Financial Management PDF

National Institute of
Business Management
Master of Business
Administration (MBA)
Financial Management
CONTENTS
Chapter Title Page No.
I BUSINESS FINANCE 5
II SOURCES OF FINANCE 16
III MANAGEMENT OF WORKING CAPITAL 33
IV MANAGEMENT OF CASH 45
V MANAGEMENT OF RECEIVABLES 54
VI MANAGEMENT OF INVENTORY 59
VII FINANCIAL ANALYSIS AND PLANNING 68
VIII FUNDS FLOW ANALYSIS 73
IX CASH FLOW STATEMENT 81
X RATIO ANALYSIS 86
XI CAPITAL BUDGETING 93
XII FINANCIAL FORECASTING 105
XIII CAPITAL STRUCTURE 116
XIV COST OF CAPITAL 120
XV BUDGETARY CONTROL 131

CHAPTER - I
BUSINESS FINANCE
OBJECTIVES
To make the reader understand the finer points of business finance which is one of the major
factors in all kinds of economic activity. This chapter is to familiarise the reader the objectives of
financial management, interphase between finance and other functions and also Indian financial system.
IMPORTANCE OF FINANCE
Finance is regarded as the life blood of a business enterprise. Finance is one of the basic
foundations of all kinds of economic activities, particularly in the present modern money-oriented
economy. The manufacturing and merchandising activities are supported by this key factor. Business
needs money to make more money. The success and health of any business enterprise is buttressed
on efficient management of its finances.
THE FIELD OF FINANCE
The field of finance is closely related to accounting and economics.
Accounting is referred to as the language of finance because it provides financial data through
income statements, balance sheets and the statement of cash flows. The financial manager must know
how to interpret and use the financial statements in allocating the firm’s financial resources to generate
the best return possible in the long run.
Economics provides a structure for decision making in such areas as risk analysis, pricing
theory through demand and supply relationships and many other important areas. Economics provides
the broad framework of the economic environment in which business enterprises must continually make
decisions. A finance manager must understand the institutional structure of the Central Banking System,
the Commercial Banking System and the interrelationship between the various sectors of the economy.
He must be well versed in economic variables, such as gross national product, industrial production,
disposable income, unemployment, inflation, interest rates, taxes etc.
MEANING OF BUSINESS FINANCE
Finance is defined as the provision of money at the time it is wanted. As a management

function, finance may be defined as the procurement of funds and their effective utilisation.
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Business finance may be defined as the process of raising, providing and managing of all the
money to be used in connection with business activities.
“Financing consists of raising, providing, managing of all the money, capital or funds of any
kind to be used in connection with the business”- J.H.Bonnevilla and Llyod Ellis Dewey.
While taking the financial decisions, Finance Manager has to consider the external and internal
factors.
The external factors are:
State of Economy
Structure of capital and money markets
Govt. Policy and regulations
Taxation Policy
Requirements of investors
The Central Bank’s credit policy
Lending policy of financial institutions.
The internal factors include:
Nature of business
Size of business
Age of the firm and stability of the organisation
Nature of product (Demand and Supply in the market)
Expected return, cost and risk
Fixed assets and working capital structure of the firm
Capital structure
Trends of earnings
Restriction in loan agreements and
Management attitude.
MEANING OF FINANCIAL MANAGEMENT
According to Ezra Soloman & John. J.Pringle, “Financial Management is concerned with
the efficient use of an important economic resource, namely, Capital Funds”.
Financial management is mainly concerned with the proper management of funds. The finance
manager must see that the funds are procured in such a manner that the risk, cost and control
considerations are properly balanced in a given situation and there is optimum utilisation of funds.
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OBJECTIVES OF FINANCIAL MANAGEMENT
What is the purpose or objective sought to be achieved by the Finance Manager?
Traditionally the basic objectives of financial management are the maintenance of liquid
assets and maximisation of profitability of the firm.
MAINTENANCE OF LIQUID ASSETS:
Maintenance of liquid assets is to ensure that the firm has adequate cash in hand to meet its
obligations at all times.
Profit Maximisation
Suppose the Finance Manager manages to make available the required funds at an acceptable
cost and that the funds are suitably invested and that everything goes according to plan because of
the effective control measures used. A business firm is a profit-seeking organisation. Hence, profit
maximisation is also well considered to be an important objective of financial management. The results
of good performance are reflected as profits of the firm.
However, profit maximisation cannot be the sole objective of a firm as there is a direct
relationship between risk and profit. If profit maximisation is the only goal, then risk factor is ignored.
Sometimes, higher the risk, higher is the possibility of profits.
Maximisation of wealth:
Profit maximisation is not considered to be an ideal criterion for making investment and
financing decisions. Prof. Ezra Soloman has suggested the adoption of wealth maximisation as the
best criterion for the financial decision-making.
The objective of a firm or company must be to create value for its shareholders. Value is
represented by the market price of the company’s common stock, which, in turn is a function of the
firm’s investment, financing and dividend decisions. The idea is to acquire assets and invest in new
products and services where expected return exceeds their cost, to finance with those instruments
where there is particular advantage, tax or otherwise, and to undertake a meaningful dividend policy
for stockholders.
Thus, wealth maximisation or value creation is considered to be the main objective of modern
financial management.
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NON-FINANCIAL OBJECTIVES
It is possible to have non-financial corporate objectives which may or may not conflict with
the financial objective of shareholder wealth maximisation. Some of the non-financial corporate
objectives are:
a) Total employment generation
b) Employee welfare
c) Rate of growth of business
d) Increase in market share

e) Technological leadership through substantial investment in research and development
f) Customer satisfaction
g) Community welfare.
Achievement of the non-financial objectives may indirectly help the company in increasing
its value. A corporate advertising campaign highlighting the above achievements may boost the share
prices in the market.
FUNCTIONS OF FINANCE
Funds requirement decision is the most important function performed or decision taken
by the finance manager. A careful estimate has to be made about the total funds required by the
enterprise taking into account both the fixed and working capital requirements.
Financing Decision is the second major decision of the firm and the financial manager is
concerned with determining the best financing mix or capital structure.
A proper balance has to be kept between the fixed and non-fixed cost-bearing securities.
Investment Decision is another major decision of the firm, when it comes to the creation
of value. Capital investment is the allocation of capital to investment proposals whose benefits are to
be realised in the future. In addition to selecting new investments, a firm must manage existing assets
efficiently.
The fourth important decision of the firm is its dividend policy, which includes the percentage
of earnings paid to the stockholders in cash dividends and the repurchase of stock. The dividend-
payout ratio determines the amount of earnings retained in the firm and must be evaluated in the light
of the objective of maximising shareholder wealth.
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Risk, Return and Trade off
A proper balance is to be maintained between risk and return in order to maximise the market
value of the share. Such a balance is called risk, return and trade off. Risk is to be minimised and
return is to be increased.
The interrelationship between market value, financial decisions and risk-return trade off is
depicted in the following chart:
Financial Management
Maximisation of Share Value
Financial Decision
Funds Requirement Financing Investment Dividend

Decision Decision Decision Decision
Maximum Minimum
Return Risk
Trade off
Liquidity Vs Profitability
Liquidity means that:
(i) the firm has adequate cash to pay for the expenses
(ii) the firm has enough cash to make unexpected large purchases
(iii) the firm has cash reserve to meet emergencies at all times.
Profitability requires that the funds of the firm are used in the most efficient and effective
way so as to yield the highest return.
When liquidity increases profitability decreases and when profitability increases liquidity decreases.
Liquidity and profitability goals conflict in most of the decisions which the finance manager takes.
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FINANCIAL TOOLS
The important financial tools or methods used by financial manager in performing his job
are:
1. Cost of Capital : Cost of capital helps the financial manager in deciding about the sources
from which funds are to be raised. There are different sources of finance, viz., shares,
debentures, loans from banks and financial institutions, public deposits etc. The financial
manager takes into account the cost of capital and opts for the source which is the cheapest.
The optimum capital structure of the firm is also determined based on the cost of capital.
2. Financial Leverage: This helps the financial manager in increasing the return to equity
shareholders.
3. Capital budgeting appraisal methods: Capital budgeting appraisal methods such as Pay-
back Period, Average Rate of Return, Internal Rate of Return, Net Present Value, Profitability
Index etc., help the financial manager in selecting the best among alternative capital investment
proposals.
4. Current Assets management tools like ABC analysis, Cash Management Models, Ageing
Schedule of Inventories and Debtors Turnover Ratio.
5. Ratio Analysis for evaluating different aspects of the firm. Different ratios serve different
purposes.
6. Cash Flow and Funds Flow analyses techniques help in determining whether the funds
have been procured from the best available source and they have been utilised in the most
efficient and effective way.
INTERFACE BETWEEN FINANCE AND OTHER FUNCTIONS
The finance manager depends upon the inputs provided by other operating managers:
the production manager or engineer, who is accountable for optimum use of equipment and
facilities and of the funds invested therein;
the marketing manager, answerable for the forecast of demand for the product, customer
satisfaction, credit policy etc;
the top management, which is interested in ensuring that the firm’s long-term goals are met.
FORMS OF ORGANISATION
The finance function may be carried out within a number of different forms of organisations.
Of primary interest are the sole proprietorship, partnership and the companies.
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Sole Proprietorship
The sole proprietorship form of organisation represents single-person ownership. The

proprietor enjoys all the powers of taking and assuming risks for his/her concern. The profits/losses
and incurring of all the liabilities of the business are to the proprietor.
The advantages of a sole proprietorship are:
easy and inexpensive setup

simplicity of decision making
low organisational and operational costs
few governmental regulations
no firm tax
The disadvantages are:
there is unlimited liability to the owner

in settlement of the firm’s debt, the owner can lose not only the capital that has been invested
in the business, but also personal assets
Life of the firm is limited to the life of the owner
Tax on the income is very high
Fund raising is possible only with attached personal liability commitment.
Partnership
The second form of organisation is the partnership, which is similar to a sole proprietorship
except that there are two or more owners. They are partners in business and they bear the risks and
reap the rewards of the business. Most partnerships are formed through an agreement between the
participants known as the articles of partnership, which specify the ownership interest, the methods
of distributing profits and the means for withdrawing from the partnership. The partnerships are
governed by Indian Partnerships Act, 1932.
The advantages of partnership form of business are:
Multiple ownership makes it possible to raise more capital and to share ownership
responsibilities.
It can be set up easily and inexpensively.
It is relatively free from governmental regulations.
The firm can make use of the experience and expertise of the partners.
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Like the sole proprietorship, the partnership arrangement carries unlimited liability for the
owners.
Possible conflict between the partners may hamper the existence of the firm.
Withdrawal of a partner from partnership or death of a partner results in dissolution of the
firm.
Companies
A group of persons working together towards a common objective is called a company.
A company is owned by shareholders who enjoy the privilege of limited liability, i.e., their
liability exposure is generally no greater than their initial investment. A company has a continual life
and is not dependent on any one shareholder for maintaining its legal existence. The ownership interest
in a company is divisible through the issuance of shares of stock.
The shareholders’ interests are managed by the company’s board of directors. The directors,
who may include key management personnel of the firm as well as outside directors not permanently
employed by it, serve in a stewardship capacity and may be liable for the mismanagement of the firm
or for the misappropriation of funds.
As the company is a separate legal entity, it pays taxes on its own income.
A company can be a private company or a public company.
A private company (means private limited company) is a corporate body that can be
formed by just two persons subscribing to its share capital. The minimum number of persons required
to form a private company is 2 and the number of its shareholders cannot exceed 50. It must have at
least 2 directors. Public cannot be invited to subscribe to its capital. The members’ right to transfer
shares is restricted.
The advantages of a private company form of organisation are:
(i) the liability of shareholders is limited

(ii) under the Companies Act, the regulation and control of private companies are not very
extensive
(iii) the promoters, by being selective in choosing the members, can hope to enjoy
unchallenged control over the firm.
The disadvantages of the private company form of organisation are :
(i) the burden of taxation is high
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(ii) the shares of a private company are not freely negotiable
(iii) the ability of the firm to raise capital is limited.
A Public Company (means a public limited company) is a corporate body that has a
minimum of seven members or shareholders. A public company unlike a private company does not
limit the number of its members. It can invite the public to subscribe to its capital. It permits free
transfer of shares.
The advantages of public company form of organisation are:
i) the company has an unlimited life

ii) the ownership of the company is easily transferable through transfer of ownership of shares.
iii) liability of shareholders is limited to the extent of the capital subscribed by them.
iv) it can raise substantial funds.
The disadvantages of public company form of organisation are:
i) there is elaborate procedure for setting up of a public company.

ii) the affairs of the company are subject to the regulations under the Companies Act.
REGULATORY FRAMEWORK
Investments in business and financing decisions are influenced by various regulations with
the aim of
a) identifying the avenues of investment available for particular form of business organisations.
b) identifying specific industries, locations etc., which are preferred for investment as state policy,
in order to promote uniform regional growth and fiscal incentives for such investment
c) restricting the sources and uses of funds by entrepreneurs, in order to protect the interest of
investors.
The following Acts/Regulations provide the regulatory framework in India:
(a) The Companies Act, 1956

(b) Monopolies and Restrictive Trade Practices Act (MRTP)
(c) Industrial Policy
(d) Foreign Exchange Management Act (FEMA)
(e) Industries (Development & Regulation) Act, 1951
(f) Guidelines issued by the Securities and Exchange Board of India (SEBI)
(g) Provisions of the Income Tax Act, 1961, Central and State notifications regarding the
various concessions, restrictive conditions etc.
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The New Industrial Policy of 1991 attempted to correct the distortions or weaknesses that
may have crept in and unshackle the Indian Industry from the multiplicity of administrative and legal
controls and enhance international competitiveness. Most of the restrictions and requirements of prior
approvals have been removed. Simultaneously, the office of Controller of Capital Issues was abolished
and capital issues and free pricing of shares were permitted subject to their conforming to the disclosure
and investor-protection guidelines issued by the SEBI.
INDIAN FINANCIAL SYSTEM
The financial system facilitates the transformation of savings into investment and consumption.
In any financial system the flow of money for business may be represented by the following chart:
The flow of money from investor is in the form of deposit, debt or shares and is represented
by deposit receipts, debt instruments or share certificates which are called financial assets.
Most of the money in the financial system flows through the financial intermediaries, whose
activities are controlled by Reserve Bank of India, the Central Bank of the country. RBI is the authority
responsible for laying down the monetary policy.
The financial intermediaries in India can be categorised as under:

1. Commercial Banks grouped as under:
a) State Bank of India and its subsidiaries

b) Nationalised Banks (Public Sector Banks)
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c) Private Sector Banks
2. Term Lending Institutions:
a) All India Financial Institutions like IFCI, IDBI, ICICI, SIDBI etc.
b) State-level institutions
3. Agricultural Financial Institutions:
a) National Bank for Agriculture and Rural Development (NABARD)
b) National Companies-operative Development Corporation (NCDC)
4. Insurance Companies and funds
a) LIC of India
b) General Insurance Corporation and its subsidiaries
5. Mutual Funds:
a) Unit Trust of India (UTI)
b) Public Sector Mutual Funds
c) Private Sector Mutual Funds
6. Non-Banking Finance Companies (NBFCs)
7. Others like Post Office Savings Bank, Chit Funds and Nidhi Companies.
The role of the above financial intermediaries are discussed later in the appropriate chapters.
SUMMARY
The chapter deals in detail with the importance of finance, field of finance meaning and
objectives of financial management and also functions of finance and the major points in Indian Financial
System.
QUESTIONS
1. What is the meaning of Business Finance?

2. What is Financial Management?
3. What are the functions of Finance?
4. Explain the Indian Financial Systems.
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CHAPTER - II
SOURCES OF FINANCE
OBJECTIVES
The objective of the chapter is to make the reader understand forms of finance with advantages
and disadvantages, forms of leasing financing, major financial institutions and internal and international
sources of finance.
INTRODUCTION
Finance is available in several forms and from several sources. The sources of finance may
be classified into 3 broad categories as under:
Owner’s funds (Equity)

(a) Long-term sources
Outsider’s funds(Debt/Loans)
(b) Short-term sources
(c) Internal sources
Sources of finance
Long-term sources Short-term sources Internal sources
Owners’ funds Outsiders’ funds
1.Equity Shares 1.Debentures 1. Trade Credit 1. Retained profits(ie.,

2.Pref.shares 2.Term Loans 2. Overdraft from banks ploughing back of
3.Leases 3. Cash Credit profits)
4.Venture Capital 4. Short-term loans 2. Issue of bonus shares
5. Seed Capital 5. Factoring 3. Depreciation fund
6. Bonds 6. Hire purchase
7. Public deposits
With growth in size of business and transnational business operations, the sources of finance
have become varied and there are a plethora of agencies available to offer finance.
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FORMS OF FINANCE
The main function of financial management is to mobilise funds for investments as and when
they are required, at the lowest possible cost and to ensure a fair return to the investors.
The various sources of long-term finance for a business firm are given below:
1. Equity Share Capital

The equity shareholders provide the “venture” capital of the company and thus the equity
shares are regarded as corner stone of capital structure of the company. The shareholders’ equity
consists of equity share capital and the retained earnings. This is the simplest and most important
source of finance. Equity capital represents ownership capital, as equity shareholders collectively
own the company. They enjoy the rewards as well as bear the risks of ownership. The equity
shareholders are entitled only to the residual profits, i.e., the balance profit available after meeting all
other obligations such as interest payments and tax on profits. The equity shareholders have the last
right on the assets of the company in the event of it being wound up. For these reasons the cost of
equity capital is the highest.
The equity shareholders are the ultimate owners of the company. They enjoy the rights to
control, to inspect books and the preemptive right to purchase whenever fresh equity capital is issued
by the company. However, their liability, unlike the liability of the owner in a proprietory concern
and the partners in a partnership firm, is limited to their capital contributions.
From the firm’s point of view, the advantages and disadvantages of financing through equity
shares are as under:
Advantages
it improves the company’s capacity to raise more debt in future
it reduces the leverage and thereby the financial risks
it balances the capital structure
it represents permanent capital and therefore, there is no liability for repayment
it does not involve any fixed obligation for payment of dividends.
Disadvantages
The cost of equity capital is high, usually the highest. The rate of return required by equity
shareholders is generally higher than the rate of return required by other investors.
The cost of issuing equity stock is generally higher than the cost of issuing other types of
securities. Usually, underwriting commission, brokerage costs and other issue expenses are
high for equity capital.
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The sale of equity stock to outsiders may result in the dilution of the control of existing
shareholders.
Equity dividends are payable from post-tax earnings. They are not tax-deductible payments.
The advantages and disadvantages of equity investment from the shareholders’ point of view
are as under:
Advantages
The liability of equity shareholders is limited to the extent of their capital contribution.
The equity shareholders enjoy the controlling power over the firm.
The rewards of owning equity capital can be very high.
Disadvantages
Equity stock prices tend to fluctuate widely, making equity investment risky.
Though equity shareholders are said to enjoy the controlling power over the firm, the real
control exercised by them is often weak, as the shareholders are scattered and ill-organised.
Equity shareholders have a residual claim to income as well as assets. They enjoy the lowest
priority.
The existing shareholders will be at a disadvantage if the new offering is not at a premium to
reflect the market price of the share.
The sources for investment in equity shares are:
(a) Individual investors

(b) Corporate investors
(c) Institutional investors
(d) Government agencies
(e) Financial corporations.
2. Preference Share Capital
Preference share capital represents a hybrid form of financing - with some characteristics of
equity and some attributes of debentures. Unless otherwise stated, preference shares are considered
as cumulative, i.e., arrears of preference dividend are to be paid first when the company makes
adequate profit. In the case of non-cumulative preference shares, the rights in a financial year will
lapse at the end of the year. Preference dividend is payable before the payment of dividend on equity
shares, though it is treated as part of the company’s equity, i.e., preference shareholders have a
priority claim over the earnings in so far as dividends are concerned and over the capital at the time
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of repayment compared to the equity shareholders, particularly at the time of liquidation. Preference
dividends are not tax-deductible. Because of this, preference share capital is less popular than debt
from the firm’s point of view.
Preference shares resemble equity share capital in the following ways:
(i) preference dividend is payable only out of distributable profits

(ii) preference dividend is not an obligatory payment (the payment of preference dividend is
entirely within the discretion of directors)
(iii) preference dividend is not a tax-deductible payment.
Preference share capital is similar to debenture in the following ways:
(i) the dividend rate on preference dividend is usually fixed

(ii) the claim of preference shareholders is prior to the claim of equity shareholders
(iii) preference shareholders do not normally enjoy the right to vote.
There are different classes of preference shares based on the features.
Preference shares
Dividends Surplus Convertibility Redemption
Cumulative Non- Convertible Non-convertible

Cumulative
Participating Non-participating Redeemable Irredeemable
Cumulation of Dividends
Preference shares may be cumulative or non-cumulative with respect to dividends. If the

preference shares are cumulative, the unpaid dividends on the shares are carried forward and payable
when the dividend is resumed. A company cannot declare equity dividends unless preference
dividends are paid with arrears. If the preference shares are non-cumulative, unpaid dividends cannot
be carried forward.
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Participation in surplus profits and assets
Companies may issue preference shares which entitle preference shareholders to participate
in surplus profits ( i.e., profits left after preference dividend and equity dividend at certain rates every
year) and residual assets (i.e., assets left after meeting the claims of preference shareholders in the
event of liquidation).
Convertibility
Preference shares may be convertible or non-convertible into equity shares. The convertible
preference shareholders enjoy the option of converting preference shares into equity shares at a certain
ratio during the specific period.
Redeemability
There are redeemable and irredeemable preference shares. Redeemable preference shares
are issued on the basis that the amount so invested may be returned at a particular point of time in
future. At present, in India, all preference capital must be redeemable.
3. Debentures
Debentures are instruments for raising long-term debt capital and it is the most popular form
of debt capital. A debenture represents a superior and refined form of the promissory note.
Debenture-holders are the creditors of the company. The obligation of the company towards its
debenture-holders is similar to that of a borrower who promises to pay interest and capital at specified
times.
Debentures are raised for long-term capital needs. Like any other form of debt, they have
the two fundamental features of periodic payment of interest and repayment at a specific point of
time.
The debenture-holders receive an interest and not a dividend. Therefore, the amount paid
to the investor is a charge against the profits and not appropriation of profits.
IMPORTANCE OF DEBENTURES
a) A company can have funds without giving any control to the debenture-holders.
b) There is certainty of finance for a specific period.
c) Interest on debentures is a charge on profit and hence payment of income tax will be less.
d) Considering the tax savings, the cost of debt is cheaper compared to any other form of
financing.
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e) It is an opportunity to the company to trade on equity and thus EPS will increase.
f) From the investors’ point of view, it is an ideal combination of high yield, low risk and potential
capital appreciation.
LIMITATIONS OF DEBENTURES
a) The debenture interest and capital repayment are obligatory payments. Payment of interest
is obligatory even if the company incurs losses.
b) There may be protective covenants associated with issue of debentures.
c) Debenture issues raise the cost of equity capital as debenture financing increases the financial
risk associated with the firm.
d) From the investors’ point of view, debenture interest is taxable.
e) The debenture-holders do not have voting rights.
According to the characteristics, debentures are classified as under:
Debentures
Convertibility Security Redemption Transfer
Convertible Non- Redeemable Irredeemable

[CD] Convertible
[NCD]
Fully Partly
convertible convertible
[FCD] [PCD]
Secured Unsecured * Bearer ** Registered
Floating charge Fixed charge
[ * Transferable by delivery of instruments

** Payable to the holders whose names are registered with the company ]
4. Term Loans
Term loan is a major source of debt finance for a long-term project. Usually term loans are
repayable in more than one year but less than 10 years. The Term Loans are utilised for purchase of
fixed assets and for providing working capital margin. This is in contrast with short-term bank loans
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which are generally employed to finance working capital needs and such loans have liquidating period,
usually less than one year. In India, the All India Financial Institutions like IDBI, ICICI etc., and the
State Level Financial Institutions provide term loans.
The salient features of term loans are the security offered, interest payment and the restrictive
covenants.
Term loans are essentially secured borrowing. The assets procured with the term loan finance
are the prime security. Securities other than the prime security by way of other assets of the firm are
collateral securities. Term Loans, which can be either in rupees or foreign currency, are generally
secured through a first mortgage or by way of deposit of title deeds of immovable properties or
hypothecation of movable properties.
Interest on term loan is payable irrespective of whether the firm has earned sufficient surplus
or not. Generally, the interest rate on the term loans are fixed by the financial institutions after proper
appraisal of the project and assessment of credit risk.
Financial institutions also place some restrictive covenants while granting term loans in order
to protect their interest. These depend upon the nature of the project and the financial situation of the
borrower. The restrictions may be of the nature of placing the nominees of the financial institution on
the company’s board, refraining the company from undertaking any new project without its prior
approval, preventing any further charge on the assets of the company, requiring clearances and licenses
from various governmental agencies, demanding periodic information about the company’s operations,
restricting the company to contain the dividend payment within a certain rate etc.
The advantages of finance by way of term loan are:
(a) The cost of term loans is lower than the cost of equity/preference capital.
(b) Since the lenders do not have the voting rights, there will be no dilution of control.
(c) For the lender, term loans earn a fixed rate of interest and have a definite maturity period.
(d) Term loan is a secured lending as far as the lender is concerned.
(a) Interest and principal payments are obligatory and threaten the solvency of the firm.
(b) The restrictive covenants of the term loan contracts may reduce managerial freedom and
the company’s future plans.
(c) Term loans increase the financial risk of the firm, and this will raise the cost of equity capital.
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5. Lease
The fundamental concept of leasing hinges on the distinction between ownership and use of
property. The purchase of an asset bestows the ownership rights and also responsibility of all
consequential gains and losses. Also, the owner has to bear the maintenance cost. Lease involves the
use of an asset without assuming ownership. This concept has its origin in farming, where the ownership
was with a few landlords while use of the land was in the hands of several farmers. The farmers had
to pay rent usually in the form of a share of the crop, for the use of the land.
A lease is a contract whereby the owner of an asset (lessor) grants to another party (the
lessee) the exclusive right to use the asset in return for the payment of rent.
The owner of the asset is called Lessor and ownership is retained with the lessor under
lease agreement. Lessee, a firm or person acquiring an asset, has to pay rental (also called lease
money) to the lessor.
Leasing has grown to be one of the methods of long-term financing. Leasing contract
stipulates the lease period rental payments, periodic intervals of payments, repairs and maintenance,
purchase options, taxes, insurance, risk of obsolescence, penalty for delay or non-payment of rental
etc. It is an agreement under which the use and control of asset are permitted without passing on
the title of the asset. If the lease is not renewed, the lessor takes possession of the asset after the
expiry of existing lease period.
FORMS OF LEASE FINANCING
There are five main types of leasing as follows:
(i) Direct Leasing:
Under direct leasing, a company acquires the use of an asset it did not own previously. The
major types of lessors are manufacturers, finance companies, banks, independent leasing companies
and special purpose leasing companies. In some cases, a lessor may pass on the surplus benefits out
of the purchase of capital assets to the lessee in the form of low lease rents.
(ii) Sale and lease back:
Under a sale and lease back arrangement, a firm sells an asset to another party at market
value and this party leases it back to the firm. The firm receives the sale price in cash and the economic
use of the asset during the basic lease period. Then the firm contracts to make periodic lease payments
and gives up title to the asset. The lessor realises any residual value the asset might have at the end
of the lease period. This type of lease back arrangement is done by insurance companies, institutional
investors, finance companies and other independent leasing companies.
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(iii) Leveraged leasing:
This type of leasing is linked with the financing of asset which requires large capital outlay.
There are three parties involved in leveraged leasing. (1) the lessee, (2) the lessor and (3) the lender.
Under this arrangement, there is no difference between a leveraged lease and any other type of lease
as far as the lessee is concerned. The lessee contracts to make periodic payments over the basic
lease period and, in return, is entitled to the use of the assets over that period of time. In this type of
leasing the position of lessee is not changed but role of lessor is changed. The lessor acquires the
asset in keeping with the terms of the lease agreement and finance the acquisition in part, say 25% of
the cost of asset and the balance 75% is financed by the long-term lender. The loan is usually secured
by a mortgage on the asset, assignment of the lease and lease payments. Being the owner of the
asset, the lessor is entitled to deduct depreciation and investment allowance. The cash flow pattern
of the lessor will be as follows:
Cash outflow: (a) Initial 25% payment less tax benefit

(b) Yearly interest on loan
(c) Yearly repayment of loan instalments.
Cash inflow: (a) Receipt of lease payment from lessee yearly

(b) On account of depreciation
(c) Residual value at the end of the lease period
(iv) Maintenance lease:
In this type of lease financing, the lessor maintains the asset and pays the insurance. Usually,
it is for a shorter period. It is also known as operating lease.
(v) Net lease:
Under net lease, (also known as financial lease) the lessee pays all the costs of maintenance,
repairs, taxes, insurance and other expenses. This form of lease is for a longer period.
Advantage of Lease
(a) Firms with limited funds can make better use of its working capital.
(b) Tax benefits are available. Lease rent is tax deductible.
(c) Lease provides cost savings over direct borrowing.
(d) The financial burden in case of lease financing is usually lower than the interestb charged by
commercial banks and other financial institutions.
(e) There is no interference by the lender and there is no much government control.
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(f) The risk of obsolescence can be shifted to the lessor.
(g) Leasing on a short-term basis will provide an insurance against out of date technology.
Disadvantages of lease
(a) The ownership remains vested with the lessor.

(b) Interest cost on leasing is usually higher than the interest on debt.
(c) Long-term leasing is generally more expensive to the lessee.
(d) The capital gain benefits in times of inflation is available only to the lessor and the lessee
losses the advantages of such appreciation in the value of asset.
A distinction is made hereunder between the processes of leasing and direct purchase.
Lease Financing Direct Purchase
1. Lessor is only a financial intermediary 1. The firm or person directly approaches the
market and arranges its own fund to own the
asset.
2. The Lessor holds the title to assets 2. The buyer holds the title to assets
3. Maintenance of asset by lessor 3. Maintenance of assets by buyer
4. Risks, insurance & obsolescence 4. Buyer takes care of risk, insurance
are borne by lessor. and obsolescence.
6. Venture Capital
This refers to financial investment in highly risky projects with the hope of earning higher
rate of return. Assistance of the project may be in the form of equity and/or loan. The venture capital
schemes of various institutions like IDBI, ICICI, RCTF(Risk Capital and Technology Finance
Corporation launched by IFCI) and such other institutions are designed
to assist projects which promote commercial applications of indigenously developed

technologies and adopt imported technologies to wider applications
to assist technocrats involved in developing commercially viable technologies or products,
implementing indigenously developed technologies on commercial scale and such other
purposes.
7. Seed Capital
In all projects the promoters are expected to bring in some funds as their contribution. For
the first-generation entrepreneurs, this may prove to be difficult. Seed capital assistance is a form of
25
project financing offered by financial institutions to encourage such class of entrepreneurs. The scheme
is aimed at providing the start-up capital. Mostly the assistance is in the form of interest free loans or
loans carrying a token interest rate, say 1%, to meet the short-fall in the required promoters’
contribution.
8. Bonds
This is a form of debt financing, which has already been discussed under compulsory subject:
Financial Management.
FINANCIAL INSTITUTIONS
The major financial institutions which operate in India on All-India basis and others functioning
within their respective states are discussed hereunder. These financial institutions provide long-term
industrial finance, concentrate on development of backward regions, encourage new entrants with
competence and facilitate modernisation activities.
Industrial Development Bank of India (IDBI)
The Industrial Development Bank of India, was established in July 1964, by an Act of
Parliament (the Industrial Development Bank of India Act, 1964) as a fully owned subsidiary of Reserve
Bank of India and later ownership was transferred to the Government in 1976. IDBI, a premier
financial institution in India, is the seventh largest development bank in the world with an asset base
of over Rs.720 billion (US$ 17 billion) and networth of over Rs.90 billion (US$ 2 billion). IDBI is
the apex term lending financial institution in India with its headquarters in Mumbai and with regional
offices at other places. This is the principal financial institution of the country for the purpose of co-
ordinating the working of institutions engaged in finance, promotion and development of industry. It
seeks to cover the gaps left by the various institutions in the field of industrial finance. IDBI funds
major modernisation, expansion and diversification projects, either directly or through forming a
consortium with other financial institutions. Also, IDBI provides support to commercial banks and
other financial institutions in their financing of industries, by way of refinancing and bill re-discounting
facilities. The affairs of the institution are managed by Board of Directors, headed by a Chairman-
cum-Managing Director.
It has made significant support in the development of the capital market through setting up
of institutional infrastructure such as :
Securities and Exchange Board of India (SEBI),

National Stock Exchange of India Limited (NSEIL),
Stock Holding Corporation of India(SHCI),
26
Credit Analysis and Research Limited (CARL, a credit rating agency),
Investor Services of India Limited (ISIL),
National Securities Depository Limited (NSDL),
The Jawaharlal Nehru Institute of Development Banking (JNIDB)
IDBI Act was amended in October 1994 to permit IDBI to raise equity from the public.
The Initial Public Offering (IPO) of equity in July 1995 raised nearly Rs.2,000 Crores. The
Government’s stake stands at 72.14% which can be diluted much below upto 51%.
Industrial Finance Corporation of India (IFCI)
IFCI was the first All India term lending institution, set up in 1948 for providing medium
and long term loans to industries. It is headquartered in New Delhi and has offices in several other
places. Risk Capital Foundation (RCF) was established by IFCI to provide seed capital to
entrepreneurs to enable them to mobilise adequate promoters’ equity. The assistance from RCF carries
only a nominal service charge and no interest or commitment charges are levied.
Industrial Credit and Investment Corporation of India Ltd (ICICI)
ICICI was founded in 1955 as a first private sector development bank, owned and financed
mainly by the private sector. It has headquarters at Mumbai. ICICI offers financial assistance like
IDBI and IFCI and it has grown into a major dynamic organisation with active involvement in merchant
banking and other financial services. It provides assistance to private sector units, particularly to meet
their foreign exchange requirements.
Industrial Reconstruction Bank of India (IRBI)
IRBI, headquartered at Calcutta, was set up in 1984. It was earlier known as the Industrial
Reconstruction Corporation of India Ltd. IRBI is an agency to help the reconstruction and
rehabilitation of industries which have closed down or which face the risk of closure. It offers assistance
through loans and advances, funding of working capital, technical assistance to risk units for revival
of sick companies, managerial assistance for administration, finance, marketing, industrial relations etc.,
providing indemnity to third parties for loans in the form of guarantees etc.
Unit Trust of India (UTI)
Unit Trust of India was set up in 1964 as a statutory investment institution to provide the
facility of making investment in equities by individuals. The principal objective of UTI is to mobilise
public savings and channeling them into productive corporate investments. UTI raises its resources
through the sale of small denomination units. UTI has grown to become a major investment institution.
27
Export Import Bank of India (EXIM Bank)
Export Import Bank of India was set up in 1982 to provide export and import finance, to
co-ordinate with others providing such finance and to promote the country’s foreign trade. It offers
financial assistance in several forms like direct financial assistance, pre-shipment credit, funding capital
expenditure of 100% Export Oriented Units, financial assistance to fund equity in joint ventures abroad,
loans to foreign agencies to fund imports from India etc.
Small Industries Development Bank of India (SIDBI)
To give focussed attention to the needs of small-scale industry, IDBI set up the Small
Industries Development Bank of India in 1990 as a wholly owned subsidiary. However, de-linking
of SIDBI from IDBI has been recently proposed by the Government to enable IDBI to focus on its
core institutional operations. SIDBI provides refinance facility to other primary lending institutions such
as Commercial Banks, State Financial Corporations, State Industrial Development Corporation etc.
Assistance in the form of bill discounting, direct finance, equipment finance, project loans, venture
capital etc., are also provided by SIDBI.
State Financial Corporations (SFCs)
SFCs are set up under the State Financial Corporations Act, 1951. SFCs render assistance
to medium and small scale industries in the respective states, through underwriting capital issues,
subscribing to capital issues, offering guarantees for loans. Their shareholders are the concerned state
governments, insurance companies, IDBI, private shareholders and credit co-operatives. Besides their
own funds, SFCs avail the refinance and rediscounting facilities from the IDBI.
State Industrial Development Corporations(SIDCs)
SIDCs are set up by the State Governments to promote industrial activities within the states.
Presently almost all the states in India have these SIDCs and are fully owned by the concerned State
Government. SIDCs act as catalyst for industrial growth and adopt several aggressive strategies to
mobilise investments from Indian companies, NRIs and foreign investments. SIDCs sponsor joint sector
projects with the participation of private entrepreneurs. SIDCs offer term loans for medium and small
scale projects, participate in equity and help in developing appropriate infrastructure. Also, they serve
as nodal agency for the state government to invest in priority areas.
Life Insurance Corporation of India (LIC)
The Life Insurance Corporation of India was established in 1956 after the merger and
nationalisation of about 245 insurance companies operating in India. LIC’s primary activity is life
insurance business, but it is more an Investment Institution and invests in Government Securities, Public
28
Sector undertakings, Private Sector Corporations etc. Thus, it has grown to become an important
All-India Financial Institution which provides substantial support to industry. LIC operates in liaison
with other financial institutions. It is headquartered in Mumbai.
General Insurance Corporation of India (GIC)
GIC was set up in 1974 upon nationalisation of general insurance business in India. It is
headquartered in Mumbai. GIC provides substantial assistance to industrial projects by way of term
loans, subscription to equity capital and debentures and underwriting of securities. GIC is a holding
company and has got four subsidiaries as follows:
(a) National Insurance Co. Ltd.

(b) New India Assurance Co. Ltd.
(c) Oriental Insurance Co. Ltd.
(d) United India Insurance Co. Ltd.
GIC mainly handles re-insurance besides overseeing the activities of the four subsidiaries
which handle the marketing of General Insurance Business.
National Bank for Agriculture and Rural Development (NABARD)
NABARD was setup in 1981 as the apex organisation to provide credit for agricultural
activities, poultry farms, dairy farms, small scale industries, cottage and rural industries, handicrafts
etc. NABARD provides refinance facility against the loans offered by Commercial Banks for
Agricultural and Rural Development.
Housing Development Finance Corporation Ltd (HDFC)
HDFC was incorporated in 1977 with its head office in Mumbai and has its branches in
several places. It finances housing activities in India.
Commercial Banks
After RBI, Commercial Banks represent the most important institutions in the financial system.
Commercial Banks include Scheduled Banks, Private Banks, Regional Rural Banks and Co-operative
Banks. One of the major activities of the Commercial Banks is to provide working capital advance
to industry. Though term loans are also provided by Commercial Banks, this is fairly small. The financial
assistance provided by Commercial Banks include rupee term loans and underwriting of share and
debenture issues. The loans offered by Commercial Banks are eligible for refinancing and rediscounting
from IDBI.
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FINANCIAL ASSISTANCE
Direct Financial Assistance
The institutions offer direct financial assistance in the following ways:
(i) Rupee Term Loan:
Project expenses such as cost of land, building, plant and machinery, miscellaneous fixed assets,
technical know-how fees, preliminary expenses, pre-operative expenses and margin money for
working capital are given directly to industrial concerns for setting up new projects as well as
for expansion, modernisation and renovation projects. These loans are payable in the long term
of about 10 years and will have a moratorium of one or two years in the initial phase of the
project.
(ii) Foreign Currency Term Loans:
Financial institutions provide foreign currency term loans for funding expenditure in foreign
currency towards procurement of plant and machinery and technical know-how fees.
(iii) Direct Subscription to Equity:
Sometimes the institutions offer assistance by Direct Subscription of Shares, especially in case
of small issues.
(iv) Seed Capital Assistance:
This assistance is offered to meet the shortfall in the promoters’ contribution of new entrepreneurs.
Indirect Financial Assistance
(i) Refinance of Industrial Loans:
Commercial Banks and state level financial institutions offer financial assistance for small and
medium scale unit and, in turn, avail the refinance facility from the IDBI.
(ii) Deferred Payment Guarantee Assistance:
The financial institutions offer guarantee to the suppliers of plant and machinery who offer to
supply the equipment on deferred credit. If there is any default by the buyer in payment of
deferred instalments, the payment would be made by the financial institutions and later recover
the amount from the buyer or the assisted unit. The institutions charge a guarantee commission
fee for the purpose.
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(iii) Suppliers Line of Credit:
This is intended to encourage manufacturers to offer their product on deferred payment terms.
The suppliers of equipment receive the funds directly from the financial institutions.
(iv) Underwriting:
The institutions also offer to underwrite issues of shares and debentures.
INTERNAL SOURCES OF FINANCE
An organisation generates substantial finance due to its operations and this is called internal
accruals. The internal generation of funds is very critical. While too low an internal generation indicates
poor control over operations and finance, an abundance of internal generation may lead to
manipulation.
The internal accruals fall under the following categories:
1. Retained earnings
2. Provisions for depreciation
3. Amortisation provisions.
Depreciation provision will be used for replacing an old machinery etc. Profits and reserves
or the retained earnings can be utilised for funding other long-term objectives of the firms. Internal
accruals enhance the self-financing capability of the organisation. On ploughing back of its profit year
after year, its capital base is widened, which can fund any capital project or to meet its expanding
needs for working capital.
The advantages of using internal accruals as a source of long-term finance are its easy
availability, elimination of expenses connected with issue of shares and the problem of dilution of control.
The disadvantages associated with internal sources of financing are:
Internal resources can be built up only through profitable operations.

Profitability of an organisation depends on various factors, both internal and external.
Ploughing back of retained earnings reduces the dividend receipts by the investors.
SOURCES OF FINANCE - INTERNATIONAL
Indian corporate sector taps money in foreign markets through one or more of the following
ways:
a) Investments by Non-Resident Indians (NRIs).

b) Investment from the foreign collaborator in the joint venture.
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c) World Bank aid or Asian Development Bank aid for Indian projects.
d) Suppliers’ credit (where foreign equipment suppliers provide credit).
e) Loans from International Financial Corporation.
f) Euro-currency market with products like Certificates of Deposits, Eurobonds, Multi-
eurocurrency Loans, Cocktail Debts etc.
g) Euro-equity placement. (i.e, an international equity issue involving a placement through an
international bank syndicate).
SUMMARY
The forms of finance like equity share capital, preference share capital, debentures, term
loans, lease, venture capital, seed capital and bonds are dealt with in detail. The various financial
institutions like IDBI, IFCI, ICICI, IRBI, UTI, EXIM Bank, SIDBI, SFCs, SIDCs, LIC, GIC,
NABARD, HDFC and Commercial Banks are given due importance and explained in the chapter.
The internal and international sources of Finance are also mentioned in brief.
QUESTIONS
1. Explain Equity Share Capital with its advantages and disadvantages.

2. Explain debentures as instruments for raising long-term debt capital.
3. What is Leasing? Give its different forms with advantages and disadvantages.
4. Explain briefly five major financial institutions.
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CHAPTER - III
MANAGEMENT OF WORKING CAPITAL
OBJECTIVES
The chapter introduces the reader to the classifications of capital, working capital cycle,
adequacy of working capital, under and over trading and also sources of short-term finance.
INTRODUCTION
The total investment in a business may be classified into two parts.
(i) Fixed Capital and
(ii) Working Capital.
Fixed capital refers to that part of the total capital invested for the acquisition of land and
building, plant and machinery, furniture and other fixed assets.
Working capital or Gross working capital is the total assets of the firm. Current assets are
those assets that are usually converted into cash within an accounting year or normal operating cycle.
Examples of Current Assets are:
• Inventories - Raw Materials, Work-in-process, Finished Goods.
• Trade Debtors
• Investments
• Loans and Advances
• Cash & Bank balances
Net Working Capital is the difference between current assets and current liabilities. Eg:
Creditors for goods supplied, Trade advances, Bank overdrafts, Provisions.
Net working capital can be defined more precisely as the excess of current assets over current
liabilities.
Net working capital = Current Assets - Current Liabilities
Technically, net working capital is that portion of a firm’s current assets which is financed
by long term funds.
Needs for Working Capital
The basic objective of Financial Management is to maximise shareholders’ wealth. Earning of
sufficient profit is the prerequisite for achieving the above objective. One of the ways of improving the
profit is by increasing the sales. However, due to the business/ market conditions all sales do not get
immediately converted into cash. There will be some time-gap before the raw materials get converted
into finished goods, the finished goods into sales, the sales on credit into cash etc. In order to sustain the
sales activity, working capital is required during this period.
a) Gross Working Capital

It refers to the firm’s investment in current assets, mainly stocks, debtors, cash and bills
receivables.
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b) Net Working Capital
It is the difference between the current assets and current liabilities. It is that portion of a firm’s
current assets which is financed by long-term funds. This can be understood by way of an
illustration.
Suppose the investment in current assets of a business in the form of different components
such as cash, bills receivables, stocks and short-term investment etc., is Rs.1,00,000 and presume
that a portion of this requirement (say Rs.75,000) can be financed by the business through credit
purchases, or by deferring or postponing some payments (ie., by creating current liabilities like accounts
payable, outstanding expenses etc). This means that the business still requires Rs.25,000 for its
working purposes. Where from this shortfall could be managed ? This amount will have to be
financed from long-term sources of funds.
c) Negative Working Capital

When the total current liabilities exceed the total current assets the net working capital is negative
and this is called the Negative Working Capital. This is an indication of crisis to the firm.
d) Fixed Working Capital

Every firm is required to maintain a minimum balance of cash, inventory etc., in order to
meet the business requirements even in the slack season. The minimum amount of investment in all
current assets which is required at all times to carry out minimum level of business activities is called
Fixed Working Capital or Permanent Working Capital or Core Current Assets.
The characteristics of this type of working capital are:
i) Investment in permanent working capital remains in the business in one form or another.
The suppliers of Fixed Working Capital should not expect its return during the life-time of
the firm.
ii) The requirement of the Fixed Working Capital remains proportionate to the size of the
business. i.e., greater the size of the business, greater is the amount of Fixed Working Capital
and vice-versa.
It will be a sound policy if fixed working capital is financed out of long-term funds.
e) Variable Working Capital

This is the difference between Net Working Capital and Fixed Working Capital.
This is also known as temporary working capital or fluctuating working capital.
The amount of such working capital keeps on fluctuating from time to time on the basis of
seasonal requirements and scale of operations in a business. This means that temporary working capital
represents additional current assets required at different times during the operating year.
Temporary working capital is generally financed from short-term sources of finance such as
bank credit. Here, suppliers of variable working capital can expect its return during off-season when
it is not required by the firm.
The Fixed Working Capital may not be fixed at all times. It may also increase depending on
the size and growth of the business. The concept of Fixed Working Capital and Variable Working
Capital can be explained with the help of diagrams.
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Variable Working Capital
Amount of
Working Capital
(Rupees)
Fixed Working Capital
PERIOD
Fig.1
Variable Working Capital
Amount of
Working Capital
(Rupees)
Fixed Working Capital
PERIOD
Fig.2
In Fig.1, fixed working capital is fixed over a period of time, while variable working capital
is fluctuating. Fig. 2 is the depiction of a growing company, wherein the fixed working capital increases
over a period of time.
ADEQUACY OF WORKING CAPITAL
Working capital should be adequate for smooth running of the operations and uninterrupted
flow of production. It should neither be excessive nor inadequate. Both situations are dangerous.
Excessive working capital represents idle funds which earns no profits for the firm. The availability of
excessive working capital leads to carelessness about costs and thus leading to inefficiency of
operations. Insufficient working capital means inadequate funds for running the operations of the
business. This causes interruptions in production activities and ultimately lowering down the profitability.
Also, lack of liquidity affects credit-worthiness of the firm in the market. Low production and low
liquidity lead to low profitability which in turn affects the liquidity.
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WORKING CAPITAL CYCLE
Working capital is needed till the firm gets cash on sale of finished products and it depends
on two factors.
(i) Manufacturing cycle
This is the time required for converting the raw material into finished product.
(ii) The credit policy of the management
i.e., credit period given to Customers for payment of bills and credit period allowed by creditors
for payment of their bills.
In every business, there is a natural cycle of activity, but this differs from one business to
another, according to the nature of the business as follows:
(i) For a business engaged only in financing:
Cash Debtors Cash
(ii) For a business engaged only in trading activity:
Cash Merchandise Debtors Cash
(iii) For public utility/service enterprises:

Materials Cash
Cash Wages
Debtors Cash
Utilities
(iv) For a manufacturing business:

Materials Work-in- Finished Cash
Cash Wages progress goods
Overheads Debtors Cash
Generally there occurs the following 6 steps in any operating cycle or working capital cycle.
(i) Conversion of cash into raw materials
(ii) Conversion of raw materials into work-in-process
(iii) Conversion of work-in-process into finished products
(iv) Time for sale of finished goods - cash sales and credit sales
(v) Time for realisation from debtors and bills receivables into cash
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(vi) Credit period allowed by creditors for credit purchase of raw materials and
inventory.
The operating cycle of a manufacturing business is shown in the form of following chart:
Cash
Raw Materials Accounts

Cash Receivable
Sales
Sales
Work-in-progress
Finished Products
ANALYSIS OF OPERATING CYCLE
The sum total of the time required to complete the above 6 stages ( i to vi ) is called an
operating cycle. i.e., the duration of the operating cycle is equal to the sum of the durations of each
of the above stages less the credit period allowed by the suppliers of the firm.
The operating cycle can be computed as follows:
O = R + W + F + D - C
where,
O = duration of the operating cycle
R = Storage period of raw materials and stores.(i.e., inventory period)

= Average stock of raw materials and stores
Average consumption of raw materials and stores per day
W = No. of days of work-in-process (or process time or period of WIP)

= Average work-in-process inventory
Average cost of production per day
F = Storage period of finished goods

= Average finished goods inventory
Average cost of goods sold per day
D = Debtors collection period = Average book debts
Average credit sales per day
C = Suppliers’ credit period = Average trade creditors
Average credit purchases per day
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Apart from the above the minimum cash balance to be kept daily also is to be taken into
consideration while assessing the working capital requirements.
Once the duration of various components of working capital is worked out, it is possible to
estimate the working capital requirements of a business for a specified future period and for the planned
activity level.
ESTIMATION OF WORKING CAPITAL REQUIREMENT
There are three methods for assessing the working capital requirement as under:
(a) Percentage of sales method:
In this method, some percentage of sale is taken based on the past experience for determining
the quantum of working capital.
(b) Regression Analysis Method:
The sale and working capital relationship is plotted on scatter diagram and the average
percentage of past 5 years is ascertained and this percentage is taken as working capital
requirement.
(c) Operating cycle approach:
This can be done either by evaluating each component separately or by using a weighted
operating cycle analysis. The latter method is simpler and involves the following steps.
(1) Calculate the duration of various stages of the operating cycle.
(2) Determine the weights for various stages of the operating cycle. The weights
are the percentage of each element of the working capital to the unit sale
price.
(3) Add all the weighted durations of the individual component.
Since working capital is excess of current assets over current liabilities, the forecast for
working capital requirements can be made only after estimating the amount of different constituents
of working capital. Let us see how the requirements of individual constituent are assessed.
1. Inventories
The term inventories include stock of raw material, work-in-progress and finished goods.
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a) Raw materials stock
The quantity of raw materials required for production and the average time taken in obtaining
fresh delivery - the combination of the above two factors decide the quantity of raw materials
required to be kept in stock. Suppose the total quantity of raw materials required in a year is
2,400 kg and one month is taken in obtaining a fresh delivery. Then a minimum stock of 200
kg of raw materials must be kept in stock (i.e., 2,400 kg / 12). Marginal increases have to be
made over this quantity on the basis of likely delays and other considerations. The quantity of
stock multiplied by the price per unit will give the amount of working capital required for holding
stock of raw materials.
b) Work-in-process
For calculation of the amount of work-in-process, the time period for which the goods are in
the production process is to be found out. The cost of WIP includes raw materials, wages
and overheads.
c) Finished goods
The period for which the finished products have to remain in the warehouse before sale
determines the amount locked up in finished goods.
2. Debtors
The amount of funds locked up in Sundry Debtors will be computed on the basis of credit
sales and the time-lag in collecting payment.
For example : Credit sales for the year = Rs.1,20,000

Average credit period allowed to debtors = 2 months
Then funds locked up in Debtors
= Monthly Credit sales x Average credit period allowed.
= Rs.1,20,000 x 2 months = Rs.20,000

12
3. Cash and Bank balances
The amount of cash and bank balance required is based on past experience and an approximate
amount is taken as the requirement for meeting day-to-day payments.
39
4. Sundry Creditors
The lag or delay in payment to suppliers of raw materials, goods etc., and the likely credit
purchases to be made during the period determine the amount of creditors.
5. Outstanding expenses
The time-lag in payment of wages and other expenses is to be calculated for determining the
amount of outstanding expenses. Eg. If monthly payments for wages and expenses are estimated
at Rs.15,000 and a time lag of 15 days in payment is estimated, the amount of outstanding
expenses on an average amounts to Rs.7,500/-.
UNDER - TRADING AND OVER - TRADING
Working capital should be adequate for smooth running of the operations and uninterrupted
flow of production. Under-trading is a situation when the volume of sales is much less than the
amount of assets employed. It is an indication that funds of the company are locked up in current
assets. This results in a lower turnover of working capital. In other words, under-trading means the
company is over-capitalised compared to the volume of sales. The basic cause of under-trading is
under-utilisation of the firm’s resources and such under-utilisation may be due to any one or more of
the following reasons:
(i) Conservative policies followed by the management.

(ii) Non-availability or shortage of basic facilities necessary for production, such as raw materials,
power, labour etc.
(iii) General depression in the market resulting in fall in the demand of the company’s product.
The symptoms of under-trading are:
A very high current ratio.

Low turnover ratio.
Increase in working capital turnover. i.e., working capital/ sales ratio.
The ill-effects of under-trading are :
sliding down of rate of return on equity,

crashing of market price of the company and
loss of reputation of the firm on account of lower profitability.
The condition of under-trading is set because of under-utilisation of the firm’s resources.
The situation can, therefore, be remedied by the management by adopting a more dynamic and result-
40
oriented approach. The firm may diversify its business into new profitable jobs, projects etc., resulting
in a better and efficient utilisation of the firm’s resources.
Over-trading is a situation where a firm attempts to increase/maintain sales at high level without
adequate working capital. Over-trading is signified by high capital-turnover ratio and low current ratio.
The following may be the causes of over-trading:
(i) Depletion of working capital
Depletion of working capital results in depletion of cash resources. Premature repayment

of long-term loans, excessive drawings, dividend payments, purchase of fixed assets, excessive net
trading losses etc., cause depletion of cash resources.
(ii) Faulty financial policy
Shortage of cash, and thereby over-trading, can happen because of faulty financial policy in
the following ways.
(a) Purchasing fixed assets using working capital

(b) Expanding the volume of business without raising the necessary resources etc.
(iii) Over-expansion
The production may be required to be increased due to pressures from Government without
providing for adequate finances, and this causes over-expansion of the business ignoring the elementary
rules of sound finance.
(iv) High taxation
Excessive and heavy taxes result in depletion of cash resources.
(v) Dividend payout
The cash position is further strained on account of efforts of the company to maintain
reasonable dividend rates for their shareholders.
(vi) Inflation
Rising prices make renewals and replacements of assets, labour and materials costlier. The
cash requirements will be high in such circumstances.
While increase in turnover of current assets is generally considered to be a virtue,

disproportionately high turnover indicates less amount of cash invested in current assets which causes
liquidity problem very often. If the working capital is inadequate, the production will suffer. Credit
41
worthiness in the market is affected because of lack of liquidity. Liquidity problem leads to difficulties
in procuring materials and results in low production. Non-payment of wages in time creates a feeling
of uncertainty, insecurity and dissatisfaction in all ranks of the labour. The company’s sales also will
suffer because the pressure for cash requirements may force it to offer liberal cash discounts to debtors
for prompt payment, as well as selling goods at throwaway prices. Shortage of cash will force the
company to delay even the necessary repairs and renewals.
The symptoms for over-trading are:
Unusual increase in the amount of creditors as compared to debtors.

Increased borrowings from banks with corresponding increase in inventories.
Purchase of fixed assets out of short-term funds.
Low current ratio and high turnover ratio.
Fall in the working capital to sales ratio.
The remedy against over-trading is either to reduce the business or to increase finance.
Practically both are difficult. However, arrangement of more finance is advisable.
What should be the Optimum level of Working Capital ?
The ill-effects of inadequate and excessive working capital have already been discussed.The
finance manager has to work out the optimum level of working capital. Working capital management
is an integral part of overall corporate management.
The following are the concepts involved in determining the optimum level of working capital.
(i) Working Capital Policy Index (WCPI):
The level of current assets can be measured by the ratio of Current Assets(CA) to Fixed
Assets(FA) or Total Assets(TA). A higher ratio of CA/FA or CA/TA indicates a conservative
current assets policy while the lower ratios indicates an aggressive current assets policy.
A conservative policy implies greater liquidity and lower risk and return and an aggressive policy
indicates poor liquidity and higher risk and return. A higher ratio of Liquid Assets (LA) to
Current Assets implies greater liquidity and lower risk and return and vice versa. The current
ratio , i.e., the ratio of Current Assets(CA) to Current Liabilities(CL) should be at least 2 : 1.
On the above basis, Working Capital Policy Index(WCPI) is calculated as follows:
C A LA C A
WC PI = x x
FA C A C L
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A conservative policy of financing is that, apart from the permanent assets, a part of the current
assets is also financed out of long-term sources. This is less risky but at the same time less
profitable. In an aggressive policy, it can finance a part of its permanent current assets with
short-term financing, which is more risky but more profitable. A firm should follow a moderate
working capital policy in terms of liquidity and profitability.
(ii) Profitability and solvency:
Profitability and solvency are the two important aims of working capital management. Solvency
should be ensured through higher liquidity. But higher liquidity reduces the profitability.
Therefore, a finance manager has to manage these opposing forces by adopting the optimum
level of working capital.
(iii) Cost of liquidity and cost of illiquidity:
Increase in Working Capital Policy Index (WCPI) is marked by excessive funds in current
assets. This causes cost of liquidity to rise. The cost of illiquidity is the cost of holding insufficient
current assets. Cost of illiquidity increases with the decrease in WCPI. Therefore, the total cost
of both liquidity and illiquidity is to be minimised in order to determine the optimum working
capital level.
The following chart shows the above effects:
Total Cost
Cost of illiquidity
Cost
Cost of Liquidity
A B
Aggressive Moderate Conservative
Level of Working Capital
WORKING CAPITAL LEVERAGE
Working capital leverage refers to the tendency of increasing profits of the firm by controlling
the amount of working capital in relation to sales. This can be achieved by financing current assets
from low cost funds or cost free funds or by current liabilities.
43
If the current assets are financed fully by current liabilities, then the current ratio i.e., CA /
CL = 1, i.e., 1:1. Investment in the working capital should be kept to the minimum in order to
maximise the profits.
Working capital leverage reflects the sensitivity of the Return On Capital Employed(ROCE)
to the changes in the level of current assets.
SOURCES OF SHORT - TERM FINANCE
The working capital requirements should be met both from short-term as well as long-term
sources of funds. It will be appropriate to meet at least 2/3rds (if not the whole) of the permanent
working capital requirements from long-term sources. The variable working capital should be financed
from short-term sources and only for the period needed.
The following sources are available for short-term finance:
(a) Loans from financial institutions

(b) Floating debentures
(c) Public deposits
(d) Issue of shares
(e) Retained earnings or internal resources
(f) Trade creditors and advances from customers
(g) Bank credit
(h) Commercial paper
(i) Bills discounting facilities
(j) Factoring
SUMMARY
The classifications of capital, adequacy of working capital, working capital cycle, capital
requirement, under trading and overtrading, optimum level of working capital are dealt with in this
chapter in great detail.
QUESTIONS
1. Explain the different classifications of capital.

2. What is Working Capital Cycle?
3. How will you estimate working capital requirement?
4. What should be the optimum level of working capital?
44
CHAPTER - IV
MANAGEMENT OF CASH
OBJECTIVES
The chapter familiarises the reader with the meaning of cash, motives for holding cash,
objectives of and problems in cash management. The reader is to get acquainted with cash management
models, financial forecasting and different aspects of Cash Budget.
MEANING OF CASH
Cash is an omnipresent phenomenon in a business. Cash, the most liquid asset, is of vital
importance to the day-to-day operations of the business. It is referred to as the ‘life blood’ of business.
Liquidity of other assets is also measured in terms of their convertibility into cash. Every business
activity has direct or indirect effect on finance, and anything done financially affects cash eventually.
Cash is the most critical asset for the successful running of the business and its efficient management
is crucial to the solvency of the business, because, even a profitable business may become bankrupt
when it runs out of cash.
The term ‘cash’ with reference to cash management is used in two senses. In a narrow
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 also includes ‘near cash assets’ such as time deposits
with banks and marketable securities, as such deposits or securities can immediately be sold or
converted into cash when needed. The term cash management is generally used for management of
both cash and near-cash assets.
MOTIVES FOR HOLDING CASH
1. Transaction motive
i.e., to meet the needs of day-to-day transactions. At times the cash outflow may exceed the
cash inflows, and in such a situation, it is necessary to maintain adequate cash balance to meet
the business obligations. Therefore, the firm keeps cash balance with the motive of meeting
daily and routine business payments.
45
2. Precautionary motive
This is to protect the firm against uncertainties and unexpected cash needs arising out of
unexpected contingencies. These happen in cases such as presentment of bills for payment earlier
than the expected date, unexpected decline in the collection of accounts receivable, increase in
price of raw materials and other internal as well as external problems and constraints.
3. Speculative motive
Holding of cash to take advantage of unexpected opportunities, usually outside the normal course
of business is referred to as holding of cash with speculative motive. A firm may like to
take advantage of an opportunity to purchase raw materials at the reduced price on payment
of immediate cash or delay purchase of materials in anticipation of declining 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. The speculative motive covers events, which
are most uncertain, unforeseen and unpredictable to forecast.
4. Compensation motive
Business of today is predominantly dependent on commercial banks for financial support. Banks
provide certain services to their clients free of charge, and in turn, the clients are required to
keep a minimum cash balance with them, which should not be withdrawn, in the ordinary course
of business. For example, if a bank guarantee is issued by the bank, the bank charges guarantee
charges based on the period and amount. In addition, it may ask for retention of some minimum
balance also, and such minimum balance is known as compensating balance.
5. Business Expansion motive
It refers to the motive of accumulating cash to meet the requirements of expansion envisaged
by the business. The business cannot wholly depend upon financial institutions to fund such
expansions and a part of the funds should be amassed from internal accruals, i.e., from its own
resources, through ploughing back of profits. Besides, in the present era of mergers and
acquisitions, ready availability of cash helps in implementing such schemes smoothly.
OBJECTIVES OF CASH MANAGEMENT
The basic objectives of cash management are:
1. To meet the cash disbursement need as per the payment schedule

The firm should have sufficient cash to meet the various payment obligations of the firm at different
periods of times, such as payment for purchase of raw materials, wages, acquisition of plant,
46
meeting tax liabilities etc. Any default in payment schedule may cause the business activity to
come to a grinding halt. Understanding the importance of cash, Bolsten.S.E has described cash
as the “oil to lubricate the ever-turning wheels of the business, without it the process grinds to
a stop”.
2. To minimise the amount locked up in cash balance

There are two aspects before the finance manager, which are of opposing nature. A higher
cash balance ensures proper payment with all its advantages. But this results in a large balance
of cash remaining idle. A low level of cash balance results in failure of the firm to meet the
payment schedule. Thus, the task for the finance manager is to have an optimum amount of
cash balance keeping the above facts in view.
PROBLEMS IN CASH MANAGEMENT
Cash management involves the following four basic problems:
(i) Controlling level of cash
Minimising the level of cash balance is one of the basic objects of cash management. This can
be achieved by means of:
preparation of cash budget,

providing for discrepancies between cash inflows and outflows on account of unforeseen
circumstances such as strikes, short-term recession, floods etc., in the cash budget,
consideration of the costs associated with shortage of cash and
finding out alternative sources of funds.
(ii) Controlling inflow of cash
The finance manager has to ensure that there is no significant deviation between the projected
cash inflows and the projected cash outflows, requiring control over both inflows and outflows
of cash. Techniques such as Lock Box System and Concentration Banking help in speedier
collection of cash.
(iii) Controlling outflow of cash
A firm can control outflow of cash effectively through
Centralised system for disbursements

Effecting payments only on the due dates
Playing float for maximising the availability of funds.
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Float means the amount tied up in cheques that have been drawn but have not yet been
presented for payment. There is always a time lag between issue of a cheque by the firm and
its actual presentment for payment. As a result of this a firm’s actual balance at bank may be
more than the balance as shown by its books. This difference is called payment in float. The
longer the float period the greater is the benefit to the firm. A firm can expand the opportunities
for playing the float by having many bank accounts at different places.
A business deals with two balances associated with its bank account. One, the balance appearing
in its books of accounts and the other the actual cash balance as per the books of the bank.
The two balances may differ due to many reasons, but the most prominent reasons are:
Cheque presented by the business but not yet collected by the bank. (This is called
collection float)
Cheques issued by the business but not yet presented to the bank for payment. (This is
called disbursement float)
Float is the sum total of the above. As soon as the cheques are deposited in the bank, the
amount is debited to the bank account in the books of the business.
But the credit to the account of the business will be effected only upon realisation of the cheques.
The time lag in the two results in the difference of balances known as Collection Float.
Disbursement Float is the sum total of all the cheques which have been issued to suppliers but
are in the process of being presented to the bank for payments. The bank account in the
books of the business is credited as soon as cheques are drawn on it and sent to suppliers, but
the bank would debit the account of the business only on receipt of the cheques from the bankers
of suppliers.
(iv) Optimum investment of surplus cash
The problems regarding the investment of surplus cash are:
Determination of the amount of surplus cash

Determination of the channels of investment.
(a) Determination of the amount of surplus cash:
Surplus cash is the cash in excess of the normal cash requirements of the firm. This has to be
assessed taking into consideration the minimum cash balance that the firm must keep to avoid
risk or cost or running out of funds. Such minimum level is termed as safety level of cash.
The safety level of cash is to be determined separately both for normal periods and peak periods.
The two basic factors to be kept in mind are:
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(1) Desired days of cash. i.e., the number of days for which cash balance should be sufficient
to cover payments.
(2) Average daily cash outflows. i.e., the average amount of disbursements which will have
to be made daily.
During normal periods,
Safety level of cash = Desired days of cash x Average daily cash outflows.
During peak periods,

Safety level of cash = Desired days of cash at the busiest period x Average of highest daily
cash outflows.
Illustration.1:
From the following data determine whether the firm has surplus or deficiency of cash.
Normal periods Peak periods

Desired days of cash 6 4
Average daily outflows Rs.40,000 Rs.60,000
Actual Cash balance Rs.1,20,000 Rs.1,60,000
Solution:
During normal periods:
Actual cash balance = Rs.1,20,000

Average daily cash outflows = Rs. 40,000
Therefore, cash is available only for 3 days requirements.
Requirement is 6 days. Therefore there is deficiency of cash.
During peak periods:
Actual cash balance = Rs.1,60,000

Average daily cash outflows = Rs. 60,000
Therefore, cash is available only for 2.67 days, whereas requirement is 4 days.
Therefore, the firm has deficiency of cash.
(b) Investing surplus cash
The criteria for investment are based on the discretion or judgement of the finance manager.
He takes into consideration the following factors while investing surplus cash.
Security of investment in terms of the price stability

Liquidity
Yield
Maturity pattern of investments.
49
STEPS TO IMPROVE EFFICIENCY OF CASH MANAGEMENT
The following steps would improve efficiency of cash management:
a) Cash planning - short term and long term forecast.
b) Cash budget - preferably monthly cash budget for next 12 months.
c) Management of cash flows - both inflow and outflow of cash.
d) Productive utilisation of excess funds, such as investment in Short Deposits or Certificate of

Deposit or other profitable investments in case of short-term excess funds. In case of long-
term excess funds, it may be utilised for repayment of loan / debentures which carry higher
rate of interest.
e) Monitoring collection of debtors.
f) Expeditious depositing and collection of cheques.
g) Effective creditors management.
h) Playing float.
i) Synchronisation of cash outflow and cash inflow.
CASH MANAGEMENT MODELS
As has already been discussed, one of the central problems of cash management is how to
fix optimum cash balance and what to do with the excess cash. i.e., cash balance above the optimum
cash balance, and also what to do if there is shortfall in cash balance. i.e., if the actual cash balance
falls below the optimum cash balance. Several types of cash management models have been designed
to help in determining optimum cash balance. Two of such models are discussed hereunder.
1) Baumol Model (named after William J Baumol)
This is same as the determination of economic order quantity in case of inventory management.
Optimum cash level is that level of cash where the carrying cost and transaction costs are the
minimum. Carrying cost is the cost of holding cash. i.e., the interest forgone on marketable
securities. It is also termed as opportunity costs of keeping cash balance. Transaction cost
refers to the cost involved in getting the marketable securities converted into cash. This happens
when the firm falls short of cash and has to sell the securities resulting in clerical, brokerage,
registration and other costs.
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Total Cost
Opportunity Cost
Cost
Transaction Costs
Optimum
Cash Balance
When carrying cost increases, transaction cost decreases and vice versa. i.e., they bear an
inverse relationship between them. Optimum cash level is that point where these two costs are
equal.
2DF
C =
O
where, C = Optimum cash balance

D = Annual (or monthly) cash disbursements
O = Opportunity cost of one rupee p.a.(or p.m.)
F = Fixed Cost per transaction.
Illustration.2:
Monthly cash requirements Rs.75,000
Fixed cost per transaction Rs.12
Interest rate on marketable securities 6% p.a.
Calculate the optimum cash balance.
Solution:
2DF 2 x 75,000 x 12
C = = = Rs.18,974 or say Rs.19,000/-
O 0.06 / 12
This means that the total cost of holding cash is the least when the cash balance is kept at
Rs.19,000 and therefore, this may be taken as the optimum cash balance.
2) Miller Orr-Model
Merton Miller and Daniel Orr suggested a model, which incorporates a stochastic element.
They assumed that cash balances change randomly for cash to investment account (marketable
securities) over a period of time both in size and direction.
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According to this model,
3bσ 2
Z=3
4i
where z = the optimum cash balance which lies between the maximum level h and the minimum level
l.
b = fixed cost of one sale/purchase transaction of marketable securities.
i = rate of interest per day on marketable securities.
s2 = variance of daily net cash flows.
Here, z is also called the return point because whenever cash balance reaches h, marketable
securities are sold by an amount = (h - z); and whenever cash balance reaches l , marketable
securities are bought amounting to (z - l ); in either case the actual cash balance is brought
back to the level of z.
FINANCIAL FORECASTING
Financial forecasting is the estimating of cash receipts and payments for a future period before
any adjustments have been made. Before cash budget is prepared a cash forecast is made. Cash
budgeting is estimation of cash receipts and payments for a future period after due consideration has
been given to the expected conditions and the overall budget plan.
Financial forecasting helps the business in the following ways:
It reveals any expected surplus of cash or shortage of cash, both long term or short term.
It generates the information useful for financial decision-making.
Provides required information for successful financial planning.
It reveals the seasonal requirements of cash such as payment of income tax.
It supports good investment and financial policies, both short-term as well as long-term.
CASH BUDGET
As every transaction of the business is affected eventually by cash, the cash budget is often
the last and the most difficult subsidiary budget to be prepared. The principal tool of cash management
is cash budgeting or short-term cash forecasting. The cash budget is a forecast of expected cash
receipts and payments for a future period. Cash forecast preceded a Cash Budget. Cash forecasting
is the estimating of cash receipts and payments for a future period before any necessary adjustments
have been made. Cash budgeting is the estimating of cash receipts and payments for a future period
after due consideration has been given to expected conditions and the overall budget plan.
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Cash budget becomes a part of the total budgeting exercise under which other budgets and
statements are prepared. Cash budget consists of three parts :
a) estimates of cash receipts
b) estimates of cash disbursement and
c) cash balances each month of budget period.
Cash budget is also called cash flow statement, which indicates the expected cash inflow
and cash outflow. Depreciation and other non-cash expenses are not taken into account for the
preparation of cash budget. Usually the period for making short-term forecast for preparing cash
budget is one year. Then it is divided into monthly cash budgets.
FUNCTIONS OF CASH BUDGET

The main functions of cash budget are:
1. To ensure that sufficient cash is available when required.
2. To reveal any expected shortage/surplus of short-term cash or long-term cash.
3. To preserve liquidity.
4. To indicate the availability of funds for replacement of assets, addition to assets, expansion
schemes, new schemes and modification of existing plant and equipment etc.
Cash budget or the short-term cash forecast is the principal tool of cash management. They
are absolutely essential and help the finance manager in the following functions.
a) Estimating cash requirement.
b) Planning short term financing.
c) Scheduling payments for capital expenditure projects and authorising release of purchase
orders based on this schedule.
d) Scheduling payments for purchase.
e) Formulating policies for extending credit to customers.
f) Monitoring the operations vis-à-vis the long term forecasts.
SUMMARY
The various aspects of Cash Management like meaning of cash, motives for holding cash
objectives and problems of cash management, models of cash management, financial forecasting, cash
budget functions are explained in detail.
QUESTIONS
1. What are the motives for holding cash?
2. What are the major problems in Cash Management?
3. What is the Baumol Model of Cash Management?
4. Explain the different aspects of Cash Budget.
53
CHAPTER - V
MANAGEMENT OF RECEIVABLES
OBJECTIVES
The chapter is designed to acquaint the reader with the meaning and cost analysis of
receivables. It is also for getting a good understanding of credit policy and credit analysis.
MEANING OF RECEIVABLES
Sales on credit are an inevitable necessity in the business world of today. No business can
exist without selling the products on credit. When a firm sells goods for cash, payments are received
immediately, and therefore, no receivables are created. But when a firm sells goods or services on
credit, the payments are postponed to future dates and receivables are created. The difference between
credit sales and cash sales is the time gap in the receipt of cash. From the point of view of business,
selling on credit constitutes an investment. The business invests money in credit sales to earn more
money by increasing sales.
Receivables are asset accounts representing amounts owed to the firm as a result of sale of
goods or services in the ordinary course of business. It represents the claims of a firm against its
customers and is shown on the asset side of balance sheet under titles such as accounts receivable,
trade receivables, customer receivables or book debts.
Debt involves an element of risk and bad debts. Selling goods on credit results in blocking
of funds in accounts receivable, and therefore, additional funds are required for the operating needs
of the business, which involve extra costs in terms of interest. Increase in receivables also increases
chances of bad debts. The goal of receivables management is to maximise the value of the firm by
achieving a trade-off between risk and profitability.
The purpose of receivables is directly connected with the objectives of making credit sales.
These are:
(i) Achieving growth in sales

(ii) Increasing profits and
(iii) Meeting competition.
The overall objective of committing funds to receivables is to generate a large flow of
operating revenue and hence profit than what would be achieved in the absence of no such commitment.
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COST ANALYSIS ON RECEIVABLES
The various kinds of costs, which have to be incurred to effect sales on credit or maintaining
receivables, are discussed hereunder.
(a) Capital Costs
The production and selling costs can be described as the capital costs pertaining to credit sales.
Funds are required for the purchase of materials, payment of wages, overhead expenses etc.,
immediately, whereas receipts against sale of the products are deferred till collection from
debtors. Maintaining of accounts receivable results in blocking of the firm’s financial resources
in them. The firm has to arrange for additional funds to meet its own obligations, such as
payment to employees, suppliers of raw materials etc., while waiting for payment from its
customers. Additional funds by way of overdraft to finance credit sales will be necessitated. A
cost is associated with such borrowing in the form of interest to the outsider. Even if a business
finances credit sales out of its own resources it bears opportunity costs.
(b) Collection Costs
The firm has to incur costs for collecting payments from its credit customers. It will have to
engage additional staff for the management of receivables. Reminders have to be sent, they
may have to be contacted over phone, their queries, if any, have to be attended. Sometimes,
additional steps may have to be taken to recover money from defaulting customers.
(c) Administrative costs
The firm has to incur additional administrative costs for maintaining accounts receivable in the
form of salaries to the staff kept for maintaining accounting records relating to customers, cost
of conducting investigations regarding potential credit customers to determine their credit
worthiness etc.
(d) Delinquency Costs
In a business, there is always a category of customers who do not settle their dues despite
reminders. Costs incurred in prodding such customers through repeated letters, telexes, faxes
and personal contacts are known as delinquency costs.
(e) Default Costs
Sometimes, after making all serious efforts to collect money from defaulting customers, the firm
may not be able to recover the overdue because of the inability of the customers. Such debts
55
are treated as bad debts and have to be written off since they cannot be realised. A bad debt
is known as default cost. It constitutes a heavy drain on the cash flow of the business since it
encompasses all types of above costs.
Credit period:
It refers to the time duration for which credit is extended to the customers. It is generally
expressed in terms of a net date. Eg. The credit term ‘net 15’ means the customers have to pay
within 15 days from the date of credit sale.
Cash Discount:
Cash discounts are offered by firms to their customers for encouraging them to pay their
dues before the expiry of the credit period. The terms of cash discount indicate the rate of discount
as well as the period for which the discount has been offered. Eg. The term “2/10 net 30” indicates
that the credit period is 30 days but 2% discount will be given if the customer pays within 10 days.
Allowing cash discount is a drain on the profit of the firm because of recovery of less amount than
what is due from the customer, but it reduces the volume of receivables and puts extra funds at the
disposal of the firm for alternative profitable investment. A cost-benefit analysis is applied here.
CREDIT POLICY
The credit policy followed by a business is crucial to its cash flow. A liberal credit policy is
expansionary in nature, resulting in increase in sales and profit, but it requires relatively more cash to
be tied up with the customers for a longer period. This results in deceleration in the cash inflow. A
business is required to make payments to suppliers for the additional procurement of materials and
disbursement of wages resulting in acceleration of cash outflow. A stringent and tight credit policy
restricts trade debts to the limited few who have been screened well. It shortens the ‘time gap’ and
there are lesser risks of bad debts.
Profitability of the firm increases on adoption of a liberal credit policy on account of increased
sales, but such a policy results in increased investment in receivables, increased chances of bad debts
and higher collection costs. This reduces the liquidity. In contrast to the above, a stringent credit policy
reduces the profitability, but increases the liquidity of the firm. The optimum investment in receivables
will be at a level where there is a trade off between costs and profitability.
56
Profitability
Cost & benefits
Liquidity
Optimum Credit Policy

Tight Credit Policy Liberal
The credit policy variables of a business are its Credit Standards, Credit Terms and
Collection Policies.
CREDIT ANALYSIS
Credit analysis provides details of ageing of debts. Debts or receivables can be categorised
into three as follows:
(a) Due Debts
These are debts, which have become due as per the terms and conditions of the agreed contract.
In the case of a credit on terms ‘net 30’, amount which remain unpaid from 31st day onward
shall be considered as due debts.
(b) Undue Debts
These are debts, which have come into existence, but have not become due as per the terms
of the contract. This means that the amount will not become due till the expiry of the number
of days as per the agreement.
(c) Overdue Debts
The debts which remains unsettled even after lapse of a long period after the due date are
called overdue debts.
SUMMARY
The meaning of receivables, its purposes and the cost analysis of receivables which have to
be incurred to effect sales on credit or maintaining receivables are discussed. Credit policy and credit
analysis are the other chief areas which are explained in detail in the chapter.
57
QUESTIONS
1. What is the meaning and purposes of receivables?

2. Explain cost analysis on receivables.
3. Explain credit policy.
4. What is credit analysis?
58
CHAPTER - VI
MANAGEMENT OF INVENTORY
OBJECTIVES
The reader should get an overall idea of inventory with its different categories, benefits and
risks of holding, cost of holding, objectives of inventory management and also its different tenchiques.
INTRODUCTION
Inventory is an important and valuable asset. Inventories, like receivables, represent a very
large portion of a firm’s current assets. Inventory covers a wide variety of items, which are meant to
be procured, used up and sold in the ordinary course of business.
The items forming inventories can be grouped into three categories:
(i) Raw materials

(ii) Work-in-process
(iii) Finished goods.
Raw material inventory represents the items of basic input for processing.
Work-in-process covers all items, which are at various stages of production process.
This is an intermediary item between raw materials and finished goods. i.e., these items
have ceased to be raw material but have not developed into final products and are at various stages
of semi-finished levels.
Finished goods are completed products awaiting sale. They are final output of the
production process in a manufacturing firm.
The levels of raw materials, work-in-process and finished goods differ depending upon the
nature of the business. Inventories form a link between production and sale of a product. The money
blocked in inventories is substantial, and monitoring the movement of this asset requires considerable
attention from the finance manager. Good inventory management is good finance management. A
company should maintain adequate stock of materials of right quality at minimum cost so that they
are issued to production when needed in order to have uninterrupted flow of production. Inadequate
inventories will disturb the production line and result in loss of sales.
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BENEFITS OF HOLDING INVENTORIES
The specific benefits of holding inventories are:
Avoiding losses of sales : Without required goods on hand, which are ready to be sold, most
firms would lose business. i.e., if the firm maintains adequate inventories, it can avoid losses
on account of losing the customers for non-supply of goods in time. Shelf stock is items that
are stored by the business and sold to the customers, with little or no modification, such as
automobile. Customers may specify minor variations, but the basic item from the factory now
available on stock is sold as a standard item.
Quantity discounts: Suppliers offer reduction in price for making bulk purchases to their
customers. Maintenance of large inventories in selected product lines enables the firm to make
bulk purchase of goods at large discounts.
Reducing Ordering cost : Each time a firm places an order, it incurs certain expenses. The
variable costs associated with individual orders, such as typing, checking, approving and mailing
the order etc., can be reduced if a firm places a few large orders rather than numerous small
orders.
Achieving efficient production runs : Each time a firm sets up workers and machines to produce
an item, start up costs are incurred. Maintenance of large inventories helps a firm in reducing
the set up costs associated with each production run. For example, if the set up cost is
Rs.20,000 and the run produces 2000 units, the cost per unit comes to Rs.10. If the number
of units produced is 20000 then the set up cost per unit comes down to Re.1 per unit. Frequent
setups produce high set up costs, and longer runs (i.e., producing more no. of units) involve
lower costs.
Reducing risk of production shortages : If any critical component for the production is not
available when required, the entire production operation will be halted, with consequential heavy
losses.
RISKS OF HOLDING INVENTORIES
The following are the risks associated with holding inventories:
i. Reduction/decline in market price

This is dependent upon the market supply of the product, introduction of a new competitive
product and price-cutting by the competitors etc.
60
ii. Deterioration of product
Product deterioration may be caused due to holding a product for too long a period or improper
storage conditions.
iii. Obsolescence of product

The changes in customers’ tastes, introduction of new production techniques, improvements in
the product design, specifications etc., may lead to obsolescence of the product.
COST OF HOLDING INVENTORIES
The costs associated with holding of inventories can be broadly classified into two.
Direct costs and indirect costs
The direct costs of holding inventories are as follows:
(a) Materials cost: These are the costs of purchasing the goods including transportation and
handling charges less any discount allowed by the supplier of goods.
(b) Ordering cost: It refers to the variable costs associated with placing an order for the goods.
The fewer the orders, the lower will be the total ordering cost for the firm. The ordering cost
per order remains more or less constant irrespective of the size of the order although
transportation and inspection costs may vary to a certain extent depending upon order size.
i.e., ordering costs are invariant to the order size. The total ordering costs can be reduced by
increasing the size of the orders.
For Example, if the demand of material for the year is 10000 units and the cost associated
with placing one order is Rs.1,000, then the total ordering costs associated with placing of orders of
different lots (no. of units in one order) is as follows.
Size of order No.of orders per annum Total ordering cost(@ Rs.1,000 per order)
(units) (Demand/size of order) (No.of orders x Rs.1,000)
10000 1 1,000
5000 2 2,000
2000 5 5,000
1000 10 10,000
It can be seen from the above table that a company can reduce its total ordering costs by
increasing the order size which in turn will reduce the number of orders. But then, it is followed by
an increase in carrying costs.
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(c) Carrying cost: This refers to the expenses for storing the goods. It comprises storage costs,
insurance costs, rent and depreciation of warehouse, salaries of storekeeper, security personnel,
spoilage costs, taxes, cost of funds tied up in inventories etc.
Carrying costs are taken as a percentage of the value of inventory held in the warehouse,
despite some of the fixed elements of costs, which comprise only a small portion of total carrying
costs.
In continuation to the example under ordering costs, let the price per unit of material be
Rs.50. Suppose on an average about half of the inventory will be held in storage and the carrying
cost or holding cost for the firm is 15%. Then the computations at different sizes of order(units) will
be as under.
Size of order Average value of inventory Carrying cost @ 15%

(No.of units) ( No.of units / 2 ) (Avg. value x 15%)
Rs.
10000 5000 750.00
5000 2500 375.00
2000 1000 150.00
1000 500 75.00
It is evident from the above, that as the order size increases the carrying cost also increases
in direct proportion.
The indirect costs of holding inventory are:
(a) Cost of funds tied up in with inventory: This is an opportunity cost, in the sense that the
firm has lost the use of funds for other purposes. Whenever a firm commits its resources to
inventory, it is using funds that otherwise might be available for other purposes.
(b) Cost of running out of stocks: This is also known as stock-out cost. These are costs
associated with the inability to provide materials to the production department and inability to
provide finished goods to the marketing department as the required quantity of inventories are
not available.
OBJECTIVES OF INVENTORY MANAGEMENT
The main objectives of inventory management are:
a) to ensure that the materials are available for use in production as and when required,
facilitating uninterrupted production,
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b) to maintain sufficient stock of raw materials in periods of short supply,
c) to ensure that inventory of finished goods is adequate to fulfil the customers’ orders as per
committed delivery schedules,
d) to optimise the investment in inventories and
e) to protect the inventory from deterioration and obsolescence by providing for proper
warehousing and insurance.
INVENTORY MANAGEMENT TECHNIQUES
We have already seen that while the total ordering costs can be decreased by increasing
the size of order, the carrying costs increase with the increase in order size, indicating the need for a
proper balancing of these two types of costs behaving in opposite directions with changes in size of
the order. Effective inventory management requires an effective control over inventories. Inventory
control refers to a system, which ensures supply of required quantity and quality of inventories at the
required time and at the same time prevents unnecessary investment in inventories.
The following are the various techniques of inventory control:
(a) Determination of Economic Ordering Quantity (EOQ)
Determination of EOQ means determination of the right quantity to be purchased. It is

important to note that only the correct quantity of materials is to be purchased. There should not be
any over stock or stock-out. A balance is to be maintained between the cost of carrying and non-
carrying costs ( i.e., cost of stock-out). EOQ is the quantity fixed at the point where the total cost
of ordering and the cost of carrying the inventory would be the minimum. If the quantity of purchases
is increased, the cost of ordering decreases while the cost of carrying increases. If the quantity of
purchase is decreased the cost of ordering increases while the cost of carrying decreases. The total
of both the costs should be kept at minimum. The behaviour of the ordering and carrying costs is as
follows:
Total Cost
EOQ
Cost Carrying Costs
Quantity ordered
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(b) Determination of Re-order level
This is with regard to the timing of purchase. i.e., as to when to purchase. Re-order level is
that level of inventory at which the firm should place an order to replenish the inventory. In case, the
order is placed at this level, the new goods will arrive before the firm runs out of goods to sell. This is
the point fixed between the maximum and minimum stock levels and at this time, it is essential to
initiate purchase action for fresh supplies of materials. In order to cover the abnormal usage of materials
or unexpected delay in delivery of fresh supplies, this point will usually be fixed slightly higher than
the minimum stock level. The following factors are considered while fixing the re-order level: (i)
maximum usage of materials, (ii) maximum lead time, (iii) maximum stock level and (iv) minimum
stock level.
The term lead time refers to the time normally taken in receiving the delivery of inventory
after the order has been placed.
Re-order level = Average usage x Lead time
For example, if the lead time is 3 weeks and the average usage is 100 units per week, the
re-order level = 3 weeks x 100 units = 300 units.
Safety Stock: In computing re-order level, it is presumed that there is no uncertainty regarding
the usage as well as the lead time. However, in actual practice, it is almost impossible to correctly
predict both of them. The actual usage as well as the lead time may be different from the normal
usage or the normal lead time. In order to guard against such a contingency, the firm maintains the
minimum of buffer stock as a cushion against possible increase in usage or delay in delivery time.
This is called safety stock.
Safety Stock = Average usage x Period of Safety Stock
If safety stock is maintained, then

Re-order level = Lead time x Average usage + Safety stock.
Danger Level : This is the level below the minimum stock level, at which point immediate
action is needed for replenishment of stock. As the normal lead time is not available, regular purchase
procedure cannot be adopted resulting in higher purchase cost. Hence this level is useful for taking
corrective action only. If danger level is fixed below the re-order level and above the minimum
level, it will be possible to take preventive action.
(c) ABC Analysis
ABC analysis is the technique of exercising selective control over inventory items. It is a
method of material control according to value. It is based on the assumption that a firm should not
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exercise the same degree of control on all items of inventory. The basic principle is that high value
items are more closely controlled than the low value items. Accordingly, the materials are grouped
according to the value and frequency of replenishment during a period.
Category ‘A’ items Constitutes small percentage of the total items,

but having higher values.
Category ‘B’ items More percentage of the total items,
but having medium values.
Category ‘C’ items High percentage of the total items,
but having low values.
Example:
Category % of total value %of total quantity
A 75 5
B 20 15
C 5 80
z
100 y
95
x
75
Percentage of
Consumption value
o
0 5 20 50 100
Percentage of number of items
Here, o-x represents ‘A’ class items, x-y represents ‘B’ class items and y-z ‘C’ class items.
The general procedure for classifying A, B and C items is as follows:
Ascertain the cost and consumption of each material over a given period of time.
Multiply unit cost by estimated usage to obtain net value.
List out all the items with quantity and value.
Arrange them in descending order in value.
Ascertain the monetary limits for A, B and C classification.
Accumulate value and add up number of items of A items.
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Advantages of ABC analysis
The following are the advantages from adoption of ABC analysis as inventory control
technique:
Minimisation of purchasing cost and carrying cost (or holding cost).
Ensuring availability of supplies at all times.

Reduction in clerical costs.
Closer control on items, which represent a high proportion of total stock value.
Maintenance of optimum level of inventory, thereby investment in inventory can be regulated.

Category ‘A’ items will be ordered more frequently and as such the investment in inventory
is reduced.
Equal attention to the three categories of items is not desirable, as it is expensive.

ABC analysis is based on the concept of Selective Inventory Management.
It helps in maintaining a high stock-turnover ratio.
(d) Inventory Turnover Ratios
Turnover ratio of each item of inventory can be calculated on the basis of the following formula:
Inventory turnover ratio = Cost of goods consumed/sold during the period
Average inventory held during the period
Comparison of inventory turnover ratios of different items of inventory with the ratios of the
earlier years as well as with each other reveals the following four types of inventories.
Slow moving inventories: These refer to inventories, which have a low turnover ratio. This
type of inventories is to be kept at the lowest level.
Dormant inventories : These are inventories, which have no demand. These may be scrapped
and sold for some value or may be kept if there is good chances of future demand.
Obsolete inventories : These are inventories, which are no longer in demand because they
have become out of date. They should be discarded or scrapped.
Fast moving inventories : These are items with good demand. Special care should be taken
in respect of these items of inventories, so that production or sales do not suffer on account of their
shortage.
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Apart from the above inventory management techniques, there are other selective control
measures as follows:
v VED analysis( Vital, Essential, Desirable),

v Just-in-Time (JIT), SDE analysis for procurement of materials(Scarce, Difficult, Easy),
v XYZ analysis for value of items in storage(X= items whose inventory values are high, Y =
inventory values are medium and Z = inventory values are low),
v SOS analysis of raw materials (Seasonal items, Off-Seasonal items),
v GOLF analysis of supply of materials (Government suppliers, Open suppliers, Local suppliers,
Foreign sources) and
v HML analysis for unit price of material(High, Medium, Low).
SUMMARY
The chapter explains inventories with its different categories. This is followed by benefits,
risks and cost of holding inventories. The chapter also has the objective of inventory management
and its different techniques.
QUESTIONS
1. What are Inventories? Explain

2. What are the benefits and risks of holding inventories?
3. Explain briefly EOQ and determination of RC order level as techniques of inventory
management level.
4. Explain in detail ABC analysis.
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CHAPTER - VII
FINANCIAL ANALYSIS AND PLANNING
OBJECTIVES
The chapter is to familiarise the reader with Financial Statements and its limitations. It also
helps the reader to understand financial statement analysis and tools of financial analysis.
INTRODUCTION
To make rational decisions in keeping with the objectives of the firm, the finance manager
must have certain analytical tools. The firm itself and outside suppliers of capital - capital and creditors
- all undertake financial analysis. The firm’s purpose is not only internal control but also better
understanding of what capital suppliers seek in financial condition and performance from it.
FINANCIAL STATEMENTS
A financial statement is an organised collection of data according to logical and consistent

accounting procedures. Its purpose is to convey an understanding of some financial aspects of a
business firm.
The following are the basic financial statements:
(i) The Income Statement,

(ii) The Balance Sheet,
(iii) Statement of Retained Earnings and
(iv) Statement of changes in Financial position.
The income statement measures profitability. The balance sheet shows assets and the financing
of those assets. The statement of changes in financial position, especially the cash flows indicates the
change in the cash position of the firm.
Statement of Retained Earnings is a connecting link between the Balance Sheet and the
Income Statement. In fact, it is a display of things that have caused the beginning of the period
retained earnings balance to be changed into the one shown in the end of the period balance
sheet. Statement of Retained Earnings is also termed as Profit and Loss Appropriation Account.
Statement of changes in Financial Position: This statement shows the movement of

working capital or cash in and out of the business.
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(i) Funds Flow Statement shows change in the firm’s Working Capital,
(ii) Cash Flow Statement shows change in the firm’s Cash position and
(iii) Statement of Changes in Financial Position shows the change in the firm’s total financial
position.
According to the American Institute of Certified Public Accountants(AICPA), financial

statements reflect “a combination of recorded facts, accounting conventions and personal judgements
and these judgements and conventions applied affect the data materially”. In other words, the data
contained in the financial statements are affected by recorded facts, accounting conventions and
personal judgements.
Recorded facts: It means facts which have been recorded in the books of accounts. Facts
which have not been recorded in the financial books do not find place in financial statements,
however material they might be.
Accounting conventions : Certain fundamental accounting principles are sanctified by long usage.
However, the real financial position of the business may be much better than what has been
depicted by the financial statements.
Personal judgements : The financial statements are influenced by the personal judgements of
the accountants. Eg. the choice of method of depreciation is at the discretion of the accountant.
LIMITATIONS OF FINANCIAL STATEMENTS
There are some limitations to the use of financial statements in achieving the objectives as
follows.
a) Financial statements are essentially interim reports
The exact profit earned by the business and the exact financial position of the business can be
known only when the business is closed down and not through the Profit & Loss Account and
the Balance Sheet prepared periodically. There will be some ambiguity or inaccuracy in
determining the existence of contingent liabilities, deferred revenue expenditure etc.
b) Accounting concepts and conventions
Because of the accounting concepts and conventions followed, the financial position as disclosed
by the Profit & Loss Account and Balance Sheet may not be realistic. For example, in the
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Balance Sheet, the value placed on the fixed asset may not be the same which may be realised
on their sale. Also, in Income Statement, true income of the business may not be disclosed,
since probable losses are considered while probable incomes are ignored.
c) Influence of personal judgement
Accountants/business differ in treatment of certain items, such as method of depreciation, mode

of amortisation of fixed assets, treatment of deferred revenue expenditure. However, indiscreet
personal judgements are overridden by the convention of consistency.
d) Disclose only monetary facts
Financial statements are made up of only monetary facts, whereas the business survives on many
other non-monetary factors such as human capital, enlightened management, reputation of
management with the public etc.
FINANCIAL STATEMENT ANALYSIS
Financial statements are indicators of the two significant factors viz., profitability and
financial soundness.
The term analysis means methodical classification of the data given in the financial statements.
The figures in financial statement, by itself, do not give much meaning unless they are put in a simplified
form. For example, all items relating to ‘Current Assets’ are put at one place while all items relating
to ‘Current Liabilities’ are put at another place. Also, the type of analysis varies according to the
specific interests of the party involved. Trade creditors are interested primarily in the liquidity of a
firm. Their claims are short- term, and anything that shows the liquidity is an indicator of the firm’s
ability to pay their claims. The claims of debenture-holders are long-term and they are more interested
in the cash-flow ability of the firm to service debt over the long run. Shareholders, on the other hand,
are concerned principally with present and expected future earnings and the stability of these earnings
and in variance with the earnings of other companies. They are concerned with the profitability of
the firm.
Apart from the above, others who are interested in the information are the government
regulators. They are concerned with the rate of return the company earns on its assets as well as
with the proportion of non-equity funds employed in the business.
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The required information for the different category of people who are interested with the
company differs and thus, the type of financial analysis undertaken varies according to the specific
interests of the analyst. Financial statement analysis is part of a larger information processing system
on which informed decisions can be based.
Whatever be the financial statement and whoever be the interested groups, jobs do not end
just with the analysis of financial statements, until it is properly interpreted for the use.
The analysis of the financial statements is done through:
i) Methodical classification of the data given in the financial statements and

ii) Comparison of the various inter-connected figures with each other by different “Tools of
Financial Analysis”.
TOOLS OF FINANCIAL ANALYSIS
The various tools or methods of Financial Analysis are as follows:
a) Comparative Financial Statements
In these statements, figures for two or more periods are placed side by side to facilitate
comparison. Both the Income Statement and Balance Sheet can be prepared in the form of
Comparative Financial Statements. The American Institute of Certified Public Accountants has
explained the utility of preparing the Comparative Financial Statements as follows:
“ The presentation of comparative financial statements in annual and other reports enhance
the usefulness of such reports and brings out more clearly the nature and trend of current changes
affecting the enterprise. Such presentation emphasises the fact that statements for a series of periods
are far more significant than those of a single period and that the accounts of one period are but an
installment of what is essentially a continuous history. In any one year, it is ordinarily desired that the
Balance Sheet, the Income Statement and the Surplus Statement be given for one or more preceding
years as well as for the current year.”
In India, the Companies Act, 1956, provides that companies should give figures for different
items for the previous period, together with current period figures in their Profit and Loss Account
and Balance Sheet.
b) Trend Percentages
Trend percentages are calculated for making a comparative study of the financial statements
for several years. Usually the earliest year is taken as the base year and a relationship is established
with percentages of each item of each of the years.
71
However, the defect of this tool is that trend percentages are not calculated for all the items
in the financial statements, instead, they are usually calculated only for major items since the purpose
is to highlight important changes.
c) Funds Flow Analysis
Funds flow analysis is an important analytical tool of financial analysts, credit granting
institutions and financial managers. Funds flow analysis reveals the changes in working capital position.
It reveals the sources from which the working capital was obtained and the purposes for which it
was used. The technique and procedure involved in funds flow analysis have been discussed in
detail later in this study material.
d) Ratio Analysis
A ratio shows the relationship in mathematical terms between two interrelated accounting
figures. The financial analyst may calculate different ratios for different purposes. There is detailed
discussion on Ratio Analysis later in this study material.
SUMMARY
Financial Analysis and planning helps to make rational decision in keeping with the objectives
of the form with the help of some analytical tools. The Financial Statement is an organised collection
of data with different basics. It has certain limitations. Financial Statement Analysis are indicates of
profitability and Financial Soundness. There are various methods of Financial Analysis like comperative
Financial Statement, Trend Persentages, Funds Flow Analysis and Ratio Analysis.
QUESTIONS
1. What is Financial Statements and what are its limitations?
2. What is Financial Statement Analysis?
3. What are the tools of Financial Analysis?
72
CHAPTER - VIII
FUNDS FLOW ANALYSIS
OBJECTIVES
The reader will have to be acquanited with funds flow statement, uses and preparation of
funds flow statements.
INTRODUCTION
There is a continuous change in the assets, liabilities, income and expenses during the course
of business operations. A statement showing the increases or decreases in different related accounts
for a specified period of time is called a funds flow statement.
Funds flow analysis touches upon an important problem of financial management, viz., how
the business is procuring and using the funds. The flow of funds in a firm is a continuous process. For
every use of funds, there must be an offsetting source. The assets of a firm represent the net uses of
funds and its liabilities and net work represent net sources.
FUNDS FLOW STATEMENT
This is one type of statement of flow of funds widely used by financial analysts, credit granting
institutions and financial managers. The Income Statement and the Balance Sheet have limited role to
perform as far as the question of analysis of financial position is concerned.
The term ‘funds’ has a variety of meanings. It may be taken as ‘cash’, and in that case,
there is no difference between a Funds Flow Statement and a Cash Flow Statement. The International
Accounting Standard on ‘Statement of Changes in Financial Position’ recognises the absence of single,
generally accepted, definition of the term. As per IAS, the term ‘fund’ refers to cash and cash
equivalents or to working capital. Here, with regard to working capital, it means net working capital.
The term ‘flow’ means change and the term ‘flow of funds’ means ‘change in funds’ or
‘change in Working Capital’. This means that any increase or decrease in working capital is ‘Flow of
Funds’. In business some transactions cause increase of funds while others decrease the funds, and
some may not make any change in the position of funds. Where a transaction results in increase of
funds, it is called a ‘source of funds’ and where a transaction results in decrease of funds, it is an
‘application or use of funds’. For example, in case of issue of shares, the transaction increases the
funds, and in case of purchase of plant and machinery, funds stands reduced. The first transaction
causes funds to increase or it is the source of funds, and the latter transaction causes funds to decrease,
and it is, therefore, an application or use of funds.
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The funds flow statement is a method by which we study the net funds flow between two
points in time. These points conform to beginning and ending financial statement dates for whatever
period of examination is relevant - a quarter or a half-year or a year.
A funds-flow cycle for a typical manufacturing company is depicted below:
Shareholders'
equity Debt
Dividends and
Repurchase of shares Loans
Investments CASH Loan Repayments
Payment for
Collections purchases
Accounts
Accounts
Payable
Receivable
Collections Sale of assets

Cash sales
Purchase of assets
Payment of
Wages & expenses
Wages & Net Fixed Raw
Expenses o/s Assets Materials
Selling & Admn.

expenses
Finished Goods Labour

Inventory
Expenses Depreciation
Work-in-
Process
1: FUNDS FLOW CYCL
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The summarised balance sheet of a company as at the close of an accounting period is given
below:
Non-current Liabilities Rs. Non-current assets Rs.
10% Pref. Share Capital 1,10,000 Machinery 2,10,000

Equity Capital 2,50,000 Building 1,26,000
Share Premium 26,000 Land 18,000
P & L Account 1,34,000 Long-term investments 70,000
Long-term Loans:
12% Debentures 64,000
Total Non-Current Liabilities 5,84,000 Total Non-Current Assets 4,24,000
Current Liabilities: Current Assets:

Creditors 46,000 Cash 32,000
Bills Payable 4,000 Debtors 38,000
Bank overdraft 12,000 Bills receivable 62,000
Outstanding expenses 8,000 Stock in hand 98,000
Total Current Liabilities 70,000 Total Current Assets 2,30,000
Total Liabilities 6,54,000 Total Assets 6,54,000
The net working capital of the company is Rs.1,60,000. (ie., Current Assets - Current
Liabilities, i.e., Rs.2,30,000 - Rs.70,000). There will be said to be a flow of funds in case the working
capital position of the company changes on account of any transaction.
Let us consider some transactions and their effect on the working capital position of the
company.
a) Issue of shares Rs.1,00,000 in cash
This will increase the cash balance of the company to the same extent. The total cash balance
becomes Rs.1,32,000. However, there is no change in the current liabilities position. Then,
the new working capital will be Rs.2,60,000 (i.e., Rs.3,30,000 - Rs.70,000) evidencing increase
in working capital. This means that issue of shares in cash increases the working capital.
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b) The firm sells one of its building for Rs.30,000. The book value of the same
is Rs.25,000.
This sale transaction increases the working capital, as the cash balance increases to the extent
of Rs.30,000, and thus the current assets to Rs.3,60,000 while the total current liabilities remain
the same. The new working capital will be Rs.2,90,000 (i.e., Rs.3,60,000 - Rs.70,000). Here,
building is a non-current asset and cash is a current asset.
c) Realisation of debtors to the extent of Rs.15,000
This transaction reduces the debtors to Rs.23,000 ( i.e., Rs.38,000 - Rs.15,000) and cash
balance increases by Rs.15,000. However, both debtors as well as cash balance are current
assets. i.e, both these accounts fall on the same side of the balance sheet. The effect is that
one component of current asset is reduced and another component of current asset increased,
with the result, the current assets remain unaltered.There is no change in the working capital
position of the firm.
d) Creditors are paid cash Rs.5,000
This transaction reduces the cash balance by Rs.5,000. The new cash balance will be
Rs.27,000 and thus the reduced current asset will be Rs.2,25,000. As the creditors are paid
Rs.5,000, creditors balance gets reduced to Rs.41,000, and this reduces the total current
liabilities to Rs.65,000. Then the new working capital will be Rs.1,60,000 ( i.e., Rs.2,25,000
- Rs.65,000). Thus, the transaction has not resulted in any change in the working capital
position. This is because the two accounts involved in the transactions, viz., creditors and cash
are the constituents of working capital itself.
e) Purchase of machinery worth Rs.15,000 by raising long-term loan
Machinery is a non-current asset and long-term loan is non-current liability. Therefore, the
above transaction will not have any effect on the working capital position.
Generalising the above and other similar transactions, we have the following set of rules with
regard to the working capital position.
(A) There will be flow of funds if a transaction involves:

(i) Current Assets and Fixed Assets
(ii) Current Assets and Capital
(iii) Current Assets and Fixed Liabilities
(iv) Current Liabilities and Fixed Liabilities
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(v) Current Liabilities and Capital
(vi) Current Liabilities and Fixed Assets
(B) There will be no flow of funds if a transaction involves:
(i) Current Assets and Current Liabilities
(ii) Fixed Assets and Fixed Liabilities
(iii) Fixed Assets and Capital
The funds flow statement can best be comprehended from the given diagram:
FIXED LIABILITIES FIXED ASSETS
Share Capital Land and Building

Reserves and Surplus Plant and Machinery
Debentures Goodwill
Long-term Loans Furniture & Fixtures
Long-term Investments
CURRENT ASSETS
CURRENT
LIABILITIES Cash & Bank balances
Marketable
Investments
Creditors Accounts Receivables
Bank Overdraft Stocks
Outstanding Expenses
Prepaid Expenses
Accounts Payable
Fig 2 : FUNDS FLOW DIAGRAM
Legend: Flow of funds
No flow of funds
77
USES OF FUNDS FLOW STATEMENT
Funds flow statement is a tool for analysis and understanding changes in the distribution of
resources between two balance sheet dates. The uses of funds flow statement are as follows:
It explains the financial consequences of business operations.
It gives reasonable answers for intricate queries such as regarding the overall creditworthiness
of the business, the sources of repayment of the term loans, funds generated through normal
business operations, utilisation of funds etc.
It acts as an instrument for allocation of resources.
It serves as a test of effectiveness or otherwise use of working capital.
PREPARATION OF FUNDS FLOW STATEMENT
q Sources of Funds : There are internal as well as external sources of funds.
Internal Sources: The only internal source of funds is funds from operations.
The following adjustments are made to the Net Profit to find out the funds from operations.
Add: (i) Depreciation on the fixed assets.

(ii) Preliminary expenses, goodwill etc., written off.
(iii) Contribution to debenture redemption fund, transfer to general reserve etc., if they have
been deducted before arriving at the figure of net profit.
(iv) Loss on sale of fixed assets.
These items do not result in outflow of funds.
Note: Provision for taxation and proposed dividend are not taken as current liabilities for
the purpose of Funds Flow Statement.
Less: (i) Profit on sale of fixed assets.

(ii) Profit on revaluation of fixed assets.
(iii) Non-operating incomes like dividend received, accrued dividend, refund of income
tax, rent received or accrued rent etc.
These items do not increase funds.
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Illustration.1:
Compute funds from operations

Profit & Loss Account
Rs. Rs.
To Salaries & Allowances 1,00,000 By Gross Profit 33,000
To Depreciation 25,000 By Rent 1,00,000
To Rent 40,000 By Int. on investments 80,000
To Preliminary expenses 35,000 By net loss 87,000
To Loss on sale of land 1,00,000
3,00,000 3,00,000
Solution:
Funds from operations
Net loss as per Profit and Loss Account (Rs.87,000)
Add: Items which do not decrease funds:
Depreciation Rs. 25,000
Loss on sale of land Rs.1,00,000
Preliminary expenses Rs. 35,000 Rs.1,60,000
Funds from operations Rs. 73,000
External Sources :
(i) Funds from Long-Term Loans: Long-term loans such as debentures, borrowings from
financial institutions will increase the working capital. Therefore, there will be flow of funds.
But, if the debentures have been issued in consideration of some fixed assets, there will be
no flow of funds.
(ii) Sale of land and building, long-term investments will result in generation of funds.
(iii) Issue of shares for cash increases working capital.
q Application of funds : Funds are utilised for purposes such as:

(i) Acquisition of fixed assets: Purchase of fixed assets such as land and building, plant and
machinery and long-term investments etc., results in depletion of current assets without
affecting the current liabilities.
(ii) Dividend Payments: Payment of dividend results in reduction of fixed liability.
(iii) Payment of fixed liabilities.
(iv) Payment of tax.
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SUMMARY
Funds flow analysis is an important problem of Financial Management, like procuring and
using business funds. funds flow statemetns is used by financial analysts, credit granting institutions
and financial managers. The funds flow statement is a method by which we study the net funds flow
between two points in time. This is a tool for analysis and understanding changes in the distribution of
resources, between two balance sheets. The chapter also deals in detail with the preparation of funds
flow statement.
QUESTIONS
1. What is funds flow statement?
2. Explain funds flow cycle for a typical manufacturing company with a diagram.
3. Explain funds flow statement with a diagram.
4. Explain the preparation of funds flow statement.
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CHAPTER - IX
CASH FLOW STATEMENT
OBJECTIVES
After going through this chapter the reader should get an idea of the sources of cash,
application of cash, difference between cash flow analysis and funds flow analysis and also the uses
of cash flow analysis.
INTRODUCTION
A cash flow statement depicts the change in cash position from one period to another. It
explains the reasons for inflows or outflows of cash, and helps the management in making future plans.
A projected cash flow statement or a cash budget will help the management in ascertaining future
cash requirements to meet the obligations to creditors, payment of bank loans and payment of dividend
to the shareholders. Planning of cash resources enables the management in managing situations of
cash shortage or to find productive avenues in case of surplus cash etc.
q Sources of Cash:
Sources of cash can be both internal as well as external.
] Internal Sources :
The main internal source of cash is cash from operations. To find cash from operations, the
profit available as per the Profit & Loss account is to be adjusted for non-cash items, such as
depreciation, amortisation of intangible assets, loss on sale of fixed assets and creation of reserves
etc. This is computed just like computation of ‘funds’ from operations as explained under Funds
Flow Analysis. However, to find out the real cash from operations, adjustments will have to be
made for ‘changes’ in current assets and current liabilities arising on account of operations.
When all transactions are cash transactions, then,

Cash from operations = Net Profit.
When all transactions are not cash transactions, then, it involves the following two steps:
(i) Computation of funds(i.e., working capital) from operations as in Funds Flow Analysis.
(ii) Adjustments in the funds so calculated for changes in the current assets (excluding cash)
and current liabilities.
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The following adjustments have to be made for each of the changes in Current Assets and
Current Liabilities to find out cash from operations.
(a) Where there are credit sales:
+ Debtors outstanding at the

beginning of the accounting year
Cash from operations = Net Profit OR
- Debtors outstanding at the
end of the accounting year.
To put it in another way,
+ Decrease in Debtors
- Increase in Debtors
(b) Where there are credit purchases:
+ Decrease in Creditors
- Increase in Creditors
(c) Effect of opening and closing stocks:
+ Decrease in Stock
- Increase in Stock
(d) Effect of Outstanding Expenses, Income received in Advance etc.
+ Increase in o/s expenses

+ Increase in income received
in advance
Cash from Operations = Net Profit
- Decrease in o/s expenses
- Decrease in income received
in advance.
(e) Effect of Prepaid Expenses and Outstanding Incomes:
+ Decrease in prepaid expenses

+ Decrease in accrued income
Cash from Operations = Net Profit
- Increase in prepaid expenses
- Increase in accrued income
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The overall effect of factors from (a) to (e) can be summarised as under:
+ Decrease in Debtors
+ Decrease in Stock
+ Decrease in Prepaid Expenses
+ Decrease in Accrued Income
+ Increase in Creditors
+ Increase in Outstanding Expenses
Cash from operations = Net Profit
- Increase in Debtors
- Increase in Stock
- Increase in Prepaid Expenses
- Increase in Accrued Income
- Decrease in Creditors
- Decrease in Outstanding Expenses
Decrease
Increase in a Current Asset in
OR Cash
Decrease in a Current Liability
Decrease in a Current Asset Increase

OR in
Increase in a Current Liability Cash
] External Sources of Cash :

The external sources of cash are:
(i) Issue of new shares
(ii) Raising of long-term loans
(iii) Purchase of plant and machinery on deferred payment terms
(iv) Short-term borrowings from banks
(v) Sale of fixed assets, investments etc.
q Application of Cash
The application of cash may be for any of the following:

(i) Purchase of fixed assets
(ii) Payment of long-term loans
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(iii) Decrease in deferred payment liabilities
(iv) Loss on account of operations
(v) Payment of tax liabilities
(vi) Payment of dividend to shareholders
(vii) Part-payment or liquidation of unsecured loans, deposits etc.
Difference between cash flow analysis & funds flow analysis
CASH FLOW FUNDS FLOW

1. Concerned with change in cash position Concerned with change in working capital
between two balance sheet dates. between two balance sheet dates.
2. It is merely a record of cash receipts For a better understanding of short-term
and disbursements. solvency of a business, cash balance as well
as other current assets are also to be considered.
3. Serves as a financial analysis It is a financial analysis tool for a long period.
tool in short period.
4. Inflow of cash results in inflow of funds. Inflow of funds may not necessarily result
in inflow of cash.
5. An increase in a current liability or decrease An increase in a current liability or decrease
in a current asset (other than cash) results in in a current asset results in decrease in
increase in cash and vice versa. working capital and vice versa.
USES OF CASH FLOW ANALYSIS

Cash Flow Statement is a short-term planning tool. Analysis of different sources and
applications of cash help the management in making proper cash flow projections for the future. The
advantages of cash flow analysis are in the areas of:
a) Cash Management
b) Internal financial management
c) Cash movements
d) Cash planning.
SUMMARY
A cash flow statement depicts a change in cash position from one period to another. Sources
of cash can be internal as well as external. The application of cash can be for different purposes.
There are major differences betwen cash flow analysis and funds flow analysis. The major uses of
cash flow analysis are in the areas of cash management, internal financial management, cash movement
and cash planning.
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QUESTIONS
1. Explain the different sources of cash.
2. Explain the different applications of cash with examples.
3. What are the differences between cash flow analysis and funds flow analysis?
4. Explain the uses of cash flow analysis with examples.
85
CHAPTER - X
RATIO ANALYSIS
OBJECTIVES
The chapter tries to acquaint the reader with different types of ratio analysis with examples,
giving importance to advantages and disadvantages.
INTRODUCTION
Ratio Analysis was introduced by Alexander Wall in the year 1919.
Ratio analysis is a technique used by management in studying the relationship between two
figures. Accounting ratios are relationships expressed in mathematical terms between figures which
are connected with each other in some manner. Analysis and interpretation of various ratios give
experienced and skilled analysts a better understanding of the financial condition and performance of
a firm than they would obtain from analysis of the financial data alone. Though the computation of a
ratio involves only a simple arithmetic operation, its interpretation is a difficult exercise. Also, no
one ratio gives us sufficient information by which to judge the financial condition and performance of
the firm. Only when we analyse a group of ratios are we able to make reasonable judgements.
The relationship between two accounting figures is known as accounting ratio. According
to J.Batty “ the term accounting ratio is used to describe significant relationships which exist between
figures shown in a Balance Sheet, in a Profit and Loss Account, in a Budgetary Control System or in
any other part of the accounting organisation”. These ratios may be compared with the previous
year or base year ratios of the same firm. A comparison may also be made with the selective firms
in the same industry, i.e., inter-firm comparison. It is also possible to compare with the ratios of the
same industry within the country and in international market as well.
Primary Ratios and Secondary Ratios
Ratios indicating the relationship between profits and capital employed are primary ratios.
Secondary ratios give information about the financial position and capital structure of the company.
Liquidity ratios and leverage ratios are secondary ratios.
Classification of Ratios
The traditional classification is as under:
1. Profit and Loss Account Ratios: These are ratios calculated on the basis of the items of the
P & L account only such as gross profit ratio etc.
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2. Balance Sheet Ratios such as current ratio, debt equity ratio etc.
3. Composite Ratios or Inter-Statement Ratios: These are ratios based on figures of Balance
Sheet and Profit and Loss Account. Eg. Fixed assets turnover ratio, overall profitability
ratio etc.
Though some valuable information can be generated using the traditional classification, some
improved methods became necessary in order to serve as a tool for financial analysis. These are
classified as follows:
FINANCIAL RATIOS
1. Fixed Assets Ratio
2. Current Ratio
3. Liquidity Ratio
4. Debt-Equity Ratio
5. Proprietory Ratio
PROFITABILITY RATIOS
1. Overall Profiability Ratio
2. Earning Per Share
3. Price Earning Ratio
4. Gross Profit Ratio
5. Net Profit Ratio
6. Operating Ratio
7. Debt Service Coverage Ratio
8. Dividend pay-out Ratio
9. Dividend Yield Ratio
TURNOVER RATIOS
1. Fixed Assets Turnover Ratio
2. Working Capital Turnover Ratio
- Debtors Turnover Ratio
- Creditors Turnover Ratio
- Stock Turnover Ratio
Although the number of financial ratios that might be computed increases geometrically with
the amount of financial data, we concentrate only on the more important and frequently employed
ratios in this chapter.
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Current Ratio
Current Ratio indicates the firm’s ability to pay its short-term or current liabilities.
Current Ratio = Current Assets

Current Liabilities
Current assets mean assets that will either be used up or converted into cash within a year’s
time or normal operating cycle of the business whichever is longer. Current liabilities mean liabilities
payable within a year or operating cycle, whichever is longer, out of the existing current assets or by
creation of current liabilities.
Book debts outstanding for more than 6 months and loose tools should not be
included in current assets. Prepaid expenses should be taken into current assets.
The ideal current ratio is 2 ( i.e., 2 : 1). The ratio of 2 : 1 is considered as a safe margin of
solvency due to the fact that, if the current assets are reduced to half, then also the creditors will be
able to get their payments in full. A very high current ratio is not desirable, since it means less efficient
use of funds. High current ratio means excessive dependence on long-term sources of raising funds.
Long-term liabilities are costlier than current liabilities, and, therefore, this will result in considerably
lowering down the profitability of the concern.
Example 1:
From the following data compute the Current Ratio:
Rs. Rs.
Sundry Debtors 80,000 Sundry Creditors 40,000
Prepaid Expenses 40,000 Debentures 2,00,000
Short-term Investments 20,000 Inventories 40,000
Loose Tools 10,000 Outstanding Expenses 40,000
Bills Payable 20,000
Solution:
Current Ratio = Current Assets* = Rs.1,80,000 = 1.8
Current Liabilities# Rs.1,00,000
(* Sundry debtors, prepaid expenses, short-term investments and inventories;

# Bills payable, sundry creditors and outstanding expenses)
The relationship between Current Assets and Current Liabilities is disturbed on account of
a number of factors such as
Seasonal changes in the business,

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Over-trading,
Repayment of a long-term liability or
Changes made in the terms of trade.
Liquidity Ratio
This is also termed as ‘Acid Test Ratio’ or ‘Quick Ratio’.
Liquidity Ratio = Liquid Assets

Current Liabilities
Liquid assets are assets which are immediately convertible into cash without much loss.
Prepaid expenses and stock are not taken as liquid assets.
From the figures of Example 1, we can compute

Liquidity Ratio = Rs.1,80,000 - Rs.80,000 = 1
Rs.1,00,000
In a more strict sense, we may use liquid liabilities instead of current liabilities for the purpose
of ascertaining this ratio. Liquid liabilities mean liabilities which are payable within a short period.
Bank Overdraft and Cash Credit facilities are excluded from current liabilities in such a case.
The ideal ratio is 1. The ratio is an indicator of short-term solvency of the company.
Debt-Equity Ratio
Debt - Equity Ratio = Long-term Debt = Loan Funds = External Equities

Shareholders Equity Own Funds Internal Equities
Debt-equity ratio, an important tool of financial analysis, depicts an arithmetical relation
between loan funds and owners funds. This is a popular measure in the hands of investors and creditors
to assess the long-term financial solvency of a firm. This reflects the relative claims of lenders and
owners against the company’s assets.
The Equity includes Equity Share Capital, Irredeemable Preference Shares, Preference Shares
redeemable after 12 years, Share Premium, General Reserve, Profit and Loss Account. Shareholders’
equity is equal to net worth.
Debt includes preference shares redeemable within 12 years, fixed interest bearing securities
such as debentures, secured loans and unsecured loans etc.
The optimum mix of debt and equity ensures maximum return for equity shareholders and
also guarantees the servicing of debt in the interest of creditors.
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The following factors are to be considered for working out the optimum debt-equity ratio.
a) Profitability potential
b) Debt servicing potential, i.e., Interest coverage ratio.
c) Current capital market conditions and
d) The economic situation in the country.
Debt-equity ratio is one of the most critical parameters that an investor should look at for
the following reasons:
i) A medium or high ratio, say 1.5 : 1 to 4 : 1 , would indicate that the capital base is low and
this would mean higher earnings per share in the future once the debt is redeemed.
ii) A debt component also ensures that the project is appraised by a financial institution. The
latter would also monitor the utilisation of funds during the project implementation stage as
also once the company commences commercial operations.
iii) In a contrast situation, when a project is entirely financed by equity, the company loses the
flexibility of rescheduling funds in future.
iv) When a project is entirely financed by equity, the risk to the shareholders is higher as there
is no financial appraisal as the investors are not equipped to have access to monitor the
course of the project.
v) The general norm for debt to equity is 1.5 : 1. But capital intensive projects are allowed a
debt to equity of 4 :1 while finance companies can have a ratio as high as 9 : 1.
Overall Profitability Ratio
Overall Profitability Ratio is also termed as ‘Return On Investments’ (ROI) or ‘Return On

Capital Employed’ (ROCE).
This ratio indicates the percentage of return on the total capital employed in the business
and is computed using the following formula.
Operating Profit
X 100
Capital Employed
where, Capital Employed = sum-total of long-term funds employed in the business.
i.e., Share Capital + Reserves + Long-term Loans
- [Non-business Assets + Fictitious Assets].
Operating Profit = Profit before Interest and Tax
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Earning Per Share (EPS)
EPS = Profit after Tax - Preference Dividend

No. of Equity Shares
Significance:
(i) It indicates the earning power of equity share capital.

(ii) Dividend declaration is based on this ratio.
(iii) EPS is of considerable importance in estimating the market price of shares. If EPS is higher,
market value of equity share will be higher in the stock exchange.
(iv) This ratio can be improved by use of borrowed funds to a greater extent.
Gross Profit Ratio
Gross Profit Ratio = Gross Profit

Net Sales
Significance:
(i) It indicates the basic profitability of a firm, i.e., trading results of a firm.
(ii) It indicates the degree of efficiency of the production department, purchase department, sales
department and the degree of cost control (i.e., material control, labour efficiency and overhead
control).
(iii) Higher ratio indicates higher profitability.
Debt Service Coverage Ratio
Debt Service Coverage Ratio = Net profit before interest and tax
Interest + Principal payment instalment
1 - Tax rate
This ratio indicates the ability of a company to make payment of interest and principal
instalment amounts on time. The principal payment instalment is adjusted for tax effects since such
payment is not deductible from net profit for tax purposes.
Turnover Ratio
Turnover ratio indicates the number of times the capital has been rotated in the process of
doing business.
Net Sales
Fixed Assets Turnover Ratio =
Net Fixed Assests
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Working Capital Turnover Ratio N et Sales
=
W o r k in g C ap ital
Students may refer to standard text books for thorough understanding of various accounting
ratios and ratio analysis.
Advantages of Ratio Analysis
Following are some of the advantages of ratio analysis:
1. Simplifies financial statements.
2. Facilitates inter-firm comparison.
3. Makes intra-firm comparison possible.
4. Helps in planning.
SUMMARY
Ratio analysis is a techniques used by management in studying the relationship between two
figures in accounting. Primary and secondary ratios initiates the relationship between profits and capital
employed and also the financial position and capital structure of the company. There are various
clasification of ratios like profit and loss account ratio, balance sheet ratio and composit ratio. The
frequently employed and important ratios are current ratio, liquidity ratios, debt-equity ratio, over all
profitability ratio, debt service coverage ratio and turn over ratio. The advantages of ratio analysis
are also depicted.
QUESTIONS
1. What are primary ratios?

2. What are secondary ratios?
3. What are the advantages of ratio analysis?
4. What are the characteristics and uses of ratio analysis? Give examples.
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CHAPTER - XI
CAPITAL BUDGETING
OBJECTIVES
The chapter enables the reader to understand the different aspects of capital budget and its
applications. Estimation of cash flow with its classifications should be embeded in the minds of the
reader. The chapter enables the study of the value of money and capital rationing.
INTRODUCTION
A business undertaking has to face quite often the problem of capital investment decisions.
In order to carry on its operations on a continuous basis, the business requires long term facilities. It
has to have land, building, plant and machinery etc., as well as working capital with which its
manufacturing, selling and distribution operations are to be carried on.
Capital investment refers to the investment in projects whose results would be available only
after a year. In other words, when a business makes a capital investment, it incurs a current cash
outlay for benefits to be realised in the future. The investments in such projects are quite heavy and
to be made immediately, but the return will be available only after a period of time.
We know that we must judge a proposed investment by its expected return. Here it is very
much required to see how close will it come to the return required by investors. This is based on
the effect of an investment decision to the price of the shares. Before we enter into the intricacies of
such decisions, we shall understand the rudiments of capital budgeting.
The characteristics of capital investments are very important. These are:
Capital investments have long-term consequences.
Capital investment decisions have considerable impact on the future prospects/activities of the
business.
It is difficult to reverse capital investment decisions due to reasons such as:
ill-organised market for used capital investments,
capital equipment made according to the specific requirement of the capital investor.
Capital investment decisions involve substantial outlays.
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Where capital investment may be required ?
The following are some of the cases where heavy capital investment may be required.
(a) Expansion :
High demand for the product whilst having inadequate production capacity compels a firm to
resort to expansion of production capacity, necessitating additional capital investment.
(b) Replacement :
For several reasons, such as obsolescence, wearing out or becoming outdated, the fixed assets
may have to be replaced. This involves heavy capital investments.
(c) Diversification :
Diversification of business is resorted to by many businesses with the intention of reducing the
risk. Instead of concentrating or confining itself in just one product or in one market, it may
diversify into different products or different markets so as to reduce the risk. This necessitates
purchase of new machinery and other facilities to handle the new products.
(d) Research and Development :
Heavy investments are required for research and development in high-tech and growing
industries.
(e) Others :
Legal and social obligations compels a business to invest heavily in various facilities and
instruments, such as effluent/waste treatment plants, pollution control equipment etc., involving
huge capital investments.
A capital expenditure project may be based on any of the following considerations:
Strategic consideration : The investment in a project may not directly yield any financial benefit.
But it may help the sales of the company’s other divisions or products. This is a deliberate
action to boost the performance of other products or divisions.
Intangible considerations : These include statutory obligations as well as the corporate philosophy
of serving the community. Beautification of areas surrounding the factory, building community
halls in the town where the plant is located are examples of social service to the community,
designed to earn goodwill.
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Purely financial (or economic) considerations.
The discussion in this chapter is concerned with projects under the third category.
CAPITAL BUDGETING
The term ‘capital budgeting’ refers to long-term planning for proposed capital outlay and
their financing. It includes both raising of long-term funds as well as their utilisation. In other words,
capital budgeting is ‘the firm’s formal process for the acquisition and investment of capital’. It is the
decision making process by which the firms evaluate the purchase of major fixed assets.
Capital budgeting process involves many activities as follows:
1. Identification of potential investment opportunities

2. Generation of investment proposals
3. Assembling of proposed investments
4. Estimation of cash flows for the proposals
5. Evaluation of cash flows
6. Decision making
7. Selection of projects based on acceptance criterion
8. Preparation of capital budget and appropriations
9. Continual re-evaluation of investment projects after their acceptance.
The capital budgeting process or procedure can be presented pictorially as follows:
Accounting,
Finance,
Engineering
Idea Collection Decision

development of data making Results
Assign Reassign
probabilities probabilities
Reevaluation
The basic features of capital budgeting can be summarised as follows:
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i) It has the potentiality of making large anticipated profits.
ii) It involves a high degree of risk.
iii) It involves a relatively long-time period between the initial outlay and the anticipated return.
ESTIMATION OF CASH FLOWS
One of the most important tasks in capital budgeting is estimating future cash flows for a
project. The final results depend on the accuracy of our estimates. Here, cash is central to all decisions
of the firm, not income. Whatever benefits expected from a project in terms of cash flows is more
important. The firm invests cash now in the hope of receiving higher cash returns in the future. It is
true that good managers may manage to get credit, but effective managers get cash.
For each investment proposal, we need to provide information on expected future cash flows
on an after-tax basis. The information must be provided on an incremental basis, so that it requires
analysis of only the difference between the cash flows of the firm with and without the project. For
this purpose, two sets of calculations would be required. One set of cash flows is to be prepared
ignoring the provision for accrued expenses and depreciation, and another set of calculations for income
for tax purposes, taking into consideration the applicable depreciation and other allowances. The
tax computed based on the second set of calculations will affect the net cash inflow from year to
year. Especially when considering for which 100% depreciation is allowed for tax purposes, the
impact of tax on cash flow would be very substantial. When cash flows relating to long-term funds
are being measured, interest on long-term debt should not be considered, because the average cost
of capital used for evaluating cash flows takes into account the cost of long-term debt. Therefore, if
interest on long-term debt is deducted in the process of cash flow analysis, the cost of long-term
debt will be reckoned twice.
In cash flow forecasts, only the incremental costs and benefits are considered. The recovery
of past costs is irrelevant. Also, certain costs do not necessarily involve in cash outlay. If we have
allocated plant space to a project and this space can be used for something else, its opportunity cost
must be included in the project’s evaluation. If presently unused building can be sold for Rs.10
lakhs, that amount should be treated as a cash outlay at the outset of the project. In deriving cash
flows, appropriate opportunity costs are to be considered.
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150
100
50
Net 0
Cash flow -50
(Rs. lakhs)
-100
-150
-200
0 1 2 3 4 5 6
YEARS
PATTERN OF CASH FLOW
CLASSIFICATION OF CASH FLOWS

The cash flow stream may be divided into three parts:
a) Initial Cash Flows:
These are cash outflows associated with investment in various project components.
Initial flow = Outlay on plant, machinery and other fixed assets

minus
Tax shields relating to investment in such assets
minus
After tax proceeds of sales of old assets
plus
Outlays on additional net working capital specific to the project.
b) Operational Cash Flows :
These are cash inflows expected during the operational phase of the project. The operational
cash inflow for a given year is equal to:
Profit after tax
+ Interest on long-term debt( 1- Tax rate)
+ Depreciation and other non-cash charges.
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The incremental cash flow after taxes,
DCFAT = (DS - DC - DD ) ( 1 - T) + DD
where,
DCFAT = Incremental Cash Flow After Taxes

DS = Incremental Sales
DC = Incremental Costs excluding interest on long-term debt
DD = Incremental Depreciation
T = Tax rate.
c) Terminal Cash Flows :
Cash flows expected from the disposal of assets when the project is terminated are referred to
as terminal flows.
Terminal flows = Post-tax salvage value of fixed assets

+ Post-tax salvage value of net working capital.
EVALUATION OF CAPITAL EXPENDITURE PROPOSALS
Once the necessary information is collected, we are able to evaluate the attractiveness of
the various investment proposals under consideration. A wide range of criteria is there to judge the
worthwhileness of investment proposals.
Evaluation
Methods
Non-Discounted Discounted Cash

Cash Flow Method Flow Method
Average Rate Net

of Return Present Value
Pay-back Internal Rate

Period of Return
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Non-discounted Cash Flow methods (i.e., Average Rate of Return method and Pay-back
method) are approximate methods for assessing the economic worth of a project.
In the discussion of all the four methods, we assume throughout that the expected cash flows
are realised at the end of each year.
AVERAGE RATE OF RETURN
This accounting measure represents the ratio of the average annual profits after taxes to the
investment in the project.
Average annual profit

i.e., Average rate of return =
Average Investment
Average investment is computed by taking the arithmetic average of the initial investment
and the book value of the asset at the end of its life.
If the average annual book earnings for a 5 year period are Rs.20 lakhs, and the initial
investment in the project is Rs.2 Crores, then,
Average rate of return = Rs.20 lakhs = 10%

Rs.200 lakhs
Once the average rate of return for a proposal has been calculated, it may be compared
with a required rate of return to determine if a particular proposal should be accepted or rejected.
Virtues :
Simple calculations are involved.
Calculations are based on accounting information, which are readily available.
The method considers benefits over the entire life of the project.
Shortcomings:
It is based on accounting income rather than on cash flows .
It fails to take account of the timing of cash inflows and outflows.
Benefits in the last year are valued the same as benefits in the first year.
Consider the following 3 investment proposals, each costing Rs.45 lakhs and each having
an economic and depreciable life of 3 years. Assume that these proposals are expected to provide
the following book profits and cash flows over the next 3 years.
Once the average rate of return for a proposal has been calculated, it may be compared
with a required rate of return to determine if a particular proposal should be accepted or rejected.
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Virtues :
Simple calculations are involved.

Calculations are based on accounting information, which are readily available.
The method considers benefits over the entire life of the project.
Shortcomings:
It is based on accounting income rather than on cash flows .

It fails to take account of the timing of cash inflows and outflows.
Benefits in the last year are valued the same as benefits in the first year.
Consider the following 3 investment proposals, each costing Rs.45 lakhs and each having
an economic and depreciable life of 3 years. Assume that these proposals are expected to provide
the following book profits and cash flows over the next 3 years.
(Rs. Lakhs)
PROJECT A PROJECT B PROJECT C
Period Book Net Cash Book Net Cash Book Net Cash
Profit Flow Profit Flow Profit Flow
1 15 30 10 25 5 20
2 10 25 10 25 10 25
3 5 20 10 25 15 30
Each proposal will have the same average rate of return i.e., Rs.10 lakhs / Rs.45 lakhs or
22.22%. However, it is improper to consider all the projects as equally favourable. Most would
prefer Project A, which provides a large portion of total cash benefits in the first year. For this reason,
the average rate of return leaves much to be desired as a method for project selection.
PAY-BACK PERIOD
The pay-back period for a project measures the number of years required to recover the
initial investment. Firms that use this method adopt a maximum or required pay-back period and
projects with expected pay-back period greater than this standard are rejected and those with pay-
back periods less than the standard are accepted. It is the ratio of the initial fixed investment over the
annual cash inflows for the recovery period. Consider two projects involving the same initial cash
outlay of Rs.10 lakhs, with net cash inflows as follows:
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PROJECT A PROJECT B
Initial Outlay Rs.10 lakhs Rs.10 lakhs
Net Cash Inflow in Year 1 Rs. 2 lakhs Rs.4 lakhs
2 Rs. 2 lakhs Rs.3 lakhs
3 Rs. 2 lakhs Rs.3 lakhs
4 Rs. 2 lakhs Re.1 lakh
5 Rs. 2 lakhs Re.0.5 lakh
6 Rs. 3 lakhs ———
7 Rs. 3 lakhs ———
Pay-back period 5 years 3 years
Applying this method, Project B will be selected because the pay-back period is shorter
than that of Project A. It could be seen that the total cash inflow during the life of the project is
higher for Project A.
The shortcomings of pay-back period method are:
i) Cash flows beyond the pay-back period are ignored
ii) The pattern of cash flow within the pay-back period ignores the time value of money.
The pay-back method continues in use, as a supplement to other more sophisticated

methods. It provides management limited insight into the risk and liquidity of a project. The shorter
the pay-back period, the less risky the project and the greater its liquidity. The company that is cash
poor may find the method very useful to gear up early recovery of funds invested.
TIME VALUE OF MONEY
One of the most fundamental principles of financial decision making is the time value of money.
In simple terms, this concept states that when faced with a choice between two identical cash flow
amounts, the individual should prefer the cash flow that occurs earlier in time, because the time value
of money makes this alternative more valuable.
An amount invested today will earn interest and be worth more than the original investment
by the end of the year. The standard formula for finding out the future value of an amount (present
value, PV) at the end of n years, invested at a compound rate of interest of i (compounded annually) is
n
Future Value (FV) = PV ( 1 + i) …….. (1)
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If the interest is calculated at shorter intervals, say, quarterly or half-yearly, the formula will be:
Quarterly Compounding , FV = PV ( 1 + i/4 )4n

2n
Half-yearly Compounding , FV = PV ( 1 + i/2 )
FV
From (1), Present Value of future cash flow, PV =
(1 + i) n
NET PRESENT VALUE METHOD
The net present value of a project is equal to the sum of the present value of all the cash
flows associated with the project. i.e., the net present value of a stream of cash flows is the difference
between the present value of the inflows and the present value of outflows. All cash flows are
discounted to present value, using the required rate of return. The present values are the after-tax
cash inflows and cash outflows, discounted at the opportunity cost of capital. The required rate of
return for a project is the minimum rate of return that the project must yield to justify its acceptance.
If the NPV is positive, the project is prima facie acceptable and if the NPV is negative, the project
has to be rejected.
n
NPV = At / (1 + k)t
t=0
where, At = cash flow for period t ; k = required rate of return
n = the last period for which cash flow is expected.
If the sum of these discounted cash flows is zero or more, the proposal is accepted, if not,
it is rejected. If the required rate of return is the return investors expect the firm to earn on the
investment proposal, and the firm accepts a proposal with a net present value greater than zero, the
market price of the shares should rise.
INTERNAL RATE OF RETURN (IRR) METHOD
The internal rate of return of a project is the discount rate which makes its net present value
equal to zero. Or, IRR is that discount rate that makes the present value of cash inflows equal to the
present value of the cash outflows. The project is accepted if its IRR is greater than the required
rate of return, and rejected if it is less than the required rate.
IRR is represented by the rate, r, so that

n
At/(1 + r)t = 0.
t=0
where, At = cash flow for period t; n = the last period in which a cash flow is expected.
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Let us consider the cash flow pattern (i.e., outflow and inflow) for the Replacement Project
illustrated above. The trial and error method of finding IRR is as under:
Year 0 1 2 3 4 5
Net cash flow (31.00) 11.25 10.31 9.60 9.08 26.43

Discount factor for 28% 1 0.7815 0.6103 0.4768 0.3725 0.2910
Present Value (31.00) 8.79 6.29 4.58 3.38 7.75
NPV = 30.79 - 31.00 = - 0.21
Discount Factor for 27%1 0.7874 0.6200 0.4882 0.3844 0.3027

Present value (31.00) 8.66 6.39 4.69 3.49 8.00
NPV = 31.43 - 31.00 = 0.43
The IRR is, therefore, between 27% and 28%

NPV Vs IRR
The NPV and IRR methods lead to the same acceptance or rejection decision. A graphical
presentation of the two methods applied to a typical investment project is made hereunder.
Net Present
Value(Rs)
Y Internal Rate of Return
Discount Rate(%)
Relation between Discount Rate and Net Present Value

The figure shows the curvilinear relationship between the Net Present Value of a project
and the discount rate employed. When the discount rate is 0, Net Present Value is simply the total
cash inflows less the total cash outflow of the project. Assuming that total inflows exceed total
outflows and that outflows are followed by inflows, the typical project will have the highest Net Present
Value when the discount rate is 0. As the discount rate increases, the present value of future cash
inflows decreases relative to the present value of outflows. As a result, NPV declines. The crossing
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of the NPV line with the 0 line establishes the internal rate of return for the project. If the required
rate of return is less than the IRR, we would accept the project, using either method. Suppose the
required rate is 15%, then the Net Present Value of the project would be Y. If Y is greater than 0
the project is acceptable using the present value method. If the required rate is greater than the
IRR, the project will be rejected.
CAPITAL RATIONING
At times, management may place an artificial constraint on the amount of funds that can be
invested in a given period. This is known as capital rationing. The executive planning committee
may emerge from a lengthy capital budgeting session to announce that only Rs.5 crores may be spent
on new capital projects this year. Although Rs.5 crores may represent a large sum, it is still an artificially
determined constraint and not the product of marginal analysis, in which the return for each proposal
is related to the cost of capital for the firm, and projects with positive net present values are accepted.
A firm may adopt capital rationing because it is fearful of growth or hesitant to use external sources
of financing ( by way of debt). Capital rationing hinders a firm from achieving maximum profitability.
Different acceptable project proposals must be ranked, and only those with the highest positive Net
Present Value are accepted.
The following procedure is suggested for selecting the set of investments in a capital rationing
situation:
1. Define all combinations of projects which are feasible within the constraints of project inter-
dependencies and overall availability of funds.
2. Choose the combination which gives the higher NPV.
SUMMARY
Capital investment refers to the investment in projects where results would be available only
after a year. We need capital investment for expansion, replacement, diversification, research and
development and others. Capital budgeting refers to long term planning for proposed capital outlay
and their financing. The most important task in capital budgeting is estimating future cash flow for a
project. A valution of capital expenditures are necessary for capital budgeting. Capital rationing is an
artificial constraint on the amount of funds, that can be invested in a given period.
QUESTIONS
1. Where are the capital investment required?

2. Write about capitl\al budgeting.
3. How will you estimate cash flows?
4. How will you evaluate capital expenditure proposals?
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CHAPTER - XII
FINANCIAL FORECASTING
OBJECTIVES
The reader should be able to do financial forecasting using the process of developing a series
of projected financial statements. The reader should understand what sales projection is and how to
prepare production schedule and also proforma Balance Sheet. Familiarise with computerised financial
planning system.
INTRODUCTION
Financial forecasting is a planning process through which the management of the company
positions the firm’s future activities keeping in view the various influencing factors such as the economic,
technical, social and competitive environment. Financial forecasting is essential to the strategic growth
of the firm. Business plans evidence strategies and actions for achieving the desired short-term,
medium-term and long-term results. The process of financial forecasting allows the financial manager
to anticipate events before they occur, particularly the need for raising funds externally.
The most comprehensive means of financial forecasting is to go through the process of

developing a series of pro forma or projected financial statements. There are three main techniques
of financial projections as follows:
Pro forma financial statements

Cash Budgets and
Operating Budgets.
Based on the projected statements, the firm is able to judge its future level of receivables,
inventory, payables and other corporate accounts as well as its anticipated profits and borrowing
requirements. The finance officer can then carefully track actual events against the plan and make
necessary adjustments. Also, the statements are often required by bankers and other lenders as a
guide for the future.
Pro forma statements are projected financial statements embodying a set of assumptions
about the future performance of a company and the funding requirements. A systematic approach is
necessary for the development of pro forma statements. The various steps involved in the construction
of a pro forma statement are as follows:
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i) Preparation of a pro forma income statement, based on sales projections and production
plan.
ii) Translation of these into a cash budget, and then finally.
iii) Assimilation of all previously developed material into a pro forma balance sheet.
This process can be depicted as under:
Prior balance
sheet
Pro forma Pro forma

Sales Production Income Balance
Projection Plan Statement Sheet
Cash
Budget
Other
Supportive
Budgets
Development of Pro forma Statements
Pro forma Income Statement
Proforma Income Statement is developed by the following four important steps:
1) Establishment of a sales projection.

2) Preparation of production schedule and the associated use of new material, direct labour
and overhead, to arrive at gross profit.
3) Computation of other expenses.
4) Determination of profit by completing the actual pro forma statement.
Sales Projection
Sales Projection or Sales Forecast is the starting point of the financial forecasting exercise.
Projection of other financial variables are based on sales projection, and therefore, the necessity for
accuracy of sales projection need not be overemphasized.
106
Suppose the company ABC Ltd. has two primary products, Product A and Product B and
the sales expected for the ensuing period is 4000 units and 6000 units at prices of Rs.25 and Rs.15
respectively. Then, from the above, the anticipated sale for the said period is calculated as under:
Product A Product B
Quantity 4000 6000
Selling price per unit Rs.25 Rs.15
Sales revenue Rs.1,00,000 Rs.90,000
Total Rs.1,90,000
There are different forecasting techniques and methods of sales forecasting, but all of them
fall within the following three categories.
Quantitative techniques
Time Series Projection methods
Casual Models
Preparation of Production Schedule
Based on the anticipated sales the necessary production plan for the projected period is
prepared. The number of units produced will depend on the beginning stock of inventory, the
sales projection and the desired level of closing stock of inventory.
Production requirement = Projected Sales + Desired Closing Stock - Opening Stock
Computation of value of opening stock
Let the cost per unit of the opening stock be Rs.16 and Rs.10 respectively for Product A
and Product B. Then, the stock of beginning inventory is computed as follows:
Product A Product B
Quantity(units) 100 1700
Cost Rs.16 Rs.10
Total value Rs.1,600 Rs.17,000
The production requirements for the next budget period is computed as under:
Product A Product B
Projected sales (Units) (A) 4000 6000
Desired closing stock of inventory
(assumed) (B) 500 1000
Opening stock (i.e.,already in stock) (C) 100 1700
Units to be produced = (A) + (B) - (C) 4400 5300
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Preparation of Cost of Production
We must now determine the cost to produce these units.
Let the unit cost be as under:

Product A Product B
Rs. Rs.
Materials 10 7
Labour 7 4
Overhead 3 1
Total Rs.20 Rs.12
Total production costs can be computed as follows:
Product A Product B
Units to be produced 4400 5300
Cost per unit Rs.20 Rs.12
Total cost Rs.88,000 Rs.63,600
Cost of Goods Sold
The main consideration in constructing a Pro forma Income Statement is the costs specifically
associated with units sold during the period under consideration. The anticipated sales of Product A
is 4000 units, but considering the closing stock requirements and availability of opening stock, the
production requirement has gone up to 4400 units. i.e., an increase of 400 units in inventory level.
For profit measurement purposes, these extra 400 units are not charged to current sales. Also, in
determining the cost of 4000 units sold during the current time period, all the items sold are not
considered as manufactured during the period. In the case of Product A, the sales expected is
Rs.1,00,000 ( i.e., 4000 units x Rs.25). Of the 4000 units, 100 units are from the opening stock (at
cost per unit Rs.16) and the balance of 3900 units are from the current production (at cost per unit
Rs.20). The total cost of goods sold for Product A is Rs.79,600, yielding a gross profit of Rs.20,400.
Similar is the case with Product B.
Product A Product B Total

Quantity sold 4000 6000 10000
Sales price Rs.25 Rs.15
Sales revenue Rs.1,00,000 Rs.90,000 Rs.1,90,000
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Cost of goods sold:
Old inventory
Quantity (units) 100 1700
Cost per unit Rs. 16 10
New inventory
Quantity (units) 3900 4300
Cost per unit Rs. 20 12
Total Cost of Goods sold Rs.79,600 Rs.68,600 Rs.1,48,200
Gross Profit Rs.20,400 Rs.21,400 Rs. 41,800
The value of closing stock can be computed as under:
Opening stock of inventory(Rs.1,600 + 17,000) Rs. 18,600

Total production costs (88,000 + 63,600) Rs.1,51,600
Total inventory available for sales Rs.1,70,200

Less: Cost of goods sold (Rs.79,600 + 68,600) Rs.1,48,200
Closing stock of inventory Rs. 22,000
Having computed total revenue, cost of goods sold and gross profits, the next step is to
subtract other expense items to arrive at the net profit before tax. These include general and
administrative expenses as well as interest expenses. Income after tax is found out by deducting taxes,
and then the dividends are deducted to ascertain the contribution to retained earnings.
Let us assume that the general and administrative expenses at Rs.11,300, interest expense
Rs.3,000 and dividends Rs.2,500.
Then the actual Pro forma Income Statement is presented as follows:
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PRO FORMA INCOME STATEMENT
for the year ended 31st March, 2000
Rs.
Sales revenue 1,90,000
Cost of goods sold 1,48,200
Gross Profit 41,800

General and administrative expenses 11,300
Operating Profit
(i.e., Earning Before Interest & Tax) 30,500
Interest expenses 3,000
Earnings Before Taxes (EBT) 27,500

Taxes (say 50%) 13,750
Earnings After Tax (EAT) 13,750

Dividends 2,500
Increase in retained earnings 11,250
Cash Budget
The generation of sales and profits does not necessarily indicate that there will be adequate
cash on hand to meet financial obligations as they come due. A profitable sale may generate accounts
receivables in the short run, but no immediate cash to meet maturing obligations. Therefore, we
must translate the pro forma income statement into cash flows. The longer-term pro forma income
statement is divided into smaller and more precise time frames in order to appreciate the seasonal
and monthly patterns of cash inflows and outflows. Cash budgets or cash flow estimates are very
specific planning tools that are prepared every month or even every week. Cash budgets show the
cash needs or excesses. We have already discussed about preparation of cash budgets in the previous
chapter.
Pro forma Balance Sheet
Preparation of Pro forma Balance Sheet involves integration of pro forma income statement
and cash budget. This is relatively a simple job. As the balance sheet represents cumulative changes
in the business over time, the prior period’s balance sheet is first examined and then these items are
translated through time to represent the latest balance sheet.
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Prior Balance Sheet
(Unchanged items)
Marketable securities
Long-term Debt
Capital stock
Pro forma Income

Statement Analysis
Pro forma Balance Sheet
Inventory
Retained earnings
Cash Budget Analysis
Cash
Accounts Receivable
Plant and Equipment
Accounts Payable
Notes Payable
COMPUTERISED FINANCIAL PLANNING SYSTEM
The present day is marked by mechanisation and automation in almost all spheres of life.
The invasion of automation in finance area is no exception. There are computerised planning models
and also the more popular computer-generated spreadsheets. Most of the available financial software
packages also offer financial simulation and projection capabilities. The financial analyst has got the
widest choice and area which could be probed with different assumptions, conditions and plans. When
the business is computerised, it becomes easy for the financial analysts to study various assumptions
and their outcomes with the given set of accounting, tax and other policy constraints. Also, budget
projections and sensitivity analysis becomes easier with the aid of computers.
111
Illustration - 1:
Consider the Balance Sheet of Goodluck Co. Ltd. as on 31st March, 2000. The company
has received a large order and anticipates the need to go to its bank to increase its borrowings. As
a result, it has to forecast its cash requirements for April, May and June. Typically, the company
collects 20% of its sales in the month of sale, 70% in the subsequent month and 10% in the second
month after the sale. All sales are credit sales.
(Rupees in ‘000s)
CAPITAL & LIABILITIES Rs ASSETS Rs.
Equity Shares 100 Net fixed Assets 1,836

Retained Earnings 1,439
Long-term debts 450

Bank Loan 400 Inventories 545
Accruals 212 Accounts receivable 530
Accounts payable 360 Cash 50
2,961 2,961
Purchase of raw materials for the product is made in the month prior to the sale and amount
to 60% of sales in the subsequent month. Payments for these purchases occur in the month after the
purchase. Labour costs including overtime, are expected to be Rs.1,50,000 in April, Rs.2,00,000
in May and Rs.1,60,000 in June. Selling, administrative, tax and other cash expenses are expected
to be Rs.1,00,000 per month for April through June. Actual sales in February and March and
projected sales for April through July are as follows:
(Rs. in ‘000s)
February 500 April 600 June 650

March 600 May 1,000 July 750
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On the basis of this information:
a) Prepare a cash budget for the months of April, May and June.
b) Determine the amount of additional bank borrowings necessary to maintain a cash balance of
Rs.50,000 at all times.
c) Prepare a Pro forma Balance Sheet for June 30.
Solution:
a) Cash Budget
(Rs. in ‘000s)
April May June
Collections, current month’s sales 120 200 130
Collections, previous month’s sales 420 420 700
Collections, previous 2 months’ sales 50 60 60
Total cash receipts (A) 590 680 890
Payment for purchases 360 600 390
Labour costs 150 200 160
Other expenses 100 100 100
Total Cash disbursements (B) 610 900 650
(A) - (B) ( 20) (220) 240
b) Computation of bank borrowings required
(Rs.in ‘000s)
April May June
Additional borrowings 20 220 (240)
Cumulative borrowings 420 640 400
The amount of financing peaks in May owing to the need to pay for purchases made in the
previous month and higher labour costs. In June, substantial collections are made on the prior month’s
sales, causing a large net cash inflow sufficient to pay off the additional borrowings.
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c) Pro forma Balance Sheet as on June 30
(Rs.in ‘000s)
CAPITAL & LIABILITIES Rs ASSETS Rs.
Equity Shares 100 Net fixed Assets 1,836
Retained Earnings 1,529
Long-term debts 450
Bank Loan 400 Inventories 635
Accruals 212 Accounts receivable 620
Accounts payable 450 Cash 50
3,141 3,141
Notes:
Accounts receivable = Sale in June x 80% + Sale in May x 10%
Inventories = Opening Stock
+ Total purchases from April to June
- Total sales from April to June x 60%
= (545 + 1,440)* - (2,250 x 60%)
Accounts payable = Purchases in June

Retained earnings = Balance as on March 31
+ Sales
- Payment for purchases
- Labour costs
- Other expenses
} All from April to June
Working Note:
Calculation of Total purchases from April to June.
Purchases for the month of April = Rs. 1,000 x 60% = Rs. 600
Purchses for the month of May = Rs. 650 x 60% = Rs. 390
Purchases for the month of June = Rs. 750 x 60% = Rs. 450
Total Purchases = Rs. 1,440*
114
SUMMARY
Financial forecasting is a planning process through which the management of the company
position the firms future activates Proforma income statement is developed through different steps.
Sales projection or sales forecast is the starting point of the financial forecasting exercise. Based on
the anticipated sales the necessary production plan for the projected period is prepared. The main
consideration in constructing a Proforma income statement is the costs specifically associated with
units sold during the period under consideration. Cash budgets are very specific planning tools that
are prepared month or even every week. Computerised financial planning system makes use of
computerised planning models and also the more popular computer generated spread sheets.
QUESTIONS
1. What is Financial forecasting?
2. How will you prepare production schedule?
3. What is cash budget and proforma balace sheet?
4. Write about computerised financial planning system.
115
CHAPTER - XIII
CAPITAL STRUCTURE
OBJECTIVES
The student should acquaint himself with the concept of Capital Structure, distinction between
Capital Structure and Financial Structure, optimum Capital Structure and also the features of an
appropriate Capital Structure.
CONCEPT OF CAPITAL STRUCTURE
One of the most important areas of the Finance Function is to make decisions about the
capital structure of the firm. According to Gerstenberg, Capital Structure refers to ‘the make up of a
firm’s capitalisation’. It represents the mix of different sources of long-term funds(such as equity shares,
preference shares, retained earnings, long-term loans etc.,) in the total capitalisation of the company.
It is, precisely, the financing plan of the company. Capital is required to finance investments in plant
and machinery, inventory, accounts receivables and so on. A finance manager has to choose the most
appropriate source of financing these activities from a variety of sources available, namely, equity,
preference shares, debenture stock, term loans from banks or financial institutions, short-term
borrowings, suppliers’ credit etc.
Consider the following case:

Rs. Crores
Equity Shares : 10.00
Preference Shares : 10.00
Debentures : 10.00
Retained earnings : 5.00
The ‘capitalisation’ in the above case is Rs.35 Crores. i.e., the long-term funds. The
term capital structure is used for the mix of capitalisation. Here, it can be said that the capital structure
of the company consists of Rs.10 Crores in Equity Shares, Rs.10 Crores in Preference shares, Rs.10
Crores in Debentures and Rs.5 Crores in retained earnings.
The capital structure decision is a significant managerial decision which influences the risk
and return of the investors. Wherever the company wants to raise finance, it involves a capital structure
decision. Both the amount of finance to be raised as well as the source from which it is to be raised
have to be decided by the management.
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DISTINCTION BETWEEN CAPITAL STRUCTURE AND FINANCIAL STRUCTURE
Financial structure refers to the way the firm’s assets are financed. It includes both long-
term as well as short-term sources of funds.
Capital structure, on the other hand, is the permanent financing of the company represented
primarily by long-term debt and shareholders’ funds by excluding all short-term credit.
This means, that a company’s capital structure is only a part of its financial structure.
Factors Determining Capital Structure
The following factors affect the capital structure of a firm:
Leverage or Trading on equity:
A company may raise funds from different sources such as equity shares, preference shares,
debentures, term loans etc. The use of these fixed charge sources of funds in the capital structure is
known as financial leverage or trading on equity.
Other factors influencing the capital structure are :

a) Retaining control
b) Nature of the enterprise
c) Size of the company
d) Purpose of financing
e) Period of finance
f) Market sentiments
g) Cost of capital
h) Cash flow projections of the company
i) Government Policy
j) Requirement of investors
k) Legal requirements
OPTIMUM CAPITAL STRUCTURE
A firm should try to maintain an optimum capital structure with a view to maintain the
profitability, flexibility, control and solvency. The optimum capital structure is obtained when the
market value per equity share is the maximum. In other words, it may be defined as that relationship
of debt and equity securities which maximises the value of a company’s share. At the optimum capital
structure, the average or composite cost of capital is the minimum.
117
Illustration - 1:
Consider the following case:
Debt as % of Total Cost of Debt (%) Cost of Equity (%)

Capital Employed (after tax) (after tax)
0 12.0 18.0
10 12.0 18.0
20 12.0 18.5
30 12.5 19.0
40 13.0 19.5
50 13.5 20.0
60 14.0 20.5
Compute the optimal debt-equity mix for the company by calculating composite cost of
capital.
Solution:
Statement showing composite cost of capital (after tax)
Debt as % of Total Cost of Debt(%) Cost of Equity(%) Composite Cost of

Capital Employed Capital (%)
0 12 18 12 x 0 + 18 x 1 = 18.00
10 12 18 12 x .1 + 18 x .90 = 17.40
20 12 18.5 12 x .2 + 18.5 x.80 = 17.20
30 12.5 19.5 12.5 x.3 + 19.5 x .70 = 17.40
40 13 21.0 13 x .4 + 21 x .60 = 17.80
50 14 22.0 14 x .5 + 22 x .5 = 18.00
60 15 23.0 15 x .6 + 23 x .4 = 18.20
The optimal debt-equity mix is 20% debt and 80% equity. At these levels, the composite
cost of capital is the least.
Features of an appropriate capital structure
An appropriate capital structure must have the following features:
1) Profitability: i.e., the capital structure of the business should be most profitable, which minimises
cost of financing and maximises earning per equity share.
2) Solvency: There should not be a risk of becoming insolvent, through excessive use of debt.
118
3) Flexibility: The capital structure should be amenable to manoeuvrability to meet the requirements
of changing conditions.
4) Conservatism: The debt content should not be beyond the controllable limits of the business, and
it should be commensurate with the company’s ability to generate future cash flows.
5) Control: The capital structure should be so devised that it involves minimum risk of loss of control
of the company.
SUMMARY
Capital Structure represents the mix of different sources of long-term funds in the total
capitalization of the company. There are both long-term as well as short-term sources of funds which
is the financial structure. Capital Structure on the other hand is the permanent financing in the company
represented primarily by long-term debt and share holders funds by excluding all short-term credit.
Factors which determine th capital structure are various. The optimum capital structure is obtained
when the market value per equity share is the maximum. There are five features for the appropriate
capital structure viz., profitability, solvency, flexibility, conservatism, and control.
QUESTIONS
1. Explain the concept of capital structure.
2. What is the difference between capital structure and financial structure with the factors
influencing capital structure?
3. What is optimum capital structure?
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CHAPTER - XIV
COST OF CAPITAL
OBJECTIVES
The chapter makes the reader understand thoroughly the concept and meaning of cost of
capital. It enumerates the importance of cost of capital in financial decisions. The chapter deals with
cost of debts, cost of preference capital, cost of equity capital, cost of term loan, cost of retained
earnings, overall cost or weighted average cost of capital.
CONCEPT AND MEANING
The term “Cost of Capital” is defined as the rate of return on investment projects necessary
to have unchanged market price of a firm’s share. It may be the rate at which funds can be borrowed
on new equity capital or, it may be the rate at which further cash flows are discounted to measure its
present values. The cost of capital of a firm is the weighted average of the cost of the various sources
of finance that have been used by it. The cost of capital to a firm is the minimum rate of return that it
must earn on its investments in order to satisfy the various categories of investors who have made
investments in the form of shares, debentures or term loans. Unless the company earns this minimum
rate, the investors will be tempted to pull out of the company.
The optimum cost of capital is the financial break-even point. It represents a minimum
rate of return. If the risk is involved, the minimum rate of return should be higher in order to cover
the business risk as well as financial risk.
Importance of Cost of Capital in Financial Decisions
Acceptance or rejection of an investment proposal depends on the cost of capital. Hence

a reasonably accurate estimate of cost of capital is essential for optimal capital budgeting decisions
leading to the maximisation of shareholders’ wealth. It also serves as a potent tool to evaluate decisions
at the time of dissolution of the firm. Estimation of cost of capital is influenced by financial decision (
i.e., debt-equity ratio) and the Dividend Policy of the company.
The financial manager must calculate the cost of capital of the firm before taking investment
decisions. Different methods are employed for computing the cost of capital and these have been
discussed separately.
The concept of cost of capital is significant in the following ways:
Designing the firm’s capital structure,
120
Deciding about the method of financing,
Evaluating the financial performance of a firm, i.e., by Return on Investment etc.,
Dividend decisions,
Working capital policy etc.
Cost of Debt
The debt may be for short-term or long-term.
i) Cost of short-term debt
Short term debt is obtained from Banks for meeting working capital requirements etc. The
interest rate as mentioned in the loan agreement may be taken as the cost of short-term debt.
But interest is tax deductible expense and as such the effective cost of short-term debt would
be computed after tax adjustments.
Kds = Interest x 100 = 18%

Principal
where, Kds = cost of short-term debt.
Illustration - 1:
Short term loan of Rs.1,00,000 obtained from Bank at 18%. The interest would be Rs.18,000.
Tax rate is 50%.
Kd = 18,000 x 100 = 18%

1,00,000
After-tax cost of short-term debt = Kds(1 - T), where T = tax rate.
= 18% (1 - 50%) = 9%
The rate of interest should be the effective rate of interest. If the interest is calculated quarterly
at 18% p.a., and debited to loan account, the effective rate of interest would be approximately
21% p.a. In such case, the after-tax cost of short-term debt would be 21%(1 - 50%) =
10.5%.
(ii) Cost of long-term debt
The formula for calculating cost of long term debt is
Kdl = Interest x 100

Principal
After-tax cost of long-term debt = Kdl ( 1 - T )
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(iii) Cost of debt issued at premium or discount
If the debenture is issued at premium or discount, the following formula is applied:
Kd = I (1-T) + (F - P)/n
(P + F)/2
where, P = net amount realised on debt issue

I = annual interest payable
T = tax rate applicable to the firm
F = redemption price
N = maturity period of debt.
Illustration - 2:
Omega Ltd. issues 12% non-convertible debentures of face value Rs.100. Net amount
realised per debenture is Rs.94. The debentures are redeemable at par after 10 years. The firm is
in 50% tax bracket. Calculate cost of debt.
Solution:
Cost of debt, Kd = I (1-T) + (F - P)/n

(P + F)/2
= 12 ( 1- 0.5 ) + (100 - 94)/10
(100 + 94) /2
= 6.80 %
Illustration - 3:
In the above case, if the debenture is sold at Rs.110 (i.e., at a premium of Rs.10), then,
after-tax cost of debt would be:
= 12 ( 1- 0.5 ) + (100 - 110)/10

(100 + 110) /2
= 4.76%
Cost of Preference Capital
Dividend paid to the preference shareholders is the cost of preference capital. Tax adjustment
is not required in this case as dividends are paid after payment of tax.
Kp = D / P
where, Kp = cost of preference share
122
D = dividend per share(fixed)
P = price paid per preference share.
Illustration - 4:
15% Preference share, face value Rs.100.

Kp = 15/100 = 0.15 or 15%.
If it is issued at Rs.95, Kp = 15/95 = 15.79%
If it is issued at Rs.110, Kp = 15/110 = 13.64%
The cost of a redeemable preference share is defined as that discount rate which equates
the proceeds from preference capital issue to the payments associated with the same. i.e., dividend
payment and principal payments.
Kp =
D + ( F - P)/n
(F+P) / 2
Cost of Equity Capital
The Cost of Equity Capital is most difficult to compute because the dividend stream
receivable by the equity shareholders is not specified by any legal contract (unlike in the case of
debenture-holders). Some people argue that the equity capital is cost free as the company is not
legally bound to pay the dividends to equity shareholders. But this is not true. Shareholders invest
their funds with the expectation of dividends. The market value of equity share depends on the dividends
expected by shareholders, the book value of firm and the growth in the value of firm. The required
rate of return which equates the present value of the expected dividends with the market value of
equity share is the cost of equity capital. ie., the cost of equity capital may be expressed as the minimum
rate of return that must be earned on new equity share capital financed investment in order to keep
the earnings available to the existing equity shareholders of the firm unchanged.
According to the dividend valuation model,
P = Df
Ke - g
where, P = Price of share today
Df = Dividend at the end of first year (or period)
Ke = Required rate of return
G = Constant growth rate in dividends.
If the current market price of the share is given (P) and the values of Df and g are known,
then the above equation can be rewritten as Ke = Df + g
P
123
Cost of Term Loan
Cost of term loan = Interest rate (1 - Tax rate).
Here, interest rate is the interest rate applicable to the new term loan. As interest is tax
deductible, interest rate is multiplied by (1 - Tax rate).
Cost of Retained Earnings
For many companies, the most important source of ownership or equity capital is in the
form of retained earnings, an internal source of funds. Accumulated retained earnings represent the
past and present earnings of the firm minus previously distributed dividends. Retained earnings belong
to the current shareholders. They can either be paid out to the current shareholders in the form of
dividends or re-invested in the firm. As the surplus is retained in the firm for re-investment, they
represent a source of equity capital to the firm that is being supplied by the current shareholders.
However, retained earning has an opportunity cost attached to it. i.e., the funds could be paid out to
the shareholders in the form of dividends and then re-deployed by the shareholders in other shares,
bonds, real estate etc. The expected rate of return on these alternative investments is the opportunity
cost of the retained earnings.
The cost of retained earnings is equivalent to the rate of return on the firm’s common stock
and this is the opportunity cost. Thus, it can be said that the cost of common equity in the form of
retained earnings is equal to the required rate of return on the firm’s stock.
Cost of common equity in the form of retained earnings, Ke = Df + g

P
where, Df = dividend at the end of the first year,
P = price of the shares today,
g = constant growth rate in dividends.
Illustration - 5:
Price of share today Rs.600; Dividend at the end of the first year Rs.50;
Constant growth rate of dividends 8%.
Cost of retained earnings ,
Ke = Rs.50 + 8% = 8.33% + 8% = 16.33%
Rs.600
Overall cost or weighted average cost of capital
It is necessary for the finance manager to know the overall cost of capital which can be
used as the decision criterion in capital budgeting or investment decisions. The method of computation
of this overall or weighted average cost of capital is given below by a numerical example.
124
Consider the following case, where a company is considering three different capital structures.
For ease of presentation, only debt and equity (common stock) are being considered. The cost of
the components in the capital structure change each time we vary the debt-equity mix (or weights).
Cost Weights Weighted
(after tax) Cost
Financial Plan A:
Debt 6.5% 20% 1.3%
Equity 12.0% 80% 9.6%
10.9%
Financial Plan B:
Debt 7.0% 40% 2.8%
Equity 12.5% 60% 7.5%
10.3%
Financial Plan C:
Debt 9.0% 60% 5.4%
Equity 15.0% 40% 6.0%
11.4%
The firm is able to initially reduce the weighted average cost of capital with debt financing,
but beyond Plan B the continued use of debt becomes unattractive and greatly increases the costs of
the sources of financing. According to the traditional financial theory, the relationship between the
cost of capital to debt-equity mixes for the firm takes a U-shape as illustrated in the following Figure.
Cost of Equity
Cost of capital Weighted average

(percent)
cost of capital
Cost of Debt
0 40 80
Debt-Equity Mix (Percent)
In this case, the optimum structure occurs at a 40% debt to equity ratio.
In determining the appropriate capital mix, the firm generally begins with its present capital
structure and ascertains whether its current position is optimal. If not, subsequent financing should
carry the firm toward a mix that is deemed more desirable. Only the costs of new or incremental
financing should be considered.
125
Significance of Debt-Equity ratio in the Cost of Capital of a business
Debt-equity ratio affects the cost of capital. When the debt-equity ratio of a company
increases, its cost of capital will decline because of incidence of tax on the interest. This is because
the interest on debt is tax deductible whereas the equity dividend and preference dividend are not tax
deductible. The following illustrations will clarify the impact of change in debt and equity on composite
cost of capital.
Illustration.6:
Rs. in Lakhs.
Debt (at 20%p.a) 800
Equity (Dividend rate 20%) 400
Total 1,200
Debt-Equity ratio =2:1
Income tax rate = 50%
Cost of Capital Rs. in Lakhs

Interest Cost 160
Less:Tax 50% 80 80
Dividend 80
160
Weighted average cost of capital = 160 x 100 = 13.33%

1,200
Illustration.7:
Rs. in Lakhs.
Debt (at 20%p.a) 400
Equity (Dividend rate 20%) 800
Total 1,200
Debt-Equity ratio =1:2
Income tax rate = 50%
Cost of Capital Rs. in Lakhs

Interest Cost 80
Less:Tax 50% 40 40
Dividend 160
200
Weighted average cost of capital = 200 x 100 = 16.67%
1,200
126
As debt-equity ratio changes from 2 : 1 to 1 : 2 , the weighted average cost of capital has
gone up from 13.33% to 16.67%. This is mainly because tax deduction is lower at Rs.40 lakhs in
illustration 7 as compared to Rs.80 lakhs in illustration 6.
Problem 1.
M/s.Progress Ltd. has the following capital structure as on 31st March, 2000.
Rs.
Equity shares
(5,000 shares of Rs.100 each) 5,00,000
9% Preference shares 2,00,000
10% Debentures 3,00,000
Total 10,00,000
The equity shares of the company are quoted at Rs.102/- and the company is expected to
declare a dividend of Rs.9 per share for the year ended March 31, 2000. The company has registered
a dividend growth rate of 5% which is expected to be maintained.
(a) Assuming the tax rate applicable to the company at 50%. Calculate the weighted average cost
of capital. State your assumptions, if any.
(b) Assuming in the above exercise, that the company can raise additional term loan at 12% for
Rs.5,00,000 to finance an expansion, calculate the revised weighted cost of capital. The
company’s statement is that it will be in a position to increase the dividend from Rs.9 per share
to Rs.10 per share, but the business risk associated with new financing may bring down the
market price from Rs.102 to Rs.96 per share.
Solution:
(a) Cost of Equity Capital:
Ke = Dividend + Growth rate

Market price per share
= 9/102 + 0.05 = 0.088 + 0.05 = 0.138 or 13.8%.
127
Statement of weighted average cost of capital
Source Proportion After tax cost(%) Weighted Average
= cost(1- Tax 50%) cost of capital(%)
Equity shares 5/10 13.8% 13.8 x 5/10 = 6.9
9% Pref.shares 2/10 9.0% 9.0 x 2/10 = 1.8
10% Debentures 3/10 10% (1 - 0.5) = 5.0% 5.0 x 3/10 = 1.5
Weighted average cost of capital = 10.2%
b) Cost of Equity Capital : Ke = 10/96 + 0.05

= .104 + .05 = .154 or 15.4%.
Additional Term Loan at 12% for Rs.5,00,000. Then the total capital structure would be
Rs.15,00,000.
Statement of weighted average cost of capital
Source Proportion After tax cost(%) Weighted Average

= cost(1- Tax 50%) cost of capital(%)
Equity shares 5/15 15.4% 15.4 x 5/15 = 5.13
9% Pref.shares 2/15 9.0% 9.0 x 2/15 = 1.20
10% Debentures 3/15 10% (1 - 0.5) = 5.0% 5.0 x 3/15 = 1.00
12% Term Loan 5/15 12% (1 - 0.5) = 6.0% 6.0 x 5/15 = 2.00
Weighted average cost of capital = 9.33%
Problem 2:
M/s Efficient Corporation has a capital structure of 40% debt and 60% equity. The company
is presently considering several alternative investment proposals costing less than Rs. 20 lakhs. The
corporation always raises the required funds without disturbing its present debt-equity ratio. The cost
of raising the debt and equity are as under:
128
Projected Cost Cost of debt Cost of equity
Upto Rs.2 lakhs 10% 12%
Above Rs.2 lakhs & upto Rs.5 lakhs 11% 13%
Above Rs.5 lakhs & upto Rs.10 lakhs 12% 14%
Above Rs.10 lakhs & upto Rs.20 lakhs 13% 14.5%
Assuming the tax rate at 50%, calculate:
(i) Cost of capital of two projects X and Y whose fund requirements are Rs.6.5 lakhs and
Rs.14 lakhs respectively.
(ii) If a project is expected to give after tax return of 10%, determine under what conditions it
would be acceptable?
Solution:
(i) Statement of cost of capital
Project cost Financing Proportion of After tax cost Weighted average
capital structure (1 - Tax 50%) cost (%)
Upto Rs.2 lakhs Debt 0.4 10%(1 - 0.5) = 5% 0.4 x 5 = 2.0
Equity 0.6 12% 0.6 x 12 = 7.2
9.2%
Above Rs.2 lakhs Debt 0.4 11%(1 - 0.5) = 5.5% 0.4 x 5.5 = 2.2
& upto Rs.5 lakhs Equity 0.6 13% 0.6 x 13 = 7.8
10.0%
Above Rs.5 lakhs Debt 0.4 12% (1 - 0.5) = 6% 0.4 x 6 = 2.4
& upto Rs.10 lakhs Equity 0.6 14% 0.6 x 14 = 8.4
10.8%
Above Rs.10 lakhs Debt 0.4 13%(1 - 0.5) = 6.5% 0.4 x 6.5 = 2.6
& upto Rs.20 lakhs Equity 0.6 14.5% 0.6 x14.5= 8.7
11.3%
Project Fund requirement Cost of Capital
X Rs. 6.50 lakhs 10.8%
Y Rs.14.00 lakhs 11.3%
(ii) If a Project is expected to give after tax return of 10%, it would be acceptable provided its
project cost does not exceed Rs.5 lakhs.
129
Acceptance criterion: After tax return should be more than or at least equal to the weighted average
cost of capital.
SUMMARY
The term cost of capital is defined as the rate of return on investment projects necessary to
have unchanged market price of a firm’s share. The optimum cost of capital is a financial break-even
point. Acceptance or rejection of an investment proposal depends on the cost of capital. A debt may
be short-term or long-term and the cost of it varies. Dividend paid to the preference share holders is
the cost of preference capital. The cost of equity capital is difficult to compute as the dividend stream
receivable by the equity share holders is not specified by any legal contract. For many companies the
most important source of ownership or equity and internal source of funds. It is necessary for the
finance manager to know the overall cost of capital which can be used as the decision criterion in
capital budgeting or investment decisions. Debt Equity Ratio affects the cost of capital. When the
Debt Equity Ratio of a company increases its cost of capital decline becuase of incidence of tax on
the interest.
QUESTIONS
1. What is a concept and meaning of cost of capital?
2. What is the importance of cost of capital in financial decisions?
3. What is cost of preference capital and cost of Equity Capital?
4. Illustrate with an example the impact of change in debt and equity on composite cost of
capital.
130
CHAPTER - XV
BUDGETARY CONTROL
OBJECTIVES
To train the reader in the various aspects of performance budgeting and zero base budgeting
and also merits and demerits of ZBB.
INTRODUCTION
In the present days, planning has become the primary function of management. Planning has
to be supplemented and reinforced by overall periodic planning followed by continuous comparison
of the actual performance with the planned performances. Budgetary control is an essential tool of
management for controlling costs and maximising profits.
A budget is a detailed plan of operation for some specific future period. It is an estimate
prepared in advance of the period to which it applies.
We have already discussed various points on budgets and budgetary control in the compulsory
subject : Financial Management. Here we confine our discussion primarily to Performance Budgeting
and Zero-Base Budgeting.
PERFORMANCE BUDGETING
We have seen that budgeting is nothing but the technique of expressing, largely in financial
terms of management’s plans for operating and financing the enterprise during specific periods of time.
Any system of budgeting, in order to be successful, must provide for performance appraisal as well
as follow-up measures. It should be capable of predicting statistically the performance for the budget
period in terms of probabilities and levels of confidence.
It involves evaluation of the performance of the organisation in the context of both specific
as well as overall objectives of the organisation. It must have clear organisational objectives and short-
term business objectives. Performance budgeting provides a definite direction to each employee and
also a control mechanism to higher management. According to National Institute of Bank Management
(NIBM), performance budgeting technique is, the process of analysing, identifying, simplifying and
crystallising specific performance objectives of a job to be achieved over a period, in the framework
of the organisational objectives, the purpose and objectives of the job. The technique is characterised
by its specific direction towards the business objectives of the organisation.
131
Performance budgeting lays immediate stress on the achievement of specific goal over a period
of time. It requires preparation of periodic performance reports. Such reports compare budget and
actual data and show any existing variances. The responsibility for preparing the performance budget
of each department lies on the respective departmental head. Each departmental head will be supplied
with a copy of the section of the master budget appropriate to his sphere. Periodical reports from the
various sections of the departments will be received by the departmental head who will in summary
form submit a report about his department to the budget committee. The report may be daily, weekly
or monthly depending upon the size of business and the budget period. These reports will be in the
form of comparison of budgeted and actual figures, both periodic and cumulative. The purpose of
submitting these reports is to convey promptly the information about the deviations in actual and
budgeted activity to the person who has the necessary authority and responsibility so that he may
take necessary action to correct any deviation from the budget.
ZERO -BASE BUDGETING
Zero-Base Budgeting (ZBB) is a new technique designed to revitalise budgeting. This

technique was first used by the U.S.Department of Agriculture in the early sixties. ZBB, in its present
form, was designed in its logical basic framework in 1970 by Peter A.Pyhrr, who developed,
implemented and popularised its wider use in the private sectors. He is termed as the ‘Father of Zero-
Base Budgeting’. In India, the Institute of Cost and Works Accountants of India and the Institute of
Chartered Accountants of India have conducted seminars to acquaint people with the ZBB technique.
ZBB is, however, yet to be implemented in real terms in India.
In this context it is worthwhile to highlight the limitations of traditional budgeting techniques.

These are as follows:
i) The inefficiencies of a prior year are carried forward in determining subsequent years’ level
of performance.
ii) Managers tend to inflate their budget requests resulting in more demand for funds than their
availability. This results in recycling the entire budgeting process.
iii) Key problems and decision areas are not highlighted. No priorities are established throughout
the organisation.
iv) Decision-making is irrational in the absence of rigorous analysis of all proposed costs and
benefits.
v) Managers neither strive nor are encouraged to identify and evaluate alternative means of
accomplishing the same objective.
vi) Programmes involving wasteful expenditure are not identified resulting in avoidable financial
and other costs.
132
The technique of ZBB provides a solution for over-coming the limitations of traditional
budgeting by enabling top management to focus on key areas, alternatives and priorities of action
throughout the organisation.
MEANING OF ZERO -BASE BUDGETING
Zero-base budgeting is a planning, resource allocation and control tool that requires an
executive to justify his/her budget requirement for projected performance starting from scratch. A
close examination of programs, projects and activities of the departments/divisions is needed so that
funds are allocated to high-priority programs by eliminating outdated programs and reducing funds to
the low-priority programs and projects. This calls for a fresh evaluation and prioritisation of ongoing
as well as new programs and projects, so that scarce resources are deployed efficiently and effectively.
The underlying philosophy of zero-base approach is a structured, systematic and analytical process
of questioning, done in two stages. The first stage involves re-defining the urgency, importance or
priority of every program, project, task or activity. For this purpose, various problems and projects
needs to be classified into vital, essential and desirable. The second stage involves an in-depth
questioning of every program, project or the task as if it is a fresh one. For this purpose the following
steps are adopted.
i) Spelling out the discrete activities or decision units by top functionaries.

ii) Construction of decision packages with specification of specific objectives, operational
objectives and alternative performance methods to achieve these objectives.
iii) Priority ranking of endorsed projects by the junior functionaries, followed by a hierarchical
review with continual consolidated re-ranking.
iv) Allocation of resources to decision units based on the consolidated ranking of accepted or
approved decision packages and projection of available funds.
v) Monitoring performance of projects on the basis of criteria established in the approved
decision packages.
Zero-base review is a resource planning and re-deployment exercise. Its implementation
leads to an improved utilisation of staff and other resources in addition to enhancing cost-effectiveness.
Therefore, it can be called a resource planning and re-deployment device. ZBB is more suitable for
budgets of administrative departments and expense centres engaged mainly in co-ordination and
provision of supportive services.
The benefits by adopting ZBB are:

Improved planning of work and re-deployment of resources.
133
Cost effectiveness by a systematised learning process that would ensure that the budget for
the following year will not be based on the pitfalls of the previous year’s performance and
resource allocation.
Increased participation of managers in the budget-making process.
It links budgets with the corporate objectives.
It can be used for introduction and implementation of the system of ‘management by
objectives’.
Merits of ZBB
i) Prioritisation among activities and efficient and effective re-allocation of resources.

ii) Goals will be more sharply established and alternative means are explicitly considered.
iii) Managers will more keenly involve themselves in a well-structured budget process that fosters
communication and consensus.
iv) It enables the management to approve departmental budgets on the basis of cost-benefit
analysis.
v) It helps in identifying areas of wasteful expenditure and if desired, it can also be used for
suggesting alternative courses of action.
Demerits of ZBB
i) Determination of performance is difficult.

ii) Time and cost of preparing the budget will be higher.
iii) Top managers fail to follow through the use of the ZBB information in making choices.
SUMMARY
Budgetary Control is an essencial tool of management for controlling cost and maximizing
profits. Performance of budgeting should be capable of predicting statistically the performance for
the budget period in terms of probablity and levels of confidence. Zero Base Budgeting is a new
technique designed to re-vitalize budgeting.
QUESTIONS
1. What is Budgeting Control?

2. What is Performance Budgeting?
3. What is Zero Base Budgeting give the meaning, mertis and demerits?
134
MODEL QUESTION PAPER
National Institute of Business Management

Chennai - 020
FIRST SEMESTER EMBA/ MBA
Subject : Financial Management
Time : 3 hours Marks : 100
Section A
I Answer all questions. Each question carries 2 marks :-

1. What is Business Finance?
2. Which are the forms of organisation?
3. Which are the different categories of international sources of finance?
4. What is the meaning of Cash?
5. What is the meaning of Receivables?
5x2=10 marks
Section B
II Answer all questions. Each question carries 6 marks :-
1. What are the benefits of holding inventories?
2. Which are the three methods for assessing the working capital requirement?
3. Which are the motives for holding Cash?
4. Which are the internal sources of Cash?
5. What is overall Profitability Ratio?
5x6=30 marks
Section C
III Answer any three questions. Each question carries 20 marks :-
1. Explain the functions of Finance.
2. Enumerate the Indian Financial System.
3. What is equity share capital? What are the advantages and disadvantages from the
firm’s point of view and the shareholder’s point of view?
4. What is a financial statement? What are its limitations?
5. Explain Funds Flow Analysis. Illustrate with a figure.
3x20=60 marks

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National Institute of

III MANAGEMENT OF WORKING CAPITAL 33

VII FINANCIAL ANALYSIS AND PLANNING 68

VIII FUNDS FLOW ANALYSIS 73

IX CASH FLOW STATEMENT 81

XII FINANCIAL FORECASTING 105

XIII CAPITAL STRUCTURE 116

XIV COST OF CAPITAL 120

XV BUDGETARY CONTROL 131

THE FIELD OF FINANCE

The field of finance is closely related to accounting and economics.

MEANING OF BUSINESS FINANCE

Finance is defined as the provision of money at the time it is wanted. As a management

The external factors are:

MEANING OF FINANCIAL MANAGEMENT

What is the purpose or objective sought to be achieved by the Finance Manager?

MAINTENANCE OF LIQUID ASSETS:

a) Total employment generation

d) Increase in market share

Maximisation of Share Value

Funds Requirement Financing Investment Dividend

Liquidity means that:

INTERFACE BETWEEN FINANCE AND OTHER FUNCTIONS

The sole proprietorship form of organisation represents single-person ownership. The

The advantages of a sole proprietorship are:

 easy and inexpensive setup

The disadvantages are:

 there is unlimited liability to the owner

The advantages of partnership form of business are:

A group of persons working together towards a common objective is called a company.

A company can be a private company or a public company.

The advantages of a private company form of organisation are:

(i) the liability of shareholders is limited

(i) the burden of taxation is high

The advantages of public company form of organisation are:

i) the company has an unlimited life

The disadvantages of public company form of organisation are:

i) there is elaborate procedure for setting up of a public company.

The following Acts/Regulations provide the regulatory framework in India:

(a) The Companies Act, 1956

INDIAN FINANCIAL SYSTEM

The financial intermediaries in India can be categorised as under:

a) State Bank of India and its subsidiaries

1. What is the meaning of Business Finance?

Owner’s funds (Equity)

Long-term sources Short-term sources Internal sources

Owners’ funds Outsiders’ funds

1.Equity Shares 1.Debentures 1. Trade Credit 1. Retained profits(ie.,

1. Equity Share Capital

The sources for investment in equity shares are:

(a) Individual investors

2. Preference Share Capital

Preference shares resemble equity share capital in the following ways:

(i) preference dividend is payable only out of distributable profits

Preference share capital is similar to debenture in the following ways:

(i) the dividend rate on preference dividend is usually fixed

There are different classes of preference shares based on the features.

Dividends Surplus Convertibility Redemption

Cumulative Non- Convertible Non-convertible

Participating Non-participating Redeemable Irredeemable

Preference shares may be cumulative or non-cumulative with respect to dividends. If the

Convertibility Security Redemption Transfer

Convertible Non- Redeemable Irredeemable

easy and inexpensive setup

there is unlimited liability to the owner

to assist projects which promote commercial applications of indigenously developed

Securities and Exchange Board of India (SEBI),

Internal resources can be built up only through profitable operations.