MEANING OF FINANCIAL MANAGEMENT

Financial management is that managerial activity which is concerned with the

planning and controlling of the firm’s financial resources. It was a branch of economics
till 1890, and as a separate discipline, it is of recent origin. Still, it has no unique body of
knowledge of its own, and draws heavily on economics for its theoretical concepts even
today.
The subject of financial management is of immense interest to both academicians
and practicing managers. It is of great interest to academicians because the subject is still
developing, and there are still certain areas where controversies exist for which no
unanimous solutions have been reached as yet. Practicing managers are interested in this
subject because among the most crucial decisions of the firm are those which relate to
finance, and an understanding of the theory of financial management provides them with
conceptual and analytical insights to make those decisions skillfully. [Financial
Management (Ninth Edition), I M Pandey, Pg no. 3]

DEFINITION
According to Soloman, “Financial management is concerned with the efficient
use of an important economic resource, namely, Capital funds,”
Phillippatus has given a more elaborate definition of the term financial
management. According to him “ Financial management is concerned with the
management decisions that result in the acquisition and financing of long-term and short-
term credits for the firm. As such it deals with the situations that require selection of
specific assets ( or combination of liabilities ) as well as the problem of size and growth
of an enterprise. The analysis of these decisions is based on the expected inflows and
outflows of funds and their effects upon managerial objectives”.

IMPORTANCE OF FINANCIAL MANAGEMENT

The importance of financial management cannot be overemphasized. In every
organization, where funds are involved, sound financial management is necessary. As
Collins Brooks has remarked, “Bad production management and bad sales management
have slain in hundreds, but faulty financial management has slain in thousands”. Finance

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 manager must realize that when a firm makes a major decision, the effect of the action
will be felt throughout the enterprise. For example, an increase in plant and equipment
expenditure will affect the firm’s cash position, its borrowing capability and its dividend
distribution.
Sound financial management is essential in both profit and non-profit
organizations. The financial management helps in monitoring the effective deployment of
funds in fixed assets and in working capital. The finance manager estimates the total
requirement of funds, both in the short period and the long period. The finance manager
assesses the financial position of the company through working out of the return on
capital, debt-equity ratio, cost of the capital from each source, etc., and comparison of the
capital structure with that of similar companies.
Financial management also helps in ascertaining how the company would perform
in future. It helps in indicating whether the firm will generate enough funds to meet its
various obligations like repayment of the various instalments due on loans, redemption of
other liabilities.
Sound financial management is indispensable for any organization. It helps in
profit planning, capital spending, measuring costs, controlling inventories, accounts
receivable, etc. financial management essentially helps in optimizing the output from a
given input of funds.

OBJECTIVES OF FINANCIAL MANAGEMENT

The objectives of financial management can be put into two categories:

1. BASIC OBJECTIVES
Traditionally the basic objectives of financial management have been (i)
maintenance of liquid assets and (ii) maximization of profitability of the firm. However,
these days there is a greater emphasis on (iii) shareholders’ wealth maximization rather
than on profit maximization.

Maintenance of Liquid Assets

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 Financial management aims at maintenance of adequate liquid assets with the
firm to meet its obligations at all times. It may be noted that investment in liquid assets
has to be adequate-neither too low nor too excessive. The finance manager has to
maintain a balance between liquidity and profitability. There is an inverse relationship
between the two. The more the assets are liquid, less they are profitable and vice versa.

Profit maximization
A business firm is a profit seeking organisaiton. Hence, profit maximization is an
important objective of financial management. However, the concept of profit
maximization has come under severe criticism, in recent times, on account of the
following reasons:
It is a Vague : It does not clarify which profits does it mean; whether short-term or long-
term. Profits in the short-term may be quite different from those in the long-run. For
example, if a firm continues to run its business without having adequate maintenance of
its machinery, the firm’s profits in the short run may increase because of savings in
expenditure. However, in the long run the firm may suffer since the machine may have to
be replaced or machine may require a heavy expenditure on its repairs because of its
improper upkeep from year to year. Moreover, it is also not clear whether profit
maximization means maximizing absolute profits or simply rate of return.
It Ignores Timing : The concept of profit maximization does not help in making a
choice between projects giving different benefits spread over a period of time. The
concept ignores the fact that a rupee received tomorrow. For example, if there are two
projects A and B each requiring equal investment. Project A gives a 20% return for 3
years while project B gives a return of 17% for five years. In order to decide which
project should be preferred, it is not only enough to see the rate of return, but also the
present value of the cash flows available from both the projects. In case of project A, the
rate of return after 3 years and hence it will be more profitable than project B only when
the firm has adequate investment opportunities. In case the firm does not have such
opportunities, project B may be more beneficial.
It Overlooks Quality aspect of Future Activities : The business is not solely run with
the objective of earning higher possible profits. Some firms place a high value on the

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growth of sales. They are willing to accept lower profits to gain stability provided by a
large volume of sales. Other firms use a part of their profits to make contribution for
socially productive purpose. Moreover, profit maximization at the cost of social or moral
obligations is a short-sighted policy even as a pragmatic approach.

Maximisation of wealth
Professor Ezra Soloman has suggested the adoption of wealth maximization as the
best criterion for the financial decision-making. He has described the concept of wealth
maximization as follows:
“The gross present worth pf a course of action is equal to the capitalized value of
the flow of future expected benefits, discounted (or capitalized) at the rate which reflects
their certainty or uncertainty. Wealth or net present worth is the difference between gross
present worth and the amount of capital investment required to achieve the benefits. Any
financial action which creates wealth or which has a net present worth above zero is a
desirable one and should be undertaken. Any financial action which does not meet this
test should be rejected. If two or more desirable courses of action are mutually exclusive
(i.e., if only one can be undertaken), then the decision should be to do that which creates
most wealth or shows the greatest amount of net present worth. In short, the operating
objectives for financial management is to maximize wealth or net present worth”.
Wealth maximisation is, therefore, considered to be the main objective of
financial management. This objective is also consistent with the objective of maximizing
the economic welfare of the shareholders of a company. The value of a company’s shares
depends largely on its net worth which itself depends on earning per share (E.P.S). the
finance manager should, therefore, follow a policy which increases the earning per share
in the long run.

Steps for Wealth Maximisaiton

In order to maximize wealth, a firm should take the following steps:
Avoid high levels of risks

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 The firm should avoid such projects which involve high profits together with high
risks. This si because accepting of such projects may be disastrous for the frim in the long
run in case any factor goes wrong.
Pay dividends
Payment of regular dividends increases the firm’s reputation ad consequently the
value of the firm’s shares. While declaring dividends the market trends and the
expectations of the shareholders must be kept in mind.
Maintain growth in sales
The firm should have a large, stable and diversified volume of sales. This protects
the firm from adverse consequences of recessions, changes in customers’ preference or
fall in demand for the firm’s products on account of other reasons. A firm should
therefore consistently seek growth in sales by developing new markets, projects, etc.
Maintain price of firm’s equity shares
Maximization of shareholders’ wealth is closely connected with maximization of
the value of the firm’s equity shares. The firm can take a number of steps to maintain the
value of its equity shares at reasonable levels. For example, the management can
encourage people to invest their savings in the firm’s shares by explaining their actions.
They can, by highlighting the firm’s past performance and glorious future, create a new
demand for firm’s shares which will push up the value of its equity shares. Similarly
adoption of sound investment policies will also considerably help in improving the image
of the firm. It may, however, be noted that wealth maximization objective cannot be
carried too far. It is subject to certain limitations.
Social responsibility
The management cannot ignores its social responsibility, e.g., protecting the
interest of the consumers, paying fair wages to workers, maintain proper working
conditions, providing educational and physical facilities to their workers and involving
themselves in environmental issues like clean air, water, etc.
Some of the social actions are in the long run in the interests of the shareholders
and may therefore be adopted. However, others, e.g., providing clean environment, may
considerably reduce the firm’s profitability and ultimately the shareholders’ wealth.
Government constraints

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 On account of the growing concept of a welfare state, there after a number of
statutory provisions which considerably reduce a firm’s freedom to act. Restriction
imposed by the government regarding establishment, expansion, closure, etc., of business
firm may force the management of the shareholders’ wealth.
In conclusion it can be said that a firm should follow the objective of wealth
maximization to the extent it is viable in the context of its social responsibility and
constraints imposed by government.

2. OTHER OBJECTIVES
The following are the other objectives of financial management:
(i) Ensuring a fair return to shareholders.
(ii) Building up reserves for growth and expansion.
(iii) Ensuring maximum operational efficiency by efficient and effective
utilization of finances.
(iv) Ensuring financial discipline in the organization.

SCOPE OF FINANCIAL MANAGEMENT

Financial management, as an academic discipline, has undergone significant
changes over the year as regards its scope and coverage. As such the role of finance
manager has also undergone fundamental changes over the year. In order to have a better
exposition to these changes it will be appropriate to study both the traditional approach
and the modern approach to the finance function.

Traditional approach
The traditional approach, which was popular in the early part of this century,
limited the role of financial management to raising and administering of funds needed by
the corporate enterprises to meet their financial needs. It broadly covered the following
three aspects:
(i) Arrangement of funds from financial institutions.
(ii) Arrangement of funds through financial instruments, viz., shares, bonds, etc.

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 (iii) Looking after the legal and accounting relationship between a corporation and
its sources of funds.
Thus, the traditional concept of financial management included within its scope the
whole gamut of raising the funds externally. The finance manager had also a limited role
to perform. He was expected to keep accurate financial records, prepare reports on the
corporation’s status and performance and manage cash in a way that the corporation was
in a position to pay its bills in time. The term “Corporation Finance” was used in place of
the present term “Financial Management”.
The traditional approach found its first manifestation, though not very systematic,
in 1897 in the book Corporation Finance written by Thomas Greene. It was further
impetus by Edward Meade in 1910 in his work, Corporation finance. However, it was
sanctified firmly by Arthur Dewing in 1919 in his book ‘The Financial Policy of
Corporation’. The book dominated the academic corks in the fields of corporation finance
for nearly three decades.
The traditional approach evolved during 1920 continued to dominate academic
thinking during the forties and through the early fifties. However, in the later fifties it
started to be severely criticized and later abandoned on account of the following reasons:
Outsider-looking-in approach
The approach equated finance function with the raising and administering of
funds. It thus treated the subject of finance from the viewpoint of suppliers of funds, i.e.,
outsiders, viz., bankers, investors, etc. It followed an outsider-looking-in approach and
not the insider-looking-out approach since it completely ignored the viewpoint of those
who had to take internal financing decisions.
Ignored routine problems
The approach gave undue emphasis to episode or infrequent happenings in the life
of an enterprise. The subject of financial management was mainly confined to the
financial problems arising during the course of incorporation, mergers, consolidation and
reorganization of corporate enterprises. As a result the subject did not give any
importance to day-to-day financial problems of business undertaking.
Ignored non-corporate enterprises

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 The approach focused attention only on the financial problems of corporate
enterprises. Non-corporate industrial organizations remained outside its scope.
No emphasis on allocation of funds
The approach confined financial management to issues involving procurement of
funds. It did not emphasis on allocation of funds. It ignored, as pointed out by Soloman,
the following central issues of financial management:
(a) Should an enterprise commit capital funds to certain purpose?
(b) Do the expected returns meet the financial standards of performance?
(c) How should these standards be set and what is the cost of capital funds to the
enterprise?
(d) How does the cost vary with the mixture of financing methods used?
Traditional approach failed to provide answer to these questions. The modern
approach, provides answer to these questions.

Modern approach
The traditional approach outlived its utility due to changed business situations
since mid-1950’s. Technological improvements, widened marketing operations,
development of a strong corporate structure, keen and healthy business competition, all
made it imperative for the management to make optimum use of available financial
resources for continued survival. The advent of computer in sixties made large quantum
of information available to the finance manager, based on which he could make sound
decisions. Computers helped in application of powerful techniques of operations
research. The scope of financial management increased with the introduction of capital
budgeting techniques. As a result of new methods and techniques, capital investment
projects led to a framework for efficient allocation of capital within the firm also. During
the next two decades various pricing models, valuation models and investment portfolio
theories also developed.
Efficient allocation of capital on suitable criterion became an important area of
study under financial management. Eighties witnessed an era of high inflation. This
caused the interest rates to rise dramatically. Thus, raising loan on suitable terms also
became a specialized art and more important became the aspect of efficient utilization of

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these scarce funds. In the new volatile environment, capital investment and financing
decisions became more riskier than ever before. These environmental changes enlarged
the scope of finance. The concept of managing a firm as a system emerged. External
factors now no longer could be evaluated in isolation. Decisions to arrange funds was to
be seen in consonance with their efficient and effective use. This total approach to study
of finance is being termed as Financial Management.
Thus, according to modern concept, financial management is concerned with both
acquisition of funds as well as their allocation. The new approach views the term
financial management in a broader sense. In this sense the central issue of financial
policy is the wise use of funds and the central process involved is a rational matching of
advantages of potential uses against the cost of alternative potential uses so as to achieve
the broad financial goals which an enterprise sets for itself.
The modern approach is an analytical way of looking at the financial problems of
a firm. The main contents of the new problem are as follows:
(i) What is the total volume of funds an enterprise should commit?
(ii) What specific assets should an enterprise acquire?
(iii) How should the funds required be financed?
The above questions relate to four broad decision areas of financial management, viz.,
investment decision, financing decision, dividend decision and liquidity decision. These
decisions, which can also be termed as functions outlining the scope of financial
management, are being discussed below. [Element of Financial management(Ninth
Edition), Dr.S.N.Maheshwari, Pg no:A-4 to A-10]

Investment decision
A firm’s investment decisions involve capital expenditures. They are, therefore,
referred as capital budgeting decisions. A capital budgeting decision involves the
decision of allocation of capital or commitment of funds to long-term assets that would
yield benefits (cash flows) in the future. Two important aspects of investment decisions
are: (a) the evaluation of the prospective profitability of new investments, and (b) the
measurement of a cut-off rate against that the prospective return of new investments
could be compared. Future benefits of investments are difficult to measure and cannot be

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predicted with certainty. Risk in investment arises because of the uncertain returns.
Investment proposals should, therefore, be evaluated in terms of both expected return and
risk. Besides the decision to commit funds in new investment proposals, capital
budgeting also involves replacement decisions, that is, decision of recommitting funds
when an asset becomes less productive or non-profitable.
There is a broad agreement that the correct cut-off rate or the required rate of
return on investments is the opportunity cost of capital. The opportunity cost of capital is
the expected rate of return that an investor could earn by investing his or her money in
financial assets of equivalent risk. However, there are problems in computing the
opportunity cost of capital in practice from the available data and information. A decision
maker should be aware of these problems.

Financing decision
Financing decision is the second important function to be performed by the
financial manager. Broadly, he or she must decide when, where from and how to acquire
funds to meet the firm’s investment needs. The central issue before him or her is to
determine the appropriate proportion of equity and debt. The mix of debt and equity is
known as the firm’s capital structure. The financial manager must strive to obtain the best
financing mix or the optimum capital structure for his or her firm. The firm’s capital
structure is considered optimum when the market value of shares is maximized.
In the absence of debt, the shareholders’ return is equal to the firm’s return. The
use of debt affects the return and risk of shareholders; it may increase the return on equity
funds, but it always increases risk as well. The change in the shareholders’ return caused
by the change in the profits is called the financial leverage. A proper balance will have to
be struck between return and risk. When the shareholders’ return is maximized with
given risk, the market value per share will be maximized and the firm’s capital structure
would be considered optimum. Once the financial manager is able to determine the best
combination of debt and equity, he or she must raise the appropriate amount through the
best available sources. In practice, a firm considers many other factors such as control,
flexibility, loan covenants, legal aspects etc, in deciding its capital structure.

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Dividend decision
Dividend decision is the third major financial decision. The financial manager
must decide whether the firm should distribute all profits, or retain them, or distribute a
portion and retain the balance. The proportion of profits distributed as dividends is called
the dividend-payout ratio and the retained portion of profits is known as the retention
ratio. Like the debt policy, the dividend policy should be determined in terms of its
impact on the shareholders’ value. The optimum dividend policy is one that maximizes
the market value of the firm’s shares. Thus, if shareholders are not indifferent to the
firm’s dividend policy, the financial manager must determine the optimum dividend-
payout ratio. Dividends are generally paid in cash. But a firm may issue bonus shares.
Bonus shares are shares issued to the existing shareholders without any charge. The
financial manager should consider the questions of dividend stability, bonus shares and
cash dividends in practice.

Liquidity decision
Investment in current assets affects the firm’s profitability and liquidity. Current
assets management that affects a firm’s liquidity is yet another important finance
function. Current assets should be managed efficiently for safeguarding the firm against
the risk of illiquidity. Lack of liquidity (or illiquidity) in extreme situations can lead to
the firm’s insolvency. A conflict exists between profitability and liquidity while
managing current assets. If the firm does not invest sufficient funds in current assets, it
may become illiquid and therefore, risky. But it would lose profitability, as idle current
assets would not earn anything. Thus, a proper trade-off must be achieved between
profitability and liquidity. The profitability-liquidity trade-off requires that the financial
manager should develop sound techniques of managing current assets. He or she should
estimate firm’s needs for current assets and make sure that funds would be made
available when needed.
In sum, financial decisions directly concern the firm’s decision to acquire or
dispose off assets and require commitment or recommitment of funds on a continuous
basis. It is in this context that finance functions are said to influence production,

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marketing and other functions of the firm. Hence finance functions may affect the size,
growth, profitability and risk of the firm, and ultimately, the value of the firm.
The function of financial management is to review and control decisions to commit or
recommit funds to new or ongoing uses. Thus, in addition to raising funds, financial
management is directly concerned with production, marketing and other functions, within
an enterprise whenever decisions are made about the acquisition or distribution of assets.[
[Financial Management (Ninth Edition), I M Pandey, Pg no: 5]

Apart from the above main functions, following subsidiary functions are also
performed by the finance manager:

To ensure supply of funds to all part of the organization

It is also the finance manager’s function to ensure that funds are available to every
part of the organization as and when it needs them so as to help in smooth operations of
the activities of the organization.

Evaluation of the financial performance

The financial performance of the various units of the organization is to be
evaluated from time to time to detect any fault in the financial policy and take the
remedial action at appropriate time, if necessary.

To negotiate with bankers, financial institutions and other suppliers of

credit
Bankers, financial institutions and other suppliers of credit are the different
sources of funds. It is necessary for the company to negotiate with them so as to obtain
the funds at most favourable terms.
To keep track of stock exchange quotations and behaviour of stock
market prices

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 Stock exchange quotations are the barometers of the economy as a whole. By
keeping an eye on the stock market, the finance manager is in a position to plan the
policy of the business enterprise with regard to finance more effectively.
Thus, we see that the Financial Management has emerged as an area of study that
encompasses variety of analytical tools and vigorous analysis. It has changed from an
area which was primarily concerned with procurement of funds to one that includes the
management of assets, the allocation of capital and the valuation of firm. With the
changing environment the scope of financial management will also change, to accept the
challenge of new environment. [Elements of Financial Management(Ninth Edition),
Dr.S.N.Maheshware, Pg no:A-12]

RATIOS INVOLVED IN FINANCIAL MANAGEMENT

Ratios are relationships expressed in mathematical terms between figures which
are connected with each other in some manner. Obviously, no purpose will be served by
comparing two sets of figures which are not at all connected with each other. Moreover,
absolute figures are also unfit for comparison. Ratios can be expressed in two ways.

1. Time : When one value is divided by another, the unit used to express the quotient is
termed as “ Times “.
2. Percentage : If the quotient obtained is multiplied by 100, the unit of expression is
termed as “ Percentage “.

 Overall profitability ratio

It is also called as “ Return on Investment “ (ROI) or Return on Capital Employed
(ROCE). It indicates the percentage of return on the total capital employed in the
business. It is calculated on the basis of the following formula:

Operating profit
Overall profitability ratio = ------------------- * 100
Capital employed

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 The term capital employed has been given different meanings by different
accountants. Some of the popular meanings are as follows:
i. Sum-total of all assets whether fixed or current,
ii. Sum-total of fixed assets,
iii. Sum-total of long-term funds employed in the business, i.e.,
Share capital + Reserves & Surplus + Long term loans –
( Non business assets + Fictitious assets )

 Earning per share (E.P.S)

In order to avoid confusion on account of the varied meanings of the term capital
employed, the overall profitability can also be judged by calculating earning per share
with the help of the following formula:

Net profit after tax and preference dividend

Earnings per share = -----------------------------------------------------
Number of equity shares

 Price earning ratio (P.E.R)

This ratio indicates the number of times the earning per share is covered by its
market price. This is calculated according to the following formula:

Market price per equity share

Price earning ratio = -----------------------------------
Earning per share

 Gross profit ratio

This ratio expresses relationship between gross profit and net sales. Its formula is:
Gross profit
Gross profit ratio = ---------------- * 100
Net sales

 Net profit ratio

This ratio indicates net margin earned on a sale of Rs.100. It is calculated as
follows:

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 Net operating profit
Net profit ratio = ------------------------- * 100
Net sales

Net operating profit is arrived at by deducting operating expenses from gross

profit.

 Operating or Expenses ratio

This ratio is a complementary of net profit ratio. In case the net profit ratio is
20%, it means that the operating ratio is 80%. It is calculated as follows:

Operating costs
Operating ratio = ------------------- * 100
Net sales

Operating costs include the cost of direct materials, direct labour and other
overheads, viz., factory, office or selling. Financial charges such as interest, provision for
taxation, etc., are generally excluded from operating costs.

 Pay-out ratio
This ratio indicates what proportion of earning per share has been used for paying
dividends. The ratio can be calculated as follows:

Dividend per equity share

Pay-out ratio = -------------------------------
Earning per equity share

A complementary of this ratio is Retained earning ratio. It is calculated as

follows:
Retained earning per equity share
Retained earning ratio = ---------------------------------------
Earning per equity share

Or

Retained earnings
Retained earning ratio = --------------------- * 100

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 Total earnings

 Dividend yield ratio

This ratio is particularly useful for those investors who are interested only in
dividend income. The ratio is calculated by comparing the ratio of dividend per share
with its market value. Its formula can be put as follows:

Dividend per share

Dividend yield ratio = -------------------------- * 100
Market price per share

 Fixed interest cover

The ratio is very important from the lender’s point of view. It indicates whether
the business would earn sufficient profits to pay periodically the interest charges. The
higher the number, the more secure the lender is in respect of his periodical interest
income. It is calculated as follows:

Income before interest and tax

Fixed interest cover = --------------------------------------
Interest charges

The standard for this ratio for an industrial company is that interest charges
should be covered sex to seven times.

 Fixed dividend cover

This ratio is important for preference shareholders entitled to get dividend at a
fixed rate in priority to other shareholders. The ratio is calculated as follows:

Net profit after interest and tax

Fixed dividend cover = --------------------------------------
Preference dividend

 Debt service coverage ratio

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 The interest coverage ratio, as explained above, does not tell us anything about
the ability of a company to make payment of principal amounts also on time. For this
purpose debt service coverage ratio is calculated as follows:

Net profit before interest and tax

Debt service coverage ratio = ------------------------------------------------
Principal payment instalment
Interest + -----------------------------------
1 – Tax rate

The principal payment instalment is adjusted for tax effects since such payment is
not deductible from net profit for tax purpose.

 Fixed assets turnover ratio

This ratio indicates the extent to which the investments in fixed assets contribute
towards sales. If compared with a previous period, it indicates whether the investment in
fixed assets has been judicious or not. The ratio is calculated as follows:

Net asset
Fixed asset turnover ratio = ----------------------
Fixed assets (net)

 Working capital turnover ratio

This is also known as Working capital leverage ratio. This ratio indicates whether
or not working capital has been effectively utilized in making sales. In case a company
can achieve higher volume of sales with relatively small amount of working capital, it is
an indication of the operating efficiency of the company. The ratio is calculated as
follows:

Net sales
Working capital turnover ratio = --------------------
Working capital

Working capital turnover ratio may take different forms for different purposes.
Some of them are being explained below:

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 Debtors’ turnover ratio (Debtors’ velocity)
Debtors constitute an important constituent of current assets and therefore the
quality of debtors to a great extent determines a firm’s liquidity. Two ratios are used by
financial analysts to judge the liquidity of a firm. They are (i) Debtors’ turnover ratio and
(ii) Debt collection period ratio

Credit sales
Debtors turnover ratio = -----------------------------------
Average accounts receivable

b) Debt collection period ratio

The ratio indicates the extent to which the debts have been collected in time. It
gives the average debt collection period. The ratio is very helpful to the lenders because it
explains to them whether their borrowers are collecting money within a reasonable time.
An increase in the period will result in greater blockage of funds in debtors. The ratio
may be calculated by any of the following methods:

Months (or days) in a year

(a) ---------------------------------
Debtors’ turnover

Average accounts receivable X Months (or days) in a year

(b) ------------------------------------------------------------------------
Credit sales for the year

Accounts receivable
(c) -----------------------------------------------
Average monthly or daily credit sales

c) Creditors’ turnover ratio (Creditors’ velocity)

It is similar to Debtors’ turnover ratio. It indicates the speed with which the
payments for credit purchases are made to the creditors. The ratio can be computed as
follows:

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 Credit purchase
Creditor turnover ratio = -------------------------------
Average accounts payable

The term Accounts payable include “ Trade creditors “ and “ Bills payable “.
In case the details regarding credit purchase, opening and closing accounts payable have
not been given the ratio may be calculated as follows:

Total purchase
Creditor turnover ratio = ---------------------
Accounts payable

d) Debt payment period enjoyed ratio (Average age of payable)

The ratio gives the average credit period enjoyed from the creditors. It can be
computed by any one of the following methods:

Months (or days) in a year

(a) ---------------------------------
Creditors’ turnover

Average accounts payable X Months (or days) in a year

(b) ------------------------------------------------------------------------
Credit purchase for the year

Average accounts payable

(c) ----------------------------------------------------
Average monthly (or daily) credit purchase

e) Stock turnover ratio

This ratio indicates whether investment in inventory is efficiently used or not. It,
therefore, explains whether investment in inventories is within proper limits or not. The
ratio is calculated as follows:

Cost of goods sold during the year

Stock turnover ratio = ------------------------------------------
Average inventory
Average inventory is calculated by taking stock levels of raw materials work-in-
process, finished goods at the end of each month, adding them up and dividing by twelve.

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f) Working capital leverage ratio
Working capital leverage indicates the way in which the profitability and return
on the investments are affected due to working capital management. The Overall Return
on investment (ROI) depends basically on two factors namely: Net profit ratio and
Capital employed turnover ratio.

Capital employed constitutes of fixed + working capital. The overall return on

capital employed depends both on Net profit ratio and Turnover ratio. The Return on
investment will, therefore, be affected by change in any of the following:
(i) Net profit margin,
(ii) Fixed capital,
(iii) Working capital, and
(iv) Total capital employed.

Liquidity ratios
These ratios are also termed as ‘ Working capital ratio’ or ‘ Short-term solvency
ratio’. An enterprise must have adequate working capital to run its day-to-day operations.
Inadequacy of working capital may bring the entire business operation to a grinding halt
because of inability of the enterprise to pay for wages, materials and other regular
expenses.
The important liquidity ratios are as follows:

a) Current ratio
This ratio is an indicator of the firm’s commitment to meet its short-term
liabilities. It is expressed as follows:
Current assets
Current ratio = ------------------------
Current liabilities

Current assets mean assets that will either be used up or converted into cash
within a year’s time or during the normal operating cycle of the business, whichever is

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 longer. Current liabilities mean liabilities payable within a year or during the 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 as current assets.

b) Quick ratio
This ratio is also termed as ‘ Acid test ratio ‘ or ‘ Liquidity ratio ‘. This ratio is
ascertained by comparing the liquid assets (i.e., assets which are immediately convertible
into cash without much loss) to current liabilities. Prepaid expenses and stock are not
taken as liquid assets. The ratio may be expressed as:

Liquid assets
Quick ratio = ----------------------
Current liabilities

c) Super quick ratio

This is a variation of quick ratio. The ratio is calculated as follows:
Cash and marketable securities
Super quick ratio = -----------------------------------------
Current liabilities

Or
Cash and marketable securities
Super quick ratio = -----------------------------------------
Quick liabilities

d) Defensive interval ratio

This ratio examines the firm’s liquidity position in terms of its ability to meet
projected daily expenditure from operations. It is calculated as follows:
Quick assets
Defensive interval ratio = --------------------------------------------
Projected daily cash requirements

Projected daily cash requirements are computed as follows:

Projected cash operating expenses
= -------------------------------------------
Number of days in a year

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 Projected cash operating expenses are computed on the basis of past experience
and future plans. They include cost of goods sold (excluding depreciation) and selling
and administration expenses payable in cash.

 Stability ratios
These ratios help in ascertaining the long-term solvency of a firm which depends
basically on three factors:

(i) Whether the firm has adequate resources to meet its long-term funds
requirements;
(ii) Whether the firm has used an appropriate debt-equity mix to raise long-
term funds;
(iii) Whether the firm earns enough to pay interest and instalment of long-term
loans in time.
The capacity of the firm to meet the last requirement can be ascertained by
computing the various coverage ratios, for the other two requirements, the following
ratios can be calculated.

a) Fixed asset ratio

This ratio explains whether the firm has raised adequate long-term funds to meet
its fixed assets requirements. It is expressed as follows:
Fixed assets
Fixed asset ratio = ---------------------
Long-term funds

The ratio should not be more than 1. If it is less than 1, it shows that a part of the
working capital has been financed through long-term funds. This is desirable to some
extent because a part of working capital termed as “ core working capital “ is more or less
of a fixed nature. The ideal ratio is 0.67.

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 Fixed assets include ‘net fixed assets’ (i.e., original cost-depreciation to date) and
trade investments including shares in subsidiaries. Long-term funds include share capital
reserves and long-term loans.

b) Capital structure ratios

These ratios explain how the capital structure of a firm is made up or the debt-
equity mix adopted by the firm. The following ratios fall in this category:

• Capital gearing ratio

Capital gearing (or leverage) refers to the proportion between fixed
interest or dividend bearing funds and non-fixed interest or dividend bearing funds in the
total capital employed in the business. The fixed interest or dividend-bearing funds
include the funds provided by the debentureholders and preference shareholders. Non-
fixed interest or dividend-bearing funds are the funds provided by the equity
shareholders. The amount, therefore, includes the Equity share capital and other
Reserves. A proper proportion between the two funds is necessary in order to keep the
cost of capital at the minimum.

Funds bearing fixed interest or fixed dividends

Capital gearing ratio = --------------------------------------------------------
Total capital employed
Or
Funds bearing fixed interest or fixed dividends
Capital gearing ratio = --------------------------------------------------------
Equity shareholders’ funds

In case the amount of fixed interest or fixed dividend-bearing funds is more than
the equity shareholders’ funds, the capital structure is said to be “high geared”. If the
amount of equity shareholders’ funds is more than the fixed interest or dividend-bearing
funds, the capital structure is said to be “low geared”. In case the two are equal, the
capital structure is said to be “even geared”.
The gearing ratio is useful in indicating the extra residual benefits accruing to the
equity shareholders. Such a benefit accrues to the equity shareholders because the

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company earns a certain rate of return on total capital employed but is required to pay to
the preference shareholders and debentureholders only at a fixed rate. The surplus earned
on their funds can be utilized for paying dividend to the equity shareholders at a rate
higher than the rate of return on the total capital employed in the company. Such a
situation is called “Trading on Equity”.

• Debt-equity ratio
The debt-equity ratio is determined to ascertain the soundness of the long-
term financial policies of the company. It is also known as “External-Internal” equity
ratio. It may be calculated as follows:

External equities
Debt-equity ratio = ---------------------
Internal equities

The term external equities refers to total outside liabilities and the term internal
equities refers to shareholders’ funds or the tangible net worth. In case the ratio is 1 (i.e.,
outsiders’ funds are equal to shareholders’ funds) it is considered to be quite satisfactory.

In case debt-equity ratio is to be calculated as a long-term financial ratio, it may

be calculated as follows:
Total long-term debt
(i) Debt-equity ratio = ---------------------------
Total long-term funds

Shareholders’ funds
(ii) Debt-equity ratio = --------------------------
Total long-term funds

Total long-term debt

(iii) Debt-equity ratio = -------------------------
Shareholders’ funds

Method (iii) is the most popular. Ratios (i) and (ii) give the proportion of long-term
debt/shareholders’ funds in total long-term funds (including borrowed as well as owned

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funds). While Ratio (iii) indicates the proportion between shareholders’ funds (i.e.
tangible net worth), and the total long-term borrowed funds.

Ratio (i) and (ii) may be taken as ideal if they are 0/5 each, while the ratio (iii) may
be taken as ideal if it is 1. in other words, the investor may take debt-equity ratio as quite
satisfactory if shareholders’ funds are equal to borrowed funds, may also not be
considered as unsatisfactory if the business needs heavy investment in fixed assets and
has an assured return on its investment, e.g., in case of public utility concerns.

It is to be noted that preference shares redeemable within a period of 12 years from

the date of their issue should be taken as a part of debt.

• Proprietary ratio
It is a variant debt-equity ratio. It establishes relationship between the
proprietor’s funds and the total tangible assets. It may be expressed as:

Shareholders’ funds
Proprietary ratio = -------------------------
Total tangible assets

[Principles of Management Accounting (Thirteenth Edition), Dr.S.N.Maheshwari,

Pg no:B-23 to B-50]

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