indications/ Precautions:

The average collection period as computed above should be compared with the normal credit period extended to the cus normal credit period allowed to the customers, it may indicate over investment in debtors which may be the result of over-ex ineffective collection procedures and so on.

However, before drawing the conclusion like this, the factor of distribution of sales throughout the year should be considere evenly distributed throughout the year, the result obtained from computation of average collection period may be mislead sales amount to Rs. 18 Lakhs out of which credit sales are of Rs. 3.60 Lakhs. The organization rarely sells on credit basis and th

of the year, with the normal credit period allowed of 60 days. As such, the entire amount of Rs. 3.60 Lakhs will be debtors. The computation of average collection period will be made as below:
a) Calculation of daily sales: Net credit sales No. of working days = Rs. 1000/ per day

b) Calculation of average collection period: Closing sundry debtors / Daily sales 3,60,000 / 1000 = 360 days 67 The average collection period thus calculated may then be compared with the normal credit period allowed to the custome there is a lapse on the part of collection department to collect the dues in time which may be a misleading one, as the outstan yet due for payment.

Capital Turnover Ratio: Sales / Capital employed

Components: The term in the denominator i.e., capital employed indicates the long term funds supplied by creditors and owners of the firms (a) Fixed Assets+ Investments+ Current Assets- Current liabilities. (b) Share Capital+ Reserves and Surplus+ Long Term Liabilities.
Indications/ Precautions:

The ratio indicates the efficiency of the organization with which the capital employed is being utilized. A high capital turnov achieve maximum sales with minimum amount of capital employed. It indicates that the capital employed is turned over in th the capital turnover ratio, better will be the situation.

Solvency Group The ratios computed under this group indicate the long term financial prospects of the company. The shareholders, debenture loans may be basically interested in the ratios may be computed under this group: 1) Debt Equity Ratio: It may be calculated in two ways (a) External Liabilities / Shareholders Funds

68 (b) Long Term Liabilities / Shareholders Funds Components: As per expression a as stated above, the external liabilities include all types of liabilities viz., long term, short term or current. The expression b as stated above, considers only long term liabilities which maybe in the form of debentures, term loans and Shareholders funds in both the expressions consist of share capital plus reserves and surplus. There are controversial views i.e., whether the preference share capital should be treated as a part of debt or equity. No clear-cut principles are available However, generally the following type of treatment may be given.

In case of the redeemable preference share capital, if they are redeemable after the period of 12 years, they may be treated be a sufficiently longer period of time. However, if the preference shares are redeemable before the period of 12 years, they m It should be noted that the treatment given to the preference share capital as described above is only a matter of convention a Indication/ Precautions:

Debt Equity ratio indicates the stake of shareholders or owners in the organization visit that of the creditors. It indicates the c organization. A high debt equity ratio may indicate that the financial stake of the creditors is more than that of the owners. A of investment in the organization a risky one. On the other hand, a very low debt equity ratio may mean that the borrowing this context, the readers of financial management may remember that to borrow the funds from outside is one of the best p equity shareholders, basically due to two reasons. Firstly, the expectation of the creditors in the form of return on their invest expected by the equity shareholders. Secondly, the return on investment paid to the creditor is tax deductible expenditure. 69 2.

Proprietary Ratio:

This ratio indicates the relationship between the owners funds and total assets. As the assets can be basically fi accordingly. As such, it can be calculated as:

a. Total Assets / Owners funds b. Fixed Assets / Owners funds c.

Current Assets / Owners funds

Components: The term in the denominator i.e., owners fund is the same as the term Equity used in Debt Equity Ratio. Indication/ Precautions: The ratio indicates the extent to which the owners funds are sunk in different kinds of assets. If the owners funds exceed f invested in the current assets also. If the owners funds are less than fixed assets, it indicates that a part of fixed assets is finan

Similarly, the ratio between the current assets to the owners funds is indicates the extent to which owners funds are locked of current assets to owners funds, as compared to proportion of fixed assets to owners funds may be treated as a sign of goo 3. Fixed Assets/ Capital Employed Ratio: It is calculated as:
Fixed Assets / Capital Employed * 100

70 Components: The term in the denominator i.e., capital employed indicates the long term funds supplied by creditors and owners of the firm. a) Fixed Assets+ Investments+ Current Assets- Current Liabilities. b) Share Capital+ Reserves and Surplus+ Long Term Liabilities. Indications/ Precautions:

This ratio indicates the extent to which the long term funds are sunk in fixed assets. It has been an accepted principle of finan financed by way of long term funds but also a part of current assets or working capital should be financed by long term funds, capital. A very high trend of this ratio may indicate that the major portion of long term funds is utilized for the purpose of fix current assets or working capital. A very high trend of this ratio coupled with a constant declining trend of current ratio ma term funds for financing the working capital in the business. 4. Interest Coverage Ratio: It is calculated as: Profit before interest and taxes /
Components:

Interest Charges

The numerator considers the profits before interest on both term and working capital borrowings. In this connection, it shoul computing the profits because; it is calculated after paying the interest.

The denominator considers the interest charges which are in the form of interest on long term borrowing and not the interest Indications/ Limitations: This ratio indicates the protection available to the lender of long term capital in the form of funds available to pay the inter desirable

71 But too high a ratio may indicate under-utilization of the borrowing capacity of the organization, whereas too low a ratio may operations.

This ratio suffers from certain limitation. a) The fixed obligations in the form of the preference dividend or installments of long term borrowings are not con b) The funds available for meeting the obligations of the interest payments may not be necessarily in the form

amount of profits so calculated may consider the amount of depreciation debited to profit and loss account which d

5. Debt Service Coverage Ratio(DSCR): This may be considered to be one of the most important ratios calculated by the Bankers or Financial Institutions giving lon behind calculating this ratio is to ascertain the capability of the organization to repay the dues arising as a result of long term b It is calculated as: Net profit after Taxes+ Depreciation+ Interest on Term Loans / Interests on Term Loans+ Installments of Term Loans

Indications/ Precautions: Considering the intention of computing this ratio is to give indications about the capability of the organization to meet th financial institution will like to get this indication before the money is lent to the organization. As such, this ratio calculate financial institutions before granting the term finance to the borrowing organizations. Too low a DSCR indicates insufficie obligations of long term borrowings. At the same time, if too high a DSCR is estimated during the currency of the long term bo may be reduced from whatever is requested by the borrowing organization. 72 d)

Profitability Group:

As the number itself suggests, the intention for calculating these ratios is to know profitability of the organization. Following ra 1) Gross Profit Ratio: It is calculated as: Gross Profit/ net sales * 100

Components: The net sales consist of sales after deducting the sales returns if any. The gross profit indicates the difference between net sales on one hand and either of the following on the other hand. a) Manufacturing cost or factory cost or production cost in the case of manufacturing concerns. b) Cost of purchases, expenses directly related to purchases and the adjustments for stack variations if any, in case Indications/ Precautions: The gross profit ratio includes the relation between production cost and sales and the efficiency with which the goods are indicate that the organization is able to produce or purchase at a relatively low cost. As such, a high gross profit ratio will be following methods: a) Increase sales price, production cost remaining same.

Reduce production cost, sales price remaining same. c) Increase sales price, reduce production cost. d) Increase volume of products having high gross profit margin.
b)

73 An undue increase in gross profit ratio as well as an undue decrease in gross profit ratio should be carefully investigated. Undue increase in gross profit ratio may indicate:

i. ii. iii. i. ii. iii. iv.

Over-valuation of closing stock. Non-consideration of purchase invoices. Consideration of non-sales as transactions. For example, goods sent on consignment basis. Under-valuation of closing stock Non-consideration of sales invoices. Inability of management to control the cost or increase the sales. Improper utilization of infrastructural facilities.

Undue decrease in gross profit ratio may indicate

2) Net Profit Ratio: It is calculated as:

Gross profit / net sales *100

Indications/ Precautions: The Net profit Ratio indicates that portion of sales available to the owners after the consideration of all types of expenses and abnormal. A high net profit ratio indicates higher profitability of the business. As such, a high net profit ratio will be desirable.

3) Operating Ratio: It is calculated as: Manufacturing cost of goods sold+ Operating Expenses / net sales *100

74

Components: The numerator includes the various operating cost which a business has to incur in order to earn the profits. Following typ numerator viz., Interest, Dividend (On equity as well as preference shares), loss on the scale and assets/ investments.

Indications/ Precautions: This ratio indicates the percentage of net sales which is absorbed by the operating costs. A high operating ratio indicates tha high expenses in the form of interest, dividend and other non-operating expenses. As such, low operating ratio will be desirab limited extent as the net profits available to the owners will be considering the non operating expenses as well as the non oper

e) Overall Profitability Group: The ratio computed under this group indicates the relationship between the profit of a firm and investment in the firm. Thes (ROI)

75 Similarly, the term assets may also be treated in two ways. Sometimes assets may mean fixed assets or sometimes they may in

Indications/ Precautions: ROA measures the profitability of the investments in a firm. As such, higher ROA will always be preferred. However, ROA do funds which finance total assets. 2) Return On Capital Employed (ROCE): It is calculated as: Net Profit+ Interest on Long Term Sources / Capital Employed

Components: There can be basically two ways in which the term net profit may be treated. Sometimes, profit may be taken to mean net pr net profit after taxes plus interest. The term capital employed refers to long term funds supplied by creditors and owners o computed in two ways.

a) Fixed Assets+ Investments+ Current Assets- Current liabilities. b) Share Capital+ Reserves and Surplus+ Long Term Liabilities. Indications/ Precautions: ROCA measures the profitability of the capital employed in the business. A high ROCE indicates a better and profitable use o high ROCE will always be preferred.

Return on Shareholders Funds: This ratio indicates the profitability of a firm in relation to the funds supplied by the shareholders or owners. As the sharehold and Preference Shareholders, this ratio can be computed basically in two ways.

76 Net Profit after Taxes / Total Shareholders Funds *100 Components:

The numerator considers the net profit after taxes before the preference dividend. The denominator considers the e surplus.

Net Profit after Taxes- Preference Dividend /

Shareholders Funds * 100

Components: The numerator considers net profit after taxes as well as preference dividend as that is the amount which is available to the dividend. The denominator considers the equity capital and reserves and surplus. Indications/ Precautions: This is the most important ratio to measure whether the firm has earned sufficient returns for its shareholders or not. As su shareholders point of view. Higher this ratio better will be the situation. f) 1)

Miscellaneous Group Capital Gearing Ratio:

Equity Capital

It is calculated as:

Fixed Income Bearing Securities /

Components: Fixed income bearing securities consist of preference share capital, debentures and long term loans. 77 Interpretation:

A high capital gearing ratio indicates that the capital structure, fixed income bearing securities are more in comparison is said to be highly geared. On the other hand, if fixed income bearing securities are less as compared to equity capital

It may be worth recalling here that a company may attempt to employ the fixed income bearing securities in the overall capi shareholders earnings. As such, a high capital gearing ratio, to a certain extent, maybe advantageous from the equity shareho the company may become risky and further borrowing may not be possible for the company. Further, if the income of the prove to be fatal, especially in the years of reducing income when a major portion of the income will be utilized to meet the ob
(2) Earnings

Per Share (EPS):

It is calculated as: Net profit after taxes- Preference Dividend / Number of Equity Shares Outstanding Indication/ Precautions:

It is widely used ratio to measure the profits available to the equity shareholders on a per share basis. EPS is calculated on the profits. As such, increasing EPS may indicate the increasing trend of current profits per equity share. However, EPS does no owners by the way of dividend and how much of the earnings are retained in the business. (3) Price Earnings Ratio (P/E Ratio): It is calculated as: Market Price per Share / Earnings per Share

Pg no 78 Indications/precautions:

P/E ratio indicates the price currently being paid in the market for each rupee of EPS. It measures the expectation o possibility of increase in EPS. A low P/E ratio may indicate that there is no possibility of any increase in EPS and the in

This ratio is important from the investors point of view. An ideal investor will compare between the current market price an future EPS also. 4. Dividend payment ratio (D/P ratio): It is calculated as : Dividend per share / Earnings per share *100 Indications / precautions : It measures the relationship between the earnings belongings to the equity shareholders and the amount finally paid to management to pay cash dividend. D/ D/P ratio when subtracted from 100, gives the indications about the policy of management to retain the profits in the business to have an effect on future market price of the share.
Limitations of ratio analysis

1. The basic limitation of the technique of ratio analysis is that it may be difficult to find a basis for making the comparisons. In an organization may vary widely from year to year. In case of the inter-firm comparison, it may become invalid due to various r I. ii.

the ratios of other organization in the same industry may not be readily available. The constituent organizations in the same industry may vary from each other in terms of age, location, extent

on.
iii.

Different accounting policies may be followed by the constituent organizations in the industry. The acco valuation of inventories, provision for depreciation etc

2. Normally, the ratios are calculated on the basis of historical financial statements. An organization, for the purpose of pro future happenings rather than transactions in the past. The management of the organization may predict the future to some but the external analyst has to depend upon the past which may not necessarily reflect financial position and performance in f

3. The technique of ratio analysis may prove to be inadequate in some situations if there is difference of opinion regarding certain ratios. E.g.. In case of the computation of debt-equity ratio, the opinions may differ as to the treatment of preferenc while the others may treat this as part of equity.

4. As the ratios are computed on the basis of financial statements, the basic limitation which is applicable to the financial state ratio analysis. Also, only those facts which can be expressed in financial terms are considered by the ratio analysis. E.g.. The co show a favourable trend thereby justifying the additional borrowings which the organization may want to make. However, outside obligations in time, the lender of the finance may be misled by the computation of debt equity ratio.

5. The technique of ratio analysis has certain limitations of use in the sense that, it only highlights the strong or problem indicate the strong or problem areas and that too only partially. For the correct and comprehensive analysis of the situations, problem areas. E.g.. A very high current ratio may not necessarily indicate a good situation. Further investigations are require non moving items of stock included in the closing stock or that there are no debts included in sundry debtors, which are outs may ideally be treated as bad debts.

6. Ratio analysis often gives a misleading indication if the effect of changes in price levels is not taken into account. Two diffe having the infrastructural facilities of different ages cannot be compared on the basis of financial statements only. This is so, as facilities years ago may be showing their value at a very lower amount while the other company might have purchased the sam

Precautions to be taken : Considering the various limitations in respect of ratio analysis, following precautions should be taken before using it as a techn

1. Ratios are compared on the basis of financial statements. If the statements are reliable, then only the ratios computed the ratio analysis, the reliability of the financial statements should be confirmed.

2. Ratio should be computed on the basis of inter-related figures which have a cause and effect relationship, computation of to wrong conclusions. E.g. ratio between sales and trade investments. 3. It should always be remembered that ratios only show symptoms and the indications given by the ratios can be interprete financial statements. E.g. a high current ratio should be treated as good sign only after confirming the fact that there are debtors.

4. If possible, the impact of the inflationary conditions or changing price levels should be taken into account before computin of current purchasing power or current cost accounting. 5. In case of inter-firm comparison of ratios following propositions should be kept in mind. a. The constituent units should be comparable in terms of size, age, nature of business, degree of automation, etc. b. The constituent units must be following similar accounting policies more particularly in the areas of charging the depreciatio c. There should not be any holding back of any information or data by the constituent units.

Illustrative problems 1. The current assets and liabilities of your company as at 30.6.2008 were rs. 16 lakh and rs. 8 lakhs respectively. Calcu individually and totally on the current ratio of the company:
Solution page no 81

2. The following are the figures extracted from the books of XYZ limited as at 30-9-2008 calculate 1. gross profit ratio, 2.Net profit ratio 3. return on assets 4.inventory turnover ratio 5. working capital turnover ratio Solution pg no 85 3. The following data are extracted from the published accounts of two companies in an industry. You are required to prepare a statement of comparative ratios showing liquidity, profitability, activity and financial position of Solution pg no 87 4.From the following information, draw the balance sheet of m/s. ravi and co. as on 31st March,2008 : solution pg no 90 5. Using the information and the form given below, compute the balance sheet for a firm having a sales of rs. 36 lakhs. Solution pg no 93 6. from the following figures of A ltd. Draw up balance sheet , sol pg no 96 7. From the following given ratios and figures, prepare a summarized balance sheet of excellent stock absorbers ltd. For the ye Summary

The technique of ratio analysis as technique of financial statements deals with computation of various ratios, by grouping appearing on the financial statements. Ratio analysis aids in assessing the firm in terms of their profitability and efficiency of p of other firms in the same industry. The ratios are broadly classified in six groups.

i. Liquidity group: the ratios computed under this group indicate the short term position of the organization and capital is being used. ii. sales. iii. iv. v. vi.

Turnover group: the ratios computed under this group indicate the efficiency of the organization to use the vari

Solvency group: the ratios computed under this group indicate the long term financial prospects of the company. Profitability group: these ratios are calculated to know the profitability of the organization. Overall profitability group: the ratios computed under this group indicate the relationship between the profits of th Miscellaneous group : this group includes Capital gearing ratio, Earning per share. Price earning ratio, dividend paym
Unit-5

Interpretation of Financial Statements (Funds Flow/Cash Flow Stat

5.1 Introduction

The traditional financial statement in the form of Balance Sheet gives the information of the assets and liabilities of a business as

However, the balance sheet itself does not take into consideration the fact that there exists certain fruitful relationship between and at the end of the said time. In order to locate this fruitful relationship, the knowledge of the techniques of the preparation of the funds flow statements( statement) is a must. Statutorily it is not required to prepare this statement, however considering the usefulness of the same, now a days many comp as a part of its Annual Statement of Accounts.

5.2 Concept of Funds The term fund is interpreted in many ways:

(1) Sometimes the term 'funds' means 'cash' and the funds flow statement prepared on this basis is in the form of a cash flow sta In other words cash flow statement is nothing else but the summary of Cash Book or Receipt and Payments Statement. (2) Sometimes the term fund is interpreted as cash equivalent i.e., cash and marketable securities. (3) The most accepted interpretation of the term 'funds' is in the form of working capital or net current assets.

It means that all those transactions which affect either the current assets or current liabilities will find the place in the funds flow s (4) A wider connotation of the term fund is found in the interpretation of the term 'funds' as a Resources Concept. This considers all the assets and all the liabilities in which funds are blocked. Uses/Advantages (1) Funds Flow statements determines the financial consequences of the business operations.

A business may be earning profits year by year still its liquidity position may deteriorate every year which may prove to be fatal f

The preparation of funds flow statement provide an answer to this critical position.

(2) The basic financial management principle is that the long term requirements of funds should be met out of long term source requirements of funds should be met out of short term sources of funds. From this context, funds flow statements may provide the answers to certain basic questions like: (a) Where did the profits earned go? (b) How was the increase in capital financed? (c ) How were the capital assets financed? (d) What happened to sale proceeds of assets? (e) What happened to proceeds of issue of the shares/debentures? (3) Now-a-days, obtaining the finance from the banks or Financial institutions has become inevitable. For this purpose, they have to be convinced about the repayment capacity of the company. The questions can be properly answered with the help of funds flow statements.

(4) Funds flow statements prepared on estimated basis for the future period enables the firm plan its financial resources properly

The firm can know how much funds it requires, how much can be raised internally and how much has to be arranged externally.

(5) The Funds flow statements prepared on estimated basis, before the commencement of the year when compared with the a about the fact that whether the firm is using its resources in the planned manner or not.

(6) Funds flow statement covering several years of operations of a company, enables the reader to know about the financial pol of funds from the operations for the growth of the company etc. It helps as a reliable guide for the future requirement of funds. Limitations:

(1) It is argued that funds flow statement does not provide any new information but only rearranges the various facts which alrea (2) It does not consider non-fund transactions. 5.3 Construction of Funds Flow Statement (a) Basic Principles: Following are the basic principles on which the construction of funds flow statement rests: (1) Any increase in Assets involves outflow of funds. (2) Any decrease in Assets involves inflow of funds. (3) Any increase in Liabilities involves inflow of funds. (4) Any decrease in Liabilities outflow of funds. (b) Process of construction:

The basic statements which are used while preparing the funds flow statement are the comparative Balance sheets as in two dif

The funds flow statements arranges the amounts appearing on the balance sheets, after some eliminations, combinations and re (a) Sources of Funds. (b) Application of funds. Following is the Proforma in which funds flow statement can be prepared: Sources 1) Issue of shares 2) Issue of Debentures 3) Receipt of Term Loans 4) Receipt of Fixed Deposits/Loans 5) Sales of Fixed Assets 6) Sales of investments 7) Non Operating Income 8) Operating Profit 9) Decrease in Working Capital OR Decrease in Current Assets OR Increase in Current Liabilities Total. . . Treatment of Special Items: (A) Operating Profit/Loss: It is calculated as below: Net profit as per Profit and Loss Account Add: 1) Depreciation on Fixed Assets 2) Preliminary Expenses written off 3) Goodwill written off 4) Loss on sale of Fixed Assets 5) Loss on sale of investment 6) Non-cash expenses or write offs 7) Non-recurring or Abnormal expenses 8) Non-operating expenses Less: 1) Profit on sale of Fixed assets 2) Profit on sale of investment Decrease in Current Liabilities Increase in Current Assets Applications 1) Redemption of shares 2) Redemption of debentures 3) Term Loan Repayments 4) Purchase of Fixed Assets 5) Purchase of Investments 6) Repayment of Deposit/Loans 7) Non Operating Expenses 8) Operating Loss 9) Increase in Working Capital

3) Non-recurring or Abnormal income 4) Non-operating income

Note:

If the net profit is taken as profit after amounts of transfer to reserves and dividends, those amount should also be added back affected.

(B) Statement showing changes in working capital:

While preparing the funds flow statement, it is customary not to show the variation in the items of current assets and current decrease in the net current assets (I.e. working capital to current assets less current liabilities) over a period of time. This total variation is verified by calculating the variations in individual items of current assets and current liabilities also. A Proforma is given below. Table - Page no 120 Following principles should be remembered: 1) An increase in current assets increases working capital. 2) An increase in current liabilities decreases working capital. 3) An decrease in current assets decreases working capital. 4) An decrease in current liabilities increases working capital.

(C ) Provision for tax or Advance tax: There can be two options to deal with this item. 1) Provision for tax my be treated as an item of current liabilities and advance tax as an item of current assets. Both these items will be routed through the statement showing changes in working capital. As such, the payment of tax made during the year will not be shown as application of funds. 2) Provision for tax may be added back to the profit as per Profit and Loss Account to arrive at the operating profits. Actual tax payments will be shown as application of funds. Neither the provision for tax nor Advance Tax will appear as the items of working capital while preparing the statement showing

(D) Dividend-Interim and Final: There can be two options to deal with this item.

1) Provision for proposed dividends may be treated as an item of current liability and will be considered for preparing statement The operating profit will be shown as source of funds net of proposed dividend.

2) Provision for proposed dividend and interim dividend is added back to the profit as per Profit and Loss Account to arrive at the Actual dividend paid Interim as well as Dividend for the previous year) will be shown as application of funds.

(E) Non recurring/Abnormal Income/ Expenses:

These items may involve flow of fund. However for clear disclosure purposes, they are shown separately on funds flow statemen

As such, non-recurring/abnormal income and non-recurring/abnormal expenses are shown as sources and applications respecti

However while computing operating profit, non-recurring/abnormal income is deducted from and non-recurring/abnormal expe account. 5.4 Cash Flow Statement While [preparing the funds flow statement, if the term 'funds' is interpreted as 'cash' the funds flow statement so prepared takes

Whereas the funds flow statement usually considers the transactions affecting the movement of working capital (i.e. either cur statement considers the movement only in respect of cash. The principles on the basis of which the cash flow statement is prepared are similar to those used for preparing the Funds Flow The way in which cash flow statement can be prepared takes the following form. Opening Cash Balance Add : Sources of Cash Inflow Less : Applications of Cash Closing Cash Balance In simple words the cash flow statement takes the form of receipts and payment statement.

However all the information required to prepare the cash flow statement in this form may not be available from the Annual Finan

As such, the cash flow statement is prepare din the same manner in which the funds flow statement is prepared with the differen working capital (as in case of funds flow statement), the increase or decrease in individual items of current assets and current liabilities are disclosed in the cash flow statement.

5.5 Illustrative Problems

1) Given below are the Balance Sheets of Liquid Ltd.

you are also informed that during 2007-2008

1) A machine costing Rs 7000 ( Book value Rs. 4000) was sold for Rs. 2,500. 2) 15% dividend was paid on equity capital in addition to preference dividend on opening balance of capital. 3) The preference shares were redeemed at the need of the year at 5% premium. 4) Depreciation written off Rs.7000 on fixed assets. Prepare funds flow statement. Solution : Page No:- 123

2) From the following balance sheet of A Ltd., prepare a funds flow statement for the year 2007-2008. Also shoe the schedule of

Solution : Page No:- 127

3) A company finds on 1st April 2008, that it is short of funds to implement its program of expansion. From the following informat Figures as per balance sheet as on 31st march of each year are as follows:

Solution : Page No:- 130

4) Balance Sheets of A Ltd. As on 31st December are as below:

1) Net profit for the year after making the provision for taxation Rs. 3,200 writing off preliminary expenses Rs. 720 and providing

2) A machine purchased for Rs.900 on 1.1.79 was sold for cash Rs. 300 on 1.1.87. Depreciation is provide don this machine at 1 4) During the year company paid dividend proposed for 86 and the interim dividend of Rs. 1000 for 87. The directors have directors have recommended a final dividend of Rs. 1,500 for the year 87. You are required to prepare: a) Statement of sources and application of funds. b) Statement showing changes in working capital. Solution : Page No:- 131

3) A portion of company's trade investment has become worthless and was written off to General reserve. Cost of such investme

5) Fair Deals Ltd. Presents the balance sheet as on -

You are informed that during 1984 1) Rs. 2,00,000 of debentures were converted into shares at par. 2) Rs 2,00,000 shares were issued to the shareholders as bonus shares, fully paid, out of reserves. 3) Rs. 1,00,000 shares were issued to a vendor of fixed assets who had supplied a machine costing Rs. 1,20,000. 4) A machine costing Rs. 50,000 book value Rs. 30,000 as on 31.03.07 was disposed off for Rs. 20,000. 5) Rs. 30,000 of marketable securities (cost) were disposed off for Rs. 36,000.

You are requested to prepare the fund flow statement of the company for 2007-08including the working capital in the beginning a Solution : Page No:- 134

6) The following is the balance sheet of KT Financiers Ltd.

1) The company declared a dividend of 20% on equity shares on 30.06.07 and on preference shares up to 30.09.07.

2) The company issued a notice to preference share holders for redemption at a premium of 5% on 1.10.07 and the entire proc call of Rs. 50 per share to make the shares fully paid. 3)The Company provided depreciation at 10% on closing balance of plant. During the year, one plant whose book value was Rs 4) There was no change in schedule of debtors as on 31.3.07. However as the company felt that certain debtors are doubtful of 5) Miscellaneous expenditure included expenses for Rs. 5 lakhs share issue and other expenses paid during the year. Prepare a statement of sources and application of funds for the year ended 31.3.08. Solution : Page No:- 138

7) Prepare a cash flow statement for the year end 31-03-08 from the following information in respect of ABC Ltd. Balance Sheet as at 31-3-08---- table at page no 141 The position of some items at 1-4-2007 as follows: RS 8% Debentures Creditors for goods Creditors for Mfg.exp Stock in trade NIL 2,00,000 15,000 1,80,000

Book debts Fixed Assets at Cost Investments Bank Balance as on 1-04-07( Overdraft) Solution : Page No:- 142

2,50,000 8,00,000 70,000 3,70,000

8) The balance sheets of Z Ltd. As on 31st March 2007 and 2008 are given below. Table page no 144 During the year 2007-08 the company 1) Sold one machine for Rs. 25,000 the cost of which was Rs.50,000 and the depreciation provided on it was Rs. 21,000. 2) Provided Rs. 95,000 as depreciation. 3) Redeemed 30% of the debentures at Rs. 103. 4) Sold some trade investments at a profit which was credited to the capital reserve.

You are require to prepare the statement of sources and applications of funds during 2007-08 showing the changes in working c Solution : Page No:- 145 5.6 Interpretation of Funds Flow Statement For the correct interpretation of the funds flow statement, the sources and application of funds can be categorized as below. (a) Sources: i) Long Term sources - Following types of sources may be treated as long term sources. - Issue of Shares/debentures. - Long Term borrowing of funds. - Operating Profit. - Sale of fixed assets. ii) Short Term sources - Following types of sources may be treated as short term sources. - short Term borrowing of funds. - Increase in current liabilities. - Decrease in current assets. (b) Applications: i) Long Term applications - Following types of applications may be treated as long term applications. - Purchases of fixed assets. - Redemption of preference shares/debentures. - Repayment of long term borrowings. ii) Short Term applications - Following types of applications may be treated as short term applications.

- Increase in current assets. - Decrease in current liabilities - Repayment of short term loans/deposits. - Dividends /Taxes.

After categorizing the sources and applications as above, a proper interpretation of the funds flow statement can be carried out a 1) Generally long term sources of funds should be used for long term applications. 2) Generally short term sources of funds should be used for short term applications.

3) In some cases, the long term sources of funds can be used for short term applications (e.g. investment in core current assets of funds should be used for long term applications. If the short term sources of funds are used for long term applications, it results into diversion o funds. it indicates that the funds raised are not utilized for the purpose for which they are intended.

It indicates that the funds which are repayable or adjustable in the immediate future, are applied for such purposes, the re immediate future but are likely to spread over a longer period of time. This indicates financial imprudence on the part of the organization. 5.7 Summary

Funds Flow Statement summarizes for a particular period the resources made available to finance the operations of an enterp put. Cash Flow statements are used to explain the cash movements between two points of time.

Whereas the funds flow statement usually considers the transactions affecting the movement of working capital (i.e. either Curr statement considers the movement only in respect of cash. Funds flow or Cash Flow statements may serve as supplementary financial information to the users.

Chapter 6 - Capitalization 6.1 Introduction

The assessment of the funds needed by the company should be done in such a way that the total amount of funds available sh As such, one of the most important financial decisions becomes the determination of the amount which the company sho required for fixed assets as well as the portion for current assets to be financed by the company out of long term sources.) This

Thus, the term capitalization means total amount of long term funds available to the company . In the words of Dewing " Capitalization includes capital stock and debt". Therefore capitalization includes shares and debentures issued by the company and also the long term loans taken from the fi The question arises regarding the inclusion of non-distributed profit in the capitalization

As far as earned profits remained to be distributed ( i.e. Reserves and Surplus ) are concerned ; it is necessary to classify them Capital Surplus will always be a part of total capitalization, though it is available for cash dividend under certain circumstances. Revenue surplus will be a part of capitalization , if the management wants to retain it in the business The importance of the determination of amount of capitalization need not be aver emphasized

The amount of capitalization should be only that much which can be justified by its profit and by the normal rate of return for If the company earns less than the other companies in the same industry, value of the shares of company will reduce and the c

For example, if the company earns an after tax profit of Rs. 20 lakhs and the other companies in the same industry ear expectation of investors will be the same from the company

As such, the ideal capitalization for the company will be Rs. 200 lakhs. If the actual capitalization is Rs. 250 lakhs, the after tax return for the company becomes 8% which is less than the industry sta As a result price of the shares of the company will be less than that of other companies in the same industry 6.2 Theories of Capitalization There are two important theories which act as guidelines for determining the amount of capitalization 1. Cost Theory

Cost Theory of capitalization considers the amount of capitalization on the basis of cost of various assets required o set up the It gives more street on current outlays than on the requirements which are necessary to accommodate the investment on a go The company may need the funds to invest in fixed and current assets and also to meet promotional and organizational expen The total sum required for all the purposes gives the amount of capitalization The cost theory of capitalization seems to be ideal as it considers the actual funds to acquire various assists, but it does not co If the amount of capitalization arrived at on the basis includes the cost of assets acquired at inflated costs or the cost of idle an the earnings are bound to be low which will not be able to pay favorable return on the cost of assets and this will result into ov Similarly, cost theory of capitalization may not be useful in case of a company with irregular earnings 2. Earnings Theory Earnings theory of capitalization considers the amount of capitalization on the basis of expected future earnings of the appropriate capitalization rate Thus, for determining the amount of capitalization , it is necessary to take the following steps : (a) To decide future earnings

Estimations of future earnings may be comparatively an easy task in case of established concerns as there can be some basis o In case of new concerns , estimating the future earnings is a difficult task While estimating future earnings, the following factors should be kept in mind

(I) Smaller the period, more accurate will be the estimations of future earnings. While estimating future earnings on the basis of past earnings, weighted average of past earnings may be considered giving ma

(ii) While considering future earnings on the basis of past earning, care should be taken to adjust the earnings on account of no made for known factors in future (iii) In case of new concerns, the estimations of future earnings depend upon correct estimation of future sales ( which in future costs

Allowance should be made for contingencies (b) To determine Capitalization rate

This is the most tricky and delicate issue and is entirely a subjective concept. The concepts of capitalization rate may take any o (I) It is the rate of return that is required to attract investors to the particular organization (ii) It is the cost of capital (iii) It is the rate of earnings of similar organizations in the same industry To capitalize the future earnings at the decided rate of Capitalization Following example will illustrate the working of earnings theory of capitalization 6.3 OVERCAPITALISATION page number 172

In simple terms over capitalization means existence of excess capital as compared to the level of activity and requirements For example, if a company is earning a profit of Rs. 50,000 and the normal rate of return applicable for the same industry is 10 should be rs 5,00,000 then the company will said to be over capitalized The term over capitalization should not be taken to mean excess funds. There can be a situation of over capitalization; still the Similarly the company maybe having more funds and still may be having a low earning capacity thus resulting into overcapitali Causes of over capitalization: The situation of over capitalization may arise due to various reasons as stated below: (1) The assets might have been purchased during the inflationary situations. A such the real value of the assets is less than the

(2) Adequate provision might not have been made for depreciation on the assets. As such, the real value of the assets is less th

(3) The company might have spent huge amounts during its formation stage or might have spent huge amounts for the trademarks, copyrights and designs etc As a result , the earning capacity of the company may be adversely affected

(4) The requirement of funds might not have been properly planned by the company. As a result, the company may have shortage of capital and to overcome the situation of shortage of capital, the company may which in its turn will reduce the earnings of the company (5) The company might have followed the lenient dividend policy without bothering much about building up the reserves As a result, the retained profits of the company may be adversely affected

(6) If there is a very high rate of taxation for companies, the company may not be having sufficient funds left with it for modern As such, the real value and the earning capacity of the assets will be lower

(7) There may be many instances , where the management of the company may arise large amounts by issuing securities, irres not, in order to take benefit of favorable capital marked conditions As a result, only the liability of the company increases but not the earning capacity

(8) According to the earnings theory of capitalization, the capitalization is the amount of earnings capitalized at a representativ As such, if the capitalization rate is wrong, the amount of capitalization will be wrong, in such a way that the lower the capitalization Effects of Overcapitalization

(1) On Company The real value of the business and its earning capacity reduces with the adverse affect on market value of shares. Credit standing of the company in the market falls down and its difficult to raise further capital. The temporary means like lower amount of depreciation and maintenance charges are followed to improve the earnings which (2) On Stakeholders

This is the worst affected class. The shares held by them are not having any backing of tangible assets Due to the reduced market values, the shares become non-transferable or are required to be transformed at extremely low pr (3) On Consumers

To overcome the situation of overcapitalization and to improve the earnings, the company may be tempted in increasing the s Due to this, the quality of products may also be affected (4) On Society at Large

The increasing selling prices and reducing quality can't be continued for a very long time due to the competition existing in the This situation means losing the backing of the share holders as well as the consumers As a result, the company is dragged towards the winding up which ultimately affects the society at large in an adverse way generated, unrest among the workers as a port of society etc Remedies Available In order to overcome the situation of overcapitalization, the company may resort to any of the following remedial measures

(1) To reduce the debts by repaying them. But the debts should be repaid out of the own earnings of the company There is no point in repaying the debts out of the fresh issue of shares or debentures as it does not reduce the amount of capit

(2) To redeem the preference shares if they carry too high rate of dividend (3) The persons holding the debentures may be persuaded to accept new debentures which carry lower rate of interest

(4) The par value of the equity shares may be reduced but this also will have to be done only after taking the shareholders into

(5) The number of equity shares may be reduced but this also will have to be done only after taking the shareholders into conf 6.4 UNDERCAPITALISATION

As against the indication of overcapitalization, the situation of undercapitalization indicates the excess of real worth of the outstanding

Thus, if a company succeeds in earning abnormally high income continuously for a very long period of time, it indicates sympto As such, undercapitalization is an indication of effective and proper utilization of funds employed in the business It also indicates sound financial position and good management of the company Hence it is said that "undercapitalization is not an economic problem but a problem in adjusting capital structure" Causes of Undercapitalization The situation of undercapitalization may arise due to various reasons as stated below

(1) Sometime, it may so happen that while deciding the amount of shares and debentures to be issued, the future earnings ma As a result , if the actual earnings turn out to be higher, capitalization of these earnings may be result into undercapitalization Similarly, use of low rate of capitalization for capitalizing the future earnings may also result in undercapitalization

(2) There may be cases where the earnings of the business come as a windfall This may arise during transition from depression to boom Thus while recovering from depression, the companies may find their earnings too high to result into the state of undercapital

(3) Sometimes, the company may follow a conservative policy for paying the dividends keeping aside more and more profit for As a result, the company may find itself to be in too high profiles and thus undercapitalization

(4) The company may be in the position to improve its efficiency through constant modernization programmers financed out o As such the earnings capacity of the company may increase to such an extent that the real value of the assets is much mor undercapitalization Effects of Undercapitalization (1) On Company

Financial stability and solvency of the company is not affected due to undercapitalization, but it still affects the company adver

(a) As earnings per share ratio is very high, it increases the competition unduly by creating a feeling that the line of business is (b) Increasing amounts of profits increases the tax liability of the company Marketability of the shares of the company gets restricted due to very high market prices of shares (d) Very high profitability of the company induces the employees to demand increase in wages, reduced working hours, more w (e) Very high profitability of the company creates a feeling among the customers that the company is charging very high prices They try to bring pressure on the company for reducing the prices of the product (f) Increasing profitability coupled with unrest among the employees as well as consumers increases the possibility of Governm This proves to be quite embarrassing for the company

(2) On Shareholders

Generally, the shareholders of an undercapitalized concerns are benefited Firstly, they get a very high dividend income regularly Due to the increasing share prices, the investment of shareholders in the company appreciates considerably which can be enca Secondly, in times of need, the shareholders may get loans on the security of these shares on easy terms due to high credit sta However, the shareholders of the undercapitalized concerns may suffer in the sense that the market for the shares is limited d (3) On Society

The effects of undercapitalization on the society as a whole may not necessarily be adverse ones. It may encourage new en expand This may increase the industrial production and reduce the unemployment problems The consumers may get a variety of products at competitive prices

However , society may not be benefited if the state of undercapitalization is not taken into right spirit If the feeling is developed among the workers and consumers that they are being exploited due to ever - increasing profitabili only the company itself but also the society as a whole Possibility of Government intervention and introduction of various control measures ( say in form of price control, dividend ce Remedies Available

The main indications about existence of the situation of undercapitalization is the ever increasing amount of earnings per share If the situation of undercapitalization is to be resolved, the company can take any of the following two measures in order to re (1) Issue of Bonus Shares

If the company has sufficient amount of reserves and surplus in hand, whole or a part of reserves and surplus may be capitalize As a result, number of shares as well as amount of share capital will increase the amount of reserves and surplus will be reduce It should be noted that it will affect neither the amount of capitalization nor the total income of the shareholders But it will reduce the amount of earnings per share

For example, Suppose that the present capitalization of the company comprise of Equity Share capital of RS. 1,00,000 ( Div reserves of Rs. 75,000

If the present earnings are Rs. 50,000,the present earnings per share will Rs. 50 i.e. Rs 50,000/1000 equity shares The company decides to issue 500 equity shares of Rs 100/- each as bonus shares As such, the equity share capital will increase to RS 150,000 and reserves will reduce to Rs 25,000 The earnings of the company will be considered against total of 1500 equity shares and as such, earnings per share will reduce (2) Splitting Of Shares

To overcome the situation of undercapitalization, the company may decide to split the shares in order to spread the earnings per share may be reduced

For example, suppose that the present capitalization of the company consists of Equity share capital of Rs. 1,00,000 ( divid present earnings are RS. 50,000

As such , present earnings per share will be Rs.50 , i.e. 50,000/1000 equity shares The company decided to reduce per value of shares by 50% and increase the number roof shares in the same proportion As such now the number of equity shares will become 2,000 and the earnings of Rs 50,000 will be distributed over 2,000 equ reduce to Rs 25/- i.e. Rs 50,000/2,000 equity shares 6.5 OVERCAPITALISATION VS. UNDERCAPITALISATION

If effects of both of these situations of overcapitalization and undercapitalization are studied and observed carefully, one will f

But the effects of overcapitalization are more serious which affect the company, shareholders, consumers and society at large situation is only the liquidation and winding up of the company, which is a very high cost for the company to pay Situation of undercapitalization increases the competition for the company, there is discontentment on the part of the emplo being exploited But the fact still remains that the shareholders and the society at large are benefited due to the increases prosperity of the com Naturally, if the choice is to be made between these two situations, undercapitalization will be a preferable situation As such a statement is usually made - " Both overcapitalization and undercapitalization are undesirable. Of the two , however, However, ideally the company should try to avoid the extremes of overcapitalization as well as undercapitalization It should ideally aim at fair capitalization or balanced capitalization 6.6 WATERED STOCK/WATERED CAPITAL

When share capital is not represented by the assets of equal value, the situation may mean introduction of water in the capita This situation may arise due to the following reasons

(1) The services of the promoters are valued highly and they are paid usually in the form of shares of the company. As such, sh

(2) Sometimes , the company pays the higher price to the vendors of the assets transfers i.e. price which is more than the wort

As such, possibility of the existence of the watered stock or altered capital can be treated to the intention of the promoters ho If the promoters deliberately acquire the assets at inflated prices, the situation of watered capital may exist 6.7.WATERED CAPITAL VS. OVER CAPITALISATION Sometimes, the terms watered capital and overcapitalization are confused with each other, but its not true The concept of watered capital is confined to the time of promotion of the company' Thus, at the time of promotion, the company is expected to acquire the assets at a price which justifies its real worth If the assets prove to be worthless or are bought at an inflate price, the situation of watered capital may exist

On the other hand, if the company has worked for several years and during these years has failed to earn sufficient earnings t in the state of overcapitalization

Thus, the existence of watered capital may be one of the causes of overcapitalization, but it is not inevitably the cause of ove the amount of capitalization though the capital may remain watered The following illustration may make the relationship between watered capital and overcapitalization more clear:

Suppose that a company issues and subscribes for 1000 equity share of Rs. 100 each (i.e. total equity share capital is Rs. 1,00,0 assets of the company, the real value of which is only Rs. 75,000 It means that the company is watered to the tune of Rs 25,000 The company operates for six years during which it has earned the average profits of Rs 16,000/ If the earnings are capitalized at the rate of 5% , the capitalized value of earnings will be Rs 3,20,000 It means that the company will be having watered capital but it will not b overcapitalized

Now suppose, that the original amount of Rs. 1,00,000 is used by the company to purchase fixed assets, the real worth of whic It means that there is no watered capital However after operating for six years the company is able to earn the average profits of only Rs. 3,000 If the earnings are capitalized at the rate of 5%, the capitalized value of the earnings will be RS. 60,000 It means that the company has no water in capital but it is overcapitalized 6.8 SUMMARY

Capitalization refers to the total amount of funds which a company should possess for conducting its business activities The capital available with the company should be justified by its profits as well as the normal rate of return for the industry con Cost theory of capitalization considers the amount of capitalization on the basis of cost of various assets required to set up and Earnings theory of capitalization considers the amount of capitalization on the basis of expected future earnings of the appropriate capitalization rate Overcapitalization means existence of excess capital as compared to the level of activity and requirements Undercapitalization indicates the excess of real worth of the assets over the aggregate of shares and debentures outstanding Both overcapitalization and undercapitalization are undesirable

Of the two, however, overcapitalization is more fatal and dangerous When share capital is not represented by the assets of equal value, the situation may mean introduction of water in the capita

7. Sources of Long Term and Medium Term Financ

7.1 Introduction
While discussing about capitalization, we have seen that the amount of long term capital should not be less than requirement There should be a situation of what can be called as fair capitalization. The next question which arises is what should be the various sources from which the long term capital may be raised?

The various sources from which a company may meet its long term and medium term requirement of funds are discussed unde a. Shares b. Debentures c. Term Loans d. Public deposits e. Leasing and Hire purchase f. Retained earnings

7.2 Shares

A share indicates a smaller unit into which the overall requirement of capital of a company is subdivided. For example, if the capital required by a company is Rs. 10 Crores , it can be subdivided into 1 crore smaller units called as 'sh each, which in technical words is referred to as 'face Value' or 'nominal value'. In the Indian circumstances, the face value or nominal value can be decided by the company of its own. Generally, found face value or nominal value is Rs. 10 or Rs. 100 each share. In the Indian circumstances, a company can raise the long term funds by issuing two types of shares. a. Equity shares b. Preference shares

Equity shares These are the corner stones of the financial structure of the company. On the strength of these shares, the company procures other sources of capital. Equity shares as a sources of long term funds for the company has the following characteristics features: 1. Investors in the equity share are the real owners of the company. As such, the investors in equity shares are entitled to the profits earned by the company or the losses incurred by the company 2. Funds raised by the company by way of equity shares are available on permanent basis. In other words, funds raised by the company by way of equity shares are not required to be rapid by the company during the li They are required to be rapid only at the time of closing down of the company i.e. winding up of the company. 3. Funds raised by the company by way of equity shares are available to the company on unsecured basis i.e., the company do investors in equity shares. 4. Return which the company pays on equity shares is in the form of dividend. The rate of dividend is not fixed. It generally depends upon the profits earned by the company.

However, a profit making company is under no obligation to pay dividend on equity shares. 5. Equity shares as a source of raising the long term funds is a risk free source for the company, as the company does not comm 6. Equity shares as an investment is very risky for the investors. As such, the investors are granted the voting rights. By exercising the voting rights, the investors can participate in the affairs regarding the business of the company. These voting rights are generally proportionate voting rights, in the sense the voting rights of the investors are in propor company. However, it should be noted that due to some recent amendments to the Companies Act, 1956, it may be possible disproportionate voting rights. 7. Equity shareholders may not be able to compel the company to pay the dividend, but they enjoy the right to maintain the the company.

As such, if the company wants to issue additional equity shares, it is under legal obligation to offer these equity shares to th market as a general offer. This right of equity shareholders is called 'pre-emptive right' 8. In financial terms, equity shares as a source of raising funds is a costly source available to the company. The reason for this will be discussed in the following paragraphs.

Advantages of equity shares To the company while issuing the shares, the company does not accept any obligation of any type. The company neither offers any security to the investors in the form of the assets of the company nor commits the repayme nor commits the payment of any dividend to the shareholders. This is a total risk free source of capital for the company.

To the investors a. As per the law, the liability of the equity shareholders is restricted only to the extent of face value of the shares purchased b The personal properties of the investors are not at stake even if the company fails to fulfill its contractual obligations. b. Possibility of getting higher returns is always there in case of equity shares. The investors can gain from equity shares in two forms. Firstly, the regular dividend paid by the company in the form of cash or by the way of bonus shares. Secondly, the capital appreciation received by the investors by selling the equity shares in the secondary market i.e., stock exch As such, equity share are a good investment attracting the risk making investors.

Disadvantages of Equity shares a. As the investors in equity shares enjoy the voting powers to control the affairs of the company, the management of the getting interfered and disturbed in the regular administration. b. The cost associated by the equity shares is on the higher side as compared to the borrowed capital. By issuing more and more equity shares, the company loses the cost advantage. c. Many categories of investors i.e. institutional investors may not be able to invest in the equity shares due to various statutor d. The excessive issue of equity shares may result in over capitalization to be realized in future. Preference Shares These are the shares which enjoy preferential treatment as compared to the equity shares in respect to the following factors:

a. Unlike the case of equity shares, the preference shares carry the dividend at a fixed rate which is payable even before any di b. In the case of winding up of the company, preference shareholders are paid back their investment even before the investme

Preference shares as a source of funds for the company involves the following characteristics features: 1. Investors in preference shares are not absolute owners of the company 2. Funds raised by the company by way of preference shares are required to be repaid during the existence of the company. As per the provisions of Section 80 of the Companies Act, the company can issue the preference shares maximum for the dura As such , unlike equity shares, preference share is not a permanent capital available for the company. 3. like in case of equity shares, funds raised by the company by way of preference shares are available to the company on uns assets by way of security to the investors in preference shares.

4. Return which the company pays on preference shares in the form of dividend which is payable by the company out of the pr However, unlike the case of equity shares, the rate of dividend is prefixed and precommunicated to the investors. 5. As compared to equity shares, risk on the part of company is more in case of preference shares. 6. Preference shares as an investment is comparatively less risky for investors. As such, generally, preference shares do not carry any voting rights and hence they do not have any say in controlling the affai However, Companies Act, 1956 provides voting rights to preference shareholders in the following circumstances. a. If any resolution directly affecting the rights to the preference shareholder is discussed by the equity shareholder ( for exam capital etc.) , the preference shareholders can vote on such resolutions. b. If the dividend has not been paid on the preference share, in case of cumulative preference shares for the aggregate preference shares, either for a period of two consecutive years or for an aggregate period of two consecutive years or non=cumulative preference shares, either for a period of two consecutive year or for an aggregate period of the three year shareholders can vote on all the matters before the company in the meeting of the equity shareholders...

Protection of interests of Debenture holders Recent amendments to Companies Act, 1956 have made some provisions with the intention to protect the interests of the deb a. A Company accepting the funds from debenture holders shall appoint one or more debenture trustees and in Prospectus or debentures trustee or trustees have given their consent to the company to act in the same capacity. The debenture trustee will be primarily responsible to ensure that the interests of the debenture holders are protected ( inclu debenture holders are effectively redressed. To be more specific, the debenture trustee should make the following effective steps: I) To ensure that the assets of the company and of the guarantors are sufficient to discharge the principal amount at all times. If it is concluded that the assets of the company are insufficient to discharge the principal amount, the trustee may file a petit both the parties, may impose restrictions on the incurring of any further liabilities by the company. ii) to Satisfy himself that the prospectus or the letter of offer does not contain any matter inconsistent with the terms of deben iii) To ensure that the company does not commit any breach of the provisions of the trust deed. iv) To take steps to remedy any breach of provisions of trust deed or terms of issue of debentures. v) To take steps to call meeting of the debenture holders as and when required.

b. The trust deed for securing the issue of debentures should be executed in the prescribed form and within stipulated period. This trust deed shall be open for inspection by any member or debenture holder of the company and he can take the copies of

IF the trust deed is not made available to the member or the debenture holder, the company and every responsible officer w 500 per day during which the offence continues.

c. A company issuing debentures is required to create debenture redemption reserve for the redemption of debentures and e reserve out of the profits until such debentures are redeemed.

The amount standing to the credit of debenture redemption reserve shall be available only for the redemption of debentures. IF the company fails to redeem the debentures on the date of maturity, on the application of any or all the debenture holde pay the principal amount of debentures and the interest thereon. In case of any default in complying with the order of Company Law Board, every responsible officer shall be punishable with a the offence continues.

7.4 Term Loans

Term loans indicate liabilities accepted by the company which are for the purpose of purchasing the fixed assets and are repay The term loans may be granted by the Banks ( Nationalized, cooperative, rural, etc) or the Financial Institutions like Industrial D Investment Corporation of India (ICICI) , Industrial Finance Corporation of India ( IFCI) etc. Features of Term Loans 1) Banks or Financial institutions grinding the term loans are not at all the owners of the company. They are creditors of the company. They lend the funds to the company.

2. Term loans are required to be repaid during the life time of the company at the predecided intervals say monthly, quarterly, The initial gap after which the repayment of term loan starts ( technically referred to as the moratorium period) also depends and the lending bank or financial institutions.

3. The term loans may be secured or unsecured, though normally all the term loans are secured. The security which is offered for the term loans is the hypothecation or mortgage of the fixed assets purchased with the help o

4. Return payable by the company on term loans is in the form of interest which may be calculated on monthly or quart outstanding balance of the term loan. The interest on term loan is payable despite the non-availability of profits.

5. Term loans as a source of raising long term funds is very risky from the company's point of view. The risk accepted by the company in case of long term loans is twofold. One, to pay the interest at the predecided rate and at predecided time intervals irrespective of non-availability of profits and S

6. Risk on the part of lending bank or financial institution is very less in case of term loans. The banks or financial institutions being the creditors of the company, they can not control the affairs of the company. As such, they do not have any voting rights. However, in the event of non-payment of interest or principal amount, they can interfere in the operations of the company by

7. In financial terms, as in case of debentures, term loans also prove to be a cheap source of funds from the company's point o The reason for this will be discussed in the following paragraphs. Operational Formalities

Term loans is a contract between the borrowing company and lending bank or financial institutions . This contract is a written contract referred to as 'term long agreement', The term long agreement stipulates the various terms and conditions on which the relationship between the borrowing regulated. Term loan agreement has various clauses. 1. Amount of loan and the period of repayment. 2. Rate of interest payable and the method of payment of interest. 3. Nature of security offered.

In addition to the general security offered for the term loans, the agreement may provide far certain additional covenants in o These covenants may take various forms, some of which are stated below: 1. That the borrowing company will submit the copy of annual accounts to the lender, soon after they are finalized. 2. that the assets purchased with the help of term loans will be properly maintained and insured by the borrowing company. 3. That the lender may have representative on the Board of Directors of the company ( viz. Nominee Director) if the loan amou 4. The lender will like to ensure that the borrowing company has the liquid resources in its hands whenever the interest or the As such, the lender will like to confirm that the liquid resources of the company are not blocked for unnecessary purposes. Hence, the agreement may stipulate thata. The company will not pay dividend without the consent of the lender. b. The company will not make long term loans to directors/officers. c. The company will not invite in outside corporate securities. d. The company will not redeem the data before maturity.

7.5 Public Deposits

In the recent past, Public Deposits has become one of the most important sources available to the companies for meeting the The companies find public deposits as an attractive source mainly due to the following reasons: a. Raising the funds in the form of public deposits is more convenient than borrowing the funds from banks and financial instit Borrowing the funds from banks or financial institutions is a tedious job involving the compliance with may procedural re requirements, submission of periodical statements etc. None of the procedural requirements are required to be compiled with in case of public deposits.

b, The rate of interest which the company required to pay on public deposits is comparatively less then the rate of interest p institutions. c. Public Deposits are unsecured borrowing for the company. d. The company can raise the funds in the form of public deposits which can be used for any purpose. The end use of the funds raised in the form of public deposits is not committed by the company. e. In the situations of credit squeeze introduced by the banks, public deposits plays a very important role.

Control over Public Deposits The phenomenon growth of public deposits as a source funds to the companies was an issue of concern for the government. the non-priority sectors to grow.

As such, the deposits of the Governments owned agencies like banks, UTI, LIC etc. were diverted to public deposits. Hence, it was thought necessary to exercise control over the growth deposits as a source of funds for the companies . This came into application by the introduction of Section 58A and 58B to the companies Act, 1956 vide Amendment Act, 1974 Deposits) Rule , 1975 which applies to the companies which are not Non-Banking Finance Companies ( NBFCs). The main provisions of these regulations are discussed below -

Applicability:In the word 'Deposits', all types of loans and deposits are covered, however the following deposit are excluded. a) Any amount received from the Government, Local Authority and Foreign Government/Citizens/Authority/Person and a government. b) Any loans from banks/financial institutions c) Amount received by a company from another company. d) Security deposits from employees. e) Advance for purchase or sales. f) Amounts received for subscribing to shares/debentures pending allotment. g) Amounts received in trust or amounts in transit. h) Amounts received from directors or from shareholders of a Private Limited Company.

Acceptance of Deposits: While accepting the deposits, the company will have to comply with the following requirements. a) No company shall accept any deposit which is repayable on demand. b) Minimum period which any deposit can be accepted will be 6 months and the maximum period will be 36 months. Note: A company, may , for the purpose of meeting its short term requirements of funds, accept the deposits for a period of le amount should not exceed 10% of paid up share capital and free reserves. c) The maximum amount of deposits which a company may accept will be 25% of the aggregate of paid up share capital and fr from a shareholder of non-private limited companies or should be guaranteed by any director. d) The maximum interest which a company can pay on its deposits depends upon the maximum rate of interest prescribe Finance Companies can pay on their public deposits per annum at rests which shall not be shorter than monthly rests. As per the prevailing guidelines applicable to Non-Banking Finance Companies (NBFCs), the maximum rate of interest whic annum at rests which shall not be shorter than monthly rests.

In case of the deposit which has matured but remains to be paid, the company will be liable to pay the penal interest @ 18% p If the deposit is accepted from a 'small depositor', the penal interest is payable @ 24% per annum. e) The maximum amount of brokerage which a company may pay on deposits accepted will be the following percentage of dep 1% for deposits up to one year 1.5% for deposits up to two years 2% for deposits up to three years Notes: Free reserves as mentioned above will include capital redemption reserve and share premium but will not include: I) Accumulated loss amount, deferred revenue expenses, and other intangible assets. ii) Revaluation reserve iii) Depreciation reserve or bad debts reserve. Maintenance of liquid assets:

Every company , before 30th day of April every year should deposit or invest, a sum equal to at least 15% of the deposits following in the form of

I) Current or other deposit account with any Scheduled Bank ii) Central or State government Securities iii) Bonds issued by Housing Development Finance Corporation Limited. The amount so deposited or invested shall not be utilized for any purpose other than repayment of deposits maturing during t

Advertisement: If a company decides to invite the public deposits, it should publish an advertisement in a leading English newspaper and in on registered office of the company is situated. Such advertisement should be issued on the authority and in the name of the Board of Directors of the company and should directors has approved the text of the advertisement.

The advertisement should contain the following details. a) Name of the company b) Date of incorporation of the company c) Business carried on by the company and its subsidiaries with the details of its branches or units, if any. d) Bride particulars of management of the company. e) Names, addresses and occupation of the Directors f) Profits before tax and profits after tax, for the three financial years immediately preceding the date of advertisement. g) The amount of deposits which can be raised by the company and the aggregate of deposits actually held on the last day of th h) Summarized financial position of the company ( in the form prescribed by Schedule VI of the Companies Act, 1956) as in t the date of advertisement. I) A statement to the effect that on the date of advertisement, the company has no overdue deposits other than the unclaime overdue deposits. j) A declaration to the effect a) That the company has compiled with the provisions of these rules. b) That the compliance with these rules does not imply that repayment of deposits is guaranteed by the Central Government. c) That the deposits accepted by the company are unsecured and rank pari passu with the other unsecured liabilities. d) That the company is not in default in the repayments of deposits and interest thereupon in accordance with the terms and c

Before the advertisement is issued, a copy of the same, signed by a majority of the Directors, Should be delivered to the Regist the advertisement so issued shall be valid until the expiry of six months from the date of closure of the financial year in which before the company in a general meeting, and if the Annual General Meeting has not been held, the last day on which the mee

If a company wants to accept the deposits without making public invitation, before accepting the deposits it should deliver a Companies. Such statement in lieu of advertisement attracts the same provision as applicable to the advertisement as to the contents and

Application form: A company can accept or renew deposits, only on application being made by the intending deposits,. such application form shall be accompanied by a statement made by the company containing all the particulars stated under th

Deposit Receipt: After accepting the deposits, every company should furnish to the depositor, within the period of 8 weeks from the date of r receipt containing the following particulars: I) Date of Deposit ii) Name and Address of depositor iii) Amount of deposit iv) Rate of interest v) Date of maturity.

Deposit Register: Every company accepting the deposits should maintain registers, at the registered office, showing the following particulars. I) Name and Address of depositor ii) Date and amount of the deposit. iii) Duration of deposit iv) date of repayment v) Rate of interest vi ) Date or dates on which interest is payable. vii) Any other particulars.

Prepayment of deposits If a deposit is repaid after 6 months of the date of deposit but before its expiry, the rate of interest on such a deposit shall would have paid had the deposit been accepted for the period for which such deposit had run. Annul Returns The companies to whom these rules apply, are required to file the Registrar of Companies, a return in prescribed form, on contain information of deposits as on 31st March of the year. Such return should be duly certified by the auditor of the company. A Copy of this return is required to be send to Reserve Bank of India

Protection of Interests of Depositors: Section 58-A of the companies Act, 1956, makes the provision for the protection of interests of depositors. The said section provides that if a company fails to repay any deposit or any part thereof as per its terms and conditions, the C company to make the repayment of such deposit or the part thereof forthwith or within such time and subject to such conditio

Such action can be taken by the Company Law Board on its own motion or on the application of the depositors. However, before making the order, company law Board should give reasonable opportunity of being heard to the company an

It is further provided that whosoever fails to comply with the order of the company Law Board shall be punishable with imp also be liable to a fine of not less than Rs. 500 per day during which such non-compliance continues. Provisions to protect the interests of small depositors: Companies Amendment Act, 2000 has made certain provisions to protect the interest of small depositors . A 'Small Depositor' means a depositor who had deposited in a financial year a sum not exceeding Rs. 20,000 in a company.

The provisions are stated below: a. Every company accepting deposits from the small depositors shall inform the Company Law Board of any default made thereon.

b. A company shall not accept any further deposit from the small depositor unless each small depositor whose deposit has m interest thereon.

c. Every company who has defaulted in the repayment of deposit or the repayment of interest thereon to a small depo application form inviting deposits from the public, the total number of small depositors and the amount due to them in respec

d. IF any interest accrued on the deposits of small depositors has need waived, the fact of such waiver shall be mentioned by form inviting deposits issued after such waiver.

e. Every application form issued by the company to a small depositor shall contain a statement stating that the applicant has b 1) Every past default of the company in the repayment of deposit or interest thereon, if any such default has taken place. 2. The waiver of interest if any and reason thereof. f. If anybody knowingly fails to comply with the above requirements or fails to comply with any order of company Law Board three years and shall be liable to pay fine of not less than Rs. 500 per day during which default continues. Point to be noted here is that the above provisions apply only in case of small depositors and not in case of larger depositors.

7.6 Lease Financing

In the recent years, the lease financing has emerged as one of the most important sources of long term financing. Under the leasing agreement, the company acquires the right to use the asset without holding the title to it. Thus, it is the written agreement between the owner of the assets, called 'the Lessor' and the user of the asset, called 't economically use the asset for a specific period of time but the title of the asset is retained by the Lessor. This economical use of the asset is permitted by the Lessor on the payment of periodical amount which is in the form of 'lease

Lease Agreement or Lease Deed: Lease Agreement/deed is the most important document in any leasing activity as it starts the legal relationship between the Le

The usual contents of the lease agreement/deed are as stated below: 1) Descriptor and cost of equipment to be acquired. 2) Commencement date of lease contract 3) Amount of lease rentals and mode of payments. 4) Fixed period of lease, renewal options and the terms during secondary period as to the amount of lease rentals or purchase Note: After the fixed period of lease, the lessee is usually given the option either to render the lease from time to time at a n which is reasonably lower than the fair value of the asset.

5) Guarantee for repayment of lease rental by lessee. 6) Variation o lease rentals. 7) Termination of the lease agreement in the event of certain occurrences. 8( In order to protect the interest of the Lessor and lessee, certain covenants as stated below may also be incorporated as a pa I) That lessee will maintain the asset in good working condition and pay all taxes, insurance, etc ii) that lessee will not sell or mortgage or charge the land or building on which equipment is installed without notifying the Less iii) That lessee will not claim any grant or relief available to the Lessor.

iv) That lessee will not alter or modify equipment without the lessor's knowledge. v) that lessee will accept the lessor's right to inspect the equipment.

Advantages of leasing for the lessee: 1) risk of ownership: Leasing facilitates lessee to avoid the risks attached with the ownership o the equipments , say ri technologies.

2) Saving of Capital outlay: Leasing enables lessee to make full use of the asset without making immediate repayment of the him.

some lessor's may also finance to the extent of 100% of the cost of the equipment where lessee is not required to make provis 3) Tax advantages: Under the leasing r-propositions, the payment of lease rents is the tax deducible expenditure. On the other hand, if the company decides to own the same asset by resorting to the borrowing, the expenses which are avai depreciation and interest on borrowing.

4) Structuring of lease rents: Lessor's may structure the payments of the lease rents in such a way that it matches the revenue may not be possible if the lessee resorts to borrowing for owing the asset.

5) No Effect on borrowing power: AS the obligations accepted by the lessee under the lease deed appear nowhere on the bala still remains unaffected ted. The lessee may still resort to debt capital provided equity base of the company permits further borrowing. 6) Convenience: Leasing is the quickest method of financing the requirements of long term capital and lessee is relieved from and conditions involved in other forms of term borrowings say term loans.

Evaluating of lease financing the alternative of leasing can be evaluated under the following headings: a) Does leasing increase borrowing capacity of a firm. The answer to this question is Yes, For example, suppose that at presen is rs. 200 lakhs which re financed by way of equity shares of rs. 100 lakhs and rs 100 Lakhs by way of debentures. AS such the present debt equity ratio is 1:1. Now, if the company wants to acquire further fixed assets worth rs 100 lakhs, it can purchase it outright by financing the sa ratio will be 2:! Which is inevitably mean reduced borrowing capacity. IF the company decides to take these assets on lease, its debts equity ratio will remain unaffected as it gets only the right use o

As such, due to lease transactions, the debt equity ratio of the company remains unaffected which indicates borrowing capacit however, with greater sophistication in the financial appraisal and improved financial disclosure practices, leases are likely to b

b) Does leasing release the firm from bad investment. An investment may turn out to be bad if the basic purpose for which it is made is defeated. For example, investment made by a company in a machine may turn out to be bad if the machine becomes obsolete or non-us

Under these circumstances it can be said that leasing releases a firm from bad investment as in case of leasing, the risk of obs the asset, and the funds of the firm may be used for more profitable purposes.

However, this argument may not be valid under all the circumstances. Lessor, if aware of the risk of obsolescence, may charge the lessee for bearing the risk and it will be in the form of higher amou Types of Leases:

a) Financial Lease: In this type of lease, the Lessor acts as a financier. Lessee selects the asset and bears the cost of repairs, maintenance and insurance of the asset. Lessor reserves the right to confiscate the asset in the event of any default on the part of lessee. The Lessor recovers a major part of the cost of asset by way of lease rent during the lease period; the Lessor agrees to transfe nominal price which is referred to as 'repurchase price'. This type of lease is also referred to as 'Capital Lease'.

b) Operating Lease In this type of lease, the lessee gets a limited right to use the asset. Lessor selects and purchases the asset and leases the same to the lessee. Lessor bears the cost of repairs, maintenance and insurance of the asset. Operating lease is for smaller duration of time and imposes no longer term obligation either on the Lessor or on the lessee. The lease rent paid by the lessee doesn't to contain any part towards the cost of the asset. After the lease period is over, the possession of the asset reverts back to the Lessor who can lease out the asset to another par The lease deed is cancellable at the option of the Lessor or the lessee after giving specific notice.

c) Sale and Lease Back In this type of lease, the lessee purchases the asset of his own choice and then sells the same to the Lessor. ON the sale of asset to the Lessor, the ownership of the asset gets transferred to the Lessor. Lessor then leases out the same asset to the lessee. After this stage, it becomes a routine lease transaction both for the Lessor as well as for the lessee. In practical circumstances, this type of lease is very regularly found in case of some old asset which used by an organization for To explain the concept of sale and lease back. Let us take an example.

company A has purchased an equipment 10 years back for an amount of Rs 5,00,000 and has been using the same since then, After providing the depreciation for the last 10 years, written down value of the equipment in the books of the company is onl This equipment is sold by the company to a leasing company for an amount of Rs. 5,00,000. Leasing company pays the purchase consideration of Rs. 5,00,000 to the company and leases back the same equipment to the In this arrangement , both the company as well as the Lessor are benefited. The company gets benefited as the company receives an amount of Rs. 5,00,000 for an equipment which is 10 years old withou For Lessor, it is a business proposition. Being a lease transaction, the Lessor can claim the depreciation on the asset leased out by him. Under ideal circumstances, Lessor should be able to claim the depreciation on Rs. 5,00,000 being the consideration paid by the However, in the light of recent amendments made to the Income Tax act, 1961, the Lessor can claim the depreciation on R asset in the books of the company at the time of transfer of the asset to the Lessor.

7.7 Hire Purchasing

Nowadays, in addition to Lease Financing, Hire purchasing is also emerging as a popular source of long term financing where facilities, say fixed assets. IT will be pertinent to note here the relationships between lease financing and the hire purchasing.

Hire purchase indicates an agreement between the owner of the goods, called as 'the hiree' and the user of the goods, called the hirer but the ownership of the goods remains with the hiree.

In return, the hirer makes the periodical payments of hire charges which are partly against the capital repayment and partly ag For accounting and tax purpose, only the interest is treated as revenue expenditure and is considered to be a tax deductible ex The hirer capabilities the asset purchased under the hire purchase agreement thought he is not the owner of the assets. Depreciation is considered by the hirer as an expenditure, debiting the same to profit and loss account and hence becomes the The further hire purchase installments towards capital which are not yet due are shown as liability on the Balance Sheet. After the hire charges are paid by the hirer in full, he gets an option of purchasing of asset entirely in which the installments the ownership of the asset is transferred to the hirer

If the hirer fails to pay any installment\not, hiree can take the possession of the asset without refunding any installment paid e It is the duty of the hirer to keep the asset in good condition.

As such, the hiree may stipulate that the asset should be properly insured, the premium being paid by the hirer. Further, it may also be stipulated that the hirer will not sell or exchange the asset till he becomes the owner of the asset. The hirer has a right to put an end to the agreement before the last installment is paid, but the installments paid by him previo

Accounting for leasing and hire purchase: It can be seen from the above discussion that leasing and hire purchase are similar to each other in certain respects. In both the cases, right to use the asset is available to the lessee or hirer but ownership of the asset remains with the Lessor o

Accounting of lease transactions from lessee's point of view. Accounting implications of lease transaction need to be considered from financial accounting point of view as well as from inco For financial accounting, the provisions of accounting standard 19 (AS19) are relevant.

From financial accounting point of view, the lease rent paid by the lessee in respect of the operation lease is treated as r account. for income tax purposes also the same is treated as revenue expenditure which reduces the taxable profits of the lessee.

From financial accounting point of view, the lease rent paid by the lessee in respect of the financial lease is split into two parts The finance charges are treated as revenue expenditure and debited to profit and loss account and principal amount is used inception of lease. At the time of inception, the asset is capitalized in the books of the lessee at the present value of committed lease rent and balance sheet.

Depreciation is calculated by the lessee as per his depreciation policy. for income tax purpose, the lease rent paid by the lessee is treated as revenue expenditure which reduces the taxable profits o

Accounting of hire purchase transactions a) Entire amount of hire charges paid by the hirer by to the hiree are not considered to be revenue expenditure in the books of The hire charges paid by the hirer are split as the payment against capital repayment and the payment against the interest. The component of interest payment against the capital repayment reduces liability for the hirer.

b) Asset taken by the hirer on hire is capitalized in the books of hirer, though the ownership does not transfer to the hirer till th

Only the payment against interest payment is a tax deductible expenditure for the hirer. Similarly, liability for the future hire charges is also disclosed as the liability on the balance sheet of the hirer. hirer claims the depreciation on the asset taken by him on hire purchase and the same is treated as a tax deductible expenditu Thus, unlike in case of leasing transactions, hire purchase is not a 'off the balance sheet mode of financing' for the hirer.

7.8 Retained Earnings

Retained earnings or ploughed back profits is one of the best source of raising long term funds for the company. It indicates that whatever profits are earned by the company are not distributed by it by way of dividend but are kept aside for

If the company follows a regular policy of ploughing back of profits i.e. keeping aside profits without distributing them, the sha As such , while deciding the amount of profits to be retained, the company has to be very careful, about its consequences on t of the shares.

7.9 Summary

The long term finance refers to the permanent sources of finance or finance available for a long period such as more than 10 y The financial sources are broadly classified into share capital (both equity and preference) and debt ( including debentures, lon

Equity shareholders are the owners of the company and company pays dividend to equity shareholders as consideration for th Preference shareholders are not the absolute owner of the company but they have the preferential right of receiving dividend Preference shares are to be paid dividend at a fixed rate. These shareholders have no voting rights.

Debentures refers to a document containing an acknowledgement of indebtedness issued by the company and a fixed rate of i Generally, debentures are secured against the asset of the company. A public limited company can only accepts deposits from public. Public deposits are unsecured borrowing for the company. In lease financing, the company acquires right to use the asset without holding the title to it and lease agreement or lease deed In hire purchase agreement, the ownership is not transferred but goods are transferred for use to the other party against a per Retained earnings indicates that whether profits are earned by the company are not distributed by it by way of dividend but a other purposes.

Unit 8 - Capital Structure

8.1 Introduction

After considering the various sources in which the long term requirements of the funds can be met, the next question which ar various sources of long term finance should be used in order to raise the required amount of capital Here comes into picture the decision regarding capital structure

Capital structure refers to the mix of sources which long term funds required by a business are raised i.e. what should be th capital, internal sources, debentures and other sources of funds in the total amount of capital which an undertaking may raise fo 8.2 Goals / Principles of capital structure management

for considering the suitable pattern of capital structure, it is necessary to consider certain basic principles which are related to giving proper weightage to each of them 1. Cost principle according to this principle, ideal capital structure should be minimize cost of financing and maximize earnings per share debt capital is a cheaper form of capital due to two reasons first the expectations of returns of debt capital holders are less than those of equity shareholders secondary interest is a deductible expenditure for tax purposes whereas dividend is an appropriation of profits 2. Risk principle

according to this principle, ideal capital structure not accept unduly high risk. Debt capital is a risky form of capital as it involve repayment of principle sum irrespective of profit or losses of business if the organization issues large amount of preferential shares out of the earnings of the organization less amount will be left for are required to be paid before any dividend is paid to equity shareholders raising the capital through equity shares involves least risk as there is no obligations as to the payment of dividend 3. Control Principle according to this principle, ideal capital structure should keep controlling position of owners intact Issue of equity shares disturb the controlling position directly as the control of residual owners is likely to get diluted 4. Flexibility principle according to this principle, ideal capital structure should be able to cater to additional requirement of funds in future

As preference shareholders and holders of debt carry limited or no voting rights, they hardly disturb the controlling position of the

If a company has already raised too heavy debt capital, by mortgaging all the assets it will be difficult for it to get further loans i will have to depend on equity shares only for raising further capital organization should avoid capital on such terms and conditions which limit the company's ability to procure additional funds

if the company accepts debt capital on the condition that it will not accept further loan capital or dividend on equity shares will no 5. Timing principle

according to this principle, ideal capital structure should be able to seize market opportunities, should minimize cost of raising fu during days of depression, debt capital may be used to raise the capital as investors are afraid to take any risk 8.3 Factors affecting capital structure before deciding the mix of various long term sources of funds, it is necessary for the company to take into consideration carious 1. Internal Factors 2. External Factors 3. General factors Internal Factors a) cost factor

during the days of boom and prosperity, company can issue equity shares to get the benefit of the investors desire to invest and

cost factor as the factor affecting the capital structure decisions refer to the cost associated with the process of raising the var cost of capital while deciding the capital structure, it should be ensured that the use of capital is capable of earning enough revenue to justify th it should be noted that the borrowed capital is cheaper form of capital for the company and this is due to following reasons

1. the expectations of the lenders of borrowed funds ( debentures, term loans) are less than expectations of the investors who i fact that the risk on part of lenders of borrowed funds is comparatively less than the risk on part of investors in own funds 2. The return which the company pays on borrowed funds ( interest) is an income tax deductible expenditure for the company w an income tax deductible expenditure for the company

when the company pays interest on borrowed capital its tax liability get reduced whereas payment of dividend does not affect th profit after taxes b) Risk factor In financial terms, risk and return always go hand in hand whichever capital is cheap for the company is risky for the company cost associated with the borrowed capital is more risky for the company. This is due to following reasons 2. the company is required to repay the principle amount of borrowed capital at the predetermined maturity rate

1. payment of interest at the predetermined rate of interest at the predetermined time intervals irrespective of non-availability of p

3. borrowed capital is usually secured capital. If the company fails to meet its contractual obligations, the lenders of borrowed fu security cost associated with the own funds is more for the company, but the risk associated with them is less. This is due to following re there are many companies who have not paid any dividend on equity shares for years together due to non-availability of profits 2. the company is not required to repay the own capital during the lifetime of company 3. own capital is unsecured capital. None of the assets of the company are offered as security to investors in own funds c) control factor while planning the capital factor and more particularly while raising additional funds required by the company, the control considered specifically for the closely held private limited companies control factor refers to the capacity of the existing owners of the company to retain control over operations of the company

1. as the return paid on own capital i.e. dividend is the appropriation of profits, the company is not bound to pay any dividends u

if the company decides to meet additional requirement of funds by issuing equity shares or preference shares, the controlling i investors in equity shares enjoy absolute voting rights while investors in preference shares enjoy limited voting rights if the company decides to meet additional requirement of funds by way of borrowed capital, the controlling interest of existing do not enjoy voting rights however it should be remembered here that if the existing owners contribute to right shares which indicate the additional share their controlling interest may not get affected by raising additional requirement of funds by way of borrowed capital, the existing owners of the company need to remember th the lending bank or financial institution appoint their representatives as Nominee directors on the board of directors of the borrow d) objects of capital structure planning while planning the capital structure, following objects of capital structure come into play 2. to issuing the securities which are easily transferrable. This can be ensured by listing securities on stock exchange 3. to issue further securities in such a way that the value of shareholding of present owners is not adversely affected 4. to issue the securities which are understandable by investors 5. to issue the securities which are acceptable to lenders or investors External Factors a) General economic conditions while planning the capital structure, the company needs to consider the general conditions existing in the company it may also be possible to raise more equity capital in boom as the investors are ready to take risk and invest if the economy is depression, the company will like to raise equity capital as it involves lesser amount of risk.

1. to maximize the profits available to the owners of the company. This can be ensured by issuing securities carrying less cost o

if the economy is boom and the interest rates are likely to decline, the company will like to raise equity capital immediately leavin

however it may not be possible to raise capital by way of equity during the period of depression as the investors may not be willi

under such circumstances, the company may be required to go for borrowed capital b) behaviour of interest rates

while planning the capital structure, the company may be required to take into consideration the likely behaviour of interest rates

if the interest rate in the economy are likely to decline, depending more upon the long term sources carrying fixed rate of re dangerous for the company if the interest rate in the economy are likely to increase, the company will be benefitted by issuing long term securities carrying fi c) Policy of lending institutions if the policy of the lending banks or financial institutions is too harsh or rigid, it will be advisable not to go for borrowed funds instead company will like to go for convenient sources like leasing or hire purchase, though they are most costly propositions d) taxation policy

taxation policy as a factor affecting the capital structure decision needs to be viewed from the angle of the company as well as th

as far as interest is concerned from company's point of view, the return paid on the borrowed capital i.e. interest is a tax-deducti from investors point of view, returns received by him on the funds lent to the company is a taxable income income received by investors in their hands gets reduced to the extent of tax deducted at source

further if the interest on debentures/bonds exceeds rs. 2500, the paying company is required to deduct the tax at sources and p

as far as dividend is concerned, as per the provisions of section 10(36) of the income tax act 1961, the dividend received by their hands however as per the provisions of section 115-O additional tax ( over and above the normal income tax payable on the taxable pr this tax is in the form of tax on distributable profits and the same is popularly referred to as dividend tax rate at which the dividend tax I payable by the company is 12,5% of the amount of dividend paid this basic rate is further increased by surcharge of 10% and education cess of 2%. as such, the effective rate of dividend tax works out as 14.025%

dividend tax is payable by the company within 14 days from the date of declaration or payment of declaration whichever is earlie e) Statutory restrictions

the statutory restrictions prescribed by the government and various other statutes are required to be taken into consideration bef

The company has to decide the capital structure within the overall framework prescribed by the government of various other stat General Factors a) Constitution of the company

while deciding the capital structures, constitution of the company plays a very important role . If the company is a private limit may play a dominant role If the company is a public limited company or a widely held company, cost factor may play a dominant role b) characteristics of the company

characteristics of the company in terms of its size, age and credit standing play a very important role in capital structure decision

very small companies and the companies in their early stage of life have to depend more upon the equity capital as they have confidence of the investors

it is better for these companies to go for equity capital in the early years of life, increase the capital base, increase the bargainin years of life the companies having good credit standing in the market may be in the position to tap the source of their own choice, where having poor credit standing in the market c) stability of earnings

if sales and earnings of the company are stable and predictable in future, the company may not mind taking the risk and it can play important role if sales and earnings of the company are not likely to be stable and predictable in over a period of time and re likely to be subje and the company will not like to have more borrowed capital in its capital structure d) attitude of management if the management attitude is aggressive, the cost factor may play an important role on capital structure decisions 8.4 Cost of capital In economic terms, the cost of capital is viewed from two different angles 1. the cost of raising funds to finance a project this cost may be in the form of interest which the company may be required to pay the suppliers of funds this may be the explicit cost attached with various sources of capital

if the management attitude is conservative, the control factor and risk factor may play an important role on capital structure decis

each sources involves some cost. The cost of capital can be defined as "rate at which an organization must pay to the suppliers

2. the cost of capital may be in the form of opportunity cost of the funds of the company. I.e. the rate of retunes which the compa

Suppose that a company has a amount of 100000 which may either be utilized for purchasing a machine or may be invested wit

if the company decides to use the amount for purchasing the machine , obviously it will have to forgo the interest which it wou with the bank thus cost of capital of this capital of 100000 is 10% Concepts of cost of capital besides the general concept of cost of capital, the following concepts are also used a) component cost and composite cost composite cost of capital refers to the combined or weighted average cost of capital of the various individual components for capital budgeting decisions, it is the composite cost of capital which is considered b) average cost and marginal cost average cost refers to the weighted average cost of capital marginal cost refers to the incremental cost attached with new funds raised by the company c) explicit cost and implicit cost explicit cost is the one which is attached with the source of capital explicitly or apparently implicit cost id the hidden cost which is not incurred directly e.g.: in case of debt capital, the interest which is the company is required to pay on the same is explicit cost of capital

component cost refers to the cost of individual components of capital i.e. equity shares, preference shares, debentures and so o

if the company introduces more and more doses of debt capital in the overall capital structure, it makes the investment in the com

the expectations of the company in terms of return on their investment may and increase and share prices of company may decr these increased expectations of the investors or decreased share prices may be considered to be implicit cost of debt capital 8.5 Importance and measurement of cost of capital the term cost of capital is important for a company basically for the following purposes 1. the cost of capital is used as a tool for screening the investment proposals. in case of net present value method, the cost of capital is used as the discounting rate for discounting the future inflow of funds any project resulting into positive net present value only will be accepted all other projects will be rejected in case of internal rate of return method (IRR), the resultant IRR is compared with the cost of capital it is expected, if the project is to be accepted, IRR should be more than cost of capital if project generates IRR which is less than cost of capital, the project will be rejected 2. the cost of capital is used as capitalization rate to decide the amount of capitalization in case of a new concern 3. the concept of cost of capital provides useful guidelines for determining the optimal capital structure optimal capital structure is the one where overall cost of capital is minimum and the overall valuation of the firm is maximum Measurement of cost of capital a) Cost of debt the debts may be either long term debts or short term debts very naturally the cost of capital in the form of debt is the interest which the company has to pay but this is not the real cost attached with the debt capital the real cost is something less than the rate of interest which the company has to pay this is due to the fact that interest on debt is tax deductible expenditure as such while computing the cost of debt adjustments are required to be made for its tax impact

suppose a company issues debentures having face value of rs. 100 and bearing rate of interest of 10% p.a. if the tax rate appli not 10% which is the rate of interest but it is to be duly reduced by the tax benefit that is available for this interest the tax benefit is 50% of 10% hence cost of debentures is only 5% further interest payable on the debentures has to be viewed from the angle of amount actually received on their issue For e.g.: if company issues 1000 debentures of Rs. 100 bearing @8% pa. company incurs this expenses in connection to the issue of debentures to the extent of rs. 10000 these expenses may be in the form of discount allowed, underwriting commission, advertisement thus the company will have to pay annual interest of rs. 8000 on the net amount received to the extent of only rs. 90000. however the debt capital has a hidden cost also

Cost of debenture in this case works out to be around 8.89% and assuming the tax rate applicable is 50%, the tax benefit makes

if the debt content in the capital structure of the company exceeds the optimum level, he investors start considering the compan increase. This is the hidden cost of debt b) cost of preference shares the cost of preference shares is the dividend rate payable on them suppose a company issues 1000 preference shares of rs. 100 each at the value of rs. 105 each

As in the case of debentures the cost capital is adjusted for the amount excess or less received on the issue of preference share

rate of dividend is 10% and the expenses involved with the issue of preference shares amount to rs. 10000 thus the net amount received works out to rs 95000 whereas the amount of dividend is rs 10000 here the cost of capital works out to (10000 * 100) / 95000 = 10.53%

as the amount of dividend payable on preference shares is not a tax deductible expenditure, there is no question of further adjus c) cost of equity shares

computation of cost of equity shares is the most complex procedure. It is due to the fact that unlike preference shares or debe dividend to be paid at fixed rate the cost of equity shares therefore depends on the expectations of equity shareholders there are the following approaches to compute the cost of equity shares 1. D/P approach:

according to this approach, before an investor pays certain price for purchasing equity shares of the company, he expects ce dividend the expected rate of dividend is the cost of equity shares

this means that the investor calculates the market price of shares by capitalizing the present dividend rate which is expected to b

if the market price of equity shares of a company is rs. 15 and if the company at present id paying a dividend @ 20% which equity shares will be (20% of rs. 10) / rs 15 = 13.33%

however it can also be argued that cost of equity shares may be 20% because on the expectation of rate of dividend at 20%, ma this may not always be correct. He may also look forward to capital appreciation in the value of his shares

this approach is objected on certain grounds. Firstly, this presupposes that an investor looks forward only to receive dividend on

secondly this approach assumes that the company will not earn on its retained earnings and the retained earnings will not resu in dividends this assumption may be a wrong assumption which may lead to wrong conclusions 2. E/P approach according to this approach, the cost of equity shares is based upon the stream of unchanged earnings earned by a company

this approach holds that each investor expects a certain amount of earnings whether distributed or by the way of dividends or no if the company is expected to earn 30%, he will be prepared to pay rs. 150 per share of rs. 100 each this approach is objected on certain grounds. Firstly, it wrongly assumes that earnings per share will remain constant in future. secondly market price of shares will not remain constant as the shareholder will expect capital gains as a result of reinvestment thirdly all earnings may not be distributed among the shareholders by way of dividend 3. D/P + G Approach

thus if an investor expects that the company in which he is investing should have at least 20% rate of earnings, cost of equity sh

according to this approach, the investor is prepared to pay the market price of the shares as he expects not only the payment o uniform rate perpetually thus cost of equity shares can be calculated as (D/P) + G D= expected dividend per share P = market price per share G - growth in expected dividends

for example, if dividend per share is rs. 1 with the expected growth of 6% per year perpetually, the cost of equity shares with the ( 1 + 0.06 / 25) * 100 = 10% this approach involves the difficulty of determining the growth rate 4. Realized yield approach

according to this approach, the cost of equity shares may be decided based on the yields actually realized over the period of pa future also this approach basically consider D/P +G approach, but instead of considering the future expectations of dividends and growth fa d) Cost of Retained earnings many a times it is argued that the retained earnings do not cost anything to the company. This is argued like this as there is retained evenings even though they constitute one of the major sources of funds for the company in case of debt, the company has fixed obligation to pay interest on it almost similar obligation exists in the case of preference shares the retained earnings do not involve any of such obligations either formal or implied it may be felt that retained earnings involve no extra cost as they are not raised from outside source assuming the profits of the company are not retained but are distributed among shareholders by way of dividend

in case of equity shares, though there is no legal obligation , the expectations of the shareholders at least provides a starting poi

but this contention is not correct. Retained earnings involve cost and this cost is in the form of opportunity cost in terms of divide

these amounts to dividends which would have been received by the shareholders after due adjustments for tax deducted at so earn some returns the company by retaining the profits prohibits the shareholders from earning these returns this is the cost of retained earnings 8.6 Composite Cost of Capital

as such the company is required to earn on the retained earnings at least equal to the rate which would have been earned by th

after ascertaining the cost of each source of capital constituting the capital structure, the next step is to compute the comp average of cost of each specific type of capital the reason behind computing weighted average and not simple average is to give consideration to the proportion of various sour thus the process of computing composite cost of capital is carried on by 2. multiply the cost of each source of funds by weight assigned 3. calculate the composite cost by dividing total weighted cost by total weight the above process can be explained with the help of illustrations ( Page 226) 8.7 Illustrative problems Page 228 to 238

1. Assign weights to various sources of funds. It may be stated here that the weights may be in the form of book value of funds o

9. Leverages And Theory of Capital Structure

9.1 Introduction
A finance manager has to estimate the requirement of funds of meeting the laid down objectives of the concern. He procures the estimated funds. before procuring these funds he determines the best mix of such funds or decides about the capital structure of the concern. The desired structure of funds influence the shareholder's return and risk.

Leverages analysis is the technique used by business firms to quantify risk-return relationship of different alternative capital st

9.2 Concept of Leverages

Before we go ahead with discussing the concept of Leverages, consider the following example - Let us assume that there ar each other in terms of nature of business, size, extent of turnover etc. As such, the amount of capitalization is also the same for both the companies which is assumed to be rs. 10,000. However, strategies for raising the capital are different from each other. Assuming that the required capital can be raised by way of equity or debt, following particulars are available. Company A Company B Equity Share Capital 1,000 9,000 (Each share of Rs. 10 each) 10% Debentures 9,000 1,000

Profitability statements of both the companies when the sales are RS. 20,000 and rs 18,00 are as below -- >> page 246 IT can be noted from the above example that A Ltd. Is able to earn more amount per equity share because in its capital s because the interest paid on debentures is tax deductible expenditure and amount of tax is less in case of A Ltd. Explanations Operating costs incurred by a company can be classified into three categories a) Variable Cost b) Fixed Cost c) Semi-variable cost Fixed cost is the cost which remains constant irrespective of changes in the sales revenue, at least over a shorter span of time. Variable cost is the cost which varies in direct proportion to the sales revenue.

Semi-variable cost lies in between the two extremes of fixed cost and variable cost. Such costs remain constant up to a certain sales revenue and increases if the sales revenue increases beyond a certain point. There may be some statistical or mathematical techniques available whereby the semi-variable cost can be segregated into th Hence, let us assume that the costs can be either fixed costs or variable costs.

Difference between the sales revenue and variable cost is referred to as contribution or marginal contribution. Significance of the term contribution is that it is equated with the term profits over a shorter period of time, as the fixed cost r

As such, sales revenue generated by the company after deducting the variable cost incurred for the same contributes to contribution. The operating profit earned by the company is in the form of contribution duly reduced by the fixed operating cost. As such, using the above referred terms, the operating statements of a company can be presented as below Sales Revenue Less: Variable Operating Cost

Contribution less: fixed operating cost Operating profit Break even point is that level of sales revenue at which there is no profit or no loss Till the sales revenue reaches the break even point, the company incurs the losses. IT is only after crossing the break even point that the profit generating capacity of the company starts. As such, it is the intention of every company to reach the break even point as early as possible.

The essential implication of high fixed cost in the cost structure is that the break even point is high which indicates that th generate to be no profit no loss situation is very high which makes the company a very risky proposition.

The operating profit earned by a company is also referred to as Profit Before Interest and Taxes ( PBIT) in financial terms. After the level of operating profit, the company is contractually required to pay the interest on the long term borrowed capital The amount of profit earned after recovering the interest on long term sources of capital is referred to as Profit Before Taxes ( The company is required to pay the taxes as pre the provision of Income Tax Act, 1961 after the amount of profit before taxes Profit remaining after the payment of income tax is referred to as Profit After Taxes ( PAT). this profit can be distributed amount the owners of the company by way of dividend.

We have already seen that before the company can pay the dividend on Equity Shares, it is bound to pay the dividend on prefe After paying the dividend on preference shares, remaining profits can be distributed among the equity shareholders by wa profits.

In financial terms, Profit Before Interest and Taxes ( PBIT) can be referred as earnings before interest (EBIT) and Profit after Ta

Using the above terms, the profitability statement of a company takes the following form Profit before interest and Taxes ( PBIT) Less: Interest on long term borrowings Profit before Taxes ( PBT) Less: Taxes Profit after Taxes ( PAT) Less: Preference Dividend Distributed profits for Equity If bother the calculations are merged together, the following relationship emerges. Sales Revenue Less: Variable operating Cost Contribution Less: Fixed operating cost Profit before interest and Taxes ( PBIT) Less: Interest on long term borrowings Profit before Taxes ( PBT)

Less: Taxes Profit after Taxes (PAT) Less: Preference Dividend Distributable Profits for Equity In continuation of these calculations, the following two calculations are made very frequently in practical situations:Earnings per Share ( EPS) Earnings per Share is widely used ratio to measure the profits available to the equity shareholders on a per share basis EPF is calculated as Profit after Tax - Preference Dividend No of Equity Shares

EPS is calculated on the basis of current profits and not on the basis of retained profits. EPS does not indicate the amount of profits distributed among the owners by way of dividend and also the amount of profits r

This calculation is very significant for an investor in equity shares as higher EPS indicates higher amount of profits available to h Price Earning Ratio (P/E Ratio) Price Earning Ratio indicates the price currently being paid in the stock market for every one rupee of EPS. P/E Ratio is calculated as Market Price per share Earnings per share

P/E ratio is of great significance to an operator on the stock exchange buying and selling the shares. An idea investor makes a comparison between the current market price and future EPS as the market value of shares depends

9.3 Leverages
In very simple words, the term leverages measures relationship between two variables. In financial analysis, the term leverage represents the influence of one financial variable over some other financial variable. In financial analysis, generally three type so leverages may be computed : a) Operating Leverage b) Financial Leverage c) Combined Leverage

1) Operating Leverage
It measures the effect of change in sales quality on Earnings before interest and Taxes ( EBIT) It is computed as sales - Variable Cost (i.e. Contribution) Earnings before interest and tax Indications: A high degree of operating leverage means that the component of fixed cost is too high in the overall cost structure.

A low degree of operating average means that the component of fixed cost is less in the overall cost structure In other words, operating leverage measures the impact of percentage increase or decrease in sales on earnings before interes

E.g.: In the example cited above, when salaries are Rs. 20,000 contribution is Rs. 10,000 and earnings before interest and t calculated as Operating Leverage = ( contribution / EBT) = 10000/5000 = 2 It means that every 1% increase in contribution will increase the EBIT by 2% and vice versa. As such, when contribution is Rs. 9,000 instead of Rs. 10,000 I.e. the contribution is reduced by 10%, the EBIT is reduced by 5,000

2. Financial Leverage

IT indicates the firm's ability to use fixed financial charges to magnify the effects of changes in EBIT on the firm's EPS IT indicates the extent to which the Earnings Per Share (Eps) will be affected with the change in Earnings Before Interest and TA It is calculated as EBIT EBIT-Interest = EBIT EBT

A high degree of financial leverage indicates high use of fixed income bearings securities in the capital structure of the compan A low degree of financial leverage less use of fixed income bearings securities in the capital structure of the company

E.g.. In the example cited above, in case of A Ltd., the EBIT is Rs. 5,000 and interest on debentures is Rs. 900, when sales are Rs and interest on debentures is Rs. 100 when sales are Rs. 20,000. As such the degree of financial leverage can be computed as EBIT EBIT - Interest A Ltd Financial Leverage = 5000/(5000-900) = 5000/4100 = 1.22 B Ltd = 5000/(5000-100) =5000/4900 = 1.02

High degree of financial leverage is supported by the knowledge of the fact that in the capital structure of A Ltd, 90% is the de the debt capital component. IT means that in case of A Ltd, every 1% increase in EBIT will increase EPS by 1.22% and vice versa As such, when EBIT is reduced from Rs. 5000 to Rs. 4000 (i.e. 20% reduction), EPS of A Ltd gets reduced from Rs. 20.50 to reduced from Rs. 2.72 to Rs 2.16 (i.e. 20.40% reduction)

Uses of Financial Leverage The degree of financial leverage gives an indication regarding the extent to which EPS may be affected due to every change in As the use of debt capital in the capital structure increases the EPS, the company may like to use more and more debt capital i

As explained in the example cited above, EPS in case of A Ltd, is Rs. 20.50 when sales are Rs. 20,000 as 90% of its capital is debt But in case of B Ltd. EPS is only Rs 2.72 when sales are Rs. 20,000 as only 10% of its capital is debt capital. As such, the phrase is often used that financial leverage magnifies both profits and losses.

However, though financial leverage magnifies the profits as well as EPS, the use of debt capital beyond certain limit will not ne Use of financial leverage is useful as long as debt capital costs less than what it earns. It reduces profits or EPS if it cost more than what it earns. As such, financial leverage also acts as a guideline in setting maximum limit up to which the company should use the debt capit However the technique of financial leverage suffers from some limitations.

Limitations 1) It ignores implicit cost of debt. IT assumes that the use of debt capital may be useful so long as the company is able to earn more than the cost of debt, i.e., in But it is not always correct. Before considering the capital structure, the implicit cost of debt should be considered. 2. It assumes that cost of debt remains constant regardless of degree of leverage which is not true. with every increase in debt capital, the interest rate goes on increasing due to the increased risk involved with the same.

3. Combined Leverage The combined effect of operating leverage and financial leverage measures the impact of change in contribution on EPS. It is computed as Operating leverage X Financial Leverage = sales - variable cost ( EBIT) = Sales - Variable cost / EBIT - Interest x EBIT (EBIT - Interest)

In the above example cited above, in case of both A ltd and B ltd, when sales are Rs. 20,000, contribution is Rs. 10,000 but ea Rs. 4,900 respectively. As such combined leverage can be classified as

Sales - Variable cost (i.e., contribution) EBIT - Interest A ltd = 10,0000/4100 = 2.44 B Ltd = 10,000 /4,900 = 2.04

It means that in case of A Ltd, every 1% increase in contribution will increase EPS by 2.44% and vice versa, while in case of B L by 2.04%.

As such when contribution gets reduced from Rs. 10,000 to Rs. 9,000 i.e. 10% reduction, EPS of A Ltd, gets reduced from RS. Ltd. Gets reduced from Rs. 2.72 to Rs. 2.16 (i.e. 20.4 reduction) Indications The indications given by the combined effect of operating and financial leverages may be studied under the following possible 1. High operating Leverage, High Financial Leverage It indicates a very risky situation as a slight decrease in sales and/or contribution may affect the EPS to a very great extent. As fast as possible, this situation should be avoided.

2. High operating Leverage, Low Financial Leverage It indicates that a slight decrease in sales and/or contribution may affect EBIT to a very great extent due to existence of high f low proportion of debt capital in the overall capital structure.

3. Low operating leverage, high financial leverage It indicates that the decrease in sales/contribution will not affect EBIt to a very great extent as the component of fixed cost is n As such, the company has accepted the risk of borrowing more debt capital in order to increase EPS to the maximum possible e This may be considered to be an ideal situation.

4. Low operating Leverage, low financial Leverage It indicates that the decrease in sales/contribution will not affect EBIT to a very great extent as the component has not accepte in its capital structure. It may indicate a very cautious policy followed by the management which need not be necessary , as it will not maximize the sh At the same time, it may also indicate that the company is not utilizing its borrowing capacity properly and fully .

9.4 Theories of Capital Structure

In the previous page, we have seen that the introduction of debt capital in the capital structure increases the earnings per shar We have also seen that introduction of debt capital increases the risk also which is the risk of insolvency due to non-availabilit shareholders.

As such, increasing the debt component beyond a certain limit will not increase the earnings per share. If debt component crosses a particular limit, the expectations of the lenders of money also increase due to the risk factor invol Similarly , the share holders also will demand a high rate of return on their investment to compensate for the risk arising o structure.

As such, introduction of a heavy amount of debt capital in the capital structure will not reduce the valuation of the firm but wil

however, this view is not universally accepted, IT is not an accepted principle that the valuation of a firm and its cost of capital may be affected by the change in financial mix. Different views have been expressed in the context. We will classify these views in the form of the following four theories of capital structure a) Net income approach b) Net operating income approach c) Traditional approach d) Modigliani - Miller approach for this purpose, following assumptions have been made. 1) Firms use only long term debt capital or equity share capital to raise funds 2) Corporate Income Tax does not exist. 3) Firms follow policy of paying 100% of its earnings by way of dividend. 4) Operating earnings are not expected to grow Following definitions and symbols are also used. S = market value of equity shares B = Market value of debt V = Total market value of firm NOI = Net operating Income i.e. EBIT I = Total interest payments NI = Net income available to equity share holders. i.e. EBIT - I = EBT Overall cost of capital = EBIT / V

a) Net Income approach According to this approach as proposed by Durand , there exists a direct relationship between the capital structure and valuati by the introduction of additional debt capital in the capital structure, the valuation of the firm can be increased and cost of cap example : Page 256 It can be seen from above, that by the increase in debentures, the total value of the firm increases and cost of capital reduces However , this will hold good only if the cost of debentures, i.e. rate of interest is less than the equity capitalization rate.

b) Net operating Income approach According to this approach, also proposed by Durand, the valuation of the firm and its cost of capital is independent of its capi any change in the capital structure does not affect the value of the firm or cost of capital, though the further introduction of d vice versa example : page 257

It has been seen from the above that the market value of the firm remains unaffected by change in the capital structure, However, the introduction of additional debentures increases the equity capitalization rate and vice versa.

c) Traditional Approach This is the mean between two extreme approaches of net income approach on one hand and net operating income on anothe It believes that up to a certain point, additional introduction of debt capital, inspite of increase in case of debt capital and eq capital will reduce and total value of the firm will tend to reduce.

Thus, for the judicious mix of debt and equity capital, it is possible for the firm to minimize overall cost of capital and maximize Such a capital structure where overall cost of capital is minimum and total value of the firm is maximum is called 'Optimal Capi example : page 258

it can be seen from the above neither the no-debentures position nor the position where debentures are issued to the extent maximize the total value of the firm.

It is when debentures are issued to the extent of Rs. 3,00,000 that the overall cost of capital is minimum and total value of t Structure

d) Modigliani - Miller ( M and M) Approach This approach closely resembles net operating income approach. According to this approach, value of the firm and its cost of capital are independent of its capital structure. IT argues, that overall cost of capital is the weighted average of cost of debt capital and cost of equity capital. Cost of equity capital depends upon shareholder's expectations. Now, if shareholders expect 10% from a certain company, they already take into consideration of the shareholders also increa also increases. Thus, each change in the mix of debt capital and equity capital is automatically offset by change in the mix of debt capital and expectations of the shareholders which in turn is attributable to change in risk element. As such, they argue that , leverage i.e. mix in debt capital and equity capital , has nothing to do with overall cost of capital a rate of pure equity stream of a risk class. Hence, leverage has no impact on share market prices or cost of capital

9.5 Illustrative problems

I) Assuming no taxes and given earnings before interest and taxes ( EBIT), interest (I) , at 10% and equity capitalization rate ( K) Refer page : 259

9.6 Summary

In financial analysis, leverage represents the influence of one financial variable over some other related financial variable. These financial variables may be costs, output, sales revenue, Earning Before Interest and Tax (EBIT) , Earning Per Share (EPS) e There are three commonly used measures of leverage in financial analysis.

1. Operating Leverage Operating leverage is defined as the firm's ability to use fixed operating costs to magnify effects of changes in sales on its earni

2. Financial Leverage Financial leverage is defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT/Ope

3. Combined Leverage Combined leverage measures the effect of a % change in Sales and % change in EPS.

Capital structure is the combination of different financial sources for the capital of the business in the most economical and eff These are four theories which are useful for determination of capital structure.

1. Net Income Approach: According to this approach, a firm can increase its value or lower the overall cost of capital by increa

2. Net Operating Income Approach: According to this approach, the market value of the firm is not affected by the capital stru

3. Traditional Approach: According to this approach, the firm should strive to reach the optimal capital structure and increase equity and debt.

4. Modigliani - Miller Approach : According to this approach, the total cost of capital of particular firm is independent of its me UNIT 10 : CAPITAL MARKET 10.1 INTRODUCTION In simple words, Capital Market refer to the market available to the company for raising the long term requirement of funds Lat decade of the twentieth century has witnessed various liberalization measures and reforms taking place in various sectors Capital Market is no exception to the rule The changes which have taken place in the capital market are basically in two forms a. Repeal of Capital issues (Control) Act, 1947 and abolition of the office of controller o Capital issues This came into effect from 29th may, 1992 b. Enactment of the Securities and Exchange Board of India Act, 1992 and formation of Securities and Exchange Board of India

As a result of this, the market for the long term securities of the companies has become freer and companies are now able to r

However in order to protect the interests of investors, SEBI has become empowered to issue the directions from time to time As such, at present, the only regulatory framework applicable to the companies trying to raise the funds by issuing their securi SEBI from time to time for disclosure and investors protection The extract of these SEBI guidelines are discussed in the following paragraphs In the Capital Market ( in technical words it is referred to as 'Primary Market') , a company can raise the funds in the following a. Public Issue

b. Rights Issue c. Private Placement of Securities Public issue indicates the sale of securities to the members of general public

According to the provisions of section 81 of the companies act, 1956, If a public limited company wants to raise further capita to be offered to the existing equity share holders first in the similar proportion

This is technically called as 'Rights Issue' of shares However, the existing shareholders are not compelled to buy those shares The existing share holder can buy those shares himself or he can renounce the right in favor of any other person Private placement of securities, as the name indicates , is the private placement made by the company to a selected few invest 110.2 10.2 SEBI GUIDELINES FOR PUBLIC ISSUE AND RIGHT ISSUE

If the company wishes to collect the funds by making Public issue or right issue of the Securities, following requirements of SE company Filling of Prospects or Letters of Offer

A company cannot make the public issue of Equity shares unless a draft prospects is filed with SEBI, Through an eligible Merc Register of Companies (ROC) Contents of the prospectus are also prescribed in the guidelines

A listed company cannot make the right issue of Equity shares where aggregate value exceeds Rs 50. Lakhs, unless the letter o Banker, at least 21 days before it is filed with the regional stock of exchange Contents of the offer letter are also prescribed in the guidelines Listing On Stock Exchange An unlisted company cannot make the public issue of equity shares unless the company has

a. a track record of distributable profits for at least three years out of immediately preceding five years b. A pre-issue net worth of more than RS 1 crore in three out of preceding five years, with the minimum net worth to be met d c. the issue size not exceeding 5 times its net-worth

If the unlisted company does not satisfy any of the above conditions, it can make the public issue only through the Book Buildin In the Book Building process, the company has to compulsorily allot at least 60% of the issue size to the Qualified Institutional have to be refunded Eligibility for a listed company for making public issue A listed company can make the public issue if the issue size is less than 5 times its pre-issue net worth

If the issue size is more than or equal to 5 times of pre-issue net worth, the company has to take the route of Book Building qualified Institutional buyers, 15% it High Net Worth Individuals and 35% to Retail Investors Partly paid shares No company can make the public issue of Equity Shares unless all the party paid shares have been fully paid up Pricing of the issue

A listed company can freely price its equity shares offered through the public issue or rights issue An unlisted company making the Public Issue Of Equity Shares and decisions of getting the shares listed on the stock exchange However the company is required to give the justification of the price in the offer document Any unlisted company or a listed company making issue of equity shares can issue them to applicants in the firm allotment c provided that the price at which the security is offered to the applicants in firm allotment category is higher than the price at w

Denomination of the shares Denomination of the equity shares in the public issue or rights issue can be freely decided by the company Promoters Contribution

In a public issue by an unlisted company , the promoters shall contribute not less than 20% of the post-issue capital In a public issue by a listed company, the promoters shall participate to the extent of 20% of the proposed issue or ensure po capital Promoters shall bring the full amount of the promoter contribution at least one day before the issue opens for public

Lock- in period

The Lock-in period for the promoter contribution shall be three years from the date of commercial production or the date of al If an unlisted company making the public issue of equity shares and desirous of getting the shares listed on the stock exchange prior to the opening of issue for the public at a price lower than the price at which shares are offered to the public, the entire and employees of the company) shall have lock-in period of six months from the date of trading of shares on the stock exchang Minimum application

If the equity shares are being issued at par, the minimum number of shares for which an application is to be made is 200 share In other words, the minimum application money payable by the applicant shall not be less than Rs. 2,000 Minimum application money payable by the applicant along with the application shall not be less than 25% of the issue price Subscription List

A public issue of shares shall be kept open for minimum three working days and not more than ten working days Rights issue shall be kept open for at least 30 days and not more than 60 days Underwriting Underwriting of the public issue of shares is compulsory for the company making the issue Minimum Subscription If the company receives less than 90% of the issued amount from the public plus the shares taken over by the underwriters, full within 60 days from the date of closure so the issue Utilization of funds

The company can utilize the funds collected by way of rights issue after satisfying the stock exchange that minimum 90% subsc Retention of oversubscription

The quantum of issue shall not exceed the amount specified in the prospectus or the letter of offer However, an oversubscription to the extent of 10% is permissible for the purpose of rounding off to the nearer multiple of 100 10.3 SEBIGUIDELINES FOR THE ISSUE OF DEBT INSTRUMENTS

Basic The company cannot issue FCDs having a conversion period of more than 36 months unless conversion is made optional with ' If the conversions take place after 18 months but before 36 months from the date of allotment of debentures, any convers of debenture holders

Rate of Interest, premium and period of conversion The rate of interest for the debentures can be freely decided by the company The amount of premium on redemption and the period of conversion can be decided by the company and disclosed in the o

Credit Rating The company cannot make the public issue of the FCDs/PCDs/NCDs unless credit rating is obtained from a credit rating agency If the size of the issue is greater than Rs. 100 crores , two ratings from different credit rating agencies are required to be obtain When the rating is obtained from more than one credit rating agency, all the credit ratings, including the unacceptable ratings, All the credit ratings obtained during the three preceding years for any listed securities of the company are required to be disc Debenture Trustees

if the issue of debentures is having the maturity period of more than 18 months , the company shall appoint a Debenture Trust The name of the debenture Trustee shall be disclosed in the offer document A trust deed shall be executed by the company in favor of the Debenture trustees within six months from the date of closure o The debenture Trustee shall have the requisite powers for protecting the interests of the debenture holders including the right

Debenture Redemption Reserve (DRR)

If the company issues the debentures with the maturity of more than 18 months , it has to create DRR DRR should be created out of the post-tax profits earned by the company The company shall create the DRR to the extent of at least 50% of the amount of debenture issue before debenture redemptio Drawl from DRR is permissible only after 10% of the debenture liability has actually been redeemed by the company DRR will be treats as free reserve while issuing the bonus shares Security

The company shall create the security within six months from the date of issue of debentures If the company fails to create the charge within 12 months of the issue, the company is liable to pay interest @ 2% penal in charge is registered 10.4 INTERMEDIARIES IN CAPITAL MARKET

If a company wants to raise the funds from various sources, services given by various intermediaries become essential in the p Among all the intermediaries, probably the most important and significant intermediary is the Merchant Banker In the area of Capital Markets, it is the basic responsibility of the Merchant Banker to ensure that the issue is a success To be more particular, the Merchant Banker performs the following functions

a. Advise the company about the structuring of the issue after taking into consideration the overall economic conditions, expec b. Assist in getting the various statutory approvals c. Drafting of the prospectus and the offer Document in consultation with the solicitors and others d. Assist the company in the appointment of other intermediaries like underwriters, brokers, bankers, registrars, advertising ag e. Develop the strategies for marketing the issue properly through the various techniques like advertisements, mailers conferences etc f. Coordinate the efforts of all the intermediaries for the success of the issue g. Monitor the issue during the period of subscription h. Assist in finalizing the basis of allotment i. Assist in securing the stock exchange listing

In addition to the Merchant Bankers, following intermediaries play a significant role in the process of raising funds in Capital M Underwriters

Underwriters provide a protection to the company in the situation of investors not fully subscribing to the issue of the securiti Thus, underwriting is a contract where the underwriter agrees to subscribe directly or to procure subscription for that portion

As a result, when the issue is underwritten , the company making the issue is assured of getting the total requirement of funds

The return received by the underwriters is in the form of underwriting commission which is based upon the amount underwrit It has already been started , that as per the SEBI regulations, underwriting is not obligatory

However, in case of every underwritten issue, the Lead Merchant Banker shall accept the minimum underwriting obligation Lakhs whichever is less Bankers to the Issue

Bankers to the issue collect the application money on behalf of the company. Bankers to the issue are the banks who provide the term finance or working capital finance to the company and who underwri Registrars to the Issue Registrars to the issue typically perform the following tasks Collection of application from the banks after the issue is closed Scrutiny of the application forms Classification and tabulation of information for allotment Finalization of basis of allotment Preparation and dispatch of allotment letters, share certificates , debentures certificates and refund orders 10.5 RECENT TRENDS IN CAPITAL MARKET We will study the recent trends in Capital Market mainly under the following headings a. Innovative instruments in Capital Market b. Credit Rating c. Buy Back of Shares d. Venture Capital Innovative instruments in Capital Market

During the last few years , the companies have entered the capital market with various innovative instruments to raise the fun We will discuss the following innovative instruments used by the companies a. Equity Warrants b. Floating Rate Bonds c. Zero Coupon Bonds d. Deep Discount Bonds e. Secured Premium Notes a. Equity Warrants

The holders of the warrants are entitled to purchase the equity shares at a specific price during the specified period ( tech holder of the equity warrants has a right but not the obligations to purchase the equity shares Naturally, the holder of the equity warrant will exercise the option to buy the equity shares if the prevailing market price of th the exercise period

The equity warrants are generally issues along with other instruments with the intention to make the issue of that other instru Equity warrants can be either detachable or non-detachable Detachable equity warrants can be detached from the underlying instruments and can be traded independently Non-detachable equity Warrants can not be detached from the underlying instrument Advantages of Equity Warrants

The issuing company gets benefited with the help of Equity Warrants particularly when the requirement of funds of the compa The company can decide the exercise period taking into consideration its requirement of funds Risks associated with Equity Warrants

If the market price of the Equity shares is less than the exercise price during the exercise period, the company not get the subs Once the exercise period is over, equity warrants are of no use to the company b. Floating Rate Bonds

In case of floating rate bonds, the rate of interest paid by the company is not fixed The rate of interest is tied up with some base rate say bank rate and the variation in base rate decide the actual rate of interes E.g. State Bank of India issued the floating rate Bonds of the face value of R.s 1,000 carrying the rate of interest of 3% over th deposits If the rate of interest payable on the term deposits increases, the rate of interests on the floating rate bonds will increase and v At the same time, the company may prescribe some rate as the 'Floor rate' ( indicating the minimum rate of interest payabl falls below a certain limit) and as the ' cap Rate' ( which indicates the maximum rate of interest payable by the company even if the base rate increases b Advantages of Floating Rate Bonds

The Floating Rate bonds avoid the risk of interest rate fluctuations in the economy both for the issuing company as well as for t C. Zero Coupon Bonds (ZCB)

Zero Coupon Bonds do not have any explicit or coupon rate of interest payable by the company E.g. ZCB can be issued on the f Face Value Rs 100 per ZCB Redemption Value Rs. 125 per ZCB Redemption Period 3 years Difference between the redemption value and the face value is the gain to the investor Advantages Of ZCB The company does not require any periodical outflow of funds to service the borrowing during the currency of the borrowing d. Deep Discount Bonds (DDB)

Deep discount bonds were issued by Industrial Development Bank of India (IDBI) in 1992 for the first time. The terms on which Face Value Rs 1,00,000 Issue Price Rs 2,700 Maturity Period 25 years

The investors were given the option to quit investment at the end of every 5 years period E.g. the investors will be paid Rs 5,70 20 years etc Advantages of DDB The company does not require any periodical outflow of funds to service the borrowing during the currency of the borrowing Risks associated with DDB The redemption period is usually very long and hence, the investors accept the risk of non-payment at the time of maturity e. Secured Premium Notes (SPN)

Secured Premium Note was issued by TISCO in 1992 for the first time. The terms on which Tesco issued the SPN were as below a. Face value of the SPN was Rs. 300 per SPN b. SPN will not carry any interest during the first three years c. Commencing from year 4, the investors were to be paid Rs 75 towards the principal and another Rs 75 towards the interest a The investors were given the following three options to choose the following mixes of the low interest/high premium or high in I)Interest Rs 37.50 and Redemption Premium Rs 37.50 ii)Interest Rs 50 and Redemption Premium Rs 25 iii)Interest Rs 25 and Redemption Premium Rs 50

d. Each SPN was attached with the warrant whereby the investor could buy one equity share of TISCO for rs.100 during the e the allotment of the SPN Advantages of SPN The company does not require may periodical outflow of funds to service the borrowing during the currency of the borrowing

10.6 CREDIT RATING

After 1990, Indian capital market saw a lot of companies entering the capital market with the intention of raising the funds by It is expected that before an investor makes the investment in the instruments issued by the company, he should satisfy himse

While investing in the equity shares of company, the investor is assumed to be knowing about the risk involved with the invest

However, in case of the debt instruments, the investors are expected to make the investment in these instruments after m investment

However a small investor is not sufficiently equipped to make such a study As such, the financial service in the form of credit rating has emerged as a tool to help the investor evaluate his investment por What is credit rating ?

Credit Rating is the expression of opinion with the help of symbols, given by an independent credit rating agency, about the ab payments of principal and interest at the specified dates The above description of credit rating reveals the following features of credit rating a. Credit rating is with respect to a particular instrument issued by the company In other words, credit rating indicates the safety associated with the particular instrument issued by the company It does not indicate the financial health of the company as a whole

b. Credit rating is not a recommendation for buying, selling or holding security Actual investment made by the investor depends upon the other important factors like expectation of returns, risk taking capa

c. For the purpose of deciding the rating about the particular instrument, the rating agency may use the various types of inform This information may be made available to the rating agency either by the company itself or it may be available to the agency f However, the rating agency does not perform the audit function In the sense, the rating agency does not certify that the information available to it is true and correct

d. Credit Rating does not create any legal relationship between the rating agency and the investor If an investor invests in a particular security on the basis of high credit rating given by rating agency and the said investme investor cannot hold rating agency responsible for the bad investment Is credit rating obligatory? In the Indian circumstances , credit rating is not obligatory in case of Equity shares It is obligatory only in case of the debt instruments To be more precise, credit rating is obligatory in case of the following debt instruments a. Convertible or Non-convertible Debentures/ Bonds irrespective of the period of maturity of redemption b. Fixed Deposits issued by non-banking financial companies c. Commercial paper

Recently amended SEBI guidelines provide that if the size of the issue is more the Rs. 100 cores , the issue is required by at leas It should be noted that the requirement of credit rating in respect of the above instruments is not a part of any particular law o It is included in the various guidelines applicable for the issue of above instruments Who can do the credit rating?

Presently there are four approval credit rating agencies who can do the credit rating of the various instruments. These agencie a. Credit Rating and Information Services of India Ltd (CRISIL) b. Investment Information and Credit Rating Agency (IICRA) c. Credit Analysis and Research Limited (CARE) d. FITCH Rating India Private Limited Advantages of credit rating

a. In the developing capital market conditions, credit rating provides the investor with the reliable and superior information fro company at no cost This facilitates the investment on the part of investors on conscious basis instead of on some ad-hoc basis b. With satisfactory credit rating, it is comparatively easy for a company to market the instrument at less cost. Similarly, with a satisfactory credit rating, it is possible for the company to approach a wide audience of the investors

c. Credit rating provides a motivation to the companies to improve their performance. A company with a low credit rating wi improve its performance

d. With the help of credit rating the investible funds of the investors are directed towards more productive investment portfoli The possibility of investment failing is comparatively less Methodology of Credit Rating

For this purpose, we will take into consideration the rating methodology follows by CRISIL The rating procedure followed by CRISIL may be based upon the information available to it either directly from the company or During this process, CRISIL considers the following aspects about the company a. Business Analysis

i) Industry Risk - This indicates the overall demand/supply position in the industry as a whole, the existing as well as the pote policies affecting the industry etc ii) Market position - This indicates the market position of the company vis--vis that of the competitors in the industr disadvantages, selling and distribution arrangements etc iii) Operating Efficiency - This involves the consideration of manufacturing process and operating efficiency of the company various infrastructural facilities, modernization/expansion/diversification plans etc.

b. Financial Analysis This involves the consideration of the various factors like ' accounting policies followed by the company , analysis of the fi capital and working capital needs, ability to raise funds from the marketed' c. Management Evaluation

This involves the consideration of the various factors like track record of the management , capacity to overcom targets/objectives/strategies etc Credit Rating Symbols CRISIL Long Term ( Debenture/Bonds) Highest Safety High Safety Adequate Safety Moderate Safety Inadequate Safety High Risk Substantial Risk Default Medium Term ( Fixed Deposits ) Highest Safety High Safety Adequate Safety Inadequate Safety High Risk Default Short Term ( Commercial Paper) Highest Safety High Safety Adequate Safety Inadequate Safety Default Note: a. The above table indicates the comparison between the symbols and used by the various rating agencies The above description for the use of symbols is as used by CRISIL The exact description used by the remaining two rating agencies varies slightly from the description used by CRISIL b. The rating agencies may add + or - sign to indicate the degree of variation The credit rating symbols used by Fitch Rating India Pvt. Ltd are as below P1 P2 P3 P4 P5 A1 A2 A3 A4 A5 F AAA FAA FA FB FC FD M AAA MAA MA MB MC MD AAA AA A BBB BB B C D LAAA LAA LA LBBB LBB LB LC LD IICRA

For Long Term ( 12 months and more) AAA (ind) AA + (ind), AA(ind), AA-(ind) A+(IND),A(IND),A-(IND) BBB+(ind),BBB(ind),BBB-(ind) BB+(ind), BB(IND),BB-(ind) C(ind) D(ind) Public Deposits tAAA (ind) tAA + (ind), tAA(ind), tAA-(ind) tA+(IND),tA(IND),tA-(IND) tBBB+(ind),tBBB(ind),tBBB-(ind) tBB+(ind), tBB(IND),tBB-(ind) tC(ind) tD(ind) For Short Term (Less than 12 months) F1+(ind),F1(ind) F2+(ind),F2(ind) F3(ind) F4(ind) F5(ind) Highest Credit Quality Good Credit Quality Fair Credit Quality Speculative Default Highest Credit Quality High Credit Quality Adequate Credit Quality Moderate Credit Quality Highly Speculative High Default Risk Default Highest Credit Quality High Credit Quality Adequate Credit Quality Moderate Credit Quality Highly Speculative High Default Risk Default

Limitations of Credit Rating

a. Credit Rating is based upon the evaluation made by the agencies which is essentially a subjective evaluation which may var individual opinion of the rators which may be biased in some cases

b. The various guidelines issued for regulating the various type of instruments for which credit rating is required, require the co However, these guidelines do not require the companies to publish these ratings As such, in certain cases the companies may not publish the ratings, particularly when the ratings are not favorable to the com This defeats the basic purpose of credit rating c. The approval credit rating agencies prevailing in the country are promoted by the government controlled organizations This may involve its own consequences

d. It is usually observed that the ratings given by the credit rating agencies is primarily based upon the past performance of companies should be given more importance while deciding the credit rating Moreover, if a particular company or a particular industry is passing through the temporary conditions, it may get a low credit

e. Multiplicity of the rating agencies can be considered to be the limitation of the credit rating If a company is not satisfied with the rating given by one agency, the company can approach another rating agency with the ho The recently introduced guidelines issued by SEBI provide that if the company has approached more than one rating agency, are made known to the investors

If there is a vast difference between the ratings awarded by the different agencies , it may be a point of concern for the investo

f. In the recent past, some cases were observed that the ratings given by the agencies were either upgraded or downgraded w

The question arises what went wrong to such an extent that the ratings were required to be upgraded or downgraded to such In the whole process, the basic rating given by the agencies gets challenged. Effectively, the credibility of the agency is at stake 10.7 BUYBACK OF SHARES

As per the provisions of Companies ( Amendment ) Act 1999, the company is now authorized to buy back its own shares\ This is one of the exceptions to the rule that no company can reduce the amount of its share capital during its life time The provisions in respect of buy back of own shares are contained in Section 77A of the companies Act, 1956 which are as belo a. Articles of association of the company should authorize the company to buy back its own shares If there is no authorization in the Articles of Association they need to be amended first

b. The but back of the shares should be approved by passing resolution in the general meeting of the company The explanatory statement enclosed to such notice should contain the details like disclosure of all material facts, necessity for back, amount required for such buy back of shares and time requires for completion of buy back After the special resolution is passed but before the buy back of shares, the company shall file with the Registrar of Companie are listed on a recognized stock exchange, a declaration that the company is capable of meeting its liabilities and will not declaration

Such declaration shall be signed by at least two directors, one of whom should be the managing director This special resolution should be filled with the Register of Companies of the respective state in form no 23. The procedure of buy back should be completed within 12 months from passing such a special resolution. If the company buys back the shares with the intention to get delisted in the stock exchange, the company has to follow the pr c, The shares can be brought back out of the following amounts : i) Free reserves of the company ii) Share premium account of the company iii) Proceeds of issue of any shares or other specified securities However , proceeds of earlier issue of shares or other specified securities cannot be used for buy back of shares

Similarly , the shares can be brought back i) From the open market ii) From the existing share holders on a proportionate basis iii) By purchasing the shares issued to the employees under the employees stock option scheme or issued to them as sweat eq

d. The amount of shares brought back should not be more than 25% of the total pays-up capital of the company and its free re A company can be able to buy back its own shares every year, however, the amount of shares brought back in any financial capital in that financial year

e. The debt equity ratio of the company after such buy back of shares should not be more than 2:1 except here the Centra companies f. The shares which are proposed to be brought back should be fully paid up shares

g. When the company buys back its own shares, it shall extinguish and physically destroy securities so brought back with a pe back

h. If the company buys back its own shares, it shall not make further issue of some kind of shares ( including right shares) with not apply toi) Issue of bonus shares ii) Conversion of preference shares/debentures into the equity shares iii) Fulfillment of obligation in respect of conversion of equity warrants, employees stock options or sweat equity

i) After the process of by back of shares is complete, the company shall file necessary particulars with Registrar of Companie company are listed on a recognized stock exchange

j) Where the company buys back its own shares , it shall maintain a registrar of the shares so brought back, consideration pa these shares, date of extinguishing/physical destruction of these shares etc 10.8 VENTURE CAPITAL

In the recent past, Ventures Capital has become one of the best possible sources for raising the funds for the companies invol normal avenues for raising the funds are unavailable as the common investors are unwilling to invest their funds into such ven Venture capital as a source of funds has become a necessity for the organization who have good growth opportunities Venture Capitalist or Venture Capital Fund (VCF) is interested in investing in these projects ( i.e. Venture Capital Undertaking) returns These returns may not be in form of recurring returns like dividend, but also in the form of capital gains over a longer span of t

A venture capitalist investing in the project is aware of the fact that the project is in the untested area, involving more amount He is also award that the projects are likely to involve larger gestation period As such, a venture capitalist is not worried about the failure of the project in which he invests his funds This is because of the fact that he knows that the project which succeeds will give huge returns which will compensate for the This is the reason why the venture capitalist is not only the investor of funds or the lender of the funds

A conventional lender of funds is not directly involved in the operation and management of the company He keeps away from managing the company and is bothered about the safety of the funds lent by him A conventional investor only trades in the shares of the company without any relationship with the management of the compa

As against , before investing in the project, Venture Capital Company or Venture Capital Fund scrutinizes the project carefully a He takes active participation in the management of the project providing the benefit of his expertise and experience to the ven Before investing the project the venture capitalist is interested in ensuring that a. The project is technically feasible b. The project is commercially viable c. The entrepreneurs are technically competent d. The project has a comparative advantage over a longer span of time Types of Venture Capital Financing The Venture capital funding can be either in the form of equity financing or debt financing However , equity financing is a more preferred route for venture capital funding This is due to the following facts

a. Projects for venture capital financing are more risky in nature and involve larger gestation period Hence, the project will require the long term funds on which it may not be able to pay the returns during the initial period At the same time, venture capitalist is not interested in interfering in the project Hence, the investment of the venture capitalist does not exceed 49% so that the effective control of the project remains with t b. Venture capitalist is not interested in keeping his investment in the project on a permanent basis He wishes to quit his investment as early as possible He can do so when the project becomes successful and profitable and he is able to sell off his equity shares EXIT Routes available to VCF As studied earlier, the VCF is not interested in remaining associated with the Venture capital. Undertaking on a permanent basis He is interested in quitting his investment at a suitable point of time In the Indian circumstances, following two options may be available to VCF for the purpose of quitting his investment a. Purchase of VCF stake by the promoters b. Intel Public Offering (IPO) Purchase of VCF stake by the promoters

This exit route is very popular in the Indian circumstances where the promoters of the Venture Capital Undertaking, purchase pre decided price This enable the promoters to maintain their stake in the Venture Capital Undertaking intact The limitation of this exit route lies in the fixation of the price which the promoters will be required to pay to the VCF FOR BUY

Initial Public Offering (IPO)

The first public offering of equity shares of a company to be followed by listing of the shares on the stock exchange is known as Once the Venture Capital Undertaking becomes profitable, it can make the public issue of its shares After the abolition of the office of Controller of Capital Issues, it is possible for the companies to decide the premium on the iss After the shares of the company are listed on the stock exchange, the VCF can sell its stake on the stock exchange earning the The limitation of this exit route is the restricted scope of IPO for the Venture Capital Undertaking as the venture promoted by an attractive proposition by the investors

Further, complexities in getting the securities listed on the stock exchange and the efficiency of the secondary markets in Ind VCFs Ventures Capital in India

The history of Venture capital in India can be traced back to the establishment of Technology Development Fund (TDF) technology import payments TDF was for providing financial assistance of innovative and high risk projects through Industrial Development Bank of India (ID In 1988 , Industrial credit and Investment Corporation of India (ICICI) PROMOTED Technology Development and Information company under the Companies Act,1956

In 1996 Securities and Exchange Board of India issued the guidelines for the operations of Venture Capitalists to carry out their This has made the entry of foreign venture capital funds more easy in Indian situations At present , the venture capital funds (VCFs) operation in India can be classified in the following categories a. VCFs promoted by All India Development Financial Institutions like IDBI, ICICI and IFCI e.g. TDICCI promoted by ICICI

b. VCFs promoted by State level Financial Institutions E.g. Gujarat Venture Finance Company Limited or Andhra Pradesh Ventu c. VCFs promoted by the Commercial Banks E.g. Can Bank Venture Capital Fund or State Bank Venture Capital Fund etc

d. Private Sector Venture Capital Funds E.g.. Venture Fund , 20th Century Venture Capital Company, Infrastructure Leasing and

In order to promote the venture capital, Section 10 (23FB) was inserted in Income Tax Act, 1961 which provides that any incom To get this exemption , following two conditions are required to be satisfied

a. Venture Capital Company or Venture Capital Fund should have been given the certificate of registration by SEBI and suc should have fulfilled all the conditions as specified by SEBI

b. Venture Capital Company or Venture Capital Fund is set up to raise the funds for investment in a Venture Capital Undertak are not listed in a recognized stock exchange

If the above conditions are satisfied, any income of Venture Capital Company or Venture Capital Fund will be exempt from subsequently listed in recognized stock exchange

10.9 SUMMARY

The Capital Market refers to the market available to the company for raising the long term requirement of funds The company can raise the funds in the following three manners 1. Public Issue , 2. Rights Issue, 3. Private placement of securit

If the company wishes to collect the funds by making the Public Issue or Rights issue for the Securities, it has to follow the S offer with the Registrar of Companies, listing on stock exchange , denomination of shares, etc

If a company wants to raise the funds from various sources, services which are provided by various intermediaries become ess The most important and significant intermediary is the merchant banker Equity Warrants, floating rate bonds, zero coupon bonds, deep discount bonds and secured premium notes are some example raise funds from the public

Credit rating is the expression of opinion, with the help of symbols, given by an independent credit rating agency, but the ab payments of principal and interest at specified dates In Indian circumstances, credit rating is not obligatory in case of equity shares It is obligatory only is case of the debt instruments Buyback of shares means purchase of own equity shares by the company i.e. the reduction equity share capital Section 77 A of the companies Act, 1956 deals with provision of Buyback of shares

Venture capital has become one of the best possible sources for raising the funds for the companies involving more business funds are unavailable as the common investors are unwilling to invest their funds into such ventures

Unit 11 - FINANCIAL MANAGEMENT

11.CAPITAL BUDGETING
11.1 INTRODUCTION

As discussed in the earlier units, the finance function has to deal with one of the most important decisions rega and the decision is technically in the form of "Capital Budgeting". Thus, the capital budgeting decisions are decisions as to whether or not money should be invested in long term

It includes analysis of various proposals regarding capital expenditure to evaluate their impact on the financial s out of the various alternatives. The function of finance in the area is to enable the management to take a proper capital budgeting decision.

Capital Budgeting decisions are the most crucial and critical decisions for a business to take. This is the fact due to the various reason.

1. Capital budgeting decisions have long term implications on the operations of the business. A wrong dec company. The investment in fixed assets more than required, may increase the operating costs of the compa may make it difficult for the company to compete and may affect its market share. 2. Capital budgeting decisions involve large amount of the funds. As such, it is necessary to take the decision v funds for the procurement of these assets. 3. The capital budgeting decisions are irreversible due to the fact that it is difficult to funds to market for suc these assets which involves huge losses. 4. Capital budgeting decisions are difficult to make because it involves the assessment of future events which required to be made immediately but the returns are expected over a number of years.

11.2 THE PROCESS OF CAPITAL BUDGETING

The process of capital budgeting involves generally the following steps: (1). Project Generation : The generation of the proposals may fall under any of the following categories: (a). Additions to the present product line (b). Expansion of the capacity of the existing product line. (c). Proposals to reduce costs of the existing product line without affecting the scale of operations.

The generation of the projects may take place at the levels of top management or at the level of workers also improve the production techniques may originate at the worker's level also.

(2). Project Evaluation : As in case of any types of decision makings, the capital budgeting decisions also ha and costs measured in terms of cash flows. Secondly, selection of an appropriated criteria to judge the desi evaluation of the projects is done by an impartial group and experts in the field. Care must be taken to cho projects and it should be consistent with the company's basic objective to maximize the wealth.

(3). Project Selection : There is no fixed and laid down procedure to select the final criteria among the variou of the project is done by the top management through it may be scrutinized at various levels. In many cases, to approve certain projects to lower management also. (4). Project Execution : After the final selection of the project is made, the funds are appropriated and the there has to be a proper system to check that the execution of the project is being made as per the predecided

Evaluation of the projects

As discussed earlier, the process of evaluation of the projects necessarily involves the cost benefit analysis. Thi financial terms, through in some cases non-financial considerations may also come into play. E.g. Sometimes a the market or to satisfy certain legal requirements or for some social welfare benefits or just for some emo analysis will be the basic evaluation criteria. There are many techniques and tools to evaluate the various investment proposals. But before going into the important aspects of the evaluation has to be studied and that is ' how to compute the cash flows? '

11.3 HOW TO COMPUTE CASH FLOWS

As estimation of cash flows- both outflows as well as inflows- is the crux for evaluating the projects, this estim The following stages should be considered for this purpose. (1) Following items constitute the cash outflow. (i) Cost of new equipment.

(ii) Cost for demolition of old equipment(similarly, if there is some scrap value receivable from the dispos of the new equipment should be suitably adjusted.) (iii) Cost of preparing site and installation charges incurred with respect to the new equipment. Following factors should also be taken into consideration.

(i) If the cost of the new equipment is not to be incurred in one single installment but is to be paid outflow not only in the first year but in the subsequent years also. Similarly, if the cost of the equipment/projec outflow will come into consideration as and when the installment of term borrowings and interest on the same a (ii) if a new equipment/project brings certain scrap value after the useful life is over, the amount inflow, but in relation to the year in which the amount is actually received. (iii) In some cases, implementation of the project may involve investment in the form of additio increased debtors etc. The additional investment in working capital constitutes cash outflow. Similarly after the in the working capital is released and hence should be considered as inflow but only with respect to the year in resorts to some outside source of funds for financing working capital requirements, the cash outflow on accou amount invested by the company itself. The amount received from the outside source of working capital finance

(iv) if a new asset is intended to be purchased in order to replace an existing asset, the sale procee cash inflow and the cash outflow required to purchase the new asset should be adjusted accordingly. (2) Following factors should be considered while computing cash inflows:

(i) Computation of cash inflows highly depends upon correct estimation of production and sales. which can be sold and the price at which they can be sold, the gross revenue from the project can be worked reduction in selling price, introduction of a cheaper product by competitors, etc. should also be considered. (ii) Second stage in deciding the cash inflows is to estimate the costs attached to the project. Th variable costs or depreciation. (iii) The difference between the gross revenue and the costs give the result of the net revenue whic computation of cash inflows as it involves the actual payment of cash. However, the amount of depreciation, if taxation factor should be added back while computing the cash inflow as depreciation does not involve the c should be computed in the following stages. Sales Revenue Less : Costs(including Depreciation) Net Revenue Less : Tax Liability Revenue after taxes Less : Depreciation Net cash inflow

(iv) Care should be taken not to include the cost of interest and dividends while considering the cost that for evaluating the proposals if cost of capital is considered as the discounting factor( as discussed in deta are already given due consideration while computing the cost of capital. (v) Sometimes the cash inflows may be considered in terms of net savings in costs rather than in te Thus, for computing the cash inflows these savings in costs will be the starting point which will have to be adjus The cash inflows will be computed as below. Saving in costs (Other than Depreciation)

Less : Depreciation Net Savings in Costs Less : Tax Liability Savings after tax Less : Depreciation Net cash inflows

11.4 TIME VALUE OF MONEY

It has already been discussed that the evaluation of capital expenditure proposals involves the comparison betw

The peculiarity of evaluation of capital expenditure proposals is that it involves the decisions to be taken tod inflow, may spread over a number of years. It goes without saying that for a meaningful comparison between the cash outflows and cash inflows, both the

As such, the question which arises is that " is the value of flows arising in future the same in terms of today? Rs. after one year, is the value of this cash inflow really Rs. 10,000 as on today when the capital expenditure prop question is 'no'. the value of Rs. 10,000 received after one year is less than Rs.10000 if received today. the rea (1) There is always an element of uncertainty attached with the future cash flows. (3) There may be investment opportunities available if the amount is received today which cannot be exploited

(2) The purchasing power of cash inflows received after the year may be less than that of equivalent sum if rec

E.g. if Mr. X is given the option that he can receive an amount of Rs. 10000 either today or after one year, he Because, if he receives Rs. 10000 today he can always invest the same, say in the fixed deposits with a bank choice is given to him, he will like to receive Rs.10,000 today or Rs.11,000 (i.e. Rs. 10,000 plus interest @ 10 to receive Rs. 10,000 only after one year, the real value of the same in terms of today is not Rs. 10,000 but time value of money.

In the capital budgeting decisions, if there has to be a meaningful comparison between the cash outflows different points of time whereas the evaluation is required to be done as on today, both the future cash outflow in terms of today. There are two techniques available for this: (a) Compounding (b) Discounting (a) Compounding:

In this techniques, the interest is compounded and becomes a part of initial principal at the end of the compoun

E.g. If Mr. X invests Rs. 10,000 in fixed deposit carrying interest @ 10% p.a. Compounded annually, at the Rs.11,000(i.e. Rs.10,000 + interest on Rs. 10,000@ 10% p.a.). If Rs.11,000 are reinvested in the same fixed d be worth Rs.12100(i.. Rs.11000 + interest on Rs.11,000@ 10 % p.a.). In other words, the value of today's Rs 12100. The compounding of interest can be calculated with the help of following equation : A = P(1+i) where A = Amount at the end of the period

P = Amount of principal at the beginning of the period i = Rate of interest n = Number of years

E.g. In the above example, after two years, the value of today's Rs.10,000 if invested in the investment carryin A = 10,000*(1 + 0.10) = 10,000*1.21 = Rs. 12,100 (b) Discounting:

These techniques involve the process which is exactly opposite to that involved in the technique of compound value of Re.1 received or spent after n years, provided that the interest rate of I can be earned on investment. The present v equation. P= A/(1+i) where, P = Present Value of sum received or spent A = Sum received or spent in future i= Rate of interest n = Number of years

E.g. if Mr.X is given the opportunity to receive Rs. 10,000 after two years, when he can earn interest of 10 amount which he should be the amount which he should invest today so that he may be able to receive Rs.10,0 it can be computed as: P = A/(1+i) = 10,000/(1+0.10) = Rs.8264.46

In other words, if Mr.X invests Rs.8264.46 today in the investment carrying interest rate of 10% p.a. he may the present value or Rs.10,000 if received after two years is only Rs.8264.46 as on today if investment opportu p.a. Present Value Tables

To simplify the computation of present value, use can be made of the present value of rupee one for the variou the present value of a future lump sum, the said sum can be multiplied by choosing the interest factor/discoun combination of i and n.

E.g. To find out the present value of Rs.4000 received after 7 years, assuming interest rate to be 15%,we asc ascertain the present value to be Rs.4000*0.513 = Rs.2052 Present Value of series of cash flows

In capital budgeting decisions, the cash flows, either cash outflow or cash inflow, may occur at various points o series of cash flows, it is necessary to find out the present value of each future cash flow and then aggregate th Illustration I A project involves cash inflows as below. Year Cash -----------------------------------------1 2 3 4 -----------------------------------------Assuming interest rate to be 15%, find out the present value of cash inflows. Solution: Calculation of present value of cash inflows.

Year Cash inflows Rs. Present Value Factor 15% ---------------------------------------------------------------------------------------------------------------------------1 10,000 0.870 2 12,000 0.756 3 15,000 0.658 4 20,000 0.572 ---------------------------------------------------------------------------------------------------------------------------39082 ---------------------------------------------------------------------------------------------------------------------------Illustration II A machine costing Rs.1,00,000 is to be purchased as below: Rs.20,000 - down payment out of own contribution.

Rs.80,000 - Borrowing by way of term loan. To be paid in 4 equal annual installment along with the intere opening outstanding balance. Calculate present value of the cash outflow. Solution: Calculation of present value of cash outflows

Year Principal Sum/ Own Contribution Rs. Interest Rs. Total Outflow Rs. ---------------------------------------------------------------------------------------------------------------------------0 20,000 20,000 1 20,000 12,000 32,000 2 20,000 9,000 29,000 3 20,000 6,000 26,000 4 20,000 3,000 23,000 ----------------------------------------------------------------------------------------------------------------------------

----------------------------------------------------------------------------------------------------------------------------If a project involves uniform cash flows, the present value of the cash flows can be calculated by a short cut m each cash flow and then summing up the present values, the discounting factors(interest factor or present v find out the Accumulated Discounting Factor for the various interest rates(i) and years(n) and the multiplicati flow will give present value of cash flow. Illustration III

A project involves the cash inflow of Rs.20,000 per year for 4 years. Assuming the interest rate of 15%, find ou

Accumulated Discounting Factor at 15% for 4years is 2.855. Present value of cash inflows Rs.20,000*2.855 = Rs. 57,100. Relevance in Capital Budgeting Decisions

As discussed earlier, to make the value of cash outflows and cash inflows comparable, it is necessary to redu present value by discounting them by proper discounting factor or interest factor or present value factor considered as the discounting factor in capital budgeting decisions.

11.5 TECHNIQUES FOR EVALUATION OF CAPITAL EXPENDITURE PROPOSALS

(a). Techniques not considering time value of money. (b). Techniques considering time value of money. (a). Techniques not considering time value of money: 1. Pay Back Period:

Various techniques are available for evaluation of capital expenditure proposals. They can be broadly categorize

Pay back period indicates the period within which the cost of the project will be completely recovered which the total cash inflows equal to the total cash outflows. Thus, Payback period = cash outlay/Annual cash inflow Illustration I pay back period for the project is Rs. 5,00,000 / Rs. 1,00,000 = 5 years If the project involves unequal cash inflows, the payback period can be computed by adding up the cash inflow Illustration II

A project requires an outlay of Rs.5,00,000 and earns , an annual cash inflow of Rs.1,00,000 for 8 years. Calcul

A project requires an outlay of Rs. 1,00,000 and earns, the annual cash inflows or Rs. 25,000, Rs. 30,000, period. if we add up cash inflows, we find that in the first 3 years, an amount of Rs.75,000 of the cash outlay is reco Rs.50,000, whereas the amount of Rs.25,000 only remains to be recovered. Assuming that the cash inflows oc be required to recover Rs.25,000 will be Rs.25,000 / Rs.50,000 * 12 months = 6 months. Thus, the pay back period is 3 years and 6 months. Acceptance Rule :

Payback period method can be used as an accept or reject criteria or as a method of ranking the project. If the than maximum payback period estimated by the management it would be rejected or vice versa. As a ranking period will be ranked highest. Advantages: (2) It Costs less.

(1) It is quite simple to calculate and easy to understand. It makes it quite clear that there are no profits on a p

(3) It may be a suitable technique where risk of obsolescence is high. In such cases, projects with shorter pay technology may make other projects obsolete before their costs are recovered. Disadvantages :

(1) It does not consider the returns from a project after its pay back period is over. Thus one project A may h project B may have a pay back period of 3 years, thus making project B more preferable. But it is quite possible after 5 years till the end of 10 years, while project B may stop generating cash inflows after 3 years only. I advantageous. (2) It may not be suitable method to evaluate the projects if they involve uneven cash inflows. (3) It ignores time value of money.

(4) To decide the acceptable payback period is a difficult task. There is no rational basis for deciding the maxim

2. Accounting Rate of Return :

Accounting rate of return (ARR) computes the average annual yield on the net investment in the project.ARR is depreciation and taxes by net investments in the project. Thus ARR can be computed as : (Total Profits / Net investment in project * No. of years of projects)*100 Illustration Year ------------------------------------------------------------------------------------1 2 3 4 5 -------------------------------------------------------------------------------------Rs. -------------------------------------------------------------------------------------At the end of 5 years, the machineries in the project can be sold for Rs. 40,000. Find the ARR. The total profits after depreciation and taxes are Rs. 2,30,000. ARR will be (Rs. 2,30,000 / Rs. 4,60,000*5 years)*100 = 10% Acceptance Rule :

A project involves the investment of Rs.5,00,000 which yields profits after depreciation and tax as stated below.

the net investment in the project will be Original cost Less salvage value i.e. Rs. 5,00,000 - Rs. 40,000 = Rs. 4,

As pay back period method, ARR also can be used as accept or reject criteria or as a method for ranking the p having the ARR more than minimum rate prescribed by the management will be accepted and vice versa. As a ARR will be ranked highest. Advantages: (1) It is simple to calculate and easy to understand. (2) It considers the profits from the project throughout its life. (3) It can be calculated from the accounting data. Disadvantages: (1) It uses profits after depreciation and taxes and not the cash inflows for evaluating the projects. (2) It ignores time value of money.

(b). Techniques considering time value of money: 1. Discounting Pay back period:

This is an improvement over the pay back period method in the sense that it considers time val indicates that period within which the discounted cash inflows equal the discounted cash outflows involved in a p Illustration:

A project requires an outlay of Rs. 1,00,000 and earns the annual cash inflows of Rs.35,000 , Rs. 40,000, Rs pay back assuming the discounting rate of 15%. Year Cash inflows Rs. Discounting Factor @15% Discounted Cash Inflow Rs. ---------------------------------------------------------------------------------------------------------------------------1 35,000 0.870 30,450 2 40,000 0.756 30,2 40 3 30,000 0.658 19,740 4 50,000 0.572 28,600 ----------------------------------------------------------------------------------------------------------------------------

Thus, pay back period is after 3 years but before 4 years. Assuming that cash inflows accrue evenly during the days. (1,00,000 - 80,430 / 28,600)*365 = 250 days Acceptance rule, advantages and disadvantages They are the same as in case of pay back period method except the fact that it considers time value of money. 2. Net Present Value :

Net Present Value (NPV) is a method of calculating present value of cash inflows and cash outflows in an inv discounting rate, and finding out net present value by subtracting present value of cash outflows from present v NPV ={ Discounted cash Inflows} Less { Discounted Cash Outflows} Illustration:

Calculate net present value of a project involving initial cash outflow Rs.1,00,000 and generating annual cash and Rs. discounting rate is 15%. Year Cash inflows Rs. Discounting Factor @15% ---------------------------------------------------------------------------------------------------------------------------1 35,000 0.870 2 40,000 0.756 3 30,000 0.658 4 50,000 0.572 -----------------------------109030 -----------------------------Less : Investment Outlay -----------------------------Net Present Value (NPV) --------------------------------------------------------------------------------------------------------------------------------------------------------Acceptance Rule :

As accept or reject criteria, all the projects which involve positive NPV i.e. NPV > 0 will be accepted and vise ver As a ranking method, the projects having maximum positive NPV, will be ranked highest. Advantages : (1) It considers time value of money. (2) It considers cash inflows from the project throughout its life. Disadvantages : (1). It is difficult to use, calculate and understand.

(2). It presupposes that the discounting rate, i.e. cost of capital is known. But cost of capital is difficult to measu

(3). It may give dissatisfactory results, if the alternative projects involve varying investment outlay. A projec desirable if it involves huge investment. (4). It presupposes that the cash inflows can be reinvested immediately to yield the return equivalent to the dis

3. Internal Rate of Return:

Internal Rate of Return(IRR) is that rate at which the discounted cash inflows match with discounte that this is the maximum rate at which the company will be able to pay towards the interest on amounts borro anything. Thus, IRR may be called as the 'break even rate ' of borrowing for the company. In simple words, IRR indicates that discounting rate at which NPV is Zero. If by applying 10% as the while by applying 12% discounting rate, the resultant NPV is negative, it means that IRR, i.e. the discounting ra 12%. Thus , by applying the trail and error method, one can find out the discounting rate at which NPV is zer any discounting rate and compute NPV. If NPV is negative, a lower discounting rate should be tried and the p Zero. The following illustration explains the process to calculate IRR. Illustration:

A project cost Rs.1,00,000 and generating annual cash flows of Rs. 35,000, Rs. 40,000, Rs.30,000 and Rs. internal Rate of return. Using 15% as a discounting rate, the present value of cash inflows can be calculated as Year Cash inflows Rs. PV Factor 15% ------------------------------------------------------------------------------------1 35,000 0.870 2 40,000 0.756 3 30,000 0.658 4 50,000 0.572 ------------------------------------------------------------------------------------109030 ------------------------------------------------------------------------------------Using 18% as a discounting rate, the present value of cash inflows can be calculated as below.

Year Cash inflows Rs. ------------------------------------------------------------------------------------1 35,000 2 40,000 3 30,000 4 50,000 ------------------------------------------------------------------------------------1,02,435 ------------------------------------------------------------------------------------NPV 2,435 Year Cash inflows Rs. ------------------------------------------------------------------------------------1 35,000 2 40,000 3 30,000 4 50,000 ------------------------------------------------------------------------------------98,385 ------------------------------------------------------------------------------------NPV 1,615

PV

Factor

18% 0.847 0.718 0.609 0.516

Using 20% as a discounting rate, the present value of cash inflows can be calculated as below. PV Factor

20% 0.833 0.694 0.579 0.482

Thus , at 18% discounting rate, NPV, is Rs. 2435 and 20% discounting rate, NPV is (-) Rs. 1615.Hence, IRR is b less than Difference between PV at 18% and 20% is Rs. 4,050 (i.e. Rs. 1,02,435 - Rs. 98,385) and the negative NPV of arrive as IRR. IRR = Discount at Higher Rate -[NPV at Higher Rate / Difference Between PV at two rates * Difference between rates] Thus, IRR will be = 20% - 1,615 * 2 / 4,050 = 20% - 0.80% =19.2% (Appr.) Acceptance Rule:

The computed IRR will be compared with the cost of capital. If the IRR is more than or at least equal to the co Cost of Capital - Accept). If the IRR is less than cost of capital, the project may be rejected. (IRR < Cost of Capi Advantages : (1) It considers time value of money. (2) It considers cash inflows from the project throughout its life.

(3) It can be computed even in the absence of the knowledge about the firm's cost of capital. But in order to dr cost of capital is a must. Disadvantages : (1). It is difficult to use, calculate and understand.

(2). It presupposes that the cash inflows can be reinvested immediately to yield the return equivalent to the IR that the cash inflows can be reinvested to yield the return equivalent to the cost of capital, which is more realist 4. Profitability Index (PI)/ Benefit Cost Ratio (B/C Ratio)

It is the ratio between total discounted cash inflows and total discounted cash outflows. Thus, the profitability In PI = Discounted cash inflows / Discounted cash outflows PI can be computed as gross one as stated one as stated above or as net one which means gross minus one. Illustration:

A project requires an outlay of Rs.1,00,000 and earns the annual cash inflows of Rs. 35,000, Rs. 40,000, Rs. index assuming the discounting rate of 15%. Year Cash inflows Rs. PV Factor 15% ------------------------------------------------------------------------------------1 35,000 0.870 2 40,000 0.756 3 30,000 0.658 4 50,000 0.572 ------------------------------------------------------------------------------------1,09,030 ------------------------------------------------------------------------------------Profitability Index can be calculated as : Discounted cash inflows / Discounted cash outflows Thus, PI (Gross) PI (net) Acceptance Rule : Rs. 1,09,030 / Rs. 1,00,000 1.09 - 1.0 = 0.09 = 1.09

As accept or reject criteria, the projects having the Profitability Index of more than one will be accepted and having profitability index will be ranked highest. Final Choice of evaluation method :

Between the basic two types of techniques as described above, the techniques considering time value of money However, the choice of evaluation technique depends upon the objective of the management in the investment of maximization of wealth of the share holders. As such, only those projects will be in the interest of the share h other alternative investment opportunities.

11.6 LIMITATIONS OF CAPITAL BUDGETING

(a) Cash outflow. (b) Revenues / Saving and costs attached with projects. (c) Life of the projects.

The basic limitation of the capital budgeting process lies in this fact that it involves various estimations. These e

Whereas the cash outflows can be estimated with a reasonable accuracy, the cash inflows and life of the proj changes in fiscal and taxation policies of the Government also have the impact on determination of cash inflow evaluate the projects, the cost of capital is used as discounting rate. Difficulties in deciding the cost of capita process.

11.7 EVALUATION CRITERIA IN CERTAIN TYPICAL SITUATIONS

(a) In certain cases, the capital expenditure may not involve any specific inflow of funds, but only outflow products which themselves cannot be marketed, there may not be any specific inflow of funds associated wit company is required to make the choice between two machines, the company should choose that machine w outflow of funds.

Illustration :

A Company has to make a choice between buying of two machines. Machine A would cost Rs. 100000 and re Machine B would cost Rs. 150000 and its cash running expenses would amount to Rs. 20,000 p.a. Both the ma value. The company follows a straight line depreciation and is subject to 50% tax on its income. The company's should it buy? Note: Present Value of Re. 1 p.a. for 10% discount rate is Rs.61446.

Solution :
Machine A

Particulars Pre-tax Amt. Post tax Amt. Years ---------------------------------------------------------------------------------------------------------------------------Cost of Machine 100000 100000 0 Running Expenses 32000 16,000 1-10 Depreciation (-)10000 (-) 5000 1-10 ---------------------------------------------------------------------------------------------------------------------------Net Cash Outflow ---------------------------------------------------------------------------------------------------------------------------Machine B

Particulars Pre-tax Amt. Post tax Amt. Years ---------------------------------------------------------------------------------------------------------------------------Cost of Machine 150000 150000 0 Running Expenses 20000 10,000 1-10 Depreciation (-)15000 (-) 7500 1-10 ----------------------------------------------------------------------------------------------------------------------------Net Cash Outflow ---------------------------------------------------------------------------------------------------------------------------As the PV of net outflow of funds is less in case of Machine B, investment in Machine B will be accepted.

(b) In certain cases, the capital expenditure may involve replacement of an existing machinery or equipments w Under such situations, the inflow of funds is in the form of savings arising from the investment which should associated with a new proposal vis - a - vis the costs and benefits associated with an existing proposal which wi Illustration:

Shree Prakash co. has been using a machine costing Rs. 15000 for the past 5 years. The machine has 15 ears 2000 and the company has been paying 50% of its profits as taxes(i.e. it is subjected to 50% flat tax rate). Now, the management desires to replace it by a new machine costing Rs.10,000 with salvage value of Rs. 2,000 capital is 10% and the expected savings are likely to be Rs.3000 per annum. (a) should the company go for new machines?

(b) what would be your advice if expected savings increase by 50% per annum and expected life decreases by 5 Solution: Part A: Calculation of Cash Outflow:

Rs. Purchase Price of new machine Less: Salvage value of old machine Less: Tax saving @ 50% on the loss on sale of old machine* Net Cash Outflow Note :Loss on the sale of old machine is calculated as below : Cost of Old machine Less: Depreciation for 5 years . . . Written down value (WDV) Less : Salvage Value . . . Loss on sales of old machine 8000 ======== Calculation of Cash Inflows: 10,000 2,000 ------------15,000 5,000 ------------10,000 2,000 4,000 -----------4,000 ========

Particulars Pre-tax Amt. Post tax Amt. Total ---------------------------------------------------------------------------------------------------------------------------Savings 3000 1500 1-10 Difference in amount of depreciation (-)200 (-)100 1-10 Salvage 2000 2000 10

Hence NPV i.e. Rs. 9375 - Rs. 4000 ----------------------------------------------------------------------------------------------------------------------------As NPV is positive, the company should go for a new machine.

Note: Assuming that the depreciation is calculated on straight line basis which is acceptable for income tax pur at the end of its life was nil, difference in the amount of depreciation is calculated as below: Old Machine (Rs.) ---------------------------------------------------------------------------------------------------------------------Cost price 15000 Less: salvage value ---------------15000 ---------------Life in years 15 Annual depreciation 1000 800 Hence, amount of depreciation will be reduced by Rs.200,if a new machine is purchased. Part B Calculation of cash outflow will remain the same. Calculation of cash inflows:

Particulars Pre-tax Amt. Post tax Amt. Years ---------------------------------------------------------------------------------------------------------------------------Savings 4500 2250 1-5 Depreciation on new machine 1600 800 1-5 Depreciation on old machine (-)1000 (-)500 1-10 Salvage value 2000 2000 5

Hence NPV i.e. Rs. 9732 - Rs. 4000 ---------------------------------------------------------------------------------------------------------------------------As NPV is positive, the company should go for a new machine in the Second case also.

11.8 PLANNING, ORGANISATION AND CONTROL OF CAPITAL EXPENDITURE

It has already been discussed that the various proposals for incurring capital expenditure may be generated e management level though the latter is the rare possibility. The various proposals generated are evaluated w above. The ultimate selection for proposals depends upon the evaluation made by these techniques, however may also play an important role. The ultimate power to reject or accept various capital expenditure proposals rests with top management whi Executive Committee or Management Committee. In some cases, the power may rest with the Chairman or outlay to a certain extent may fall within the powers of the chief executive also and the proposals involving referred to top management as described above. if the actual implementation of the selected proposals involv institution or require certain Government approvals, it is the responsibility of middle management to arrange fo if it is intended to exercise proper control on the capital budgeting process, an organization may be required to

1. Planning: The capital expenditure has to be planned properly taking into consideration the present and fut in such a way as to ensure the balanced development of all the sections of the organization individually as wel plans in respect of capital expenditure are prepared in the form of capital expenditure budget should be prepare 2. Evaluation : Utmost care should be taken while evaluating the capital expenditure proposals. As the capit irreversible decisions, a wrong decision may disturb the entire financial structure of the organization. The eva rationally as possible. Proper weightage should be given to the elements of risk and uncertainly. 3. Control over progress: Usually, the implementation of capital expenditure proposals are spread over m required to be exercised over issue of work orders/purchase orders, acquisition of material, labour force and oth 4. Periodic and post completion audit : These are required to be conducted in order to confirm whether original plan or not. If some faults are pointed out regarding planning process, they ay be corrected while pointed out during mid term review of the projects, corrective actions may be taken during the remaining period 5. Forms and Procedure : In order to ensure proper control over capital expenditure, certain forms and proce that the said forms are used and procedures are followed at each and every stage of implementation of the cap

11.9 CAPITAL RATIONING

The various techniques available with the company for evaluating the capital expenditure proposals facilitate th be accepted. If the company has sufficient funds to invest in all the acceptable projects, the problem is very simple. However

The company may not have enough funds to invest in all the acceptable projects. Or the company may not be w acceptable projects due to the external and internal reasons(E.g. Fixed budget for capital expenditure). Thus, capital rationing refers to a situation where the company has more acceptable proposals requiring a gre company. As such, under capital rationing, it is not only necessary to decide profitable investments, but it is also necessar their relative profitabilities.

With limited funds, the company must obtain the optimum combination of acceptable investment proposals. The normal process which may be followed under the capital rationing situation may be: (1). To rank the projects according to some measure of profitability. (2). To select projects in the descending order of profitability till the available funds are exhausted. However, the situation of capital rationing may involve the consideration of other problems also.

(1). Project Indivisibility : There may be some projects which cannot be divided while execution. They ca These projects cannot be undertaken partially or in pieces. Consider the following situation:

The company has the following four acceptable proposals ranked according to Profitability Index Method with th Rs.10,00,000. Project Proj Cost Rs. Profitability Index ------------------------------------------------------------------------------------------------A 500000 1.25 B 350000 1.20 C 250000 1.18 D 100000 1.15 -------------------------------------------------------------------------------------------------

According to capital rationing process, projects A and B can be executed completely. Project C is costing Rs.250 of projects A and B is only Rs. 150000. If project C can be either accepted and rejected completely. The problem

(2). Avoidance of smaller projects: if the process of capital rationing is strictly followed it may result into th projects though the smaller projects may be competitively profitable when c Consider the following situation. The company has the following four acceptable proposal ranked according to Profitability Index Method with th Rs.1000000. Project Proj Cost Rs. Profitability ==================================================================== A 650000 1.26 B 350000 1.25 C 50000 1.24 D 40000 1.23 ====================================================================

if capital rationing process is to be applied strictly , project A and B will be selected for execution, whereas pro equally profitable like projects A and B.

(3). Mutually Dependent Project: The projects available before the company may be basically of two types. the execution of one project rules out the possibility of execution of other projects. E.g. Five different machines if the company decide to purchase one machine, the possibility of purchasing other four machines is ruled out. i.e. the execution of one project depends upon the execution of another project. Now under the capital rationing situation, if sufficient funds are available to invest only in machine A but not mutually dependent, then the problem is how to face such a situation?

(4). Multi Period Projects: There may some projects the execution of which cannot be completed in one a over in various accounting periods. In such situation, the constraints of capital rationing are required to be c which are required for the execution of the project.

11.10 CAPITAL BUDGETING AND RISK

The various techniques, as discussed above, for evaluating the capital expenditure proposals may be ideally possibility. As stated above, the capital budgeting process involves the estimation of various future aspects regarding futur

The accuracy of these estimates and hence reliability of investment decisions mainly depends upon the precision

Howsoever carefully these aspects are forecast, there is always the possibility that the actual situations may not

As such, the term risk with reference to investment decisions may be defined as the variability in the actual ret working life in relation to the estimated return as forecast at the time of initial capital budgeting decision.

Several mathematical and non - mathematical methods have been developed to consider the risk in capital budg we will consider mainly three methods which are commonly used. 1. Informal Method : This method does not follow any mathematical or statistical model to consider the risk factor. The standard fixed to consider a project to be risky is strictly internal and is not specified Illustration :

This is surely an informal or subjective method, which depends on the knowledge and experience of the evaluat

A company has under consideration two mutually exclusive projects for increasing its plant capacity, the man and optimistic estimates of the annual cash flows associated with each project. The estimates are as follows : Project A (Rs.) --------------------------------------------------------------------------------------Net investment 30,000 Cash flow Pessimistic 1,200 Most likely 4,000 Optimistic 7,000 ----------------------------------------------------------------------------------------

estimates

(a) Determine the NPV associated with each estimate given for both the projects. The projects have 20 years 10%. (b) Which project do you consider should be selected by the company and why? P.V.Factor is 8.514 Solution: Calculation of NPV

Pessimistic Most Likely -------------------------------------------------------------------------------------------------------Project A Annual Cash inflows 1200 Present value of annual (At PV factor for 20 years) 10217 Outflow 30000 NPV (-)19783 Project Annual cash inflows 3700 Present value of Annual (At PV factor for 20 years 31502 Outflow 30000 NPV 1502 ----------------------------------------------------------------------------------------------------------

340

345

Conclusion:

It can be seen from the above calculations that in case of most likely cash inflows, both the projects are equally As such, if risk involved with the projects is considered as the criteria, Project B will be selected. 2. Risk Adjusted Discounting Rate :

However, Project A involves more risk as the variation of NPV in pessimistic conditions and optimistic conditions

According to this method, the discounting rate is used not only to consider the futurity of the returns from th with the project. As such, in this method, the discounting rate is increased in case of projects involving greater risk whereas it risk. This can be explained with the help of the following illustration. Suppose that following two projects involving outflow of cash of Rs. 1200 generate the cash inflows as below : Year -------------------------------------------1 2 3 4 -------------------------------------------Project 800 700 300 150 A (Rs.)

Obviously, Project A is more risky than Project B. As such, the discounting rate of 14% is applied in case of Pr applied in case of Project B, the difference of 4% being to take care of risk involved in case of Project A. Thus, the computations of net present value are made as below:

Project -------------------------------------------------------------------------------------------------------Year Cash inflows Rs. PV factor 14% -------------------------------------------------------------------------------------------------------1 800 0.877 2 700 0.769 3 300 0.675 4 150 0.592 ----------------------1531.20 Less: Outflow ----------------------331.20 ------------------------------------------------------------------------------------------------------------------------------Project -------------------------------------------------------------------------------------------------------Year Cash inflows Rs. PV factor 14% -------------------------------------------------------------------------------------------------------1 to 4 500 per year 3.169 Less: Outflow -----------------------NPV -------------------------------------------------------------------------------------------------------------------------------As Project B involves greater NPV, it will be accepted.

This method is advantageous in the sense that it is simple to understand and incorporates the risks attac expenditure proposals. However, this method certainly suffers from some limitations. (1) Additional discounting rate is considered to compensate for the risk attached to a project as compared to an

How much additional discounting rate will be sufficient to take care of this risk cannot be decided accu mathematical formula. Charging additional discounting rate is a subjective concept to be decided by the evaluator of the proposals.

(2) This method takes into consideration the risk factor by considering additional discounting rate, however th are considered without taking into consideration the risk factor. E.g. if the cash inflows of Rs.50,000 are estimated to be received in a riskless situation, this method assumes t even in a risky situation. As such, only the discounting rate is increased to take care of risk factor.

(3) This method presupposes that the investors are not willing to take the risk and may demand the compensat

However, it ignores the possibility of existence of risk - seekers who may be willing to pay premium for taking th 3. Certainty - Equivalent Approach :

According to this method, rather than adjusting the discounting rate to take care of risk factor, the future cas certainty certainty cash ---------------------risky cash inflows E.g. cash inflows from a project are expected to be Rs. 25000.However generation of cash inflow of Rs.20,000 i co-efficient ca be computed as

Rs. ----------Rs. 25000

Accordingly, depending upon the degree of risk, the certainty equivalent co-efficient is decided. Higher the risk vice versa. To explain this approach, the following illustration may be considered.

Year Cash inflows Rs. Certainty Equivalent Co-efficient Adjusted Cash Inflows Rs. ---------------------------------------------------------------------------------------------------------------------------1 6000 0.90 5400 2 4000 0.80 3200 3 2000 0.70 1400 4 4000 0.60 2400 ----------------------------------------------------------------------------------------------------------------------------

Less : Outflow NPV ----------------------------------------------------------------------------------------------------------------------------

11.11 ILLUSTRATIVE PROBLEMS Refer Page No : 328 - 338 11.12 SUMMARY

This chapter introduces the important concept of capital budgeting and its process. Capital Budgeting includes expenditure to evaluate their impact on the financial situation of the best out of the various alternatives. The process of capital budgeting generally involves project generation, project evaluation, project selection, pro There are two broad categories of techniques of evaluation of capital expenditure proposals. i) Techniques not considering time value of money: It includes (b) Accounting rate of return - it computes the average annual yield on the net investment in the project. (ii) Techniques considering time value of money : it includes

(a) Pay back period-pay back period indicates the period within which the cost of the project will be complet

(a) Discounted Pay back period - it indicates that period within which the discounted cash inflows equal t project. (b) Net Present Value - it is a method of calculating present value of cash inflows and cash outflows in an inv

(c) Internal rate of return - it is the rate at which the discounted cash inflows match with discounted cash ou

(d) Profitability index / Benefit cost ration - it is the ratio between total discounted cash and total discounted

Capital rationing refers to a situation where the company has more acceptable proposals requiring a great company.

11.13 SELF - ASSESSMENT QUESTIONS

Refer Page No : 339

11.14 PROBLEMS
Refer Page No : 339 - 345

Unit 12 :
12.1 Introduction :

Working Capital Management

In the previous units , we have seen that whatever funds are raised by a company can be applied basically for two purposes : a) To acquire fixed assets , the technical terminology used being Capital Budgeting . b) To invest in the current assets , technical terminology used being Working Capital Management .

Working Capital management is considered to be one of the most important functions of finance , as a very large amoun circumstances. Unless working capital is managed properly , it may lead to the failure of business. 12.2 Working Capital - The Term

The Term "Working Capital" may mean Gross Working Capital or Net Working Capital . Gross Working Capital means Curre less Current Liabilities. Unless otherwise specified , Working Capital means Net working Capital . As such , Working Capital Assets and Current Liabilities.

The term current assets refers to those assets held by a business which can be converted in the form of cash or used during time say one year , without any reduction in value . Current assets change the shape very frequently . The current assets e considered to be the life-blood of the business. In case of a manufacturing organization , current assets may be found in the for sundry loans and advances.

The term current liabilities refers to those liabilities which are to be paid off during the course of business , within a short span o of current assets or the earnings of the business . Current liabilities consist of sundry creditors , bills payable , bank overdraft or 12.3 : Principles Of Working Capital Management

The basic objective of Working Capital Management is to avoid over investment or under investment in Current Assets , as bo investment in Current Assets may lead to the reduced profitability due to cost of funds blocked, extra storing space require possibility of malpractice etc. The objective of Working Capital Management is to ensure Optimum Investment in Current As intends to ensure that the investment in Current Assets is reduced to the minimum possible extent. However, the normal adversely . If the normal operations of the organization are affected adversely , reducing the investment in Current Assets is fruit Why the need for Working Capital arises?

Generally , it will not be possible for any organization to operate without the working capital . Let us assume that a manufacturi amount of cash . This cash will be invested to buy the raw material .The raw material purchased will be processed with th machinery etc. to convert the same in the form of finished products. These finished products will be sold in the market on credit receivables make the payment to the organization , cash is generated again . As such , there is a cycle in which cash availa cash. This cycle is referred to as Working Capital Cycle.

In between each of these stages , there is some time gap involved . The entire requirement of working capital arises due requirement of working capital is unavoidable . The finance professional is interested in reducing this time gap to the minimum properly. 12.4 : Factors Affecting Working Capital Requirement .

a) Nature Of Business : Some businesses are such that due to their very nature , their requirement of fixed capital is more r services and not the commodities and that too on cash basis. As such , no funds are blocked in piling the inventories and no services like railways , electricity boards , infrastructure oriented projects etc. Their requirement of working capital is less .Wh requirement of working capital will be on higher side, as huge amount of funds get blocked in mainly two types of current assets

b) Size of the organization : In small scale organizations , requirement of working capital is quite high due to high amount of o

such, medium sized organizations have an edge over the small scale organizations . However , if the business grows beyond a be adversely affected by the increasing size.

c) Phase of trade cycles : During the inflationary conditions , the working capital requirement will be on the higher side as t

increase the production to take the advantage of favourable market conditions and due to increased sales more funds are bloc the requirement of working capital will be on the lower side due to reduced operations but more working capital may be req payment of dues by customers in time. As such, in both the extreme situations of trade cycles , requirement of working capital

d) Trading Terms : The terms on which the organization makes the purchases and sales affect the requirement of working ca

made on cash basis and sales are to be made on credit basis to cope with competition existing in the market , it will result into purchases can be made on credit basis and sales can be made on cash basis , it will reduce the requirement of working ca financed out of credit offered by the suppliers.

e) Length of Production Cycle : The term production cycle refers to the time duration from the stage raw material is acquire

principle will be "longer the duration of production cycle , higher the requirement of working capital ." In some business li acquisition of raw material till the completion of production is quite high. As such, more amount is blocked in raw materi receivables . Requirement of working capital is always very high in this case . Whereas in case of the industries like paper in short . As such , the requirement of working capital , at least for stocks , may be very less.

f ) Profitability : High profitability reduces the strain on working capital as the profit to the extent they are earned in cash c

capital . However, the profit which reduces the strain on working capital is the post-tax profit. ( i.e. the profit earned after pa the profit remaining in the business after paying the dividend on the shares . )
12.5 : Financing Of Working Capital Requirement :

Before we go ahead with the discussions on the various methods available for financing the working capital requirement , the t angle. a) Fixed or Permanent Working Capital b) Variable or Temporary Working Capital

Fixed Working Capital is the minimum working capital required to be maintained in the business on permanent or uninterrupted is unaffected due to the changes in the level of activity. Variable working capital is the working capital required over and above the fixed or permanent working capital and changes w changes in production and sales. The relationship between fixed and variable working capital can be shown with the help of the following diagram . For Diagram please refer Page Number 352 in Book :

The basic principle of finance states that the permanent requirement of working capital should be financed out of long term or p profits , shares or debentures etc.

For financing temporary requirement of working capital , the organization can go for various sources which can be discussed as a) Spontaneous Sources b) Inter Corporate Deposits c) Commercial Papers d) Banks. a) Spontaneous Sources :

Spontaneous Sources for financing the working capital requirement arise during the course of normal business operations. Du may be able to buy certain goods or services for which the payment is to be made after a certain time gap . As such , the com payment for the same . These spontaneous sources are unsecured in nature and vary with the level of sales . These spontane the same . They are generally know as ' Current Liabilities .' Following forms of current liabilities may be used as spontaneous s

1: Trade Credit : If the company buys the raw material from the suppliers on credit basis , it gets the raw material for utilizat

at a delayed time . By accepting the delayed payment , the suppliers of raw material finance the requirement of working capi important role * Trends in the industry * Liquidity position of the company * Earnings of the company over a period of time. * Record of payment by the company to the suppliers over a period of time. * Relationship of the company with the suppliers.

2: Outstanding Expenses : All the services enjoyed by the company are not required to be paid for immediately . They are paid

able to get the benefit of these services without paying for the same immediately , thus getting the finance for working capit This may apply to salaries , wages, telephone expenses , electricity expenses , water charges etc.
b ) Inter - Corporate Deposits ( ICD ) :

Intercorporate Deposits indicate the amount of funds borrowed by one company from under the same management but not necessarily so . Point to be noted here is that ICDs are not considered to be deposits as Act , 1956 and as such the regulations applicable to the public deposits do not apply to ICDs.
Intercorporate Deposits as a source for financing the working capital requirement has the following characteristics features. 1: ICDs are for a very short period of time , viz. three months or six months. 2: ICDs is an unsecured source for raising the funds required for working capital purposes. 4: ICDs is a relationship based borrowing made by the company .

3: ICDs as a source is not regulated by any law . As such , the rate of interest , period of ICD etc. can be decided by the compan

c) Commercial Papers : In the recent past , Commercial Papers ( CPs ) have become one of the best methods for financing th

companies trying to raise the funds by issuing the CP are regulated by Guidelines for issue of Commercial Papers (CPs) , 2000 These guidelines applies to the companies trying to raise the funds by issuing the CPs. As per these guidelines , a compan Reserve Bank Of India Act , 1934. Section 45-I(aa) of Reserve Bank Act , 1934 defines a company as the company as defined in S

What is CP :

Commercial Paper is an unsecured promissory note issued at a discount . The rate of discount is required to be decided by the be issued at Rs 98, indicating that the investor has to pay Rs 98 while at the time of maturity , he will get Rs 100 .It means that d form of interest on investment made by the investor.

Who can issue the CP : A company will be eligible to issue the CP provided: a) the tangible net worth of the company as per latest audited balance sheet is not less than Rs 4 Crores.

Note : Tangible net worth means share capital plus free reserves duly reduced by intangible assets like accumulated losse include share premium and debenture redemption reserve but do not include revaluation reserve. b) company has been sanctioned working capital limits by banks. c) borrowed amount of the company is classified as a standard asset by the bank.

Before the company issues the CPs , it is required to obtain satisfactory credit rating from an approved credit rating agency . approved by RBI for this purpose. a) Credit Rating Information Services of India Ltd. ( CRISIL ) b) Investment Information and Credit Rating Agency of India Ltd. ( ICRA ) c) Credit Analysis and Research Ltd. ( CARE ) d) FITCH Rating India (P) Ltd.

The minimum credit rating required is P-2 of CRISIL . If the rating is given by any other agency , equivalent minimum rating w should be current and should not have fallen due for review. Who can invest in CP : a) Individuals b) Banks c) Corporate Bodies incorporated in India. d) Unincorporated Bodies. e) Non - resident Indians f) Foreign Institutional Investors. Nature of a CP : a) A CP can be issued for the maturity period of 7 days to one year. b) A CP has the denomination of Rs 5 Lakhs and every single investor should invest minimum Rs 5 Lakhs in the CP. c) Every issue of CP , including the renewal , will be considered to be the fresh issue.

Following persons can invest in the CP

d) The amount of CP shall be within the overall limit sanctioned by the Board Of Directors . It can be issued as a 'stand alone' p limits after considering the CPs issued by the company. It will not be out place to mention here that CP is not treated as a deposit as per the provisions of Section 58-A of the Companie

Procedure for issuing the CPs : Every company issuing the CP should appoint a scheduled bank as the Issuing and Paying Agent ( IPA ) . IPA will satisfy it rating. It shall also verify the documents submitted by the issuing company and issue a certificate that the documents are in ord with the issuing company.

The issuing company shall arrange to place the CPs on private placement basis with the investors .The issuing company shall After the deal is confirmed , the issuing company shall issue physical certificates to the investor . Investors shall be given company has a valid agreement with the IPA and documents are in order. Every issue of CP should be reported to RBI through the IPA within three days from the date of completion of the issue. Advantages of Commercial Papers : a) As CPs are required to be rated , good rating reduces the cost of capital for the company.

b) CP is one of the best possible ways available to the company to take the advantage of short-term interest fluctuations in the m c) CP being the negotiable instrument , it provides the exit option to the investor to quit the investment. d) As CPs are unsecured , no charge is required to be created on the assets of the issuing company. Disadvantages of Commercial Papers : a) CP is a source for short term financing available only to a few selected blue chip and profitable companies. b) By issuing CP , the credit available from the banks may get reduced. c) Issue of CP is very closely regulated by the RBI guidelines . d) Banks .

In the Indian circumstances , banks play a very major role in financing the working capital requirement of the organizations. W working capital requirement of the organizations under the following heads : a) What should be the amount of assistance ? b) What should be the form in which working capital assistance is extended ? c) What security should be obtained for working capital assistance ? d) What are the various applicable regulations to be considered by the banks while extending the working capital assistance ? Amount of Assistance :

To obtain the bank credit for financing the working capital requirements , the company is required to estimate the working capita working capital requirement properly , the company will be required to estimate its level of current assets and current liabilities current assets and current liabilities . For this , the techniques like ratio analysis , trend analysis etc. can be used by the compa assets and current liabilities , more accurate will be estimation of the requirement or working capital .Then the company will supporting data. On the basis of the estimates submitted by the company , the bank may decide the amount of assistance that assistance , the bank may prescribe the margin money requirement .The margin money stipulation is made by the banks in ord business and also to provide the cushion against the possible reduction in the value of security offered to the bank. The percent credit standing of the borrowing company , fluctuations in the price of the security and the directives of RBI from time to time .Th nature of security , higher will be the margin money stipulations. "

Form Of Assistance : After deciding the amount of overall assistance to be extended to the company , the bank can disburse the a) Non -Fund Based Lending. b) Fund Based Lending. Non - Fund Based Lending

In Case of Non - Fund - Based Lending , the lending bank does not commit any physical outflow of funds . As such, the funds Fund Based Lending can be made by the banks in two forms :

a) Bank Guarantees : The mechanism of bank guarantees is described below : Suppose Company A is the selling company and Company B is the purchasing company . Company A does not know Compan make the payment or not. In such circumstances , D who is the bank of Company B , opens the Bank Guarantee in favour of C to Company A , if Company B fails to honour its commitment to make the payment in future. As such, interests of Company either from Company B or from its Bank D. As such, Bank guarantee is the mode which will be found typically in the seller's m a guarantee in favour of Company A , it does not commit any outflow of funds. As such, it is a Non Fund Based Lending for Ban payment to Company A due to failure on account of Company B to make the payment , this Non-Fund based Lending beco recovered by Bank D from Company B. For issuing the Bank Guarantee , Bank D charges the Bank Guarantee Commission to Company B which gets decided on the Guarantee and What is the period of validity of Bank Guarantee. In case of this conventional form of Bank Guarantee , bo Company A is benefited as is assured to get the payment . Company B is benefited , as it is able to make the Credit purchas such , Bank Guarantee transactions will be applicable in case of credit transactions.

In some cases , interests of purchasing company are also to be protected . Suppose that Company A which manufactures ca Company B . If company A fails to fulfill its part of the contract to supply the capital goods to Company B , there needs to circumstances , Bank C which is the Banker of Company A opens a bank guarantee in favour of Company B in which it und contract, it will reimburse any losses incurred by Company B due to this no fulfillment of contractual obligations . Such Bank Gu Guarantee and is ideally found in the buyer's market. b ) Letter Of Credit :

The non-fund based lending in the form of Letter of Credit ( LC ) is very regularly found in the international trade. In this case , Under these circumstances , the exporter is worried about getting the payment from importer and the importer is worried as to importer applies to his bank in his country to open a letter of credit in favour of the exporter whereby the importer's bank unde drawn by the exporter on the exporter fulfilling the terms and conditions specified in the letter of credit . Thus, there are essentia I) The Importer ii) The Issuer who is the bank of the importer iii) The Exporter who is the beneficiary in case of Letter of Credit. In practical circumstances , there may be some other parties involved in case of Letter of Credit. 1) Advising Bank : This bank is in the exporter's country, which notifies the exporter about opening of Letter of Credit. 2) Confirming Bank : If the exporter is not satisfied about the security offered by the importer , he may insist that the letter

the issuing bank. In this case, both the banks are liable to honour the bills of exchanges.
The letter of credit may be of different varieties.

a) Revocable or Irrevocable : In case of revocable letter of credit , the issuing bank can cancel or change the obligation to m

upon it . In case of irrevocable letter of credit , the issuing bank agrees not to cancel or modify the terms of Letter of Credit. b) Conformed or Unconfirmed : If the exporter is not satisfied with the security offered by the importer , he insists upon the which guarantees the payment and /or acceptance of the drafts or bills drawn by the exporter . In case of unconfirmed letter o

The combination of irrevocable and confirmed letter of credit can be considered to be a guaranteed payment on the part of the e beneficial both for the exporter as well as the importer.

Advantages to the Exporter : a) Exporter is assured to get the payment for the goods exported by him , if he satisfies all the terms and conditions specif ied in with an unknown importer in a different country. b) If the exporter has fulfilled all the terms and conditions of the letter of credit , he can approach his local bank and get the adv the importer.

Advantages to the Importer : a) The issuing bank specifies various terms and conditions in the letter of credit which are required to be fulfilled by the expor issuing bank. As such, the importer is assured to get a proper supply of the goods. b) As the letter of credit assures the payment to the exporter , the importer can bargain for better trading terms with the exporter It should be noted here that the mechanism of letter of credit could be equally applicable in case of domestic trade also. Fund based lending :

In case of Fund based lending , the lending bank commits the physical outflow of funds. As such , the funds position of the Lending can be made by the banks in the following forms:

(1) Loan : In this case , the entire amount of assistance is disbursed at one time only , either in cash or by transfer to the com

repaid in installments , the interest will be charged on outstanding balance.

(2) Overdraft : In this case , the company is allowed to withdraw in excess of the balance standing in its Bank Account . How

which the company will not be able to withdraw the account. Granting of the assistance in the form of overdraft presuppo overdraft is a demand assistance given by the bank i.e. bank can ask for the payment at any point of time. Overdraft is given b of which the company is supposed to repay the same. Interest is payable on the actual amount drawn and is calculated on dail
(3) Cash Credit : In practice , the operations in cash credit facility are similar to those of overdraft facility except the fact that

Here also a fixed limit is stipulated beyond which the company is not able to withdraw the amount. Legally , cash credit also is basis. Here also, the interest is payable on actual amount drawn and is calculated on daily product basis.

(4) Bills Purchased /Discounted :This form of assistance is comparatively of recent origin. This facility enables the compa

bills/invoices raised by the company . The bank holds the bills as a security till the payment is made by the customer . The e company only gets the present worth of the amount of the bill, the difference between the face value of the bill and the amou However, on maturity , the bank collects the full amount of bill from the customer. While granting this facility to the compan worthiness of the customer and the genuineness of the bill. A fixed limit is stipulated in case of the company , beyond which th

(5) Working Capital Term Loans : To meet the working capital needs of the company , banks may grant the working capital te

or half yearly installments . (6) Packing Credit : This type of assistance may be considered by the bank to take care of specific needs of the company w facility given by the bank to enable the company to buy /manufacture the goods to be exported .If the company holds a confi irrevocable letter of credit in its favour , it can approach the bank for packing credit facility . Basically , packing credit facility m
i) Pre-shipment Packing Credit : To take care of needs of the company before the goods are shipped to the overseas buyer.

ii) Post - shipment Packing Credit : To take care of needs of the company from the shipment of goods to the overseas buyer till Necessarily , both these facilities are short term facilities. The company may be required to repay the same within a predec exported. ( c) Security for Assistance:

The bank may provide the assistance in any of the modes as stated above . But normally no assistance will be available u following forms :

1) Hypothecation : Under this mode of security , the bank extends the assistance to the company against the security of mova

security neither the property not the possession of the goods hypothecated is transferred to the bank. But the bank has th outstanding amount of assistance granted by it to the company.

2) Pledge : Under this mode of security , the bank extends the assistance to the company against the security of movable

hypothecation , possession of the goods is with the Bank and the goods pledged are in the custody of the bank. As such, it i custody .In case of default on the part of company to repay the amount of assistance , the bank has the right to sell the goods

3) Lien : Under this mode of security , the bank has a right to retain the goods belonging to the company until the debt due to i) Particular Lien: It is valid till the claims pertaining to specific goods are fully paid. ii) General Lien : It is valid till all the dues payable to the bank are paid. Normally , banks enjoy general Lien.

4) Mortgage : This mode of security pertains to immovable properties like land and buildings .It indicates transfer of legal in

the payment of debt. Under this mode , the possession of the property remains with the borrower while the bank gets full lega debt. The party who transfers the interest (i.e. the company ) is called mortgager and the party in whose favour the interest is

12.6 Control Over Working Capital :

It can be seen from the preceding discussions that the commercial banks play a very significant role in financing working capita mainly in the form of cash credit facilities and these advances used to be totally security oriented rather than end-user orie securities to the banks were able to get main chunk of the finances provided by the banks whereas others experienced short production and ultimately threat of closure .Reserve Bank Of India has attempted to identify major weakness in the system of f control the same properly . These attempts were mainly in the form of appointment of following committees. a) Dahejia Committee b) Tandon Committee c) Chhore Committee d) Marathe Committee e) Nayak Committee and Vaz Committee. (a) Dahejia Committee :

This committee was appointed in October 1968 to examine the extent to which credit needs of industry and trade are likely to be

Findings : The committee found that there was a tendency of industry to avail of short term credit from Banks in excess of gr Secondly, it found out that there was a diversion of short-term bank credit for the acquisition of long term assets. The reason finance in the form of cash credit , as it was easy to operate. Banks took into consideration security offered by the client rather such , cash credit facilities granted by the banks was not utilized necessarily for short-term purposes.

Recommendations: The committee , firstly , recommended that the banks should not only be security oriented , but they sh

the client. Secondly , it recommended that all cash credit accounts with banks should be bifurcated in two categories.

i) Hard core which would represent the minimum level of raw materials , finished goods and stores which any industrial conc production. ii) Short-term component which would represent of funds for temporary purposes , i.e. Short-term increase in inventories , tax, d

It also suggested that hard core part in case of financially sound companies should be put on a term loan basis subject to repa asked to arrange for long term funds to replace bank borrowings. In practice, recommendations of the committee had only a marginal effect on the pattern and form of banking. (b) Tandon Committee : In August 1975, Reserve Bank Of India appointed a study group under the Chairmanship of Mr. P.L.Tandon ,to make the study i) Can the norms be evolved for current assets and for debt equity ratio to ensure minimum dependence on bank finance ? ii) How the quantum of bank advances may be determined ? iii) Can the present manner and style of lending be improved ?

iv) Can an adequate planning , assessment and information system be evolved to ensure a disciplined flow of credit to meet gen The observations and recommendations made by the committee can be considered as below :

(1) Norms: The committee suggested the norms for inventory and accounts receivables for as many as 15 industries excluding

represent maximum level of inventory and accounts receivables in each industry .However if the actual levels are less than the

The norms were suggested in the following forms: For Raw Materials : Consumption in months . For Work in Progress: Cost of production in months. For Finished Goods : Cost of Sales in months . For Receivables: Sales in months .

It was clarified that the norms suggested cannot be absolute or rigid and the deviations from the norms may be allowed unde norms should be reviewed constantly . It was suggested that the industrial borrowers having an aggregate limits of more than Rs 10/- Lakhs from the Banks should b extended even to the small borrowers.

(2) Methods of Borrowings : The committee recommended that the amount of bank credit should not be decided by the capa

it should be decided in such a way to supplement the borrower's resources in carrying a reasonable level of current asset purpose , it introduced the concept of working capital gap i.e. the excess of current assets over current liabilities other than b methods to decide the maximum limits according to which banks should provide the finance.

Method 1: Under this method , the committee suggested that the banks should finance maximum to the extent of 75% of w

long term funds i.e. own funds and term borrowings. Method 2: Under this method , the committee suggested , that the borrower should finance 25% of current assets out of l finance. Method 3: Under this method , the committee introduced the concept of core current assets to indicate permanent portio should finance the entire amount of core current assets and 25% of the balance current assets out of long term funds and the

It can be observed from above that the gradual implementation of these methods will reduce the dependence of borrowers committee suggested that the borrowers should be gradually subjected to these methods of borrowings from first to third. However, if the borrower is already in second or third method of lending , he should not be allowed to slip back to first or suggested that if the actual bank borrowings are more than the maximum permissible bank borrowings , the excess should suitable period depending upon the cash generating capacity. (3) Style Of Lending : The committee suggested changes in the manner of financing the borrower. It suggested that the cash

i.e. Minimum level of borrowing required throughout the year should be financed by way of a term loan and the demand cash suggested that both these limits should be reviewed annually and that the term loan component should bear a slightly lower to use the least amount of demand cash credit. The committee also suggested that within overall eligibilities , a part of the receivables ) rather than in the form of cash credit.

(4) Credit Information Systems: In order to ensure the receipt of operational data from the borrowers to exercise con

recommended the submission of a quarterly reporting system, based on actual as well as estimations , so that the requiremen production needs. As such , borrowers enjoying total credit limits aggregating Rs 1 Crore and above were required to sub statements and projected balance sheet and profit and loss account at the end of the financial year .The working capital lim Within the overall permissible level of borrowing , the day to day operations were to be regulated on the basis of drawing pow

(5) Follow up , Supervision and Control : In order to assure that the assumptions made while estimating the working capit

utilized for the intended purpose only , it was suggested that there should be a proper system of supervision and control. Va be permitted to the extent of 10% , but variations beyond that level will require prior approval. After the end of the year , cred when the banks should re-examine terms and conditions and should make necessary changes . For the purpose of proper cont in each bank within a credit rating scale.

(6) Norms for Capital Structure : As regards the capital structure or debt equity ratio , the committee did not suggest any spec

relative concept and depends on several factors. Instead of suggesting any rigid norms for debt equity ratio , the committee than the medians , the banker should persuade the borrowers to strengthen the equity base as early as possible.

Actions Taken by RBI : According to the notification of RBI dated 21st August , 1975 , RBI accepted some of the main recomme

1) Norms for Inventories and Receivables : Norms suggested by the committee were accepted and banks were instructed to

the levels of inventories and receivables are found to be excessive than the suggested norms, the matter should be discussed w justification , after giving reasonable notice to the borrowers , banks may charge excess interest on that portion which is consid

2) Coverage : Initially, all the industrial borrowers ( including small scale industries ) having aggregate banking limits of more

extended to all borrowers progressively.

3) Method Of Borrowing : RBI instructed the banks that all the covered borrowers should be placed in method 1 . As far as

However, in case of the borrowers already in Method 2 , matter of application of Method 3 may be decide on case to case bas

4) Style of Credit : As suggested by the committee , instead of granting entire facility by way of cash credit , banks may bifurca

requirement and (ii) fluctuating cash credit. Within the overall limits , bill limits may also be considered.

5) Information System : Suggestions made by the committee regarding the information system were accepted by RBI and w

overall banking limits of more than Rs 1 crore.

( c ) : Chhore Committee :

In April 1979 , Reserve Bank of India appointed a study group under the chairmanship of Mr. K.B. Chhore to review mainly th The observations and recommendations made by the committee can be discussed as below : 1) The committee has recommended increasing role of short-term loans and bill finance and curbing the role of cash credit limits

2) The committee has suggested that the borrowers should be required to enhance their own contribution in working capital. lending as suggested by Tandon Committee . If the actual borrowings are in excess of maximum permissible borrowings as transferred to Working Capital Term Loan ( WCTL) to be repaid by the borrower by half yearly installments maximum within a p more than interest on cash credit facility.

3) The committee has suggested that there should be the attempts to inculcate more discipline and planning consciousness am basis of quarterly projections submitted by them . Excess or under utilization beyond tolerance limit 10% should be treated as ir 4) The committee has suggested that the banks should appraise and fix separate limits for normal non-peak levels and also pe enjoying the banking credit limits of more than Rs 10 Lakhs. 5) The committee suggested that the borrowers should be discouraged from approaching the banks frequently for ad hoc and contingencies . Requests for such limits should be considered very carefully and should be sanctioned in the form of deman interest of 1% p.a. should be charged for such limits. (d) : Marathe Committee :

In 1982 , Reserve Bank Of India appointed a study group known as Marathe Committee to review the Credit Authorization Sch CAS , the banks are required to take the prior approval of RBI for sanctioning the working capital limits to the borrowers. As p 1988 , CAS was replaced by Credit Monitoring Arrangement ( CMA ) according to which the banks were supposed to report to the prescribed amounts for the post-sanction scrutiny. (e) : Nayak Committee and Vaz Committee:

Recently , RBI has accepted the recommendations made by Nayak Committee . This was with the intention to recognize the con

According to Nayak Committee recommendations , for evaluating working capital requirements of village industries , tiny indu working capital limits up to Rs 50 Lakhs , the norms for inventory an and receivables as suggested by Tandon Committee will no will be considered to be 25% of their projected turnover ( for both new as well as existing units ) , out of which 20% is suppose requirements and remaining 80% can be financed by the bank. In other words , there are 4 working capital cycles assumed in ev Vaz Committee has extended the recommendations of Nayak Committee to all the business organizations . This has also been

As a result of Nayak Committee and Vaz Committee recommendations , projected turnover of the borrowers is the basis for projected turnover , 5% is supposed to be introduced by the borrower in the form of own contribution and remaining 20% can capital has nothing to do with the level of current assets and current liabilities , which was the basis of Tandon Committee and C

Evaluation of working capital requirements by the banks relaxed with the intention to give greater autonomy to the banks w officially withdrawn the concept of MBPF with effect from 15th April , 1997. As a result of this , now the banks are free to hav requirement of the borrowers. 12.8 Summary :

Working Capital refers to the funds invested in current assets i.e. investment in stocks, sundry debtors, cash and other current to ensure Optimum Investment in current assets. There are certain factors affecting working capital requirement such as na length of production cycle, profitability etc.

The sources of working capital can be a) Spontaneous sources : These sources arise during the course of normal business op services on credit for example : trade creditors and outstanding expenses. b) Intercorporate deposits: Intercorporate Deposits in from another company only. c) Commercial Papers : A Commercial paper is an unsecured promissory note issued at a discoun to working capital on two broad basis i.e. non-fund based lending and fund based lending. i) Non-fund based lending includes t is no physical outflow of funds . ii) Fund based lending includes Loans , Overdraft , Cash Credit , working capital term loans etc.

Reserve Bank of India has attempted to identify major weakness in the system of financing of working capital needs by Banks were mainly in the form of appointment of various committees namely Dahejia Committee , Tandon Committee , Chhore Comm Committee . These committees have suggested various norms for Working Capital Finance.

UNIT 13 - CASH MANAGEMENT

13.1 INTRODUCTION Management of cash is one of the most important areas of overall working capital management. This is 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 ca 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 i 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. 13.2 MOTIVES OF 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, various expenses, interest ,taxes, dividends e

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 honor the commitments whenever they become due. This requirement of cash balances to meet routine needs is known as transaction motive. (2)Precautionary Motive: In addition to the requirement of cash for routine transactions, the company may also require the cash purposes which ca sudden decline in the collection from the customers, there may be a sharp increase in the prices of the law materials etc.

The company may like to hold the cash balance to take care of such contingencies and unforeseen circumstances. This need of (3)Speculative Motive The company may like to hold some reserve kind of cash balance to take the benefit of favorable market conditions of some s at low races 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. 13.3 ESTIMATING THE CASH REQUIREMENTS As has been discussed in the preceding paragraphs, the company should hold adequate cash balance but should necessarily av For this purpose, basically the company is required to assess its need for cash properly. For this purposes, one of the best tools available with the company is to prepare the cash budget. A cash budget is the statement showing the various estimated sources of cash receipts on one hand and the various applicatio Thus, by preparing the cash budget ,the company may predict whether at any point of time there is likely to be excess or short If the shortage of cash is estimated, the company has to arrange the cash from some other source. If the excess of cash is estimated ,the company may explore the possibility of investing the cash balance profitably. Before preparing the cash budget ,following principles must be kept in mind: (1) The period for which the cash budget is to prepared should be selected very carefully. There is no fixed rule as to the period to be covered by the cash budget. It depends on company and individual circumstances. As a general rule ,the period to be covered by the cash budget should neither be too long nor too short. if it is too long, it is possible that the estimates will be inaccurate. If it is short, the areas which are beyond the control of the company will not be given due consideration. (2)The items which should appear in the cash budget should be carefully decided. Naturally ,all those items which do not have bearing on the cash flows will not be considered while preparing the budget. E involve any cash outflow, it does not affect the cash budget, through the amount of depreciation affects the determination of While preparing the cash budget, the various items appearing the same maybe classified under the following two categories: (1)Operating cash flows: These are the items of cash flow which arise as the result of regular operations of the business. (2) Non-Operating cash flows: These are the items of cash flow which arise as the result of other operations of the business. The standard items which may appear on a standard cash budget may be stated as below:

13.4 PRINCIPLES OF CASH MANAGEMENT The basic objective of cash management is to reduce the operating cash requirement to the minimum possible extent without In particular, the objectives of cash management can be stated as below: (a) Accelerate the cash collections. (b) Delay the cash payments. (C )Maintenance of optimum cash balance. (d) Investment of excess cash available. 13.5 CONCEPT OF FLOAT In absolutely non-technical language, Float indicates the difference between the bank balance as per the bank book and as per This float arises mainly due to the fact that there is always a time gap between the time a cherub is written by the compa payment or there is a time gap between the time when a cheque is deposited by the company in the bank and the time company.

This time gap may arise due to various reasons. (a) Time required for receiving the cheque from the customer through the post office. This is called postal float. (b)Time required by the company to process the received cheque and deposit the same in the bank. This is called deposit float ( C) Time required by the banker of the company to collect the payment from the customers bank. This is called bank float. (a) Accelerate cash collections: This can be done with the help of following techniques: (1) As far as possible insist upon the payment from the customer in the safe modes like demand drafts, letters of credit ,preacc the bank float. (2) In order to ensure the prompt payment from customers, a self-addressed envelope can be sent along with the bill/invoice i Allowing the cash discounts is the best possible way to induce the customer to make prompt payments. (3) In case of the outstation customers, faster means of communications can be used so as to reduce the postal float to the Post etc. (4) Decentralized Collection: In case of the company which has the branches at different places, the company can establish the decentralized collection cen The customers in a certain area are required to make the payment at the local collection centre and the cheques collected b bank account. The balance in the local bank account beyond a predetermined level may be transferred to the central or head office bank acco The decentralized collections may be useful for reducing the postal float as well as bank float.

(5) Lock Box System: Under this arrangement, the company hires a post office box at important collection centers. The customers are instructed to make the payment directly to the lock box. The local bankers of the company are authorized to pick up the cheques from the lock box. After crediting the cheques to the company's account, the bank informs the company about the details of cheques credited. The lock box systems reduces the postal float as well as bank float. The clerical work of handling the cheques before deposits is performed by the banker and the process of collection of cheque from the customer.

It should be noted in this connection that both the above systems of decentralized collections as well as lock box system, he cost.

Before taking any decision in this connection, it is necessary to carry out a cost-benefit analysis to ensure that the funds rel costs.

(b) Delay cash payment: This can be done with the help of following techniques: (1) payments can be made from a bank which is distant from the bank of the company to which payment is to made. This may increase the postal float and bank float. (2) Attempts should be made by the company to get the maximum credit for the goods or service supplied to it. E.g. In case o services in advance which are to be paid for later. Thus, they provide the credit to the company for the period after which they are paid, say a week or a month. As such, if the company can make monthly payment of wages rather tan weekly payment of wages, it can enjoy extend requirement of operating cash balance. (3)Avoid Early Payments: if according to the terms of credit available to the company, it is required to make the payment within the stipulated period date unless the company is entitled to cash discounts. The delay in making the payment beyond the stipulated time may affect the credit standing of the company. (4)Centralized Disbursements: Under this methods, the payments are made by the head Office of the company from its central bank account. This involves the benefits mainly in three respects as compared to decentralized payments. Firstly, it increase the transit time. E.g. If the creditor at Madras is to be paid out of the Central bank account of the company float, which is ultimately beneficial for the company.

secondly if the company decides to make decentralized payments by maintaining various bank accounts at various branches balance at all these bank accounts, whereas in case of centralized disbursement system, the problem of maintaining minim account.

Thirdly ,to maintain the bank accounts at different branches may prove to be administratively difficult. (5)In case of a company operating on decentralized basis, the arrangements can be made in such a way that the local branch bank accounts but are not authorized to withdraw the amounts from there. This facilitates speedy collections as well as ensures proper control over the disbursements from the bank accounts. (6)It may not be necessary for the company to arrange for the funds immediately after it issues the cheque. If it is possible to analyze the time lag in the issue of cheque and their presentation for payment, which is possible on th arrangements for funds only on the expected date of presentation of cheque for payment. ( C )Maintenance of optimum cash balance: As stated earlier, maintenance of cash balance which is more than requirement as well as less than requirement involves the c As such, one of the basic objectives of cash management is to maintain the optimum cash balance.

One of the tools available to the company to ensure the maintenance of optimum cash balance is to prepare the cash budget. By preparing the cash budget in a proper way, the company can have an idea in advance of the timing and quantum of excess a Accordingly, the company can take the decision of investment of excess cash on short term basis(in cash of excess cash ava cash).

(d) Investment of excess cash balance: As stated earlier, one of the basic objectives of cash management is to optimize the investment in cash. The company cannot afford to keep the excess cash balance idle as it involves the opportunity cost. As such, one of the basic objectives of cash management requires the company to think about the possibility of investing the e The avenues available to the company to invest the excess cash on short term basis may be in various forms. E.g. Inter-corp ,stock market operations ,commercial paper, bank deposits etc.

However ,the final selection of the avenue for investing the cash balance may depend upon various factors. (1)ReturnThe basic factor affecting any investment decision is essentially in the form of return on investment. Higher the return ,better the investment. (2)RiskRisk and return always go hand in hand. High return investments may involve high risk. While selecting the investment yielding high return ,the company should take into consideration the risk involved with the pro (3)LiquidityIn some cases, due to unexpected cash needs, it may be necessary to sell the investment before maturity. Under these circumstances, liquidity associated with the investment becomes an important criteria to formulate the investmen (4) Legal requirementsSome organizations may be subjected to certain legal requirements before they can select their investment portfolio. E.g. Pub

These organizations are required to invest funds in certain specified forms. 13.7 SUMMARY This chapter introduces you to techniques of cash management. The motives of holding cash may be the transaction motive, precautionary motive or speculative motive. By preparing the cash budget, the company may predict any likely excess or shortage of cash and thereby the company may ta The basic objective of cash management is to reduce the operating cash requirement to the minimum possible extent without Float indicates the difference between the bank balance as per bank book and as per the bank pass book/bank statement. 13.6 & 13.9 Problems - Refer Book page # 396-411 UNIT 14 - MANAGEMENT OF RECEIVABLES

14.1 Introduction Receivables or debtors as current assets get created on account of the credit sales made by the company i.e., the company ma not make the payment immediately. Even if the customers do not pay the cash immediately, the company has to make credit competition and also to attract the new and potential customers to buy the goods or services from the company. 14.2 Objects of Management of receivables

As in case of general objective of working capital management, the receivables management is also to achieve a trade off betw management is to ensure optimum investment in receivables i.e., the investment in receivables should be neither less or more investment in receivables to the minimum extent, the company will not make any credit sales at all, as receivables is the result reduce the investment in receivables, but the company will suffer in terms of profitability as the customers will not buy from th credit to the customers. On the other hand, if the company makes credit sales to the customers in order to increase the sales risk of bad debts, more collection efforts etc. As such, the objective of receivables management is to increase the credit sales t dues is reasonable and within control. As in case of any other financial decisions, decisions regarding receivables management with receivables management may be in the form of credit administration costs, cost of bad debts and opportunity cost of fund receivables management are naturally in the form of profits from sales made on credit basis. An effective receivables manage an extent that the profits arising there from are more than the costs attached to it. 14.3 Float in receivables management The concept of float can be extended to receivables management as well. The time gaps in the receivables management can b a) Frequency of period of service at which invoices or bills are raised in favour of the customers. b) Administrative delay for raising the invoices or bills in favour of the customers. c) Period of credit offered to the customers. An effective receivables management will target at reducing these time gaps to the maximum possible extent. From this angle

a) if the invoices or bills are raised in favour of the customers at periodic intervals, attempts should be made to reduce this tim customers on monthly basis, raising the bills on customers on fortnightly basis may be an effective way of managing the receiv

b) invoices or bills should be raised in favour of the customers immediately after the dispatch of materials or rendering the ser completed as early as possible. This will reduce the second category of time gap c) Period of credit offered to the customers get affected due to many other factors which are discussed later on. 14.4 Areas covered by receivables management Receivables management may be concerned with following aspects: a) Credit Analysis b) Credit Terms c) Financing of receivables d) Credit collection e) Monitoring of receivables (a) Credit Analysis: Even though the intention of the company will be to increase the profits by increasing the sales, the company will not like to se For this purpose, the company has to decide the customers to whom it should its products on credit. The credit should be exte creditworthiness is established. For deciding the creditworthiness of the customers, the company may consider various factor reputation of the customer, record of previous dealing of the customer with the company, quality and character of the manage etc. For deciding the credit worthiness of the customer, the company may need information which may be available from the (1) Trade References: The company can ask the prospective customers to give trade references. The company may insist that the references should with the company. The company in turn can obtain the information from these references, either by personal interview or by honesty, seriousness and integrity of the references should be examined. (2) Bank Reference:

The company can ask the prospective customers to instruct its banker to give the relevant information to the company. In this of the prospective customer may not give clear answers to the enquiries made by the company. Secondly, even though the ba conduct of the account, it may not mean that he will settle his dues of the company in time. As such along with bank reference be used.

(3) Credit Bureau reports: The sources of trade and bank references may be biased in some cases. In such cases, the credit bureau reports may be consid industries maintain a credit bureau that may give useful and authentic information about their members.

(4) Financial statements: This is one of the easiest ways to obtain the information about the creditworthiness of the prospective customer. If the prospe may not be any difficulty in getting the financial statements in the form of profit and loss account and Balance sheet. However of private limited companies or partnership firm.

(5) Past Experience: This can be considered to be the most reliable source of getting the information about the creditworthiness of the customer w question of extending further credit to the existing customer, the company should inevitably consider the past experience whi

(6) Salesman Interview and reports: Many a times, companies may depend upon the reports given by the sales personnel for evaluating the creditworthiness of the customer is ascertained, the next question is to decide the limit on the credit to be allowed to them, both in terms of amount a of anticipated sales, increased cost of monitoring and servicing the receivables and financial strength of the customer. If the cu of credit for selling may also be established which means the maximum amount of credit which the company may extend. In s order of the customer so long as it is within the limit line of credit. The line of credit granted for the customer should be review previous dues, specific requirements of the customer for the failure and so on.

(b) Credit Terms: Credit terms indicate the terms on which the company should extend the credit to the customer. This involves the considerati * Credit Period * Credit Limit * Discount Policy Credit Period: Credit period is the time allowed by the company to the customers to pay their dues. The duration of this credit period may de products having inelastic demand, the credit period may be small, however if the demand is elastic, small credit period may aff upon the nature of the industry. In the buyer's market, the company may be required to offer more credit period. In the selle credit period. Further, it also depends upon the policies followed by the competitors. Three, decisions regarding the credit pe management attitude is aggressive, it may offer more credit period to increase sales and profits. However, if management att period. Lastly, the credit period may depend upon the amount of funds available and also upon possible bad debts losses. Na as possible, whereas the customers will like to have a longer credit period. As such, by liberalizing its credit period, the compa proposition of liberalizing the credit period may involve the consequences in the form of more investments in receivables, pos monitoring and servicing the receivables etc. As such, policy to liberalize the credit period should be viewed from this angle. Illustration: A company is currently selling 12000 units at Rs. 50 per unit. Variable cost per unit is Rs. 40 At present, the company gives cre two months, whereby it will be able to increase sales by 25%. If the required rate of return is 18% and average cost per unit is Solution Calculation of incremental profits Thus the new credit policy will result into increased profit of Rs 30000

The cost involved with new credit policy will be as follows.

As such, incremental investment in debtors is Rs 65000 i.e. 110000 - Rs 45000. As the required rate of return is 18% per annum Rs 11700 i.e 18% of Rs 65000

As the increased profit of Rs 30000 are more than increased costs of Rs 11,700, the new credit policy will be desirable. However, before liberalizing the credit period, the following factors should also be considered. (1) Liberalizing the credit period is likely to increase the demand. It should be verified whether the company has the capacity t operating at its full capacity and it is necessary to increase the capacity to meet the additional demand, the effect of this possib to be considered

(2) Liberalizing the credit period may increase the demand which in turn may call for the additional investment in working capi liberalize the credit period, cost associated with the additional investment in working capital is also required to be considered.

Discount Policy Discounts are usually allowed to speed up the collection process and to induce the customers to pay the dues early. The decis discount depends upon the usual cost benefit considerations i.e the cost of carrying the debts on one hand and on another han released from debtors immediately, which may be available for some different and beneficial use. Proposal to liberalize the discount policy should be evaluated in terms of loss of revenue on one hand and the benefits arising hand.

Illustration: A limited company is considering to introduce cash discount policy of 3 /10 net 30, i.e if the customer pays his dues within 10 d otherwise he has to pay the dues within 30 days. The company expects that 60% of the sales will opt for this facility which will to 18 days. If the sales of the company amount to Rs 50 lakhs and if required rate of return is 15%, should the proposal be acc

Solution (a) Loss of revenue: 60% of Rs 5000000 * 3% = Rs 90000 (b) Receivables before discount: (50000000 / 360 ) * 30 = Rs 416666 Receivables after discount: (5000000 / 360) * 18 = Rs 250000 (d) Investment in receivables released: i.e B minus C i.e 416666 - 250000 = 166666 (e) Return on investment released: 15% on Rs 166666 = Rs 25000 As the return on investment released is likely to be less than loss of revenue, the proposal of cash discount should not be accep Financing the Receivables:

Whichever sources are available to the company for financing the working capital requirement, are equally the sources availab fact that receivables is a part of working capital. However the following sources may be identified as the sources available for

a) Bills discounting b) Cash credit against hypothecation of book debts as the security c) In the recent past, factoring has become one of the sources available for financing the receivables. The mechanism of factor

(d) Credit Collection: This indicates the steps taken by the company to collect the dues from the customer. For this purpose, the company may follo just before the due date. This can be done by sending the reminder letters or making telephone calls or by paying the persona

The customers who are slow paying ones should be handled properly. If they are permanent customers, they may object to ha them ultimately. If the slow paying customer is facing some temporary funds problem, the company should understand the sa company should decide as to how many reminders should be sent and how each of them should be drafted. If these measures customers or personal visit by company's representative. If all the above course of action fail, the company may decide to take resort.

It is very regular practice to offer cash discounts to the customers in order to speed up the credit collection process. While designing the credit collection policy, following propositions should be remembered. (a) Before deciding collection policies and procedures, it is essential to make cost benefit analysis. The costs are the administra and the benefits are reduced bad debts losses and interest on release investment in debtors. As a financial management prop by the benefits.

(b) Before deciding collection policies and procedures, provisions of the Indian limitation act should be kept in mind. In spite o the amount due from him, the legal action should be initiated against him before the limitation period is over. (e) Monitoring the receivables: It may be necessary to ensure that outstanding receivables are within the framework of credit policy decided by the company. regular checks and have a regular system to monitor the receivables properly. For this, the company may use the following tec Techniques available on Macro basis: One of the most common methods to monitor the receivables on macro basis is to calculate the average collection period (ACP customer to make payment to the company or the average period of credit allowed by the company to the customers ACP: may be calculated in two stages described below. a: Calculation of daily or monthly sales: Credit sales during the year / Number of days or Number of months b: Calculation of average collection period: Sundry Debtors in Balance sheet / Daily or monthly sales. For the purpose of proper interpretation of ACP, it needs to be compared with the NCP, i.e normal credit period offered by the ACP works out to be more than NCP, it indicates inefficiency on the part of marketing department or sales department or colle dues from the customers. If other way, it indicates efficiency of on the part of marketing department or sales department or c dues from the customers. However calculation of ACP as a tool to monitor the receivables involves some limitations;

a) Calculation of ACP assumes that the credit sales are evenly spread throughout the year. In practical circumstances, credit sa such situations, ACP may give wrong indications. b) Calculation and interpretation of ACP as tool to judge the efficiency or inefficiency of the company in collecting the dues fro published financial statements of the company due to non-availability of sufficient data for the same. E.g. The amount of cred period offered by the company are not available in the published financial statements. Techniques available on Micro basis:

Considering the limitations associated with the calculation of ACP, it may not be a tool available to monitor the receivables on analysis of receivables may be made. Age-wise analysis of the receivables involves the classification of outstanding receivables month) into different age group(age of receivables indicating the number of days since the date receivables become outstandi group may also be calculated. For example,

Now, if the normal credit period offered by the company to customers is 30 days, any amount which is outstanding for than 30 part of collection department of the company in collecting the receivables. Thus age-wise analysis of the receivables may prov receivables and the company can concentrate its collection efforts on those receivables which are outstanding for a longer per

14.5 Factoring: In the recent past, factoring has emerged as one of the major financial service receivables management What is Factoring? Factoring indicates relationship between a financial institution (called as the factor) and business organization (called as the cli customer (called as the customer) whereby the factor purchases book debt of the client, either with recourse or without recou extended to the customers and administers the sales ledger of the client. In non-technical language, the financial service in th the marketing department of an organization will be undertaking. E.g. the factor may provide the following services to the clien

a) Factor may undertake the credit analysis of the customers of the client. Factor may also help the client in deciding the credi like period of credit, discount to be allowed etc. It should be noted that the factor need not factor all the debts of the client. H the client and accordingly, he will factor the debts of the client.

b) Factor will undertake various bookkeeping and accounting activities in relation to the receivables management. This will co generation of the various periodical reports on behalf of the client (like outstanding from the customers age wise analysis of th

c) The factor undertakes the responsibility of following up with the customers for the purpose of making the collection from th client informs its customers about the fact that the debts have been factored by the factor and that the customers should mak

d) Factor can purchase the debts of the client making the immediate payment of these debts to the client after maintaining ab the working capital requirements of the client and the client can concentrate on manufacturing and other activities. After the date, the factor passes on the funds to the client after adjusting the funds advanced by him to the client. If the factor purchase and the cost is slightly higher than the interest which the client would have paid had he borrowed the funds from the bank. If the client can borrow from the bank against these debts.

e) Factor can assume the risk of non-payment by the customers if the factoring is without recourse factoring and in such cases client. If the factoring is with recourse factoring, the risk of non-payment by the customer is assumed by the client and not by the funds advanced by him to the client. Factoring Vs Bill Discounting:

Factoring is different from bill discounting in two ways.. One, Bill discounting is essentially a financial function whereby the clie factoring is financial as well as administrative function. The factor is engaged not only in financing the book debts of the client activities as well like the maintenance of sales ledger, generation of the various reports, follow up with the customers, collectio of bills discounting, the risk of non-payment of dues by the customers is essentially assumed by the client, whereas in the case customers may be assumed by the factor if the factoring is without recourse factoring.

Procedure of Factoring: a) After the careful evaluation of customers and setting the credit limit upon the customers, the factoring firm enters into an a b) Sales invoices raised by the selling company in favour of its customers consists of an indication to the customer that the amo date, the customer should make the payment to the factor directly. c) The factor makes the prepayment of the invoice to the selling company after keeping the margin as stipulated. d) On the due date, when the customer makes the payment, the factoring firm recovers its fees / charged as agreed upon and company and passes on the balance amount to the selling company

The various steps involved in the factoring operation may be explained with the help of the following figure. Ref Fig 14.1 Page Description of numbers in the figure 14.1 : #1 -----Places the order #2 ----- Fixes the limit #3 ----- Delivers the goods and instructs the customer to make the payment to the factor. #4 ----- Sends the invoice copy #5 ----- Makes prepayment of invoice #6 ----- Follows up #7 ----- Makes the payment #8 ----- Pays the balance amount Types of Factoring: On the basis of above features of factoring, factoring can be classified in the following ways: a) Without recourse factoring: In this type of factoring, the risk on account of non-payment by the customer is assumed by the amount from the selling company. Thus without recourse factoring results into the outright buying of selling company's receiv referred to as Full Factoring

b) With Recourse Factoring: In this type of factoring, the risk on account of non-payment by the customer is assumed by the se the funds advanced by him from the selling company. Advantages of Factoring: a) Factoring is the way in which the company can finance its requirement of working capital in respect of receivables. Immedia working capital of the company. As the financing in the form of factoring moves with the level of receivables directly, the com requirement of working capital due to the increased amount of sales.

b) Factoring organization is a professional specializing in the various fields. The company can take the advantage of expertise analysis, deciding the credit limits upon the customers, etc. c) With the help of factoring as financial service, the company can be relieved of the administrative responsibilities of maintain and following up with the customer for collecting dues etc. This not only result in cost saving for the company, but the compan developments.

Disadvantages of Factoring: a) As the amount charged by the factoring organization, consists of the components towards the administrative services rende provided by the factor, the effective financial burden on the company increases. b) In Indian circumstances, Factoring is mainly with-recourse factoring. This means that the risk of non-payment on the part of by selling firm. This has restricted the popularity of factoring services in Indian circumstances.

c) While making the credit evaluation, if the factor adopts a very conservative approach with the intention to minimize the risk of the selling company.

d) Factoring may be considered to be a symptom of financial weakness on the part of the selling company. It may indicate tha receivables effectively on its own and is required to take the help of an outside agency in the form of factor.

Factoring in Indian Situations: Factoring services in Indian circumstances started on the basis of recommendations of Kalyanasundaram Committee which wa studying the scope of starting factoring services in India. The committee recommended the factoring in India. Reserve Bank o wished to get involved in the factoring business. The distribution of zones bank wise was as follows:

Western Zone - State Bank of India Southern Zone - Canara Bank Northern Zone - Punjab National bank Eastern Zone - Allahabad Bank. Recently, export credit guarantee commission (ECGC) has been authorized to start the export factoring business. Out of the above banks, State bank of India started its factoring services in 1991 by forming a separate subsidiary viz, SBI Facto Generally, factoring in India is with recourse factoring, ie. The risk of non-payment by the customer is not accepted by the facto experience of factoring in India is not very encouraging. 14.6 Illustrative Problems: Refer Page 429 14.7 Summary: The basis objective of management of receivables is to optimize the return on investment receivables. And it also has to achie Receivables management has the following aspects: Credit analysis, setting of credit terms, financing of receivables, credit coll indicates the relationship between a financial institution (called as factor) and a business organization (called as client) who in the factor purchases book debts of the client either with or without recourse and in relation thereto controls the credit extend of the client.
UNIT 15 - Management of Inventory MANAGEMENT OF INVENTORY INTRODUCTION The various forms in which a manufacturing concern may carry inventory are:

Management of inventory assumes importance due to the fact that investment in inventory constitutes one of the major investme

(1) Raw Material: These represent inputs purchased and stored to be converted into finished products in future by making certa (3) Finished Goods: These represents the finished products ready for sale in the market. They may be in the form of cotton waste, oil and lubricants, soaps, brooms, light bulbs etc. Normally, they form a very minor part of total inventory and do not involve significant investment. MOTIVES FOR HOLDING INVENTORY A company may hold the inventory with the various motives as stated below: It may not be possible for the company to procure raw material whenever necessary. There may be a time lag between the demand for the material and its supply. Hence, it is needed to hold the raw material inventory.

(2) Work in Progress: These represents semi-manufactured products which need further processing before they can be treated

(4) Stores and Supplies: These represent that part of the inventory which does not become a part of the final product but are re

(1) Transaction Motive: The company may be required to hold the inventories in order to facilitate the smooth and uninterrupte

Similarly, it may not be possible to produce the goods immediately after they are demanded by the customers. Hence, it is needed to hold the finished goods inventory. The need to hold work in progress may arise due to the production cycle.

(2) Precautionary Motive: In addition to the requirement to hold the inventories for routine transactions, the company may like changes in demand and supply forces. E.g.: The supply of raw materials may get delayed due to the factors like strike, transport, disruption, short supply, lengthy proce Hence the company should maintain sufficient level of inventories to take care of such situations.

Similarly, the demand for finished goods may suddenly increase (especially in case of seasonal types of products) and if the c the competitions. Hence , the company will like to maintain sufficient stock of finished goods.

(3) Speculative Motive: The company may like to purchase and stock the inventory in the quantity which is more than needed f This ,ay be with the intention to get the advantages in terms of quantity discounts connected with bulk purchasing or anticipated OBJECTS OF INVENTORY MANAGEMENT Usually the company is faced with the following conflicting objectives in the area of inventory management: (1) To carry maximum inventory in order to facilitate efficient and smooth production and sales operations. (2) To minimize investment in investment in inventory to maximize profitability. Both over-investment and under-investment in inventories is undesirable as both involve the consequences. The over-investment involves the consequences like: (i) Unnecessary blocking of funds in inventory and hence loss of profit. (ii) Excessive storage and insurance cost. (iii) Risk of liquidity. The inventories once purchased and stored are normally difficult to dispose off at the same value. In other words, the value of inventory reduces with the increasing holding period. The under-investment involves the consequences like: (i) If sufficient stock of raw material and work in process is not available, it may result into frequent interruptions in production.

(ii) If sufficient stock of finished goods is not available, it may not be possible for the company to serve the customers properly an Thus , the objective of inventory management is to avoid the situation of over-investment as well as under-investment. The inventories should be maintained at the optimum level.

To conclude, it can be said that the objective of inventory management is to minimize the investment in inventory without affectin TECHNIQUES OF INVENTORY MANAGEMENT (1) Economic Order Quantity It indicates that quantity which is fixed in such a way that the total variable cost of managing the inventory can be minimized. Such cost basically consists of two parts. First, Ordering Cost (which in turn consists of the costs associated with the administrative efforts connected with preparation of statements and handling of more number of bills and receipts).

Second, Carrying Cost ie, the cost of carrying or holding the inventory (which in turn consists of the cost like godown rent, hand of capital blocked i.e, interest etc) There is a reverse relationship between these two types of costs i.e. if the purchase quantity increases ordering cost may get re A balance is to be struck between these two factors and it is possible at economic. Quantity where the total variable cost of managing the inventory is minimum It is possible to fix the economic order quantity with the help of mathematical formula The following assumptions may be made for this purpose Let Q be Economic Order Quantity A be annual Requirement of material in units O be the cost of placing an order(Which is assumed to remain constant irrespective of size of order) C be the cost of carrying one unit per year

Now, if A is the annual requirement and Q is the size of one order, the total number of orders will be A/Q and the total ordering c

Similarly if the size of one orders is Q and if it is assumed than the inventory is reduced at a constant rate from order quantity to be Q/2 and the cost of carrying one unit per year being C, the total carrying cost will be Q/2 x C Thus Total cost = Ordering Cost + Carrying Cost = A/Q X O + Q/2 X C The intention is that the value of Q should be such that the total cost should be minimum. Hence, taking the first derivative of the equation with respect to Q and setting the result to zero. d0/dq = AO (-(1/q2) + c/2 = 0 or Q = (2 x A x O) / C Where Q = Order Quantity A = Annual Requirement in Units O = Cost of Placing an Order C = Cost of Carrying One Unit Per year Illustration: A manufacturer uses 200units of a component every month and he buys them entirely from the outside supplier. The order placing cost is Rs.100 per order and annual carrying cost per unit is Rs. 12 From this set of data, calculate the economic order quantity. Solution :Refer Page No 445 Illustration: From the following data, work out the EOQ of a particular component, Annual Demand : 5000 units Ordering Cost : Rs.60 per order

Price per unit : Rs.100 Inventory Carrying Cost : 15% On average inventory Solution : Refer Page No 446 Illustration: Kapil Motors purchase 9000 motor spare parts for its annual requirements, ordering one month usage at a time Each spare part costs Rs.20. The Ordering cost per order is RS.15 and the carrying charges are 15% of the average inventory per year You have been asked to suggest a more economical purchasing policy for the company. What advice would you offer and how much would it save the company per year. Solution : Refer Page No 447 (2) Fixation of Inventory Levels:

Fixation of various inventory levels facilitates initiating of proper action in respect of the movement of various materials in tim proper way. However the following propositions should be remembered: (i) Only the fixation of inventory levels does not facilitate the inventory control.

There has to be a constant watch on the actual stock level of various kinds of materials so that proper action can be taken in tim (ii) The various levels fixed are not fixed on a permanent basis and are subject to revision regularly The various levels which can be fixed are as below: (1) Maximum Level: It indicates the level above which the actual stock should not exceed. If it exceeds it may involve unnecessary blocking of funds in inventory While fixing this level following factors are considered: (i) Maximum usage (ii) Lead time (iii) Storage facilities available, cost storage and insurance etc. (iv) Prices for material (v) Availability of funds (vii) Economic Order Quantity (2) Minimum Level: It indicates the level below which the actual should not reduce If it reduces it may involve the risk of non-availability of material whenever it is required While fixing this level following factors are considered: (i) Lead time (ii) Rate of consumption

(vi) Nature of material e.g. If a certain type of material is subject to Government regulations in respect of import of goods etc. ma

(3) Re-order Level: It indicates that the level of material stock at which it is necessary to take the steps for procurement of further lots of material.

This is the level falling in between the two existences of maximum level and minimum level and is fixed in such a way that the r lot of material is received. (4) Danger Level: This is the level fixed below minimum level If the stock reaches this level it indicates the need to take urgent action in respect of getting the supply

At this stage the company may not be able to make the purchases in a systematic manner but may have to make rush purchase CALCULATION OF VARIOUS LEVELS The various levels can be decided by using the following mathematical expressions (1) Re-order level: Maximum lead time x Maximum usage (2) Maximum Level: Re-order Level + Re-order Quantity - (Minimum Usage x Minimum lead time) (3) Minimum Level: Reorder Level - (Normal Usage + Normal Lead Time) (4) Average Level: Minimum level + Minimum level / 2 (5) Danger Level: Normal Usage x Lead time for emergency purchases

Note: It should be noted that the expression of the reorder quantity in the calculation of maximum level indicates economic orde Illustration: Two components X and Y used are as follows: Normal usage - 50 units per week each Minimum usage - 20 units per week each Maximum usage - 75 units per week each Re-order quantity - X-400 units Y - 600units Re-order period - X -4 to 6 weeks Y - 2 to 4 weeks Calculate for each component: a) Reorder Level b) Minimum level c) Maximum level d) Average stock level Solution : Refer Page No 451 Illustration: Sriram enterprises manufactures a special product 'ZED'.

The following particulars are collected for the year 1986 a) Monthly Demand of ZED -1000units b) Cost of placing an order - Rs.100 Annual Carrying cost per unit - Rs.15 Normal usage - 50units per week Minimum usage - 50 units per week each Maximum usage - 75 units per week each Re-order period - 4 to 6 weeks Calculate for each component: a) Reorder Level b) Minimum level c) Maximum level d) Average stock level e) Re-order Quantity. Solution : Refer Page No 453 Illustration: You have been asked to calculate the following levels for Part No. 007 from the information given thereunder: (a) Re-ordering level (b) Maximum level (c ) Minimum level (d) Danger level (e) Average level There, the ordering quantity is to calculate from the following data. (i) Total cost relating to one order : Rs. 20 (ii) Number of units to be purchased during the year: 5,000 (iii) Purchase price per unit : Rs. 50 (iv) Annual cost of storage of one unit : Rs. 5 Lead Times: Average Maximum Minimum Maximum for emergency purchases Rate of consumption: Average Maximum Solution: Refer Page No: 456 (3) Inventory Turnover: - 15 units per day - 20 units per day - 10 days - 15 days - 6 days - 4 days

Inventory turnover indicates the ratio of materials consumed to the average inventory held. It is calculated as below: (value of material consumed) / (Average inventory held) Where value of material consumed can be calculated as : Opening Stock + Purchase - Closing Stock Average inventory held can be calculated as : (Opening Stock + Closing Stock) / 2 Inventory turnover can be indicated in terms of number of days in which average inventory is consumed. It can be done by dividing 365 days (a year) by inventory turnover ration. Illustration: Material A Rs. Opening Stock 1.1.86 Purchases during the year Closing Stock 31.12.86 Solution : Refer Page No: 458 10,000 52,000 6,000 Material B Rs. 9,000 27,000 11,000

From the following data for the year ended 31st December, 1986, calculate the inventory turnover ratio of the two items and forw

A high inventory turnover ratio or low inventory turnover period indicates that maximum material can be consumed by hold indicating fast moving items. Thus, high inventory turnover ratio or lower inventory turnover period will always be preferred.

Thus, knowledge of inventory turnover ratio or inventory turnover period in case of various types of material will enable to reduc and will enable the organization to exercise proper inventory control. (4) ABC Analysis:

This technique assumes the basic principle of 'Vital Few Trivial Many' while considering the inventory structure of any organizati

It is an analytical method of inventory control which aims at concentrating efforts in those areas where attention is required most

It is usually observed that, in practice, only a few number of items of inventory prove to be more important in terms of amount of a very large number of items of inventory account for a very meager amount of investment in inventory or value of consumption. This technique classifies the various inventory items according to their importance. E.g.. A class consists of only a small percentage of total number of items handled but are most important in nature. B class items include relatively less important items. C class items consists of a very large number of items which are less important. The importance of the various items may be decided on the basis of following factors. (i) Amount of investment in inventory. (ii) Value of material consumption. (iii) Critical nature of inventory items. An example of ABC Analysis can be given as below:

In order to exercise proper inventory control, A class items are watched very closely and control is exercised right from initial level/lead times, following proper purchase/storage procedures etc. Whereas in case of C class of items, only those inventory control measures may be implemented which are comparatively simpl Advantages of ABC Analysis:

(a) A close and strict control is facilitated on the most important items which constitute a major portion of overall inventory val costs associated with inventories may be reduced. (b) The investment in inventory can be regulated in proper manner and optimum utilization of the available funds can be assured (c ) A strict control on inventory items in this manner helps in maintaining a high inventory turnover ratio.

However it should be noted that the success of ABC analysis mainly upon correct categorization of inventory items and henc personnel. (5) Bill of Materials: This aim can be achieved by preparing what is normally called as 'Bill of materials'. A bill of material is the list of all materials required for a job, process or production order. It gives the details of the necessary materials as well as the quantity of each item.

In order to ensure proper inventory control, the basic principle to be kept in mind is that proper material is available for productio

As soon as the order for the job is received, bill of materials is prepared by the Production Department or Production Planning D The form in which the bill of material is usually prepared is as below: For figure Refer page No: 460 The function of bill of materials are below: (1) Bill of materials give an indication about the orders to be executed to all the persons concerned. (3) Bill of material may serve as a base for the Production Department for placing the material requisition slips. (4) Costing/Accounts Department may be able to compute the material cost in respect of a job or a production order. A bill of material prepared and valued in advance may serve as a base for quoting the price for the job or production order.

(2) Bill of materials gives an indication about the materials to be purchased by the Purchase Department if the same is not availa

(6) Perpetual Inventory System: As discussed earlier, in order to exercise proper inventory control, a perpetual inventory system may be implemented. It aims basically at two facts. (1) maintenance of Bin Cards and Stores Ledger in order to know about the stock in quantity and value at any point of time. (2) Continuous verification of physical stock to ensure that the physical balance and the book balance tallies. The continuous stock taking may be advantageous from the following angles: (1) Physical balances and book balance can be compared and adjusted without waiting for the entire stock taking to be done at Further, it is not necessary to close down the factory for Annual stock taking. (2) The figures of stock can be readily available for the purpose of periodic Profit and Loss Account. (3) Discrepancies can be located and adjusted in time. (4) Fixation of various levels and bin cards enables the action to be taken for placing the order for acquisition of material. (5) A systematic maintenance of perpetual inventory system enables to locate slow and non-moving items and to take remedial (6) Stock details are available correctly for getting the insurance of stock. ILLUSTRATIVE PROBLEMS (1) A company uses annually 50,000 units of an item each costing Rs. 1.20. Each order costs Rs. 45 and inventory carrying cos (a) Find EOQ.

(b) If the company operates 250 days a year, the procurement time is 10 days, and safety stock is 500 units, find reorder level, m Solution Refer Page No: 463. (2) M/s. Kailas Pumps Ltd. uses about 75,000 valves per year and the usage is fairly constant at 6,250 per month. The cost to place an order and to process the delivery is Rs. 18. It takes 45 days to receive from the date of an order and minimum stock of 3,250 valves is desired. You are required to determine: (a) The most economical order quantity and the number of orders in a year. (b) The reorder level. (c ) The most economic order quantity, if the value cost Rs. 4.50 each instead of Rs. 1.50 each. Solution Refer Page No: 464

The value costs Rs. 1.50 per unit when purchased in quantities and inventory carrying cost is 20% of the average inventory inve

(3) The Purchase Department of your organization has received an offer of quantity discounts on its order of materials as under. Price per Tonne Rs. 1,200 1,180 1,160 1,140 1,120 Tonnes Less than 500 500 and less than 1000 1000 and less than 2000 2000 and less than 3000 3000 and above

The annual requirement for the material is 5000 tonnes. The delivery cost per order is Rs. 1,200 and the stock holding cost is estimated at 20% of material cost per annum.

You are required to advice the Purchase Department the most economic purchase level. Solution Refer page No: 465

(4) A company needs 24,000 units of raw materials which costs rs. 20 per unit and ordering cost is expected to be Rs. 100 per o The company maintains safety stock of 1 month's requirements to meet emergency. The holding cost of carrying inventory is supposed to be 10% per unit of average inventory. Find out: 1. Economic lot size. 2. Ordering cost. 3. Holding cost. 4. Total cost. The supplier of raw material has agreed to supply the goods at a discount of 5% in price on a lot size of 4,000 units. Find where the concession price should be availed. Solution Refer Page No: 467 SUMMARY Inventory includes raw material, stores and supplies, work in progress and finished goods.

The basic objective of inventory management is to optimize the returns of investment in inventory by stocking enough inventory same time avoiding unnecessary blocking of funds. The various techniques of inventory management include i) Economic Order Quantity ii) Fixation of Inventory levels iii) C Preparation of Bill of Materials vi) Perpetual Inventory System.

UNIT 16 - DIVIDEND POLICY

16.1 INTRODUCTION The Finance Manager has to decide the dividend policy very carefully. A wrong dividend policy may put the company into financial troubles and the capital structure of the company may get unbala The growth of the company mat get hampered if sufficient resources are not available to implement growth programmers. The Finance Manager has to formulate the dividend policy in such a way which coincides with the ultimate object of the finan and value of the firm. 16.2 IMPORTANCE OF DIVIDEND POLICY Profits earned by a company may be handled by it basically in two ways. (1) To distribute the profits among the shareholders by way of dividend. (2) To retain the profits in the business to be used in future. There are no strict rules and guidelines available to decide as to what portion of the profits should be distributed by way of d decisions which the management of the company may be required to take. If the management decides to retain a large portion of the profits in the business ,funds required for future expansion and mo it on long term basis, without any obligations to repay the same. The expansion or modernization programmers may improve the earning capacity of the company in future which may carry fo The company may be able to absorb the shocks of business fluctuations and adverse situations boldly. A strong and stable company may earn the confidence of the investors and creditors and funds may be available to it at reason As a result ,the share prices and the value of the company will increase. Thus ,though the shareholders are required to forego the dividends in the short run, they get benefit in the long run.

On the other hand, if the management decides to distribute a large portion of profits by way of dividend ,the company may b may be able to attract the prospective investors to invest in the securities of the company.

Shareholders are necessarily interested in getting larger dividends immediately due to the time value of money and also due to Shareholders are thus attracted to the companies paying high dividends, due to which prices of the shares and value of the com Thus, it can be seen that both high retentions and high dividends may be desirable, but there is necessarily a reciprocal rela the relations, lower the dividends; Lower the retentions, higher the dividends.

The skill of the finance Manager lies in striking the balance between these extremes. 16.3 APPROACHES TO DIVIDEND POLICY However, there are conflicting opinions regarding the impact of dividend policy on the valuation of the firm According to one school of thought, dividends are irrelevant, so the dividends have no impact on value of the firm. According to the second school of thought, dividends are relevant to the value of the firm measured in terms of market prices (A)Irrelevance Approach: This approach is suggested mainly by Modigliani and Miller. According to this approach, the value of the company remains unaffected by the dividend policy of the company. It is the earnings potential and the investment opportunities available to the company which affects its value and not the divid Suppose ,that a company wants to invest in a project ,it has two options open before it. (1) Pay the earnings and raise the funds from market. (2) Retain the earnings to be used to finance the project. If the company pays the dividend, it will have to go to the market for raising the funds. Acquisition of the funds from the market will dilute the shareholding which results in reduced share values. As such, whatever the shareholders receive by way of cash dividends, they lose in terms of reduced share values. As such, they are not concerned with the fact whether the earnings are retained or are distributed by way of dividend. The market price of the shares and as such value of the company remains the same in both the situations. It is worth recollecting here the Modigliani Miller approach in relation to capital structure which suggests that the value of fir structure. As such, in relation to dividend policy also, the source from which the funds required to finance the investment programmed a

(B)Relevance Approach: This approach is suggested mainly by Walter and Gordon. They hold that there is a direct relationship between the dividend policy of the company and its value in terms of market price The propositions of the above approach can be stated, in most simple words as below. The investors prefer current dividend income to future dividend income as it does not involve any risk. As such, increasing payout ratio increases the share prices under normal circumstances. However, if the company has the investment opportunities open before it where expected rate of return is more than cost o declining payout ratio which is due to the anticipated and future dividend income. 16.4 FACTORS DETERMINING DIVIDEND POLICY Before formulating the dividend policy of the company ,the finance manager is required to take into consideration various fact a. External factors b. Internal factors External Factors 1.Phase of Trade Cycles: The company's dividend policy depends upon the phase of trade cycles through which the company m During the phase of boom and prosperity, the company may not like to distribute huge amount of profits by way of dividen permit it to do so.

The company will like to retain more profits which can be used during the depression which is likely to follow. Further, the company will like to take the benefits of investment opportunities prevailing during the period of boom. Similarly, during the period f depression, the company will like to withhold the dividend payments to retain the profits in the b

At all the times, though it may be necessary to declare higher dividends to increase marketability of its shares. 2.Legal Restrictions: The company can formulate its dividend policy within the overall legal framework. If the company wants to pay the dividend in cash, relevant provisions of companies Act,1956 are required to be followed by th If the company wants to issue the bonus shares with the intention to capitalize its reserves, relevant SEBI guidelines are requir The relevant provisions of companies Act,1956 and SEBI guidelines are discussed later. 3.Tax Policy: Tax policy as a factor affecting the dividend policy of the company needs to be considered from the point of view

As far as the company is considered ,dividend can be paid out of profit after tax. As such, the company does not get any tax advantage by paying the dividend. On the other hand, as per the provisions to section 115-O of the Income Tax Act,1961,it increases the tax burden for the comp pay' tax on distributable profits' which is common language referred to as' dividend tax'. The rate at which the company is required to pay the dividend tax is 12.5% of the amount of dividend paid and the said basic the education cess of 2%. As such, the effective rate of dividend tax works out as 14.025%.As far as shareholders are concerned ,as per the provisions received by the ,whether interim or final, is a tax free income. As such, they are not required to pay the tax on dividend received by them. 4.Investment Opportunities: Formulation of dividend policy of the company depends upon the investment opportunities avail If the investment opportunities involve a higher rate of return than the cost of capital of the company, the company will like to

5.Restrictions imposed by the lending institutions: In practical circumstances, the lending banks or financial institutions impo payment of dividend entirely or limiting the amount of dividend or disallowing the payment of dividend if certain conditions ar This is due to the fact that the payment of dividend amounts to the withdrawal of profits from the business and company p lending banks or financial institutions so long as the loans are still unpaid to them. Internal factors 1.Attitude of the Management: If the attitude of the management is aggressive, it may decide to pay more dividend as the income of the shareholders.

Whereas if the attitude of the management is conservative, the company will like to retain more profits in the business to take 2.Composition of Shareholding: The composition of the shareholding may play an important role in the dividend policy formul If the company is a private limited company having less number of shareholders, the company will like to retain more profits a the tax liability of the individual shareholders, as the dividend received by the shareholders is a taxable income in their hands.

If the company is a public limited company, tax brackets of the individual shareholders may not have a significant impact on th 3.Age of the company: A young and growing concern will like to retain maximum profits in the business in order to finance its it to raise the funds from the open market whenever the need arises. On the other hand, an old or established company having reached the saturation point, may follow a high dividend policy. 4.Nature of business /Earning: The nature of business of the company inevitably affects its dividend policy. A company having stability of earnings may be able to formulate long term dividend policy and may even follow a high dividen On the other hand, a company having unstable income may like to retain its profits during boom to ensure that dividend policy 5.Growth Rate of company: The growth rate of the company closely affects its dividend policies. A rapidly growing company may like to retain majority of its profits in order to take care of its expansion needs.

However, care should be taken by the management to invest only in those projects which yield more returns than its cost of ca 6.Liquidity Position: Profitability and Liquidity are separated from each other. In spite of existence of high profitability or huge reserves, the company may not have sufficient funds to pay cash dividends. As such, before formulating the dividend policy, due considerations should be given to the liquidity positions of the company. At the same time, future commitments affecting the liquidity should also be considered. E.g. At present, company's cash position may be comfortable ,but it may need cash within a short time to pay installments of t In such case, the finance Manager may not like to impair its liquidity for making dividend payment. 7.Customs and Traditions: In some cases, the customs and traditions built by the company may affect its dividend policy. E.g. If the company is following the stable dividend policy for 20 years, it may like to maintain the trend in the 21st year also, in

16.5 CHOOSING THE DIVIDEND POLICY As discussed above, a most of factors are required to be considered by the company before formulating its dividend policy. The selection of ultimate dividend policy varies from industry to industry. There may be various pattern in which a company may pay dividends. 1.Stable Dividend Policy: According to this policy, the company pays a fixed amount of dividend irrespective of the fluctuations in income. During the periods of prosperity, the company withholds extra income to be used for paying dividends in lean years. Stable dividend policy does not indicate stagnation in dividend payout. If the company is assured about permanent increase in earnings, amount of dividend per share may be increased. Stable dividend policy helps the company in following respects: (1) The credit standing of the company in market increases. The investors are assured of a stable income and the company can raise as much funds as required in the market. (2) The share prices of the company increase. The marketability of the shares increase and the investors are ready to pay high (3) The management of the company enjoys confidence of the shareholders. This may enable the company to raise the funds whenever required and it also improves the moral of management. (4)The company following a stable dividend policy can formulate financial plan on long term basis as future demand and supply While formulating stable dividend policy, care should be taken not to fix the dividend payout ratio at a very high level which ca For this purpose, correct estimations of earnings capacity and future earnings of the company should be made. 2.No Immediate Dividend Policy: According to this policy, the company does not pay any dividend despite the huge earnings. The company retains the earnings to be used in future for its growth and expansion programmes if it is feared that the access t The main drawback with this policy is that the shareholders do not get immediate cash income by way of dividend and hence get regular income may not be in favor of this policy.

However ,this policy may attract the shareholders who are willing to devote short term dividend income for long term capi company. 3.Regular and Extra Dividend Policy: This Policy may be used as supplement to stable dividend policy. In case of a stable dividend policy, the dividend pay out is maintained at a constant rate. However ,if in a particular year, the earnings of the company increase abnormally, the additional earnings may be distributed dividend payout rate itself. The advantage attached with the policy is that the shareholders are aware of the fact that the extra dividend are solely due abnormal earning in a particular year.

However, if a company follows a policy of regular and extra dividends for years together, a wrong impression may be created dividends as a part of regular dividends and the omission to pay extra dividend in some year may result into loss of confidenc prices and credit standing of the company.

4.Regular -stock Dividend Policy: According to this policy, the company may decide to pay dividends in the form of stock rather than in the form of cash i.e.by is This policy may be useful to the company as it does not involve the effect on liquidity position of the company. However, following its policy on a regular basis may prove to be disadvantageous due to two reasons. Firstly, if the company is not in the position to increase future earnings on a permanent basis, issue of Bonus shares may redu the share prices and credit standing of the company.

Secondly, the shareholders who are interested in getting cash income on regular basis may not approve of this policy on a perm

5.Irregualar Dividend Policy: According to this policy ,the dividend payout are is not fixed by the company. The dividend per share varies according to the level of earnings. As such , high earnings may result into dividends whereas less earnings may result into less or no dividends. As such ,this policy believes that the shareholders are entitled to dividends only when the earnings and liquidity position of the

This policy may be followed by the companies having unstable income. This policy may be advantageous for the company as it does not commit itself to any fixed and regular payment of dividend . However, it may not be approved by the shareholders as it does not assure ant fixed or regular dividend income. 16.6FORMS OF DIVIDEND PAYMENT If a company wants to distribute the profits among the shareholders by way of dividend ,it can do so in two forms: a. Payment of dividend in cash b. issue of Bonus shares Cash dividend If the company wants to distribute the dividend by way of cash i.e.by issuing the dividend warrants, the company is required to

a. The rate of dividend to be paid needs to be decided by the Board of Directors. However, the capacity of the Board of directors is only the recommender capacity. The dividend is declared but the shareholders in their meeting i.e. Annual General Meeting. However, the shareholders cannot increase the rate of dividend recommended by the Board of Directors. According to the provisions of section 205-1(B) of the companies Act,1956,the Board of Directors can declare the interim divid The term interim dividend refers to the dividend declared in between two Annual General Meetings. bathe dividend is payable out of the current year's profit after providing for sufficient amount of depreciation as per the provis

C. Before any dividend is paid in cash, the company is required to transfer a certain minimum amount to reserves from the pro The provision is made to ensure that the company does not withdraw the entire amount of profits from the business. The rates at which the profits needs to be transferred to reserves, are stated below:

d. Generally ,the company will not be able to pay the dividend unless the company has the profits in the current year. However, in some cases, the company can pay the dividend out of the profits earned by the company in the past and retained If the company pays the dividends out of the retained profits, the company needs to comply with the following conditions:

(1) The rate do dividend declared shall not exceed the average rate at which the dividend was declared during 5 immediately p (2) The total amount to be drawn from the reserves shall not exceed an amount equal to 10% of its paid up capital and free res e. Any amount of dividend declared including interim dividend shall be deposited in a separate bank amount within five days amount so deposited shall be used for the payment of interim dividend.

If the dividend has been declared but has not been paid or the dividend warrants are not posted within 30 days from the decl payment of dividend ,every director of the company who is knowingly a party to the default, shall be punishable with simple Rs.1000 for every day during which the default continues.

Further, the company shall be liable to pay simple interest @18% p.a. during for which the default continues. f. Any dividend which has been declared by the company but which remains to be paid or claimed within 30 days from its d expiry of such 30 days, transfer this amount of unpaid or unclaimed dividend to a separate account opened with a scheduled b

If any amount remains pending in this amount for a period of 7 years, such amount will be transferred by the company to a fu Education and Protection Fund ' which is supposed to be used for promotion of investors' awareness and protection of the inte

Bonus Shares: Bonus Shares indicate the payment of dividend in the form of shares of the same company in proportion to their existing share This form of paying the dividend does not involve any outflow of cash, but involves only transfer of retained earnings to share Profits earned by a company in the previous years effectively belong to the equity shareholders as they are the ultimate owner However, so long as the reserves appear on the balance sheet of the company, the legal ownership of the reserves remain with By issuing the bonus shares, the company transfer ownership of reserves to the shareholders legally. As such, issue of bonus shares is technically referred to as the capitalization of reserves. When a company issues bonus shares, reserves of the company get reduced and share capital of the company increases. Advantages: (1) To the company: (1) Conservation of cash: The company can satisfy the desire of shareholders for dividend without affecting its cash position. Thus, issuing of bonus shares may be a best remedy for a company having deficiency of the funds inspite of the huge earnings. (2) Remedy for Undercapitalization: As discussed earlier, the conditions of undercapitalization indicate huge amount of earnin By issuing bonus shares, the company increases number of shares thereby reducing the amount of earnings per share and the Thus bonus shares can be a best remedy for overcoming the situation of undercapitalization. (3) Transferring Ownership of Reserves: Existence of huge reserves may tempt a company to indulge itself in the speculative a

Issuing the bonus shares the company from doing so. (4) Increased Marketability: Bonus shares may increase the marketability of the shares. Increased number of shares and reduced earnings per share may keep the market price of the shares within the reach of an or Thus, the market foot he shares of the company may become wide. (5) Increased Prestige: Issuance of bonus shares increases the credit standing of the company in the eyes of the lending fina reasonable cost. (6) Proper Presentation of Earning Capacity: Issuance of bonus shares results into proper presentation of earning capacity of t If bonus shares are not issued, the accumulated reserves go an increasing with no change in shares capital which may create a of the company. To Shareholders: Due to bonus shares, shareholders are benefited from two angles. First, their equity holding in the company increases. Though they get dividend per share at a reduced rate, their total income is Second, the increased prestige of the company in the eyes of probable investors creates a ready market for their shareholding.

To Creditors: Creditors react favorably as company's liquidity position is not affected and the margin of safety available for the creditors incr But id the company continues to pay dividend at old rates on increased capital, it increases the strain on the liquidity position o Disadvantages: (1) Issue of Bonus shares presupposes that the earnings of the company will increase proportionately, otherwise the increases If the earnings per share are not increased with respect to the increased capital, it may suggest low profitability of the compan This may prove to be fatal to the company. (2) The stock dividends are more expensive to administer as compared to cash dividends. Guidelines for the issue of Bonus Shares: Earlier, the companies issuing bonus shares were governed by the guidelines issued by Controller of Capital Issues(CCI). After the abolition of office of CCI, these guidelines were replaced by SEBI guidelines. Whereas the guidelines issued by CCI were restrictive in nature, the guidelines issued by SEBI are more administrative in natur Even though the guidelines issued by SEBI are more particularly applicable to the companies listed on the recognized stock exc well.

The SEBI guidelines in respect of issue of bonus shares are as below: a. Articles of Association of the company should permit the issue of bonus shares. If there is no provision in the Articles of Association, they need to be amended first. b. The authorized share capital of the company should be sufficient to absorb the share capital of the company after the issue If the authorized share capital is not sufficient ,the same needs to be increased first. c. The bonus shares cannot be issued in respect of partly paid shares. d. The issue of bonus shares needs to be approved by the board of directors and the company should issue the bonus shares given by the board of directors. Approval given by the board of directors cannot be reversed. e. Bonus shares can be issued out of the free reserves appearing on the balance sheet and the share premium amount collecte It is made very clear in the SEBI guidelines that revaluation reserve cannot be used for issue of bonus shares. f. The company cannot issue the bonus shares if it has defaulted(1) in respect of payment of interest or repayment of principal amount ,either in case of debentures or in case of public deposi This provision is to protect the interests of debenture holders or depositors. (2) in respect of payment of employee dues, like provident fund, gratuity, bonus etc. This provision is to protect the interests o g. Pending the conversion of Fully Convertible Debentures(FCDs) or partly convertible Debentures(PCDs)into the shares of t unless the same benefit is extended to holders of these FCDs or PCDs by reserving a part of shares for them.

Such shares can be actually issued when the conversion into shares takes place. h. A company which is a listed company shall forward certificates duly signed by the company and countersigned by its s certifying that the company has compiled with all the terms and conditions in respect of issue of bonus shares.

When CCI guidelines were applicable, no company could issue the bonus shares in the proportion of more 1:1 i.e. for every share could be issued by the company. This restriction was removed by SEBI guideline. First company to take the advantage of these revised SEBI guidelines was Cipla of 5:1 i.e. .for every one share held in the company ,the shareholders got five bonus shares. 16.7 SUMMARY This chapter introduces you with the factors determining Dividend Policy and its impact on the valuation of firm. The factors may be classified in External factors and Internal factors. The External factor generally includes legal restrictions, tax policy and investment opportunities. The Internal factors may include attitude of management ,nature of business ,growth rate of company and liquidity position of

Dividend can be paid in cash or by issue of bonus shares to the shareholders. There are various procedures and legal formalities which are required to be complied by the company for the payment of divid In case of Bonus shares, company issues shares to the shareholders as dividend in proportion of their shareholding in the same