Microsoft Word Finance Notes

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Financial Management
Functions Of Finance Manager & How They Have Changed In

Recent Years
The twin aspects procurement & effective utilization of funds are the crucial
tasks, which the finance manager faces. The financial manger is required to
look into financial implications of any decision in a firm. The finance manager
has to manage funds in such a way as to make their optimum utilization & to
ensure that their procurement is in a manner so that the risk, cost & control
considerations are properly balanced under a given situation.
It is pertinent here to distinguish between the nature of job of the finance

manager and that of the accountant .An accountant is not concerned with
management of funds which is a specialized task though historically many
accountants have been managing funds also. In the modern day business, since
the size of business has grown enormously the finance function in separate &
complex one. The finance manager has a task entirely different from that of an
accountant. He has to manage funds, which involves a number of important
decisions, which are as follows:
Estimating The Requirement Of Funds: In a business the requirement of

funds have to be carefully estimated. Certain funds are required for long term
purpose i.e. investments in fixed assets etc. A careful estimation of such funds
& the timing of requirement must be made. Forecasting the requirements of
funds involves the use of technique of budgetary control. Estimates of
requirements of fund can be made only if all physical activities of the
organization have been forecasted.
Decisions Regarding Capital Structure: Once the requirements of funds have

been estimated, decisions regarding various sources from where these funds
would be raised have to be taken. Finance manager has to carefully look into
existing capital structure and see how the various proposals of raising funds
will affect it. He has to maintain a proper balance between long-term funds and
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short-term funds. Long-term funds rose from outside have to be in a certain

proportion with the funds procured from the owner. He has to see that
capitalization of company is such that company is able to procure funds .All
such decisions are financing decisions.
Investment Decisions: Funds procured from different sources have to be

invested in various kinds of assets. Investments of funds in a project have to be
made after careful assessment of the various projects through capital
budgeting. A part of long-term funds is also to be kept for financing working
capital requirement. The production managers &-finance manager keeping in
view the requirement of production & future price estimates of raw material
availability of funds would determine inventory policy.
Dividend Decision: Finance manager is concerned with the decision to pay or

declare dividend .He has to assist management is deciding as to what amount
of dividend should be retained in business. & This depends on whether the
company can make a more profitable use of funds. But in practice trend of
earning, share market prices; requirement of funds for future growth, cash flow
situation, tax position of shareholders has to be kept in mind while deciding
dividend.
Cash Management: Finance manager has to ensure that all sections & units of
organization are supplied with adequate funds. Sections, which have an excess
of funds, have to contribute to the central pool for use in other sections, which
needs funds. Even if one of the 200 retail branches does not have sufficient
funds whole business may be in danger. Hence the need for laying down cash
management & cash disbursement policies with a view to supply adequate
funds at all times is an important function of a finance manager.
In the last few years, the complexion of the economic and financial environment
has altered in many ways. The important changes has been as follows:
The industrial licensing framework has been considerably relaxed.
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The Monopolies and Restrictive Trade Practices (MRTP) Act has been
virtually abolished.
The Foreign Exchange Regulation Act (FERA) has been substantially

liberalized.
Considerable freedom has been given to companies in pricing their equity

issues.
The
scope
for
designing
new
financing
instruments
has
been
substantially widened.
Interest rate ceilings have been largely removed.

The rupee was devalued and, in two stages, has been made fully
convertible on the current account.
Investors have become more demanding and discerning.

The system of cash credit is being replaced by a system of syndicated
loans.
A number of new investment opportunities have emerged in the money

market.
The relative dependence on the capital market has increased.

These changes have made the job of the finance manager more important,
complex and demanding. Here is a sampling of views expressed by leading
finance professionals:
Bhaskar Banerjee of the Duncan Group states, There has been a total
attitudinal change owners towards the finance manager. He is no longer
referred at as my accountant. Instead of being a commodity, the finance
manager is now a part of the top management.
Anand Rathi of Indian Rayon proclaims, The finance managers job has
vastly changed. Earlier it was a support function, now its mainline. And
finance itself has been a profit centre.
Bhaskar Mitter, Corporate Finance Director of ITC asserts, Today and in

the future, finance heads will face a tremendous challenge to shape their
organisations. A challenge to upgrade accounting practices, improve
reporting systems, utilize the international market for sourcing finance,
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operate adeptly in the forex market, as well as aid companies to compete

internationally.
N. Gopalkrishnan, of Shriram Fibres avows, The finance mans job has

become more creative and cerebral than just juggling with figures.
Accounting is no longer means just maintaining log books.
Hemany Luthra of Ballarpur Industries Limited says, In the paper

business, the returns may be 16 per cent while in the Agri-business it
may be 20 per cent. So how much to invest in which sector becomes very
crucial. The finance department tells the management where it should
increase its presence and where it should get out from.
The key challenges for the finance manager in India appear to be in

Investment planning, financial structure, Treasury operations, Foreign
exchange, Investor communication and Management control.
According to Feroz Ahmed and Dilip Maitra in Money from Money,

Business Today, September 22, 1992, Clearly, the clout of the finance
manager is growing along with the change in his role. And as the reforms
in the financial sector gather pace, this trend will only increase. If the
1970s were the age of the Organization Man and the 1980s that of the
Marketing Man, the 1990s will be the age of the Finance Man.
Profit Maximization
It means the rupee income of firms. Firms may function in the market economy
or government economy. In market economy prices are determined in
competitive markets and those are expected to produce goods and services
desired by the society.
In accounting sense it tends to become a long-term objective, which measure

not only the success of the products but also development of the market for it.
The word profit implies a comparison of the operation of the business between
two specific dates, which are usually separated by an interval of one year. In
order to optimize those corporate sources of wealth on which national
prosperity depends, the basic financial objectives of the companies is to
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maximize within socially acceptable limits, profit from the funds use of funds
employed to them.
Wealth Maximization
Wealth Maximization is also known as Value Maximization or Net Present
Worth Maximization. The company, which has profit Maximization as its
objective, may adopt the policies fielding exorbitant profit in the short run
which are unhealthy for the growth survival and overall interest of the
business. Hence it is commonly agreed that the objective of the firm should be
to maximize its value or health of the firm.
Features of Wealth Maximization:
It measures the benefit in terms of cash flow and avoids the ambiguity
associated with the accounting profits.
It consider both quality and quantity dimensions of benefits.

It also incorporates the time value of money.
Gross Working Capital

Gross working capital refers to the firms investment in current assets.
Accounts receivables
When goods are sold on credit, finished goods get converted into accounts
receivables in the books of the seller. A firms investment in accounts
receivables depends upon how much a firm sells on credit and how long it will
take to collect receivable. For example, if a firm sells Rs. 1 million worth of
goods on credit a day and its average collection period is 40 days, its accounts
receivables will be Rs. 40 million. Accounts receivables (or sundry debtors)
constitute the third most important asset category for business firms after plant
equipment and inventories. Hence, it behoove a firm to mange its credit well.
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Control of receivables: Monitoring and controlling of accounts receivables is

often neither very thorough nor systematic. Very few firms have well- defined
systems for monitoring and controlling accounts receivables. The measures
generally adopted by firms for judging whether accounts receivables are in
control are:
Bad Debt Losses

Average Collection Period
Ageing Schedule.
Room For Improvement: Management of receivables should be accorded the

importance it deserves. A senior executive should shoulder this responsibility.
Credit policies need to revise periodically in the light of internal as well a

external changes.
Firms granting credit should examine the published statements of

prospective customers with greater rigors.
Reference provided by the customers should be consulted and necessary

follow-up should be taken.
A well defined programmed must be developed.
Net Worth
While there is no doubt that the preference shareholders are the owners of the
firm, the real owners are the ordinary shareholders who bear all the risk,
participate in the management and are entitled to all the profits remaining after
all possible claims of preference shareholders are met in full.
Thus it can be said that,
Average Ordinary Shareholders Equity = Net Worth Of Company
Return on Net Worth = Net Profit After Tax Preference Dividend

Average Equity of the Ordinary Shareholders Equity or Net Worth
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It is probably the single most important ratio to judge whether the firm has
earned satisfactory return for its equity shareholders or not. Its adequacy is
judge by
Comparing with the past records of the same firm

Inter-firm comparison
Comparison with the overall industry average
Capital Employed
Total resources are also known as total capital employed and sometimes as
gross capital employed or total assets before depreciation. Thus total capital
consists of all assets fixed and current. In other words, the total of the assets
side of the balance sheet is considered as total assets employed.
While calculating capital employed on the basis of assets, following points must
be noted.
Any asset which is not in use should be excluded.

Intangible assets like goodwill, patents, trademarks etc should be
excluded. If they have some potential sales value, they should be
included.
Investments which are not concerned with business, should be excluded

Fictitious assets are to be excluded
Return on Capital Employed (ROCE) or Return on Investment (ROI)

The strategic aim of a business enterprise is to earn a return on capital. If in
any particular case, the return in the long-run is not satisfactory, then the
deficiency should be corrected or the activity be abandoned for a more
favourable one. Measuring the historical performance of an investment centre
calls for a comparison of the profit that has been earned with capital employed.
The rate of return on investment is determined by dividing net profit or income
by the capital employed or investment made to achieve that profit.
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ROI =
Net Profit
X 100
Capital Employed
Common Size Statement

The common size statement is often called as Common Measurement or
Common Percentage or 100 Percent statement, since each statement is
reduced to the total of 100 and each individual component of the statement is
represented as a percentage of the total, which invariable serves as the base.
This facilitates comparison of two or more business entities with a common

base. In the case of Balance sheet, total assets or liabilities or capital can be
taken as the common base and in the case of income statement, net sales can
be taken as the base.
Thus, the statement prepared to bring out the ratio of each assets or liability to
the tool of the balance sheet and the ratio of each item of expense or revenue to
net sales is known as common size statement.
State Merits/ Limitations of Common Size Statement, Comparative

Statement, trend analysis and ratio analysis
Ratio Analysis
It has been said that you must measure what you expect to manage and
accomplish. Without measurement, you have no reference to work with and
thus, you tend to operate in the dark.
One-way of establishing references and managing the financial affairs of an

organization is to use ratios. Ratios are simply relationships between two
financial balances or financial calculations. These relationships establish our
references so we can understand how well we are performing financially.
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Ratios also extend our traditional way of measuring financial performance; i.e.
relying on financial statements. By applying ratios to a set of financial
statements, we can better understand financial performance.
Limitations of Ratio Analysis
Ratios by themselves mean nothing. They must all be compared.

Ratios are calculated from financial statements which are affected by the
financial bases and policies adopted on such matters as depreciation and
the valuation of stocks.
They do not represent a complete picture of business and do not refer to

other facts, which affect performance.
A ratio is comparison between both numerator and denominator. In

comparing both it would be difficult to determine whether differences is
due to numerator or denominator.
They are inter-connected. They cannot be treated in isolation.

Over use of ratios as controls can be dangerous as management might then
concentrate more on simply improving the ratio than on dealing with the
significant issues. For example the return on capital employed can be improved
by reducing the assets than increasing profits.
Remember ratios are result of good performance and not cause of good
performance.
Comparative Financial Statements

One final way of evaluating financial performance is to simply compare financial
statements from period to period and to compare financial statements with
other companies. This can be facilitated by vertical and horizontal analysis.
Advantages
They indicate the direction of the movement of the financial position.
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They can be used to compare the position of the firm every month or
quarter.
It presents a review of the past activities and their cumulative effect.

Disadvantages
They lose their purpose and significance and tend to mislead if the
accounting principle is not applied consistently.
Constant changes in price levels render accounting statements useless

Inter-firm analysis cannot be made, unless the firm is of the same size,
age, and follow the same accounting principles
Common Size Statement

In this, the figures shown in the financial statements viz. Profit and loss
account and balance sheet are converted in to percentages so as to establish
each element to the total figure of the statement and these statements are
called common size statements. It is useful in analysis of the performance of the
company by analyzing each individual element to the total figure of the
statement. These statements will also assist in analyzing the performance over
the years and also with the figures of the competitive firm in the industry for
making analysis of relative efficiency.
Advantages:
It reveals the sources of capital and all other sources of funds and
distribution or use or application of the total funds in the assets.
Comparison of common size statement over a period will clearly indicate

the changing proportions of the various components of assets, liabilities,
costs etc.
Comparisons of two or the firms v/s industry as a whole helps in

corporate evaluation and ranking.
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Disadvantages:
It does not show variations in the various account item from period to
period.
It is regarded by many as useless as there is no established standard

proportion of an asset to the total assets or of an item of expense to net
sales.
If the statements are not followed consistently for years then the common
size statement would mislead.
It presents a review of the past activities and their cumulative effect.
Give Any Three Objectives Of Financial Analysis

Financial statement analysis is an integral part of interpretation of results
disclosed by financial statements. It supplies to decision makers crucial
financial information and points out the problem areas which can be
investigated. Financial statements may be analyzed with a view to achieve the
following purposes:
Profitability Analysis
Objectives of
Financial Statement
Analysis
Liquidity Analysis
Solvency Analysis
Profitability Analysis: Users of financial statements may analyze financial
statements to decide past and present profitability of the business. Prospective
investors may do profitability analysis before taking a decision to invest in the
shares of the company.
Liquidity Analysis: Suppliers of goods, moneylenders and financial institutions

may do liquidity analysis to find out the ability of the company to meet its
obligations. Liquid assets are compared with the commitments in order to test
liquidity position of a company.
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Solvency Analysis: It refers to analysis of long-term financial position of a

company. This analysis helps to test the ability of a company to repay its debts.
For this purpose, financial structure, interest coverage are analyzed.
Comparative Common Size Analysis

In comparative size analysis, the items in the balance sheet are stated
percentages of total assets and the items in the income statement are expressed
as percentages of total sales. Such percentage statements are called common
size statements. Common size analysis reinforces the findings of time series
analysis. These 2 kinds of analysis provide a useful perspective & facilitate
better understanding. They may be viewed as a valuable adjustment to the
traditional financial ratio analysis. They are useful aids in sensitizing the
analyst to secular changes & emerging.
Ratio Analysis Is Only A Tool And Not A Final Decision

Ratio analysis is a powerful tool of measuring a companys performance, but it
has certain limitations, which doesnt bring out any final decision. There are
certain limitations of which care has to be taken which are as follows:
Development of benchmarks: Many firms, particularly the larger ones

have operations spanning a wide range of industries. Given the diversity
of product lines it is difficult to find out suitable benchmarks for
evaluating the financial performance and condition. Hence it appears
that meaningful benchmarks may be available only for firms, which have
a well-defined industry classification.
Window dressing: Firms may resort to window dressing to project

favorable financial picture. For example. A firm may prepare its balance
sheet when its inventory level is low. As a result it may appear that he
firm has a very comfortable liquidity position and high turnover of
inventories.
Price level changes: financial accounting as it is currently practiced in

India and most other countries does not take into account price level
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changes. As a result, balance sheet figures are distorted and profits are
misreported. Hence financial statement analysis can be vitiated.
Variations in accounting policies: business firms have some latitude in

the accounting treatment like depreciation, valuation of stocks, research
and developmental expenses, foreign exchange transactions installment
sales, preliminary and pre-operative expenses, provision of reserves, and
revaluation of assets. Due to diversity of accounting policies comparative
financial statement analysis may be vitiated.
Interpretation of ratios: though industry averages and other yardsticks

are commonly used in financial ratios, it is somewhat difficult to judge
whether a certain ratio is good or bad. E.g. a high current ratio may
indicate a strong liquidity position. Likewise, a high turnover of fixed
assets may mean efficient utilization of plant and machinery. Another
problem is that, in interpretation when a firm has some favorable and
some unfavorable ratios. In such a situation, it may be somewhat
difficult to form an overall judgment about its financial strength and
weakness.
Correlation among ratios: in view of ratio correlations it is often

confusing to employ a large number of ratios in financial statement
analysis. Hence it is necessary to choose a small group of ratios,
consisting of say six to nine ratios, from the large set of ratios. Such a
selection requires a sharp understanding of the meaning and limitations
of various ratios and a good judgment about the business of the firm.
Financial statements do not represent a complete picture of the business but

merely a collection of facts expressed in monetary terms. These may not refer to
other factors, which affect performance of the company.
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Explain Various Components Of The Given Ratios With Illustrative

Examples
Current Ratio
1. Inventories of Raw Materials, Finished goods, work in progress, stores
and spares
2. Sundry Debtors
3. Short-term loans, Deposits & advances
4. Cash in hand and Cash at bank
5. Prepaid Expenses & Accrued Income
6. Bills Receivable
7. Marketable Investments and short-term securities
Liquid Ratio
Quick Assets and quick liabilities are the two elements of this ratio. All current
assets with the exception of inventories and prepaid expenses are considered as
quick assets. Deposits with customs, excise are not quick assets. All current
liabilities with an exception of bank overdraft and incomes recd in advance are
regarded as quick liabilities.
Proprietary Ratio
Proprietary Ratio includes equity share capital, preference share capital, capital
reserves, revenue reserves, securities premium, surplus and undistributed
profits.
Stock to Working Capital Ratio

This ratio includes stock (closing inventory & working capital) i.e. current
assets less current liabilities.
Capital Gearing Ratio

This Ratio includes fixed interest or dividend bearing capital & comprises of
debentures, secured and unsecured loans & preference share capital. Capital
that does not bear fixed interest or dividend is the equity share capital.
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Debt equity Ratio

Shareholders funds consist of preference share capital, equity share capital,
capital reserves, revenue reserves and reserves representing earmark surplus.
The amount of fictitious assets is deducted from the above.
Debts represent long-term debts. It includes mortgage loans and debentures.
Gross Profit Ratio

This Ratio includes the gross profit, net sales & cost of goods sold.
Operating Ratio
The components of this ratio are operating cost and net sales. Net sales is gross
sales less returns, allowances and trade discounts on sales. Operating cost is
the total of cost of goods sold and other operating expenses like office and
administrative expenses and selling & distribution expenses. They do not
include finance expenses & other non-operating cost like taxes on income, loss
on sale of asset etc.
Net Operating Profit Ratio

This ratio includes net operating profit and net sales.
Stock Turnover Ratio

This ratio includes cost of goods sold and average stock.
Return On Equity Share Capital

The components of this ratio are net profit after tax, financial charges and
preference dividend. Ordinary share capital without adding the reserves or
deducting the miscellaneous expenditure items.
Debtors Turnover Ratio

The components of this ratio are Sundry debtors, Accounts Receivables like
bills receivables and average daily sales. For computing this ratio, average
collection period is to be ascertained.
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What is Common Size Statement, Comparative Statement & Trend

Analysis? When & Why are they used?
Until about the turn of the century, preparation of financial statements was a
part of the work to be done by a bookkeeper. In due course of time, bankers
began to request balance sheets of applicants obviously with a view to consider
the desirability of granting credit. In spite of this, the statements were hardly
used, analyzed and interpreted in the real sense of these terms. However, in
due course of time, they started to prescribe certain minimum current and
liquid ratios for the purpose of lending and which eventually led to the practice
of analysis and interpretation of financial statements. The growth and
development of management as a science and decision making accepted as the
most important function of management, have contributed to the extensive use
of analysis of financial statements.
Analysis of financial statements means a systematic and specialized treatment

of the information found in financial statement so as to derive useful conclusion
on the profitability and solvency of the business entity concerned.
Objective Of Financial Statement Analysis

Financial statement analysis is an integral part of interpretation of results
disclosed by financial statements. It supplies to decision makers crucial
financial information and points out the problems areas, which can be
investigated. Financial statements may be analyzed with a view to achieve the
following purpose
Profitability Analysis
Objectives of
Financial Statement
Analysis
Liquidity Analysis
Solvency Analysis
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Methods and devices used in analysis of financial statements

1. Comparative Financial Statement
2. Common Size Statement
3. Trend Analysis
4. Cash Flow
5. Fund Flow And Many More
Comparative Financial Statement

Comparative financial statements are statements of the financial position of a
business so designed as to facilitate comparison of different accounting
variables for drawing useful inferences.
Financial statements of tow or more business enterprises may be compared

over a period of years. This is known as inter-firm comparison.
Common Size Statements

With a view to overcome the serious limitations of comparative financial
statements common size statements came into use.
The common size statements are prepared to bring out the ratio of each asset or
liability to the total of the balance sheet and the ratio of each item of expense or
revenue to net sales is know as the common-size statements.
The analysis, which employs these statements as a tool, is called vertical

analysis or static analysis because it is a study of relationship between
accounts as existing at a particular date.
Trend Analysis
Study of one years financial statements in isolation hardly serves any purpose.
An analyst should study three to five years financial statements and compare
the trend of sales, cost of production and different ratios etc. during the year.
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The trend will reveal whether the unit is prospering or deteriorating year after
year. Such analysis of the trend is known as trend analysis. For example by
comparing the sales figures of last 5-6 years one can find out what is the
growth pattern of the sales and what is the percentages of increase year after
year. Similarly by studying trend of cost of sales, cost of production and other
parameters one can infer whether the business is progressing or deteriorating.
Explain The Implication Of An Improvement In Current Ratio From

1 In 1999 To 2.5 In 2000
Current ratio indicates the short-term solvency of any type of company whether
it is trading, manufacturing or service provider. But the ratio varies from
industry to industry.
As per the banking norms, the minimum current ratio should be 1:3:1. It
means the current ratio should be 1.33 times more than current liability, to pay
for the current liability in the short-term period.
But in this question its not mentioned which type of industry is to be taken, so
we will take as general and all the banking norms applies on it.
Firstly, the current ratio was 1:1, which means that the current assets are
equal to current liabilities, which is less than the limit mentioned by the RBI.
So, it indicates that company wont be able to pay its short-term creditors in due
course and it may face problem of liquidity in near future. This bad ratio will
also pose negative impression on the creditors and they may not give any credit
facility. Even if the company applies to bank for loan facility to fund their
working capital requirement, they may not give the loan due to bad ratio i.e. 1:1
Now the ratio of the company has improved to 2.5:1 i.e. current asset are 2.5
times more than current liability which is approximately double of 1:3:1, as per
the banking norms.
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By 2.5:1, we can say that company would be easily able to pay its creditors in
due course of time. Company is solvent and liquid. Company wont be able to
face any problem of liquidity if its creditors demand for money, as current
assets are 2.5 times more than current liability. If the company ants to increase
its operation or want to go for expansion, them to fund its working capital
requirement, bank would without any problem will shell out money from their
surplus to fund the working capital requirement.
So, at last this improvement in ration is good for the company, which shows
that company is trying to improve their short-term solvency. This improvement
in current ration also indicates that companys operations are increasing dayby-day.
Explain The Precautions To Be Taken In Trend Analysis

Trend percentages as a tool of analysis, are employed when it is required to
analyze the trend of data shown in a series of financial statements of several
successive years. The trend obtained by such an analysis is expressed as
percentages.
Trend percentage analysis moves in one direction either upward or downwardprogression or regression. This method involves the calculation of percentage
relationship that each statement bears to the same item in the base year. The
base year may be any one of the periods involved in the analysis but the earliest
period is mostly taken as the base year.
Method of Calculation
Any of the statements is taken as the base.

Every item in the base statement is stated as 100.
Trend ratios are computed by dividing each amount in the statement
with the corresponding item in the base statement and the result is
expressed as a percentage.
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Precautions to be taken
While calculating trend percentages, following precautions should be taken:
There should be consistency in the principles and practices followed by

the organization through out the period for which analysis is made.
The base should be normal i.e. representative of the items shown in the
statement.
Trend percentages should be calculated only for the items which are
having logical relationship with each other.
Trend percentages should be studied after considering the absolute

figures on which they are based.
Figures of the current year should be adjusted in the light of price level
changes as compared to the base year before calculating trend
percentages.
Classify & Explain Profitability/ Solvency ratios etc.
Solvency Ratio/Liquidity Ratio

Liquidity refers to the ability of a firm to meet its obligations in the short run
usually one year. Liquidity ratios are generally based on the relationship
between current assets & current liabilities. The important solvency ratios are: -
Current Ratio = Current Assets/Current Liabilities

Current assets include cash, marketable securities, debtors, inventories, loans
and advances and prepaid expenses. Current liabilities include loans &
advances, trade creditors, accrued expenses and provisions. The current ratio
measures the ability of the firm to meet its current liabilities-current assets get
converted into cash in the operating cycle of the firm and provide the funds
needed to pay current liabilities. Apparently the higher the current ratio, the
greater the short term solvency.
Quick Ratio/Acid Test Ratio

Quick ratio = Quick Assets (Current Assets - Stock)/current liabilities
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The acid test ratio is a fairly stringent measure of liquidity. It is based on those
current assets which are highly liquid inventories are excluded from the
numerator of this ratio because inventories are deemed to be the least liquid
component of current assets.
Cost Of Preference Shares

The computation of the cost of preference shares is conceptually difficult as
compared to the cost of debt. In the case if debt, the interest rate is the basis of
calculating cost, as payment of a specific amount interest is legal commitment
on the part of the firm. There is no such legal obligation in regard to preference
dividend. It is true that a fixed dividend rate is stipulates on preference shares.
It is also true that holders of such shares have a preferential right as regards
payments of dividend as well as return of principal, as compared to ordinary
shareholders. But unlike debt there is no risk of legal bankruptcy if the firm
doesnt pay the dividend due to the holders of such shares. Nevertheless, firms
can be expected to pay the stipulated dividend, if there are sufficient profits, for
a number of reasons. First, the preference shareholders, as already observed,
carry a prior right to receive dividends over the equity shareholders. Unless,
therefore, the firm pays out the dividend to its preference shareholders, it will
not be able to pay any thing to its ordinary shareholders. Moreover, the
preference shares are usually cumulative which means that preference dividend
will get accumulated till it is paid. As long as it remains in arrears nothing can
be paid to the equity holders, further the non-payment of preference dividend
may entitle their holders to participate in the management of the firm as voting
rights are conferred on them in such cases. Above all, the firm may encounter
difficulty in raising further equity capital mainly because the non-payment of
preference dividend adversely affects the prospects of ordinary shareholders.
Therefore, the stipulated dividend on preference shares, like the interest on
debt, constitutes the basic for the calculation of the cost of preference shares.
The cost of preference capital may be defined as the dividend expected by the
preference shareholders.
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However, unlike interest payments on debt, dividend payable on preference

shares is not tax-deductible because preference dividend is not charge on
earnings or an item of expenditure; it is an appropriation of earnings. In other
words, they are paid out of after-tax earnings of the company. Therefore, no
adjustment is required for taxes while computing the cost of preference capital.
There are two types of preference shares: i) irredeemable and ii) redeemable.
Cost Of Debt
The cost structure of a firm normally includes the debt component also. Debt
may be in the form of debentures, bonds, term loans from financial institutions
and banks etc. The debt is carried a fixed rate of interest payable to them,
irrespective of the profitability of the company. Since upon rate is fixed, the firm
increases its earnings through debt financing. Then after payment of fixed
interest charges more surplus is available for the equity shareholders and
hence EPS will increase. An important point to be remembered that dividends
payable to equity shareholders and preference shareholders is an appropriation
of profit, where as the interest payable on debt is a charge against profit.
Therefore any payment towards interest payable on debt is a charge against
profit. Therefore, any payment towards interest will reduce the profit and
ultimately the companys liability would decrease. This phenomenon is called
Tax shield. The tax shield is viewed as a benefit accrued to the company which
is geared. To gain the full tax shield the following conditions apply:
The company must be able to show a taxable profit every year to take full
advantage of the tax shield.
If the company makes loss, the tax shield goes down and cost borrowings
increases.
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Discuss Cash Budget As A Management Tool With Illustrative

Examples
Cash budget is a statement showing the estimated cash inflows and cash
outflows over the planning horizon in other words. The net cash position of a
firm as it moves from one budgeting sub period to another is highlighted by the
cash budget.
The various purposes of cash budget are:
To coordinate the timing of cash need.

It pinpoints the period when there is likely to be excess cash.
It enables the firm which has sufficient cash to take the advantage of
cash discount on its account payable to pay the obligations when due to
formulate the dividend policy.
It help to arrange needed funds so that the most favourable terms and
prevents the accumulation of excess funds.
The principle aim of cash budget as a tool to predict cash flows over a given
period of time is to ascertain whether at any point of time there is likely to be an
excess or shortage of cash.
The preparation of cash budgets involves various steps and is called the
element of cash budgeting system. The first element is selection of period of
time to be covered by the entire budget. It is referred to as the planning horizon
which mean the time span and the sub period within that time span and the
sub period within that time span over which the cash flows are to be protected.
The second element of cash budget is the selection of the factors that have a
bearing on cash flows. The items included in the cash budget are only cash
items. The factors that generate cash flows are generally divided for the
purposes of preparing cash budget into two broad categories: (a) operating (b)
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financial. While the former category includes cash flows generated by the
operations of the firms and are known as operating cash flows.
Distinguish Between Cash Budget And Cash Flows Statement

Meaning
outflows over the planning horizon in other words. The net cash position of a
cash budget.
Cash Flow Statement generally prepared annually, which shows the sources
and the uses of cash during that period. It measures the changes in the
financial position on each basis.
Objectives
Cash Budget
To coordinate the timing of cash need.

It pinpoints the period when there is likely to be excess cash.
It enables the firm which has sufficient cash to take the advantage of
cash discount on its account payable to pay the obligations when due to
formulate the dividend policy.
It help to arrange needed funds so that the most favourable terms and
prevents the accumulation of excess funds.
Cash Flow Statement
Cash Flow Statement is useful for the management to assess its ability to
meet the obligation to trade creditors and to pay bank loan to pay
interest to debenture holders and dividend to its shareholders.
Cash Flow Statement can also be prepared month wise which is useful in
presenting the information of excess cash in some months and shortage
of cash in other months.
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State The Need For Preparing A Cash Budget

outflows over the planning horizon. In other words, the net cash position of a
cash budget.
The principle aim of preparing a cash budget, as a tool to predict cash flows
over a period of time is to ascertain whether at any point of time there is likely
to be an express or shortage of cash. The preparation of cash budget involved
various steps. They may be described as the elements of the cash budgeting
system.
Cost of Capital
The cost of capital is the rate of return the company has to pay to various
suppliers of funds in the company. There are variations in the costs of capital
due to the fact that different kinds of investment carry different levels risk
which is compensated for by different levels of return on the investment.
Opportunity Cost of Capital

When an organization faces shortage of capital and it has to invest capital in
more than one project, then the company will meet the problem by rationing the
capital to projects whose returns are estimated to be more. The firm might
decide to estimate the opportunity cost of capital in other projects.
Financial Leverage
This ratio indicates the effects on earnings by rise of fixed cost funds. It refers
to the use of debt in the capital structure. Financial leverage arises when a firm
deploys debt funds with fixed charge.
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Operating Leverage
Operating leverage is concerned with the operation of any firm. The cost
structure of any firm gives rise to operating leverage because of the existence of
fixed nature of costs. This leverage relates to the sales and profit variations.
Sometimes a small fluctuation in sales would have a great impact on
profitability. This is because of the existence of fixed cost elements in the cost
structure of a product.
Combined Leverage
The operating leverage has its effects on operating risk and is measured by the
percentage change in EBIT due to percentage change in sales. The financial
leverage has its effects on financial risk and is measured by the percentage
change in EPS due to percentage change in EBIT. Since both these leverages
are closely concerned with ascertaining the ability to cover fixed charges, if they
are combined, the result is total leverage and the risk associated with combined
leverage is known as total risk.
How is Weighted Average Cost of Capital calculated? What weights

should be used in its calculation?
Weighted Average Cost of Capital (WACC) is defined as, The weighted average
of the cost of various sources of finance, weight being the market value of each
source of finance outstanding cost of various sources of finance refers to the
return expected by the respected investors.
The Weighted Average Cost of Capital of a company is calculated in two ways:
Based on weight of costs by the book value of the different forms of

capital.
Based on weight of market value of each form of capital.
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The market value approach is more realistic for the reasons given below:
The cost of funds invested at market prices is familiar with the investors.
Investments are generally rated by the reference to their earnings yield,
and the company has a responsibility to maintain that yield.
Historic book values have no relevance in calculation of real cost of

capital.
The market value represents near to the opportunity cost of capital.
Explain The Dividend Approach To Calculate Cost Of Equity

The funds required for the project are raised from the equity shareholders,
which are of permanent nature. These funds need not be repayable during the
lifetime of the organization.
Hence it is a permanent source of funds.
The
equity shareholders are the owners of the company. The main objective of the
firm is to maximize the wealth of the equity shareholders. Equity share capital
is the risk capital of the company. If the companys business is doing well the
ultimate beneficiaries are the equity shareholders who will get the return in the
form of dividends from the company and the capital appreciation for their
investment. If the company comes for liquidation due to losses, the ultimate
and worst sufferers are the equity shareholders. Sometimes they may not get
their investment back during the liquidation process.
Profits after taxation, less dividends paid out to the shareholders, are funds
that belong to the equity shareholders which have been reinvested in the
company and therefore, those retained funds should be included in the category
of equity, the cost of retained earnings is discussed separately from cost of
equity capital. The cost of equity may be defined as the minimum rate of return
that a company must earn on the equity financed portion of an investment
project so that market price of the shares remain unchanged. The following
methods are used in calculation of cost of Equity.
Dividend yield method: The dividend yield per share is expected on the current
market price per share
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KE = Dividend X 100
Market price
The company is expected to earn at least this yield to keep the shareholders
content.
The main drawback with this method, as it does not allow for any
growth rate.
Normally a shareholder expects the returns from his equity
investment to grow over time. This approach has no relevance to the company.
What Are Marketable Securities?

Marketable securities are short-term investment instruments to obtain a return
on temporarily idle funds. In other words, they are securities, which can be
converted into cash in a short period of time, typically a few days. The basic
characteristics
of
marketable
securities
affect
the
degree
of
their
marketability/liquidity and are a ready market and safety of principal.
Policies Of Collection Of Receivables

Policies of collection of receivables refer to the procedures followed to collect
accounts receivables when, after the expiry of the credit period, they become
due. These policies cover two aspects:
Degree of effort to collect the over dues, and

Type of collection efforts
The collection policies of a firm may be categorized into
Strict
Lenient
A tight collection has implications which involve benefits as well as costs. In
case of lenient collection policy the cost benefit trade off is affected.
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Types of Risk
Risk
Systematic Risk
Unsystematic Risk
Market Risk
Interest Rate Risk
Business Risk
Financial Risk
Inflation Risk
Internal
External
Systematic Risk
Systematic risk refers to that portion of variation in return caused by factors
that affects the price of all securities. The effect in systematic return causes the
prices of all individual shares/bonds to move in the same direction. This
movement is generally due to the response to economic, social and political
changes. The systematic risk cannot be avoided. It relates to economic trends
which affect the whole market.
When the stock market is bullish, prices of all stocks indicate rising trend and
in the bearish market, the prices of all stocks will be falling. The systematic risk
cannot be eliminated by diversification of portfolio, because every share is
influenced by general market trend. This type of risk will arise due to the
following reasons.
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Market Risk
Variations in price sparked off due to real social, political and economic events
is referred to as market risk.
Interest Rate Risk

The uncertainty of future market values and the size of future incomes, caused
by fluctuations in the general level of interest is known as interest Rate Risk.
Generally, price of securities tend to move inversely with changes in the rate of
interest.
Inflation Risk
Uncertainties of purchasing power is referred to as risk due to inflation. If
investment is considered as consumption sacrificed, then a person purchasing
securities foregoes the opportunity to buy some goods or services for so long as
he continues to hold the securities. In case, the prices of goods and services,
increases during this period, the investor actually looses purchasing power.
Unsystematic Risk
Unsystematic risk refers to that portion of the risk which is caused due to
factors unique or related to a firm or industry. The unsystematic risk is change
in the price of stocks factors unique or related to a firm or industry. The
unsystematic risk is the change in the price of stocks due to the factors which
are particular to the stock. For example, if excise duty or customs duty on
viscose fibre increases, the price of stocks of synthetic yarn industry declines.
The unsystematic risk can be eliminated or reduced by diversification of
portfolio. The unsystematic risk will arise due to the following reasons:
External Business Risk

External business risk arises due to change in operating conditions caused by
conditions thrust upon the firm which are beyond its control such as
business cycles, government controls etc.
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Internal Business Risk

Internal business risk is associated with the efficiency with which a firm
conducts its operations within the broader environment imposed upon it.
Financial Risk
Financial Risk is associated with the capital structure of a firm. A firm with no
debt financing has no financial risk. The extent of financial risk depends on the
leverage of the firms capital structure.
Collection Cost
Collection costs are administrative costs incurred in collecting the re from the
customers to whom credit sales have been made. Included in this category of
costs are
Additional expenses on the creation and maintenance of a credit

department with staff, accounting records, stationery, postage and other
related items.
Expenses involved in acquiring credit information either through outside

specialist agencies or by staff of the firm itself. These expenses would not
be incurred if the firm does not sell on credit.
Default Cost
The firm may not be able to recover the over dues because of the mobility of the
customers. Such debts are created as bad debts and have to be written off, as
they cannot be realized. Such costs are known as default costs associated with
credit sales and accounts receivable.
Capital Cost
The increased level of account receivable is an investment in assets. They have
to be financed thereby involving a cost. There is a time lag between the sale of
goods to, and payment by, the customers. Meanwhile, the firm has to pay
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employees and suppliers of raw materials, thereby implying that the firm
should arrange for additional funds to meet its own obligations while writing for
payment from its customers. The cost on the additional capital to support credit
sales, which alternatively could be profitably employed elsewhere, is, therefore,
a part of the cost of extending credit or receivables.
Delinquency Cost
This cost arises out of the failure of the customers to meet their obligations
when payment on credit sales becomes due after the expiry of the credit period.
Such costs are called delinquency costs. The important components of this cost
are: (1) blocking up of funds for an extended period, (2) cost associated with
steps that have to be initiated to collect the over dues, such as, reminders and
other collection efforts, legal charges, where necessary, and so on.
Del-Credre Commission/Agent
An agent who bears the risk of nonpayment by a customer to whom the agent
sold goods on behalf of a principal
An extra commission paid by a principal to a del credre agent to cover the risk
of nonpayment by a customer to whom the agent has sold goods on behalf of
the principal.
Various Collection Methods from Receivables

Sometimes a customer fails to pay on the due date. The following procedure will
help in efficient collection of overdue receivables:
A reminder
A personal letter
Several telephone calls
Personal visit of sales man
A telegram
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A visit from salesman responsible to customer

A reminder to the sales person that commission is based on cash
received not on invoiced sales.
Restriction of credit
Use of collection agencies
Legal action, as a last resort
Treasury Bills
It is a type of marketable security, which is an obligation of government. These
bills are sold on discount basis. Here, the investor does not receive an actual
interest payment so the return is nothing but the difference between the
purchase price and the face value of the bill. The treasury bills are issued only
in bearer form so we can say that ownership is easily transferable.
Bills Discounting
Under this system, a borrower can obtain credit from the bank against the bills.
The amount provided under this system is covered within the overall cash
credit or overdraft limit. Before purchasing or discounting the bills, the bank
satisfies itself as to the creditworthiness of the drawer. Though the term bills
payable implies that the bank becomes owner of the bills but in practice the
bank holds bills as security for the credit. A bill discounted, the borrower is
paid the discounted amount of the bill. A bank collect full amount of maturity.
Inter Corporate Deposits

A deposit made by one company with another, normally for a period up to six
months, is referred to as inter corporate deposit. Such deposits are usually of
three types;
Call Deposits: A call deposit is withdrawable by the lender on giving a

days notice. In Practice, however the lender has to wait for at least three
days. The interest rate on such deposit may be around 16% p.a.
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Three Months Deposit:
These are more popular in practice. These
deposits are taken from borrowers to tide over a short term cash
inadequacy that may be caused by one or more of the following factors:
disruption in production, excessive imports of raw materials, tax
payment, delay in collection, dividend payment and unplanned capital
expenditure. The interest rate on such deposits is around 18% p.a.
Six Months Deposits: Normally, lending companies do not extend

deposits beyond this time frame. Such deposits usually made with first
class borrowers. These deposits carry an interest rate of around 20% p.a.
Objectives of Cash Management

A sound cash management scheme maintains the balance between the twin
objective of liquidity and cost. These are two basic objectives of cash
management.
To meet the cash disbursement needs as per the payment schedule

In the normal course of business, firms have to make payment in cash on a
continuous and regular basis to the suppliers of goods, employees and so on. At
the same time there is constant flow of cash through collection of debtors. Cash
is, therefore aptly described as the oil to lubricated the ever-turning wheels of
business: without the process grinds to a stop.
To minimize the amount locked up as cash balance

The second objective of cash management is to minimize the cash balances. In
minimizing the cash balances, two conflicting aspects to be reconciled. A high
level of cash balances ensures prompt payment together with all the
advantages. But it also implies that large funds will remain idle as cash is the
non-earning asset and the firm will have to forego profits. A low level of cash
balances, on the other hand, may mean failure to meet the payment schedule.
The aim of cash management therefore should be to have an optimal amount of
cash balances.
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What is Cash Operation Cycle?

The
need
for
working
capital
(gross)
or
current
assets
cannot
be
overemphasized. Given the objective of financial decision making to maximize

the shareholders wealth, it is necessary to generate sufficient profits. The extent
to which profits can be earned will naturally depend, among other things, upon
the magnitude of the sales. A successful sales programme is, in other words,
necessary for earning profits by any business enterprise. However, sales do not
convert into cash instantly; there is invariably a time lag between the sale of
goods and the receipt of cash. There is, therefore, a need for working capital in
the form of current assets to deal with the problem arising out of the lack of
immediate realization of cash against the goods sold. Therefore, sufficient
working capital is necessary to sustain sales activity. Technically, this is
referred to as the operating or cash cycle. The operating cycle can be said to be
at the heart of the need for working capital. The continuing flow from cash to
suppliers, to inventory, to accounts receivable and back into cash is what is
called the operating cycle. In other words, the term cash cycle refers to the
length of time necessary to complete the following cycle of events:
1. Conversion of cash into inventory;
2. Conversion of inventory into receivables;
3. Conversion of receivables into cash.
The operating cycle, can further be understood with the help of following chart:
Phase 3
Receivables
Cash
Phase 2
Inventory
Phase 1
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The operating cycle consists of three phases. In phase 1, cash gets converted
into inventory. This includes purchase of raw materials, conversion of raw
materials into work-in-progress, finished goods and finally the transfer of goods
to stock at the end of the manufacturing process. In the case of trading
organizations, this phase is shorter as there would be no manufacturing activity
and cash is directly converted into inventory. This phase is totally absent in the
case of service organizations.
In phase 2 of the cycle, the inventory is converted into receivables as credit

sales are made to customers. Firms, which do not sell on credit, will not have
phase 2 of the operating cycle.
The last phase, phase 3 represents the stage when receivables are collected.
This phase completes the operating cycle. Thus, the firm has moved from cash
to inventory, to receivables and to cash again.
Motives For Holding Cash

The term Cash with reference to cash management is used in two senses. In a
narrower sense it includes coins, currency notes, cheques, bank drafts held by
a firm with it and the demand deposits held by it in banks. In a broader sense it
includes near-cash assets such as marketable securities and time deposits
with banks. Such securities or deposits can immediately be sold or converted
into cash if the circumstances require.
A distinguishing feature of cash as an asset, irrespective of the firm in which it

is held, is that it does not earn substantial return for the business. In spite of
this fact cash is held by the firm with the following motives: -
(1) Transaction Motive

An important reason for maintaining cash balances is the transaction motive.
This refers to the holding of cash to meet routine cash requirements to finance
the transactions, which a firm carries on in the ordinary course of business. A
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firm enters into a variety of transactions to accomplish its objectives, which

have to be paid for in the form of cash. For example, cash payments have to be
made for purchases, wages, operating expenses, financial charges like interest,
taxes, dividends and so on. Similarly, there is a regular inflow of cash to the
firm from sales operations, returns on outside investments, etc.
(2) Precautionary Motive

A firm keeps cash balance to meet unexpected contingencies such as floods,
strikes, presentments of bills for payment earlier than the expected date,
unexpected slowing down of collection of accounts receivables, sharp increase
in prices of raw materials, etc. The more is the possibility of such contingencies;
more is the amount of cash kept by the firm for meeting them.
(3) Speculative Motive

A firm keeps cash balance to take advantage of unexpected opportunities,
typically outside the normal course of the business. Such motive is, therefore,
of purely a speculative nature. For example, a firm may like to take advantage
of an opportunity of purchase raw materials at the reduced price on payment of
immediate cash or delay purchase of materials in anticipation of decline in
prices. Similarly, it may like to keep some cash balance to make profit by
buying securities in times when their prices fall on account of tight money
conditions, etc.
(4) Compensation Motive

Banks provide a variety of services to business firms, such as clearance of
cheque, supply of credit information, transfer to funds, and so on. While for
some of these services banks charge a commission or fee, for others they seek
indirect compensation. Usually clients are required to maintain a minimum
balance of cash at the bank. Since this balance cannot be utilized by the firms
for transaction purposes, the banks themselves can use the amount to earn a
return. Such balances are compensating balances.
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Options For Investing In Surplus Funds

Companies often have surplus funds for short periods of time before they are
required for capital expenditures, loan repayment, or some other purpose.
These funds may be deployed in a variety of ways. At one end of the spectrum is
the term deposit (to be made for the minimum period of 46 days) in a bank,
virtually a risk free investment that offers a relatively modest rate of interest: at
the other end of the spectrum is the investment in equity shares, which can
produce highly volatile returns. In between lie units, public sector bonds,
treasury bills, Intercorporate and bill discounting.
Some of the options for investing surplus funds are as follows: -
(1) Ready Forwards

A commercial bank or some other organization may do a ready forward deal
with a company interested in deploying surplus funds on a short-term basis.
Under this arrangement, the bank sells and repurchases the same securities
(this means the company, in turn, buys and sells securities) at the prices
determined before hand. Hence the name Ready Forward. Ready Forwards are
permitted only in certain securities. The return on a ready forward deal is
closely linked to money market conditions.
(2) Badla Financing

A company providing badla financing is essentially lending money to a stock
market operator who wishes to carry forward his transaction from one
settlement period to another. Typically such finance is security of shares
bought by the stock market operator. For example, a company may provide Rs.
5 crores of badla finance through a broker with an understanding that it is only
meant for the forward purchases of, say Reliance shares. Based on the demand
and supply funds, the badla financing ratio are determined on the last day of
the settlement. Badla financing offers attractive interest rates.
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(3) Treasury Bills

It is a type of marketable security, which is an obligation of government. They
are sold on discount basis. The investor does not receive an actual interest
payment. The return is the difference between the purchase price and the face
value of the bill.
(4) Bill Discounting

Surplus funds can be deployed to purchase/discount bills. Bills of Exchange
are drawn by seller (drawer) on the buyer (drawee) for the value of goods
delivered to him. During the pendency of the bill, if the seller is in needs of
funds, he may get it discounted. On maturity, the bill should be presented to
the drawee for payment.
Types of Marketable Securities

Marketable securities are short-term investment instruments to obtain a return
on temporarily idle funds. In other words, they are securities, which can be
converted into cash in a short period of time.
The more prominent marketable/near-cash securities available for investment

are as follows: -
(1) Treasury Bills

It is a type of marketable security, which is an obligation of government. They
are sold on discount basis. The investor does not receive an actual interest
payment. The return is the difference between the purchase price and the face
value of the bill.
(2) Negotiable Certificates of Deposit

These are marketable receipts for funds that have been deposited in a bank for
a fixed period of time. The deposited funds earn a fixed rate of interest. When
the certificates mature, the owner receives the full amount deposited plus the
earned interest.
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(3) Commercial paper

It refers to a short-term unsecured promissory note sold by large business firms
to raise cash. As they are unsecured, the issuing side of the market is
dominated by large companies, which typically maintain sound credit ratings.
Commercial paper can be sold either directly or through dealers.
(4) Bankers Acceptance

These are drafts (order to pay) drawn on a specific bank by an exporter in order
to obtain payment for goods he has shipped to a customer who maintains an
account with that specific bank. They can also be used in financing domestic
trade.
(5) Repurchase Agreements

These are legal contracts that involve the actual sale of securities by a borrower
to the lender with a commitment on the part of former to repurchase the
securities at the current price plus a stated interest charge. The securities
involved are government securities and other money market instruments.
(6) Units
The units of Unit Trust of India (UTI) offer a reasonably convenient alternative
avenue for investing surplus liquidity as (a) there is a very active secondary
market for them, (b) the income form units is tax-exempt up to a specified
amount and (c) the units appreciate in a fairly predictable manner.
(7) Inter Corporate Deposits

It is also a type of marketable security. Intercorporate deposits are short-term
deposits as compared to other companies with a fairly attractive form of
investment of short-term funds in terms of rate of return, which currently
ranges between 12 to 15 per cent.
(8) Bills Discounting

Surplus funds can be deployed to purchase/discount bills. Bills of Exchange
are drawn by seller (drawer) on the buyer (drawee) for the value of goods
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delivered to him. During the pendency of the bill, if the seller is in needs of
funds, he may get it discounted. On maturity, the bill should be presented to
the drawee for payment.
(9) Call Market

It deals with funds borrowed/lent overnight/one day (call) money and notice
money for the period upto 14 days. It enables corporates to utilize their float
money gainfully. However, the returns (call rates) are highly volatile.
Factors Determining Cash Needs

The factors that determine the required cash balances are:
1. Synchronization of Cash Flows
2. Short Costs
3. Excess Cash Balance
4. Procurement and Management
5. Uncertainty
Synchronization of Cash Flows: The need for maintaining cash balance

arises from the non-synchronization of the inflows and outflows of the cash: if
the receipts and payments of cash perfectly coincide or balance each other,
there would be no need for cash balances. The first consideration in
determining the cash need is, therefore, the extent of non-synchronization of
cash receipts and disbursements. For this purpose, the inflows and outflows
have to be forecast over a period of time, depending upon the planning horizon,
which is typically a one-year period with each of the 12 months being a sub
period.
Short Costs: Another general factor to be considered in determining cash

needs is the cost associated with a shortfall in the cash needs. Every shortage
of cash - whether expected or unexpected - involves a cost depending upon the
severity, duration and frequency of the shortfall and how the shortage is
covered. Expenses incurred as a result of shortfall are called short costs.
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Following the various Short Costs:
Transaction costs associated with raising cash to tide over the shortage. This
is usually the brokerage incurred in relation to the sale of some short-term
near-cash assets such as marketable securities.
Borrowing costs associated with borrowing to cover the shortage. These
include items such as interest on loan, commitment charges and other
expenses relating to the loan.
Loss of cash discount, that is, a substantial loss because of a temporary

shortage of cash.
Cost associated with deterioration of the credit rating, which is reflected

in higher bank charges on loans, stoppage of supplies, demands for cash
payment, refusal to sell, loss of image and the attendant decline in sales and
profits.
Penalty rates by banks to meet a shortfall in compensating balances.
Excess Cash Balance Costs: The cost of having excessively large cash
balances is known as the excess cash balance cost. If large funds are idle, the
implication is that the firm has missed opportunities to invest those funds and
has thereby lost interest, which it would otherwise have earned. This loss of
interest is primarily the excess cost.
Procurement and Management: These are the costs associated with

establishing and operating cash management staff and activities. They are
generally fixed and are mainly accounted for by salary, storage, handling of
securities, and so on.
Uncertainty and Cash Management: The impact of uncertainty on cash

management strategy is also relevant, as cash flows cannot be predicted with
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complete accuracy. The first requirement is a precautionary cushion to cope

with irregularities in cash flows, unexpected delays in collections and
disbursement, defaults and unexpected cash needs.
The impact of uncertainty on cash management can, however, be mitigated

through:
1. Improved forecasting of tax payments, capital expenditure, dividends,
and so on; and
2. Increased ability to borrow through overdraft facility.
Working Capital
Working capital is defined as the excess of current assets over current
liabilities. Current assets are those assets which will be converted into cash
within the current accounting period or within the next year as a result of the
ordinary operations of the business. They are cash or near cash resources.
These include:
Cash and Bank balances

Receivables
Inventory
Raw materials, stores and spares
Work-in-progress
Finished goods
Prepaid expenses
Short-term advances
Temporary investment
The value represented by these assets circulates among several items. Cash is
used to buy raw materials, to pay wages and to meet other manufacturing
expenses. Finished goods are produced. These are held as inventories. When
these are sold, accounts receivables are created. The collection of accounts
receivables brings cash into the firm. The cycle starts again.
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Current liabilities are the debts of the firms that have to be paid during the
current accounting period or within a year. These include:
Creditors for goods purchased

Outstanding expenses i.e., expenses due but not paid
Short-term borrowings
Advances received against sales
Taxes and dividends payable
Other liabilities maturing within a year
Working capital is also known as circulating capital, fluctuating capital and
revolving
capital.
The
magnitude
and
composition
keep
on
changing
continuously in the course of business.
Permanent and Temporary Working Capital

Considering time as the basis of classification, there are two types of working
capital viz, Permanent and Temporary. Permanent working capital represents
the assets required on continuing basis over the entire year, whereas temporary
working capital represents additional assets required at different items during
the operation of the year. A firm will finance its seasonal and current
fluctuations in business operations through short term debt financing. For
example, in peak seasons more raw materials to be purchased, more
manufacturing expenses to be incurred, more funds will be locked in debtors
balances etc. In such times excess requirement of working capital would be
financed from short-term financing sources.
The permanent component current assets which are required throughout the
year will generally be financed from long-term debt and equity. Tandon
Committee has referred to this type of working capital as Core Current Assets.
Core Current Assets are those required by the firm to ensure the continuity of
operations which represents the minimum levels of various items of current
assets viz., stock of raw materials, stock of work-in-process, stock of finished
goods, debtors balances, cash and bank etc. This minimum level of current
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assets will be financed by the long-term sources and any fluctuations over the
minimum level of current assets will be financed by the short-term financing.
Sometimes core current assets are also referred to as hard core working
capital.
The management of working capital is concerned with maximizing the return to

shareholders within the accepted risk constraints carried by the participants in
the company. Just as excessive long-term debt puts a company at risk, so an
inordinate quantity of short-term debt also increases the risk to a company by
straining its solvency. The suppliers of permanent working capital look for longterm return on funds invested whereas the suppliers of temporary working
capital will look for immediate return and the cost of such financing will also be
costlier than the cost of permanent funds used for working capital.
Gross Working Capital

Gross Working Capital is equal to total current assets only. It is identified with
current assets alone. It is the value of non-fixed assets of an enterprise and
includes inventories (raw materials, work-in-progress, finished goods, spares
and consumable stores), receivables, short-term investments, advances to
suppliers, loans, tender deposits, sundry deposits with excise and customs,
cash and back balances, prepaid expenses, incomes receivable, etc.
Gross Working Capital indicated the quantum of working capital available to

meet current liabilities.
Thus, Gross Working Capital = Current Assets
Net Working Capital

Net Working Capital is the excess of current assets over current liabilities, i.e.
current assets less current liabilities.
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This concept of working capital is widely accepted. This approach, however,

does not reflect the exact position of working capital due to the following
factors:
Valuation of inventories include write-offs

Debtors include the profit element
Debts outstanding for more than a year likewise debtors which are
doubtful or not provided for are included as asset are also placed under
the head current assets
Non-moving and slow-moving items of inventories are also included in

inventories, and
Write-offs and the profits do not involve cash outflow

To assess the real strength of working capital position, it is necessary to
exclude the non-moving and obsolete items from inventories. Working Capital
thus arrived at is termed as Tangible Working Capital.
Working Capital Cycle

Alternatively known as Operating Cycle Concept of working capital. This
concept is based on the continuity of flow of funds through business
operations. This flow of value is caused by different operational activities during
a given period of time. the operational activities of an organization may
comprise of:
Purchase of raw materials

Conversion of raw materials into finished products
Sale of finished products and
Realization of accounts receivable.
Material cost is partly covered by trade credit from suppliers and successive
operational activities also cash flow. If the flow continues without any
interruption, operational activities of the company will also continue smoothly.
Movement of cash through the above processes is called circular flow of cash.
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The period required to complete this flow is called the operating period or the
operating cycle.
To estimate the working capital required, the number of operating cycles in a

year is to be calculated. This is calculated by dividing the number of days in a
year by the length of the cycle. Total operating expenses of a year divided by the
number of operating cycles in that year is the amount of working capital
required.
Short Term Sources of Finance

Short-term finance is concerned with decisions relating to current assets and
current liabilities. The main sources of short-term finance are as follows:
Letter of Credit: Suppliers, particularly the foreign suppliers insist that the
buyer should ensure that his bank would make the payment if he fails to
honour its obligations. This is
ensured through letter of credit (LC)
arrangement. A bank opens a LC in favour of a customer to facilitate his

purchase of goods. If the customer doesnt pay to the supplier within the credit
period, the bank makes the payment under the LC arrangements. This
arrangement passes the risk of supplier to the bank. Bank charges the amount
for opening LC. It will extend such facilities to the financially sound customers.
Cash Credit: cash credit is the arrangement under which a customer is allowed
an advance upto certain limits against credit granted by the bank. Under this
arrangement, a customer need not borrow entire amount of advance at one go,
he can only draw to the extent of his requirement and deposits his surplus
funds in his account. Interest is charged not on the full amount of advance but
on the amount actually availed by him. Generally cash credit limits are
sanctioned against the security of goods by way of pledge or hypothecation.
Overdraft: Overdraft arrangement is similar to the cash credit arrangement.

Under the overdraft arrangements, the customer is permitted to overdraw upto
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a prefixed limit. Interest is charged on the amounts overdrawn subject to some

charge as in the case of cash credit arrangements. Overdraft account operates
against security in the form of pledging of share security, assignment of the LIC
policies and sometimes even mortgage of fixed assets.
Bills Discounting: Under this system, a borrower can obtain credit from the
bank against the bills. The amount provided under this system is covered
within the overall cash credit or overdraft limit. Before purchasing or
discounting the bills, the bank satisfies itself as to the creditworthiness of the
drawer. Though the term bills payable implies that the bank becomes owner
of the bills but in practice the bank holds bills as security for the credit. A bill
discounted, the borrower is paid the discounted amount of the bill. A bank
collect full amount of maturity.
Factoring: A factor is the financial institution, which offer services related to

management and financing of debts arising from credit sales. Factoring provide
resources to finance receivables which could help company in short period to
finance their working capital.
Commercial Paper: Commercial paper represents short-term unsecured

promissory notes issued by firms, which enjoy a fairly high credit rating.
Generally, large firms with considerable financial strength are able to issue
commercial paper. The important features of commercial paper are as follows:
i.
ii.
The maturity period of commercial paper ranges from 90 to 180 days.

Commercial paper is sold at a discount from its face value and
redeemed at its face value. Hence, the implicit interest rate is a
function of the size of the discount and the period of maturity.
iii.
Commercial paper is either directly placed with investors or sold

through dealers.
iv.
Investors who intend holding it till its maturity usually buy commercial
paper. Hence, there is no well-developed secondary market for
commercial paper.
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Inter Corporate Deposits: A deposit made by one company with another,

normally for a period up to six months, is referred to as inter corporate deposit.
Such deposits are usually of three types;
a)
Call Deposits: A call deposit is withdrawable by the lender on giving a

days notice. In Practice, however the lender has to wait for at least
three days. The interest rate on such deposit may be around 16% p.a.
b)
Three Months Deposit:
These are more popular in practice. These
deposits are taken from borrowers to tide over a short term cash
inadequacy that may be caused by one or more of the following factors:
disruption in production, excessive imports of raw materials, tax
payment, delay in collection, dividend payment and unplanned capital
expenditure. The interest rate on such deposits is around 18% p.a.
c)
Six Months Deposits: Normally, lending companies do not extend

deposits beyond this time frame. Such deposits usually made with first
class borrowers. These deposits carry an interest rate of around 20%
p.a.
Long Term Sources of Finance

Equity Share Capital: Equity shareholders are the owners of the business.
They enjoy the residual profits of the company after having paid the preference
shareholders and other creditors of the company an their liability is restricted
to the amount of share capital they contributed to the company. The advantage
of equity capital to the issuing firm is that without any fixed obligation for the
payment of dividends, it offers permanent capital with limited liability for
repayment. However, the cost of equity capital is higher than other capital.
Firstly, since the equity dividends are not tax-deductible expenses and
secondly, the high costs of issue. In addition to this since the equity
shareholders enjoy voting rights, excess of equity capital in the firms capital
structure will lead to dilution of effective control.
The book value of an equity share is equal to:
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Paid-up equity capital + Reserves and surplus

Number of outstanding equity shares
Preference Share Capital: Preference shares have some attributes similar to

equity shares and some to debentures. Like in the case of equity shareholders,
there is no obligatory payment to the preference shareholders and the
preference dividend is not tax-deductible (unlike in the case of the debenture
holders, wherein interest payment is obligatory). However similar to the
debenture holders the preference holders earn a fixed rate of return for their
dividend payment. In addition to this, the preference shareholders have
preference over equity shareholders to the post-tax earnings in the form of
dividends and assets in the event of liquidation.
Other features of the preference capital include the call feature, wherein the
issuing company has the option to redeem the shares, (wholly or partly) prior to
the maturity date, at a certain price. Prior to the Companies Act, 1956
companies could issue preference shares with voting rights. However, with the
commencement of the Companies Act, 1956 the issue of preference shares with
voting rights has been restricted only to the following cases:
a) There are arrears in dividends for two or more years in case of
cumulative preference shares.
b) Preference dividend is due for a period of two or more consecutive
preceding years, or
c) In the preceding six years including the immediately preceding financial
year, if the company has not paid the preference dividend for a period of
three or more years.
Term loans: Term loans are directly from the banks and financial institutions
in India. Term loans are generally obtained for financing large expansions,
modernization, and diversification projects. Therefore, this method of financing
is also called as project financing. Term loans have majority of more than one
year. Financial institutions provide term loans for the period of six to ten years
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and in some cases a grace period of one to two years is also granted.
Commercial banks advance term loans for the period of three to five years.
Debentures: Another way of raising a loan is to issue a financial instrument

called debentures. A debenture is the loan raised by the company from the
capital market against which, assets of the company are mortgaged with the
trustees. Debentures carry a fixed rate of interest. Debenture holders are the
creditors of the company. There exist obligation on the part of the company to
pay contractual interest as well as to repay the principle amount. Debenture
finance is also cheaper than share capital. It also command a tax benefit as a
debenture interest is allowed as deductible business expenses.
Types of Debentures:
1. Registered Debentures
2. Bearer
3. Mortgage or Secured
4. Simple
5. Redeemable
6. Irredeemable
7. Convertible
8. Non-Convertible
Lease Financing: A lease is a form of financing employed to acquire the

economies use of assets for a stated period without owing them. Every lease
involves two parties: the lessee and the lessor. Leasing is the contractual
arrangement between the lessor and lessee; where in companies can enter into
a lease deal with the manufacturer of the instrument or through some
intermediary. This deal will give the company, the right to use the asset till the
maturity of the lease deal and can later retain the asset or buy it from the
manufacturer. During the lease period the company will have to pay lease
rentals, which generally be at negotiated rate and payable every month.
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Hire purchase: Finance company usually offers the facility of leasing as well as
hire purchase to the clients. The features of hire purchase are given as follows:
Features:
The hiree purchases the assets and gives it on hire to the hiree.
The hiree pays regularly the hire purchase installments cover interest as
well as repayment of the principle amount. When the hiree pays the last
installments, the title of the asset is transferred to the hirer.
The hiree charges interest on a flat basis. This means a certain rate of
interest usually around 14% is charged on the initial investment and not
on diminishing balance.
The total interest collected by the hiree is allotted over various years. For
this purpose sum of years digits method is commonly employed.
Retained Earnings: Retained earnings represent the internal sources of finance

available to the company. Retained earnings represent the only internal source
of financing, expansion and growth. Infact they are an important source of longterm finance for corporate enterprises.
Global Depository Receipt (GDR): GDR is a new financial instrument. It made

its appearance in 1991 and become an instant success. It all started when
companies in countries like South Korea and Malaysia began attracting
investors from Europe and USA. Inspite of the investor interest companies faced
difficulties. A novel way was found and it works in this way.
A bank in Europe acquires the shares of such a company and then issues its
own receipts or certificates to the investors. This bank is also called
depository and such certificates are called GDR. These GDRs can be traded
on the European exchange or in private placement in USA. A GDR is a dollar
denominated instrument tradable on a stock exchange in Europe or private
placement in USA. A GDR represents one or more shares of the issuing
company.
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Reliance was the first Indian company to issue GDRs in May 1992. To raise US
$100 million. The bookings were about five times the size of issue and reliance
retained US $150 million.
Arvind mills issued GDRs worth US $125 million in February 1994. The issue
price of GDR was $9.78. One GDR represent one share of Arvind mills.
American Depository Receipts (ADR): ADR is an instrument similar to GDR.

It is issued in the capital markets of USA alone. Generally, far mare stringent
rules and regulation prevail for bringing out an ADR issue.
ADR is defined as, a receipt or the certificate issued by the bank, representing
title to the specified number of shares of a non-US company. The US bank is
the depository in this case. ADR is the evidence of ownership of underlying
shares. ADR is freely traded in the US without actual delivery of underlying
non-US shares.
In this case the issuing company actively promotes the companys ADR in USA.
A single depository bank is normally chosen and the ADR are routed through
this bank.
The organization with ADRs with Security Exchange Commission (SEC) is not
compulsory. Technically ADRs are different from GDRs. The size of ADRs can
be expanded or reduced, generally it depends upon demand as depository
banks can issue or withdraw corresponding shares in the local market.
Fixed Deposits: Fixed deposits are of two types: -
Banks Fixed Deposits and

Corporate Fixed Deposits
Banks Fixed Deposit provides interest at specified rate depending upon the
tenure. Banks also provide loan facility, which is known as demand loan to the
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investor for which extra interest of 2% is charged in addition to the principle

amount.
Corporate fixed deposits are the fixed deposits given by the companies. Interest
is depending upon the company policy and regulations. Generally, it differs
from company to company.
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T.Y.

Functions Of Finance Manager & How They Have Changed In

It is pertinent here to distinguish between the nature of job of the finance

Estimating The Requirement Of Funds: In a business the requirement of

Decisions Regarding Capital Structure: Once the requirements of funds have

short-term funds. Long-term funds rose from outside have to be in a certain

Investment Decisions: Funds procured from different sources have to be

Dividend Decision: Finance manager is concerned with the decision to pay or

The industrial licensing framework has been considerably relaxed.

The Foreign Exchange Regulation Act (FERA) has been substantially

Considerable freedom has been given to companies in pricing their equity

Interest rate ceilings have been largely removed.

Investors have become more demanding and discerning.

A number of new investment opportunities have emerged in the money

The relative dependence on the capital market has increased.

Bhaskar Mitter, Corporate Finance Director of ITC asserts, Today and in

operate adeptly in the forex market, as well as aid companies to compete

N. Gopalkrishnan, of Shriram Fibres avows, The finance mans job has

Hemany Luthra of Ballarpur Industries Limited says, In the paper

The key challenges for the finance manager in India appear to be in

According to Feroz Ahmed and Dilip Maitra in Money from Money,

In accounting sense it tends to become a long-term objective, which measure

Features of Wealth Maximization:

It consider both quality and quantity dimensions of benefits.

Gross Working Capital

Control of receivables: Monitoring and controlling of accounts receivables is

Bad Debt Losses

Room For Improvement: Management of receivables should be accorded the

Credit policies need to revise periodically in the light of internal as well a

Firms granting credit should examine the published statements of

Reference provided by the customers should be consulted and necessary

A well defined programmed must be developed.

Thus it can be said that,

Average Ordinary Shareholders Equity = Net Worth Of Company

Return on Net Worth = Net Profit After Tax Preference Dividend

Comparing with the past records of the same firm

Any asset which is not in use should be excluded.

Investments which are not concerned with business, should be excluded

Return on Capital Employed (ROCE) or Return on Investment (ROI)

Common Size Statement

This facilitates comparison of two or more business entities with a common

State Merits/ Limitations of Common Size Statement, Comparative

One-way of establishing references and managing the financial affairs of an

Limitations of Ratio Analysis

Ratios by themselves mean nothing. They must all be compared.

They do not represent a complete picture of business and do not refer to

A ratio is comparison between both numerator and denominator. In

They are inter-connected. They cannot be treated in isolation.

Comparative Financial Statements

They indicate the direction of the movement of the financial position.

It presents a review of the past activities and their cumulative effect.

Constant changes in price levels render accounting statements useless

Common Size Statement

Comparison of common size statement over a period will clearly indicate

Comparisons of two or the firms v/s industry as a whole helps in

It is regarded by many as useless as there is no established standard

It presents a review of the past activities and their cumulative effect.

Give Any Three Objectives Of Financial Analysis

Liquidity Analysis: Suppliers of goods, moneylenders and financial institutions

Solvency Analysis: It refers to analysis of long-term financial position of a

Comparative Common Size Analysis

Ratio Analysis Is Only A Tool And Not A Final Decision

Development of benchmarks: Many firms, particularly the larger ones

Window dressing: Firms may resort to window dressing to project