Directorate of Distance Education

Guru Jambheshwar University

HISAR-125001
Bachelor of Business Adminis-
tration
(B.B.A.)
BBA - 205
FINANCIAL MANAGEMENT
CONTENTS
Lesson No. Lesson Name Page No.
1. Finance Function : Scope and Objectives 1
2. Financial Resources : Long Term, Medium Term 18
andShort Term Financial Resources with
Reference to India
3. Capital Structured Decisions 53
4. The Cost of Capital 85
5. Capital Budgeting 110
6. Working Capital Management 142
7. Management in Cash 162
8. Management of Receivables 191
9. Inventory Management 218
10. Dividend Decisions 240
11. Business Failures and Mergers 252
12. Ratio Analysis 271
13. Funds Flow Statement 318
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Lesson : 1
FINANCE FUNCTION: SCOPEANDOB1ECTIVES
(Dr. B.S. Bodla)
Introduction
Finance is regarded as the liIe blood oI a business enterprise. This is because
in the modern money-oriented economy, Iinance is one oI the basic Ioundations
oI all kinds oI economic activities. Long considered a part oI economics,
corporation Iinance emerged as a separate Iield oI study in the early part oI
20th century. At Iirst it dealt with only the instruments, institutions, and
procedural aspects oI capital markets. Accounting data and Iinancial records
were not the kind we use today, nor were regulations making it necessary to
disclose Iinancial data. But interest in Iinancial innovations, promotions,
consolidations, and mergers has always been increasing.
In a modern company`s development, the Iinancial manager plays a dynamic
role. Besides records, reports, the Iirm`s cash position, and obtaining Iunds,
the Iinancial manager is concerned with (1) investing Iunds in short-term as
well as in long-term assets and (2) obtaining the best mix oI Iinancing and
dividends in relation to the overall solution oI the Iirm. All oI this demands a
broad outlook and an alert creativity that will inIluence almost all Iacts oI the
enterprise and its external environment.
Nature of Financial Management
The term `nature` as applied to Iinancial management reIers to its relationship
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with closely related Iields oI economics and accounting, its scope, Iunctions
and objectives. Traditionally, `Iinance` was not considered a separate input until
Iinance theory became well developed. Finance Iunction as an area oI
management is oI recent origin. Financial management has gained considerable
importance over the years. It is concerned with overall managerial decision
making, in general, and with the management oI economic resources in
particular. The term Iinancial management can be deIined as the management
oI Ilow oI Iunds in a Iirm and thereIore it deals with the Iinancial decision
making oI the Iirm. Since raising oI Iunds and their best utilisation is the key
to success oI any business organisations, the Iinancial management as a
Iunctional area has got a place oI prime relevance. All business activities have
Iinancial implications and hence Iinancial management is inevitably related to
almost every sphere oI business operations.
Relation of Finance Function with other Disciplines
Finance Iunction is not a totally independent area oI Business. Being an integral
part oI the over-all management, it draws heavily on related disciplines and
Iields oI study, namely, economics, accounting, marketing, production and
operations research. These areas are both inter-related and diIIerent as well.
Now, we discuss the relationship among Iinance Iunction and the various related
disciplines.
Finance and Economics : Traditionally, `Iinance` was not considered a separate
input. In the traditional theory, Iinance was supposed to take the Iorm oI either
circulating capital or Iixed capital, and the concept oI Iiance as distinct Irom
capital was not well conceived and developed. In modern theory Iinance is
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diIIerent Irom capital. The Iield oI Iinance is closely allied to the Iield oI
economics. Finance management is a Iorm oI applied economics, which draws
heavily on economic theory. Economics deals with supply and demand, costs
and proIits, production, consumption and so on. Finance is closely related to
economics, Ior it is seriously concerned with supply and demand in the Iinancial
markets, including the stock exchange, the money market, Ioreign exchange
market, etc. It is equally concerned with the policies oI the Reserve Bank oI
India as they are reIlected in commercial banks and Iinancial institutions in
general. When money-market is tight, Iinancial environment is hard-hit. In a
period oI economic depression, business activity recedes and the Iinancial
market is adversely aIIected. The importance oI economics in the development
oI Iiance Iunction and economic theory is more evident in two areas oI
economics-macro economics and micro-economics.
Macro economics is concerned with the structure oI banking system, Iinancial
intermediaries, the public Iinance system and economic policies oI the
Government. Since the business Iirm has to operate in the macro economic
environment, the Iinance manager has to be aware oI the institutional Iramework
it contains. He must be alert to the consequences oI the varying levels oI
economic activities and changes in economic policies. In the absence oI an
understanding oI the broad economic environment, the Iinance manager will
not be able to achieve Iinancial success.
Micro economics is concerned with the determination oI optimal operating
strategies Ior Iirms as individuals, with the eIIicient operations and with
deIining an action that will make it possible Ior a Iirm to achieve Iinancial
success. The concepts involved in supply and demand relationships and proIit
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maximising strategies are drawn Ior the micro economic theory. The theories
related to the management oI utility preIerence, risk and determination oI value
are rooted in micro economic theory. The rationale oI depreciating assets is
taken Irom this area oI economics. Although the Iinance manager does not
directly apply the theories oI micro economics, he must act in conIormity
with the general principles established by these theories. Thus a knowledge oI
both micro and macro economics is necessary Ior a Iinance manager so as to
understand the Iinancial environment. Stated simply, economics is closely
interwined with Iiance.
Finance and Accounting : Much oI modern business management has only been
possible by accounting inIormation. Management is a process oI converting
inIormation into action; and accounting is a source oI most oI the inIormation
that is used Ior this purpose. Accounting has been described by Richard M.
Lynch and Robert W. Williamson as "the measurement and communication oI
Iinancial and economic data". It is a discipline which provides inIormation
essential to the eIIicient conduct and evaluation oI the activities oI any
organisation. The end-product oI accounting is Iinancial statements such as
the balance sheet, the income statement and the statement oI changes in
Iinancial position (sources and uses oI Iunds statement). The inIormation
contained in these statements and reports assists the Iinancial managers in
assessing the past perIormance and Iuture directions oI the Iirm and in meeting
certain legal obligations, such as payment oI taxes and so on. Thus, accounting
and Iinance are Iunctionally closely related. However, there are key diIIerences
in viewpoint between Iinance and accounting. The Iirst diIIerence relates to
the treatment oI Iunds while the second relates to decision-making.
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As Iar as the viewpoint oI accounting relating to the treatment oI Iunds is
concerned, the measurement oI Iunds in it is based on the accrual system. For
example, revenue is recognised at the point oI sale and not when collected.
Similarly, expenses are recognised when they are incurred rather than when
actually paid. The accounting data based on accrual system do not reIlect Iully
the Iinancial circumstances oI the Iirm. On the other, the viewpoint oI Iinance
relating to the treatment oI Iunds is based on cashIlows. The revenues are
recognised only when actually received in cash and expenses are recognised
on actual payment (i.e. cash outIlow). This is on account oI the Iact that the
Iinance manager is concerned with maintaing solvency oI the Iirm by providing
the cash Ilows necessary to satisIy its obligations and acquiring and Iinancing
the assets needed to achieve the goals oI the Iirm.
Regarding the diIIerence in accounting and Iinance with respect to their
purpose, it needs to be noted that the purpose oI accounting is collection and
presentation oI Iinancial data. The Iinancial manager uses these data Ior
Iinancial decision-making. But, Irom this one should not conclude that
accountants never make decisions or Iinancial managers never collect data.
The Iact is that the primary Iocus oI the Iunctions oI accountants is on
collection and presentation oI data while the Iinance manager `s major
responsibility is concerned to Iinancial planning, controlling and decision-
making.
Finance and other concerned Disciplines
There exists an inseparable relationship between the Iinance Iunctions on the
one hand and production, marketing and other Iunctions on the other. Almost
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all kinds oI business activities, directly or indirectly, involve the acquisition
and use oI money. For instance, recruitment and promotion oI employees in
production is clearly a responsibility oI the production department. But it
requires payment oI wages and salaries and other beneIits, and thus, involves
Iinance. Similarly, buying a machine or replacing an old machine Ior the
purpose oI increasing productive capacity aIIects the Ilow oI Iunds. Sales
promotion policies require outlays oI cash, and thereIore, aIIect Iinancial
resources. How, then, we can separate production and marketing Iunctions and
the Iinance Iunction oI making money available to meet the costs oI production
and marketing operations ? We can`t give precise answer to this question. In
Iact, Iinance policies are devised to Iit production marketing and personnel
decisions oI a Iirm in practice.
Scope of Financial Management
Financial management, as an academic discipline, has undergone signiIicant
changes over years as regards its scope and coverage. As such the role oI
Iinance manager has also undergone Iundamental changes over the years. In
order to have a better exposition to these changes, let us study both the
traditional approach and the modern approach to the Iinance Iunction.
Traditional Approach
Initially the Iinance manager was concerned and called upon at the advent oI
an event requiring Iunds. The Iinance manager was Iormally given a target
amount oI Iunds to be raised and was given the responsibility oI procuring
these Iunds. So, his Iunction was limited to raising Iunds as and when the need
arise. Once the Iunds were raised, his Iunction was over. Thus, the traditional
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concept oI Iinancial management included within its scope the whole gamut oI
raising the Iunds externally. The Iinance manager`s role was limited to keeping
accurate Iinancial records, prepare reports on the corporations status and
perIormance and manage cash in a way that the corporation is in a position to
pay its bills in time. The term `Corporation Finance` was used in place oI the
present term `Financial Management`.
The traditional approach dominated the scope oI Iinancial management and
limited the role oI the Iinical manager simply to `raising oI Iunds`. And it was
during the major events, such as promotion, reorganisation, expansion or
diversiIication in the liIe oI the Iirm that the Iinancial manager was called
upon to raise Iunds. Because oI its restricted role, the Iinance text books, Ior
example, in the USA, till the mid-1950s covered discussion oI the instruments,
institutions and practices through which Iunds are obtained. Further, as the
problem oI raising Iunds was more intensely Ielt in the case oI an `episodic
event`, these books also contained detailed descriptions oI the major events
like mergers, consolidations, reorganisations and recapitalisations. The notable
Ieature oI the traditional view oI Iinancial management was the assumption
that the Iinancial manager had no concern with the decisions oI allocating the
Iirm`s Iunds. These decisions were assumed to be given to him.
The traditional approach did not go unchallenged even during the period oI its
dominance. It has been criticised because it Iailed to consider the day-to-day
managerial problems relating to Iinance oI the Iirm. It concentrated itselI to
looking into the problems Irom management`s the insider`s point oI view (see
Solomon, Ezra, The Theory oI Financial Management, Columbia University
Press, 1969, p.3). The second ground Ior criticism oI the traditional treatment
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was that the Iocus was on Iinancing problems oI corporate enterprises. To that
extent the scope oI Iinancial management was conIined only to a segment oI
the industrial enterprises, as non-corporate organisations lay outside its scope.
Finally, this approach was having lacuna with regards to its Iocus only on long-
term Iinancing. The issues involved in working capital management were not
in the perview oI Iinance Iunction.
Modern Approach
The modern or new approach is an analytical way oI looking into the Iinancial
problems oI the Iirm. Financial management is considered a vital and an integral
part oI overall management. To quote Ezra Soloman : "The central issue oI
Iinancial policy is the wise use oI Iunds, and the central process involved is a
rational matching oI advantages oI potential uses against the cost oI alternative
potential sources so as to achieve the broad Iinancial goals which an enterprise
sets Ior itselI."
Thus, in a modern enterprise, the basic Iunction is to decide about the
expenditure decisions and to determine the demand Ior capital Ior these
expenditures. In other words, the Iinance manager, in his newrole, is concerned
with the `eIIicient allocation oI Iunds`. This problem was not considered
important in achieving the Iirm`s long run objectives. The main contents oI
modern approach to Iinancial management according to Soloman Ezra are :
What is the total volume oI Iunds an enterprise should commit ? What speciIic
assets should an enterprise acquire ? Howshould the Iunds required to Iinanced
? These three questions cover between them the major Iinancial problems oI a
Iirm. In other words, Iinancial management according to the new approach, is
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concerned with the solution oI three problems namely, investment, Iinancing
and dividend decisions. We may reIer to these decisions as managerial Iinance
Iunctions since they require special care and extraordinary administrative
ability.
Decision Areas of Financial Management/Functions of Finance
Depending upon the nature and size oI the Iirm, the Iinance manager is required
to perIorm all or some oI the Iollowing Iunctions. These Iunctions outline the
scope oI Iinancial management.
Investment Decision
Investment decision is the `oldest` area oI the recent thinking in Iinance. The
investment decision relates to the selection oI assets in which Iunds will be
invested by a Iirm. The assets which can be acquired Iall into two broad groups
: (i) long term assets which yield a return over a period oI time in Iuture, (ii)
short-term or current assets deIined as those assets which in normal course oI
business are convertible into cash usually within a year. The decisions related
to the Iormer aspect are called `capital budgeting` decisions while the latter
type oI decisions are termed as working capital decisions. Because oI the
uncertain Iuture,, capital budgeting decision involves risk. Other major aspect
oI capital budgeting theory relates to the selection oI a standard or hurdle rate
against which the expected return oI new investment can be assayed. This
standard is broadly expressed in terms oI the cost oI capital. The measurement
oI the cost oI capital is, thus, another major aspect oI the capital budgeting
decision. For details oI these decisions, please see lesson 5.
Working Capital Management, on the other hand, deals with the management
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oI current assets oI the Iirm. Though the current assets do not contribute
directly to the earnings, yet their existence is necessitated Ior the proper,
eIIicient and optimum utilization oI Iixed assets. There are dangers oI both
the excessive as well as the shortage oI working capital. A Iinance manager
has to ensure suIIicient and adequate working capital to the Iirm. Atrade-oII
between liquidity and proIitability is required. The working capital management
has been discussed in details in lessons numbering 6 to 9.
Financing Decision
Provision oI Iunds required at the proper time is one oI the primary tasks oI
the Iinance manager. Every business activity requires Iunds and hence every
Iinancial manager is conIronted with this problem. The investment decision is
broadly concerned with the asset-mix or the composition oI the assets oI a
Iirm. The concern oI the Iinancing decision is with the Iinancing-mix or capital
structure or leverage. The term capital structure reIers to the proportion oI
debt and equity capital. The Iinancing decision oI a Iirm relates to the choice
oI the proportion oI these sources to Iinance the investment requirements.
There are two aspects oI the Iinancing decision - (i) the theory oI capital
structure which shows the theoretical relationship between the employment
oI debt and the return to the shareholders. The use oI debt implies a higher
return to the shareholders as also the Iinancial risk. A judicious mix oI debt
and equity to ensure a trade-oII between risk and return to the shareholders is
necessary. AIinance manager has to evaluate diIIerent combinations oI debt
and equity and adopt one which is optimum Ior the Iirm. Leverage analysis,
EBIT-EPS analysis, capital structure models etc. are some oI the tools available
to a Iinance manager Ior this purpose. The capital structure decision has been
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discussed in detail in lesson 3.
Dividend Decision
Another major area oI decision making by a Iinance manger is known as the
Dividend decisions which deal with the appropriations oI aIter tax proIits. The
Iinance manager must decide whether the Iirm should distribute all proIits, or
retain them, or distribute a portion and retain the balance. Like the debt policy,
the dividend should be determined in terms oI its impact on the shareholder`s
value. The optimum dividend policy is one which maximises the market value
oI the Iirm`s shares. Thus, iI shareholders are not indiIIerent to the Iirm`s
dividend policy, the Iinancial manager must determine the optimum dividend
payout ratio. The dividend-payout ratio is equal to the percentage oI dividends
distributed to earnings available to shareholders. The Iinancial manager should
also consider the questions oI dividend stability, bonus shares and cash
dividends.
Objectives of Financial Management
The Process oI decision making by a Iinance manager must be goal oriented
one. He must have a speciIic goal in mind as he plans Iuture course oI action.
It is generally agreed in theory that the Iinancial goal oI the Iirm should be the
maximisation oI owners` economic welIare. Owners` economic welIare could
be maximised by maximising the shareholders` wealth as reIlected in the market
value oI shares. In this section, we shall discuss that the shareholder`s wealth
maximisation is theoretically logical and operationally Ieasible normative goal
Ior guiding the Iinancial decision making. This part also throws some light on
`proIit maximisation goal`.
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Profit Maximisation Goal
Abusiness Iirm is proIit-seeking organisation. Hence, proIit maximisation is
well considered to be an important means Ior achieving the objective oI
maximising the owners` economic welIare. According to Iinancial experts too,
one approach to determine the decision criterion Ior Iinancial management is
the proIit maximisation goal. Under this approach, actions that increase proIits
should be undertaken and those that decrease proIits are to be avoided. In
speciIic operational terms, as applicable to Iinancial management, the proIit
maximisation criterion implies that the investment, Iinancing and dividend
policy decisions oI a Iirm should be oriented to the maximisation oI proIits.
Firms in market economy are expected to produce goods and services desired
by society as eIIiciently as possible. Price system is the most important organ
oI a market economy indicating what goods and services society wants. Goods
and services in great demand can be sold at higher prices. This results in higher
proIits Ior Iirms. Thus price system provides signals to managers to direct
their eIIorts towards areas oI high proIit potential. The buyers behaviour and
extent oI competition determine the prices, and thus, aIIect the allocation oI
resources Ior producing various kinds oI goods and services.
The economists are oI the opinion that under the conditions oI Iree competition,
businessmen pursuing their own selI interests also serve the interest oI society.
It is also assumed that when individual Iirms pursue the interest oI maximising
proIits, society`s resources are eIIiciently utilized. Thus proIit is a test oI
economic eIIiciency. It provides the yardstick by which economic perIormance
can be judged. Moreover, it leads to eIIicient allocation oI resources as
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resources tend to be directed to uses which in terms oI proIitability are the
most desirable. Also, it ensures maximum social welIare.
The proIit maximisation objective has, however, been criticised in recent years.
It is argued that proIit maximisation is a consequence oI perIect competition,
and in the Iace oI imperIect modern markets, it cannot be a legitimate objective
oI the Iirm. It is also argued that proIit maximisation, as a business objective,
was developed in the early oI 19th century, when the characteristic Ieatures oI
the business structure were selI-Iinancing, private property and single
entrepreneurship. The only aim oI sole proprietor then was to enhance his
individual wealth and personal power, which could easily be satisIied by the
proIit maximisation objective. The modern business environment has the
Ieatures oI limited liability and a divorce between management and ownership.
In this changed business structure, the owner manager oI the 19th century has
been replaced by proIessional manager who has to reconcile the conIlicting
objectives oI all the parties connected with the business Iirm. So, now-a-days
proIit maximisation is regarded as unrealistic, diIIicult, unIair and immoral.
Besides the aIoresaid objections, proIit maximisation Iails to serve as an
operational criterion Ior maximising the owners` economic welIare. It suIIers
Irom the Iollowing limitations :
(i) It is vague : It does not clariIy what exactly does it mean. For example,
which proIits are to be maximised, short-term or long-run, rate oI proIit
or the amount oI proIit ?
(ii) It ignores timings : The concept oI proIit maximisation does not help in
making a choice between projects giving diIIerent beneIits spread over
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a period oI time. The Iact that a rupee received today is more valuable than a
rupee received later, is ignored.
(iii) It ignores risk : The streams oI beneIits may posses diIIerent degree oI
certainty. Two Iirms may have same total expected earnings, but iI the
earnings oI one Iirm Iluctuate considerably as compared to other, it will
be more risky. Possibly owners oI the Iirm would preIer smaller but
certain proIits to a potentially large but less certain stream oI beneIits.
Wealth Maximisation
On account oI the reasons cited above, these days proIit
maximisation is not considered to be an ideal criterion Ior making investment
and Iinancing decisions. ProIessor Ezra Soloman has suggested the adoption
oI wealth maximisation as the best criterion Ior the Iinancial decision making.
This objective is generally expressed in terms oI maximisation oI the value oI
a share oI a Iirm.
Wealth maximisation means maximising the `net present value` (or wealth) oI
a course oI action. The net present value oI a course oI action is the diIIerence
between the present value oI its beneIits and the present value oI its costs. A
Iinancial action which has a positive net present value creates wealth and, and
thereIore, is desirable. On the other hand, a Iinancial action resulting in
negative net present value should be rejected. Between a number oI desirable
mutually exclusive projects the one with the highest net present value should
be adopted. The wealth oI the Iirm will be maximised iI this criteria is Iollowed
in making Iinancial decisions (Soloman, Ezra, 1969).
The wealth maximisation criterion is based on the concept oI cash Ilows
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generated by the decision rather than accounting proIit which is the basis oI
the measurement oI beneIits in case oI the proIit maximisation criterion.
Measuring beneIits in terms oI cash Ilows avoids the ambiguity associated
with accounting proIits. This is the Iirst operational Ieature oI the net present
wealth maximisation criterion. Another important Ieature oI the wealth
maximisation criterion is that it considers both the quantity and quality
dimensions oI beneIits. At the same time, it also incorporates the time value
oI money. The quality oI beneIits has reIerence to the certainty with which
beneIits are expected to be received in Iuture. The more certain the expected
returns (cash inIlows), the better the quality oI beneIits and the higher the
value. Similarly, money has time value. For the above reasons, the Net Present
Value maximisation is superior to the proIit maximisation as an operational
objective.
The net present worth can be calculated as shown below :
A
1
A
2
A
n
W ............ C
0
(1k)
1
(1k)
2
(1k)
n
Where W net present value
A
1
, A
2
............. A
n
represent the stream oI cash Ilows expected to occur Irom
a course oI action over a period oI time ;
k is the appropriate discount rate to measure risks and timing; and C
0
is the
initial outlay to acquire that asset or pursue the course oI action.
It can, thus, be seen that in the wealth maximisation decision-criterion the
time value oI money and handling oI the risk as measured by the uncertainty oI
the expected beneIits is an integral part oI the exercise. It is, moreover, a
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precise and unambiguous concept. It is, thereIore, an appropriate and
operationally Ieasible decision criterion Ior Iinancial management decisions.
Organisation of the Finance Function
Because oI the vital importance oI the Iinancial decisions to a Iirm, it is
essential to set up a sound and eIIicient organisation Ior Iinance Iunction. The
ultimate responsibility oI carrying out the Iinance Iunctions lies with the top
management. Thus, a department to organize Iinancial activities may be created
under the direct control oI the board oI directors. Figure 1.1 depicts the
organisation oI the Iinancial management Iunction in a large typical Iirm.
It should be remembered that the job oI the chieI Iinancial executive does not
cover only routine aspects oI Iinance and accounting. As a member oI top
management he is closely associated with the Iormulation oI policies as well
as deci si on maki ng. Under hi m ar e cont r ol l er s and t r easur es,
Board of Directors
Managing Directors
Production Personnel Financial Marketing
Director Director Director Director
Treasurer Controler
Auditing Credit Tax Cost Financial
Manager Manager Manager Accounts Accounting
Manager Manager
Capital Data
Expenditure Processing
Manager Manager
Fig. 1.1 Organisation Ior Finance Function
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although they may be known by diIIerent designations in diIIerent Iirms. The
tasks oI Iinancial management and allied areas like accounting are distributed
between these two key Iinancial oIIicers. The Iunctions oI the treasurer include
obtaining Iinance, banking relationship, investor relationship, cash management,
working capital Iinance, insurance and credit management. The typical Iunctions
perIormed by the controller are : (a) Iinancial accounting, (b) internal audit,
(c) taxation, (d) budgeting, planning and control, (e) economic appraisal, (I)
management accounting and control.
Questions
1. DeIine the scope oI Iinancial management. What role should the Iinancial
manager play in the modern enterprises ?
2. What are the basic Iinancial decisions ? explain.
3. "The proIit maximisation is not an operationally Ieasible criterion". Do
you agree ? Illustrate your views.
4. "The wealth maximisation objective provides an operationally appropriate
decision-criterion". Comment.
5. How should the Iinance Iunction oI an enterprise be organised? What
Iunctions are perIormed by the Iinancial oIIicers ?

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Financial Resources : Long Term, Medium Term and Short Term
Financial Resources with Reference to India
(Dr. B.S. Bodla)
The Financial Manager has to assemble Iunds Irom a variety oI
sources to satisIy varied Iinancial needs oI the Iirm. Some capital is provided
by the suppliers, creditors, and owners, while other Iunds arise Irom earnings
retained in the business. AIirm needs long-term Iunds to purchase Iixed assets
and to carry a portion oI current assets as permanent investment in Iixed assets
to ensure smooth Ilow oI business activity. AIirm needs medium term Iunds
Ior a period oI three to Iive years Ior Iinancing aggressive advertising campaign
and Ior complete overhauling oI its machines and equipments. The short-term
Iunds are also needed to meet the day-to-day business needs. Among these
diIIerent types oI capital requirements, Iunds needed Ior acquiring Iixed assets
are oI considerable importance because the Iunds have to be arranged Ior a
long period. The business Iirm procures Iunds Irom external as well as internal
sources. The Iinance manager procures Iunds Irom external sources to Iloat
new ventures and to expand existing ones. The Iirm approaches the general
investing public, government and Iinancial institutions Ior the purpose. In the
present lesson we shall explain the nature and characteristics oI Iinancial
instruments, viz., equity shares, preIerence shares and debentures and their
respective implications Ior long term Iinancing oI business. We shall also
Lesson : 2
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describe brieIly medium and short term sources oI Iinance.
(A) Sources of Long-term Finance
Long-term Iunds are needed by the Iirm either to replace existing capital
assets or to add to its existing capacity or both. The nature oI long-term Iunds
is static and permanent. As a matter oI Iact, it is this capital which bears the
ultimate risk oI the business. That is why, a major portion oI long-term capital
is collected through the sale Ior equity shares, preIerence shares, and obtaining
long-term loans. Equity shares constitute the most important source oI Iunds
to a new business, and provides basic support Ior existing Iirm`s borrowing.
AIter sometime, the retained earnings may also become a good source oI a
Iirm`s long-term requirements oI Iunds. When long-term needs are not Iully
met through shares, the long-term loans are also utilized. So the real bases Ior
division oI Iund requirements are the time, conditions oI its use, and the degree
oI risk attached to it. II management gets ample time to plan and provide Ior
the repayment oI Iunds, and iI management can appropriate these Iunds Ior a
very long time, it must be included in long-term Iinancing no matter whether it
is ownership claim or a creditorship claim. Now, we will discuss these sources
in somewhat detail.
1. Shares and Stocks :
Shares are the universal and typical Iorm oI long-term capital
raised through capital market. All companies (except companies limited by
guarantee) have statutory right to issue shares to raise capital aIter
incorporating provisions thereoI in the capital clause oI the Memorandum oI
Association. Capital procured by issue oI shares is termed as `Ownership
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Capital`.
In simple words, share is a speciIic portion oI capital which, in
turn, reIer to the amount oI money raised by issue oI shares. According to
Justice Lindley, "The common stocks (contributed by members) is denoted in
money and is the capital oI the company, the persons who contributed it or to
whom it belongs are members. The proportion oI capital to which each member
is entitled is his share". Section 2 (46) oI Indian Companies Act, 1956, has
deIined a share as "a share in the share capital oI a company, and, includes
stock except, where a distinction between stock and share is not expressed or
implied". Aword may be said here about the `stock` oI a company. "When shares
have been Iully paid up they may, iI so authorized by the articles, be turned
into stock by the company in general meeting" |Sec. 94 (i) c|. Stock has no
Iace value and stock is not divided in equal shares or parts and dividends are
not numbered but it may be divided into any amount. Thus, a shareholder may
hold Rs. 100 worth oI stock though his shares had originally been worth Rs.
1000/- each. However, the Registrar must be given the notice oI the conversion
oI paid-up shares into stock (Section 95). Thus, stock is merely a name Ior the
aggregate ownership oI a company which is divided into a number oI units,
each unit is called share. AIter the allotment oI shares oI a company the share
holders are given a certiIicate with regard to their shares, which is called share
certiIicate.
Features of Shares and Stocks :
The Iinancial manager must be well-versed with the diIIerent
characteristics oI shares and stocks since these have bearing on the interests
oI the company and the shareholders, ThereIore, now we shall discuss the main
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characteristics oI shares.
(a) Permanent capital of Company :
Shares bring in permanent capital which the Iinancial manager can
utilize during the whole liIe oI the company. The Iinancial manager need not
bother Ior reIunding the share capital to the owners. The company and
shareholders have no such contractual agreement with respect to reIund oI
capital. The shareholders may only get back their capital aIter the company is
liquidated. In addition to this, the residual leIt aIter meeting all the obligations
is returned to shareholders. But it should be noted that Ior shareholders it is
not always a permanent investment. A shareholder can get back his money
invested in the company. He can do so by selling his shares to others, as he is
authorised to transIer shares under the Companies Act, 1956. But, it may
constitute permanent investment Ior those who want to retain shares Ior the
whole liIe oI the company.
(b) No fixed Charge on the Company
The shares do not involve any Iixed charge, nor the company is
under obligation to pay dividends. The company has to pay dividends only iI it
has suIIicient proIits to do so. The company may even use whole oI its earnings
Ior reinvestment and shareholders have no right to object or interIere. The
company seeking share capital has not to mortgage its assets Ior acquiring
share capital.
(c) Shareholders are owners of the Company
Stockholders become owner oI the company. The company gives
voting rights to the shareholders. For the administration oI the company
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directors are appointed by the share-owners oI the company. But their liability
(in case oI limited companies) is limited to the part value oI shares held by
them. Liability is unlimited in case oI unlimited company.
A company can issue only two kinds oI shares, viz., (i) Equity
Shares and (ii) PreIerence Shares (U/S 86 oI the Companies Act, 1956). We
shall now discuss the characteristics oI these two types oI shares separately
and examine their signiIicance as source oI Iinance.
Preferred Stock :
As the name implies, preIerence shares are those share which
carry preIerential right and privileges with respect to income and assets over
equity stock. Section 85 oI the Indian Companies Act, 1956 deIines preIerence
share as the one which IulIits the Iollowing two conditions :
(i) It will carry a preIerential right in the payment oI dividends over
equity stock, either Iree or subject to income tax, and
(ii) In the re-payment oI capital, at the time oI winding it will carry
or it carries a preIerential right irrespective whether there is a
preIerential right to the payment oI any money in respect oI
dividends remaining unpaid upto the date oI such winding up or
repayment oI capital or any amount oI premium speciIied in the
memorandum or articles oI association oI the company or both.
In the absence oI any special qualiIication, preIerred stock carries
the same rights as equity stock.
We see that preIerred stock is a hybrid Iorm oI Iinancing,
combining Ieatures oI debt and common stock. In the event oI liquidation, a
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preIerence shareholder`s claim on assets comes aIter that oI creditors but
beIore that oI common stockholders. Usually this claim is restricted to the
par value oI the stock. The maximum return to preIerred stockholders is usually
limited to the speciIied dividend, and these shareholders ordinarily do not share
in the residual earnings oI the company.
Features of Preference Shares
(a) Claims of Income : PreIerred stockholders have priority oI claim to
dividend over equity stockholders. They are paid dividend at a Iixed rate
speciIied in the agreement. Only aIter payment oI stipulated dividend to
preIerred stock holders can the company distribute earnings among equity
stockholders. However, the stockholders have no legal recourse against the
company Ior not distributing dividend even though it has earned a large income.
Distribution oI income is the prerogative oI the Board oI Directors who can
decide whether to pay dividends or to reinvest its earnings wholly. But once
the dividend is declared, preIerred stockholders must be paid Iirst in accordance
with the agreement beIore any distribution to the residual stockholders.
However, the claim oI the preIerred stockholders unlike equity stockholders
is Iixed Ior all time to come and does not change in correspondence with
variation in level oI earnings. They have no right to share in extra earnings.
Occasionally, however, a participating Ieatures is inserted in the preIerred stock
which gives the stockholder a right to participate in the balance oI proIits in
an agreed proportion along with equity stockholders whose claims are Iirst
met on reasonable grounds. Stocks carrying participating Ieatures are known
as "Participating PreIerred Stocks". The Iormula Ior participation varies Irom
case to case. In the case oI "Non-Participating Stocks", they are entitled only
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to Iixed rate oI dividend in preIerence to equity stockholders but they do not
share in additional return. It may be noted that in the absence oI any speciIic
right to participate in the surplus proIits, preIerence shares are presumed to
be non-participating.
(b) Cumulative Dividends : Almost all preIerred stocks have a cumulative
Ieature, providing Ior unpaid dividends in any one year to be carried Iorward.
BeIore the company can pay a divided on its common stock, it must pay the
dividends in arrears on its preIerred stock. II the terms oI issue oI such shares
are silent on this point or the Articles oI the company makes no provision
concerning whether the preIerred stock dividend is to be cumulative, preIerence
shares are presumed to be cumulative. The cumulative Ieature is beneIicial to
the shareholders, but the company suIIers. It experiences much problem in
selling additional ordinary shares iI it Iails to clear arrears on preIerred stock.
(c) Preference to Assets : In the event oI liquidation oI the Iirm, the
preIerred stockholders occupy a middle ground between creditors and common
stockholders. AIter the assets are liquidated, the bondholders are paid Iirst. II
any money is leIt, the preIerred shareholders are paid second. II money is still
remaining, it is shared by the holders oI junior security, the common
shareholders.
(d) Basically a Fixed Return : The maximum return on preIerred stock is
usually limited to the stated dividend. Thus, a 12 preIerred share oI Rs. 100
each will return no more than Rs. 12 per share per year. In some cases the
preIerred stock contains a participating Ieature that allows the holder to share
in earnings above some speciIic point. As an example, a participating Ieature
may state that, iI the common stock dividend is greater than Rs. 2 per share,
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the preIerred stockholders will share equally in the additional dividends.
(e) Maturity : Most preIerred stock issues have no maturity. It, thereIore
brings in permanent capital. Frequently, provision Ior retirement oI stock is
made by call or redemption Ieature in preIerence stock. This gives an option
to the company oI redeeming or buying back the stock Irom the stockholders
under the terms and conditions speciIied in the Articles oI Association. This
type oI shares are called redeemable preIerence shares. The right oI redemption
rests with the company only, no shareholder compels the company Ior
redemption oI their shares. The companies (Amendment) Act, 1988 has
prohibited a company limited by shares Irom issuing any preIerence shares
which is irredeemable or redeemable aIter the expiry oI a period oI ten years
Irom the date oI its issue. PreIerence share issued beIore the commencement
oI this Amendment Act shall be redeemed by the Company within a period not
exceeding Iive years Irom such commencement.
More oIten than not, conversion Ieature is incorporated in
preIerred stock to provide and added inducement to buy such stock. The
conversion privilege permits the holder to convert his stock into common
stock. It must be remembered that this privilege is exercised almost without
exception wholly at the option oI the stockholders. Such type oI preIerred
stock is known as "Convertible PreIerred Stock". Conversion price is clearly
spelt out in the Articles oI Association. It is usually expressed in terms oI
share. For example, one preIerred share will be exchanged Ior two common
shares.
(f) Controlling Power : Most preIerred stock does not contain provisions
to allow its shareholders to vote or have other voices in the management oI
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the company. However, under the companies Act, 1956 (Sec 87) preIerence
shareholders have been given right to vote on resolutions which directly aIIect
the rights attached to his preIerence shares and in this connection, any
resolution Ior winding up the company or reduction oI its share capital is to
be regarded as directly aIIecting the rights attached to the preIerence shares.
Some other provisions Ior voting are also Iound.
Evaluation of Preferred Stock as a Source of Corporate Finance
In context oI the above discussions, we may now appraise oI
preIerence shares. One oI the principal drawbacks to its use is the Iact that the
preIerred dividend is not tax deductible. No-deductibility oI preIerred stock
dividend Ior taxation purpose makes cost diIIerential between preIerred stock
and bond much greater. Even iI dividend rate on preIerred stock is equal to
bond interest rate, eIIective cost oI the Iormer will be higher by 40 percent (iI
company is in the tax bracket oI 40) relative to debt. This tax Iactor has,
thereIore, limited the potentiality oI the preIerred stock as the source oI
Iinance.
Fixed dividend rate provision on the preIerred stock has reduced
the utility oI this kind oI security particularly Ior company earning less than
the dividend rate because that will reduce returns to the residual owners. This
is why residual owners are mostly indiIIerent to issuance oI this stock.
However, the advantage oI preIerence-stock Iinancing is that it is
a Ilexible Iinancing arrangement; the dividend is not a legal obligation oI the
corporation issuing the securities. II earnings turn bad and the Iinancial
condition oI the company deteriorates, the dividend can be omitted. To be sure,
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companies that are accustomed to paying dividends on their common stock
certainly regard the preIerred dividend as a Iixed obligation. Nevertheless,
under dire circumstances, a company that omits its common stock dividend
can also omit its preIerred dividend.
Further signiIicance oI preIerred-stock is that it brings in
permanent capital without involving the company in Iixed obligation and without
creating any charge against its assets. Though dividend payable on preIerred
stock is Iixed, but that does not mean that the management is Iorced to distribute
dividends to the stockholders. Thus, a newand expanding concern needing larger
Iunds Ior expansion purposes may Iind it more convenient to raise Iunds through
the preIerred stocks.
Another beneIit oI the preIerred stock is that it provides Ilexibility
to the capital structure oI the company. By issuing redeemable preIerence
shares, the manager can keep the door oI the company open Ior alternative
sources oI Iunds Ior Iurther Iinancing. PreIerence shares capital also helps
the management to keep controlling power oI the current stockholders in Iact.
Managerial Issues
So as to decide whether to issue preIerred stock, the Iinancial
manager should take into account the pros and cons oI the stock and Iinancial
conditions oI the enterprise. Where levels oI sales and income oI the enterprise
have been relatively unstable in the past but on an average earning rate is higher
than what is promised on the preIerred stock, it will be in the interest oI the
enterprise to issue preIerred stock, Furthermore, iI the Iirm does not have
suIIicient Iixed assets to oIIer as security Ior acquiring Iunds, preIerred stock
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Iinancing would be oI considerable use.
The use oI this stock will be strongly Iavoured iI the use oI debt
entails the risk oI insolvency in the enterprise and issuance oI common stock
poses a threat oI parting control with new equity stockholders.
The cost Iact or shoul d al so recei ve t he at t ent i on oI t he
management. While the cost oI preIerred stock is likely to be lower than that
oI the common stock, the use oI preIerred stock is conditioned essentially by
the prevailing interest rates. ThereIore, the current interest rates should be
compared with the average dividend rates on common stock to take a decision.
Equity Shares
The equity stockholders oI a corporation are its residual owners;
collectively, they own the company and assume the ultimate risk associated
with ownership. Their liability, however, is restricted to the amount oI their
investment. In the event oI liquidation, these stockholders have residual claim
on the assets oI the company aIter the claims oI all creditors and preIerred
stockholders are settled in Iull. Common stock, like preIerred stock, has no
maturity date, and stockholders can liquidate their investments by selling their
stocks in the secondary market.
Features of Equity shares
(a) Maturity : Equity capital is the permanent capital Ior the company.
Company has no contractual obligation to repayment oI capital during its
working liIe. The shareholders have a right oI demanding reIund oI their capital
only at the time oI liquidation oI the company and that too when Iunds are leIt
aIter meeting all prior claims. The shareholders cannot be compelled by a
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company to sell back their shares iI they were Iully paid-up and the shareholders
not engaged in competitive business to the business oI the company.
(b) Right to Income : Common stockholder`s claim on income arise only
when claims oI creditors and preIerence shareholders have been met. II the
income oI the company is suIIicient only to meet the claims oI the creditors,
then equity stockholders will get nothing. More than this is that, iI a company
has adequate earnings leIt aIter covering all obligations, the common
stockholders can`t compel the company to pay dividends to them. The Directors
oI the company have Iull right to utilize the earnings in whatever manner they
like. Only iI the management, the board oI directors, or both are engaged in
Iraud may stockholders take their case to the court and possibly Iorce the
management to pay dividends.
(c) Voting Power : The common stockholders being the owner oI the
company, they are entitled to elect a board oI directors. The board, in turn,
selects the management which actually controls the operations oI the company.
In a proprietorship, partnership Iirm and a small corporation, the owners
directly control the operations oI the business. But in a large corporation, the
owners have an indirect control over the aIIairs oI the company. Outside
stockholders have the right to expect that the directors will administer the
aIIairs oI the corporation properly on their behalI.
(d) Right to examine books : A stockholder is legally entitled to inspect
the books and records oI a corporation. This access is limited, Ior most
companies Ieel that the audited Iinancial statement is suIIicient to satisIy the
requirement.
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(e) Preemptive right : Under a pre-emptive right, existing common
stockholders have the right to preserve their proportionate ownership in the
corporation. II the corporation issues additional common stock. They must be
given the right to subscribe to the new stock so that they maintain their prorata
interest in the company. The objective oI the pre-emptive right is to saIeguard
the interest oI existing stockholders.
Evaluation of Equity Stock as a Source of Corporate Finance
Equity stock is the most potent source oI Iinancing that provides
substantially large amount oI Iunds without involving the company and the
management in any Iixed obligations. The management is leIt Iree to utilise
the Iunds so raised without being bothered to repay them to their owners till
the business oI the enterprise continues. Further, the manager is under no
statutory obligation to distribute earnings as dividends to the stockholders.
They an reinvest business income entirely and the stockholders have no legal
recourse to compel the management to pay dividend. Furthermore, the company
need not mortgage any portion oI its assets to secure equity share capital.
Equity stock Iacilitates the company to reap the beneIits oI
leverage by taking recourse to debt which is the cheapest source oI Iinance.
Creditors are desirous oI investing in debentures oI a company with a
considerable amount oI equity capital because it provides a Cushion to absorb
and loss. Accordingly, a company with a tidy amount oI equity share capital
experiences no problem in raising long-term loan capital at convenient terms
and conditions. In sum, it strengthens the credit capacity oI the company.
The management in a company with an all equity stock structure
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has complete discretion in distributing as much oI the earnings in dividends as
it wishes. Since the company is under no legal obligation to pay dividends to
the shareholders, the management can retain its earnings entirely Ior their
investment in the business oI the enterprise. Thus, a newand growing company
seeking large Iunds Ior its expansion programmes secures ample resources at
cheaper cost and without any inconvenienced and obligations.
In view oI the above Iactors, equity shares have proved to be the
most prominent source oI Iinancing. It also appeals to a large number oI
investors who are venturesome and are willing to assume risks Ior a larger
income. By purchasing equity shsares, they become owners oI the beneIits oI
prosperity and progress oI the company. This is why a good company does not
experience great diIIiculty in garnering Iunds through equity stock issues.
However, there is a danger oI losing contrl to outsiders iI the
company elects to raise additional Iunds in substantially large amounts through
equity issues. Controlling position oI the current stockholders is jeopardized,
new entrants become owners oI the Company and reap the beneIits oI the
Company`s prosperity and progress. Current stockholders are, thereIore, averse
to additional Iinancing by means oI equity stock.
DEBENTURES :
Debentures are the securities through which the corporation can
collect long-term Iunds. Debentures are creditorship securities. By issuing
bonds and debentures the Iirm can procure Iunds Irom lenders. What is a
debenture? It is an instrument which is written, signed by the company under
its common seal acknowledging the debt due by it to its holders. Bond and
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debentures have not been deIined under the Indian O`s Act, 1956. It simply
states that a debenture includes debenture stock, bonds and any other securities
oI a company whether constituting a charge on the assets oI the company or
not.
Clear understanding oI the two terms bond and debentures is
necessary beIore discussing these securities in detail. In the U.S.A., bond reIers
to security that has lien on speciIic assets oI the Iirm. Debenture on the other
hand, reIers to a security instrument which is not secured by a lien on any
speciIic assets. In the event oI liquidation the debenture-holder becomes a
general creditor. There is no such diIIerence between these two terms in our
country.
Since debenture is a security representing a long term promise
to pay a certain sum oI money at a certain time or over the course oI the loan,
with a Iixed rate oI interest payable to the holder oI the bond. Long-term
agreement is entered both between the company and creditors, and a deed is
executed to set the terms oI borrowing. Such a deed is known as bond indenture`
or `trust deed`. The `indenture` contains, among other things, protective
provisions that generally include limits on indebtendness, restrictions on
dividends, provision Ior redemption oI debentures, etc. For individual
debenture-holders it is somewhat diIIicult to protect their rights since they
are scattered all over the country and can not unite. A reperentative called a
`trustee` is appointed to deal with the company and enIorce the provisions oI
indenture on behalI oI the debenture-holders.
Features of Debentures
(a) Maturity : Virtually all bonds have a maturity date and the company
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agrees to pay oII in cash the outstanding bonds at a Iixed date. Such bonds
which are repayable at Iixed date are called `Redeemable bonds`. Other which
have no maturity date are called `Irredeemable bonds`. Irredeemable debentures
are rare in use in India. An indebenture also contains the provisions about the
repayment oI debt. Companies generally set aside Iunds out oI earnings oI the
company at periodic interval Ior retiring all or a portion oI bonds beIore or at
maturity. This type oI provision is known as "Sinking Fund Provision` and bonds
carrying sinking Iund provision are called `Sinking Fund Bonds`.
Sinking Iund requires the corporation to make periodic sinking
Iund payment to a trustee, in order to retire a speciIied amount oI Iunds each
period. Payments can be cash or bonds that the company purchases in the
open market. The trustee uses the cash to call bonds Ior redemption. Usually
bonds are called on a lottery basis by their serial numbers. Because oI the
orderly retirement oI debt as well as the liquidity provided by the regular
purchase activity, many investors Iind the sinking-Iund provision valuable. Many
sinking Iunds begin not at the time oI issuance oI the bond, but aIter a period
oI 5 or 10 years.
Sometimes in order to spread the payment oI bonds over a long
period starting usually one year aIter the issue, the management may arrange
the entire bond issue in such a way that part oI the total issue retires serially,
i.e., every year. Such bonds are known as `Serial Bonds`. Serial bonds are not in
existence in our country because oI rigid provisions oI annual retirement oI
debt which adds to the risks oI the company.
(b) Convertible Bonds : Aconvertible bond is one that may be changed, at
the option oI the holder, into a certain number oI shares oI common stock oI
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the corporation. The number oI shares into which the bond is convertible is
speciIied in the bond, and these shares remain unissued until actual conversion.
Conversion takes place usually beIore maturity. When there is slump in the
stock market and acquisition oI capital through equity stock poses a problem
or temporarily adverse income position oI the company at the time the capital
is needed, the management may deIer the stock issue. In place oI stock issue,
convertible bond may be Iloated with an intention to convert them in Iuture
near when, it is believed, earnings oI the company will improve and market
conditions will change.
(c) Claims on Income : Bondholders have priority oI claim to income over
stockholders. They have legal recourse Ior enIorcing their rights. For protecting
their claim to income and assuring regularity oI receipt oI that income they
may even put restrictions on dividend payments to residual owners and Ior
maintenance oI adequate liquidity.
Another aspect oI bondholder`s claim to income is that it is Iixed
and certain and the borrowing company is under a legal obligation to pay it in
cash regardless oI the level oI earnings oI the company. DeIault in payment oI
interest may entail the company in extreme predicament and bondholders may
even approach the court oI law Ior closure. Bondholders oI course, do not
have the right to share in the proIits oI the company.
(d) Claims on Assets : Bondholders have priority in respect oI their claim
on assets in the event oI liquidation oI the company. But they are entitled only
to get principle amount oI their money which was lent. Bonds that are secured
by a lien on speciIic assets oI the company are called `Secured Bond` and those
do not have a assets pledged are termed as `Unsecured Bonds`.
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(e) Controlling Power : Holders oI debentures are creditors oI the
company. They do not have controlling power because they have no right to
vote Ior the election oI directors and Ior the determination oI important
managerial policies. They may, however, indirectly inIluence Managerial
decision through protective covenants in indenture. For instance, to protect
their interest, bond indenture may provide Ior maintenance oI minimum
liquidity ratio and Ior building up stipulated amount oI reserves beIore making
dividend payments to stockholders.
Evaluation of Debentures as Source of Finance :
The use oI debentures in the pattern oI corporate Iinancing has
got wider and deeper signiIicance. Recourse to debt generally tends to reduce
cost oI capital and consequently helps improve the overall return oI the
company. Interest on debentures is deductible as a tax expense. ThereIore, the
debentures reduce the cost oI capital and consequently it helps in improving
the overall return oI the company. Debenture is a cheaper source oI Iunds due
to less interest rate and less issuance cost. During the liIe cycle oI many Iirms
when Iurther equity capital are not available at reasonable cost but the same
Iirm may be in a position to attract debt. With the use oI debentures a company
may take its capital structure Ilexible and also can have controlling power oI
the existing owners intact.
However, a corporation should not consider that long-term capital
requirements should always be met by issue oI bonds. Bonds are such securities
which impose Iix burden oI payment oI interest by the company. Another
limitation oI debenture Iinance is that with successIul doses oI debt the Iirm
has to pay higher rate oI interest because each Iurther issue oI debt involves
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the lender in greater risk.
AIter discussing positive and negative aspects oI debt Iinancing,
we may conclude that companies with certain speciIic Ieatures can avail the
beneIits oI debt. Those companies whose proIits are usually constant and high
enough to cover Iixed interest charges on debentures can aIIord the luxury oI
Iinancial leverage (ratio oI debt-equity). Abusiness Iirm which is engaged in
providing service or in the production oI an essential product will certainly
have more stability oI income that one producing a luxury product. Acompany
with Iluctuating earnings should issue common-stock Ior its meeting Iinancial
requirements.
(3) Retained Earnings :
A business Iirm satisIies its initial Iund requirements by using
external resources oI Iunds but resorts to internal Iinancing to meet its
subsequent Iinancial needs Ior expansion, modernization and rationalization
programmes. Internal Iinancing reIers to Iinancing by internal sources which
comprise earnings retained by the business in the Iorm oI depreciation and
other reserves and income leIt over aIter covering all expenses and which is
not distributed among stockholders oI the enterprise. The Iirms which are
running successIully and set out a portion oI proIit Ior Iuture purposes can
use these earnings when needed by the Iirm. This process is technically termed
as `ploughing back oI proIits`
Retained earnings constitute a source oI Iinancing Ior which the
company does not bother much. Firms get large amount oI Iunds at relatively
cheaper rate and without any legal obligation to reIund the same to meet major
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portion oI its expansion and moernisation requirements and without creating
charge against any asset. In another direction too retained earnings prove very
useIul to the company. With the past accumulated Iunds the management can
repay the matured debts and thereby relieve the company oI the rigors oI debt
burden. In brieI, retained earnings provide the best means Ior company`s Iuture
growth. The stockholders also stand to gain by internal Iinancing. In the
beginning, they have to Iorego dividend in the short-run, but they will be getting
Iairly large amount oI dividends regularly in Iuture when the company`s
earnings improve considerably. It also oIIers tax saving advantage to the
stockholders. However, internal Iinancing may not always be useIul to the
company and its owners. The reckless use oI retained earnings will always
harm the interests oI the stockholders. The management may use the
accumulated reserves to Iinance the needs oI companies in which they are
keenly interested even though the shareholders may have least interest in them.
Another disadvantage oI retained earnings is that it may result into over-
capitalisation.
Capital Market Financing : Recent Trends
Capital raised through the primary market has been showing a declining trend
Ior the last 4 years. In 1994-95, Rs. 27,632 crore were raised through 1692
public and right issues. In 1995-96 the amount raised declined to Rs. 20803.7
crores. In 1996-97, there was a Iurther decline in amount raised to Rs. 14,276
crores as also in the number oI issues to 882. The down trend also continued
in 1997-98. The total amount raised was Rs. 4570 crore approximately through
only 111 issues registering a sharp Iall oI 68 percent and 87 per cent
respectively as compared to the previous year.
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4. Finance From Central and State Governments :
In India, Central and State governments also provide long-term
Iinance directly to business houses. They not only provide direct Iinance to
industrial units but give guarantees also Ior the loans raised Irom banks or
public. The period oI loans varies Irom 10-15 years. Since independence
assistance Irom central and state governments have been progressively
increasing.
5. Development Banks and Investing Institutions :
With the declaration oI the First Industrial Policy Resolution in
1948 Ior the rapid industrialisation oI the country, the government oI India
established a series oI special Iinancial institutions like, Industrial Finance
Corporation oI India, State Finance Corporations, the Industrial Development
Bank oI India, etc.
Industrial Finance Corporation of India (IFCI) :
IFCI was the Iirst national level development bank set up in 1948
by an Act oI Parliament to make medium and long-term Iunds readily available
to industrial concerns particularly when the normal banking support is
inappropriate or going to the capital market is impracticable.
In Iurtherance oI the above objective IFCI provides Iinancial
assistance by granting loans, underwriting the issue oI shares and debentures
and subscribing to shares and debentures oI industrial concerns. The Corporation
also helps business enterprise in raising share capital Irom capital market and
procuring term loans Irom other Iinancial institutions.
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While considering assistance application oI an enterprise IFCI
looks into the detailed technical, Iinancial, managerial, economic and social
aspects oI the project in addition to national priorities indicated in Iive-year
plans and policies oI the Government.
IFCI caters to the needs oI medium and large projects either singly
or jointly with other all-India Financial Institutions. Normally, the Corporation
considers projects consting upto Rs. 5 crore independently. In respect oI
projects cosisting over Rs. 5 crores, the Corporation invites other all-India
institutions to Iinance such projects under the system oI consortium Iinancing.
Industrial Credit and Investment Corporation of India (ICICI)
The basic idea underlying the creation oI ICICI was to meet the
needs oI industry Ior permanent and long-term Iunds in the private sector. Thus,
the Corporation aims at :
i) assisting the creation, expansion and modernisation oI industrial
enterprises within the private sector oI industry in India ;
ii) encouraging and promoting participation oI private capital, both internal
and external in such enterprise ; and
iii) encouraging and promoting private ownership oI industrial investment
and expansion oI investment markets.
ICICI renders Iinancial assistance to industrial undertakings by
providing loans repayable over period oI 15 years, subscribing to equity shares,
sponsoring and underwriting new issues oI shares and securities, guaranteeing
loans Irom the private investments sources, providing loans in Ioreign currency
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towards the cost oI imported capital equipment, providing lease Iinancing and
by acting as a merchant banker.
Industrial Development Bank of India (IDBI)
IDBI was established in 1964 with a viewto propelling the wheels
oI industrial sector to achieve maximum growth by eliminating gaps in the
capital market and supplying sinews oI development to all Iinancial agencies
engaged in this task. To achieve this basic objective, IDBI is empowered to
perIorm the Iollowing Iunctions :
a) Coordinating Function : IDBI coordinates operations oI all miniature
Iinancial institutions including IFCI, ICICI, LIC and UTI into a single
integrated Iinancial structure so that each might contribute to the total
eIIect as it could.
b) Financing Function : As an industrial Iinancier, IDBI can assist all
deserving projects regardless oI their size which are experiencing
enormous problems in assembling Iunds Irom normal channels. Its main
endeavor in this regard is to ensure that no worthwhile project, howsoever
small, is allowed to languish Ior insuIIiciency oI institutional support.
IDBI can assist an enterprise directly and indirectly.
As direct Iinancier, it renders assistance to business concerns in the Iollowing
ways :
1) Granting term loans and advances.
2) Subscribing to purchasing, or underwriting the issue oI shares or
debentures.
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3) Guaranteeing deIerred payment due Irom industrial concerns to third
parties and loans raised by them in the open market or Irom Iinancial
institutions.
State Financial Corporations (SFCs)
SFCs are the state level development banks set up in India under
State Financial Corporations Act, 1951 Ior the purpose oI providing Iinancial
assistance to new as well as existing industrial concerns Ior purpose oI
establishment, modernisation, renovation, expansion and diversiIication. These
institutions assist a concern in Iollowing ways :
1) Granting loans or advances or subscribing to debentures oI industrial
concerns repayable within 20 years;
2) Guaranteeing loans raised by industrial concerns on such terms and
conditions as may be mutually agreed upon but they should be repayable
within 20 years;
3) Guaranteeing such deIerred payments oI any industrial concern as are
in connection with the purchase oI capital goods within India;
4) Underwriting issue oI stocks, bonds or debentures oI industrial concerns
subject to their being disposed oII in the market within 7 years;
5) Providing Ioreign exchange loans under world bank scheme;
6) Participation in equity capital oI the small scale industrial units coming
up in backward areas.
A concern can get Iinancial support Irom a State Financial
Corporation upto Rs. 60 laks. Only small scale units engaged in all industrial
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activities including mining, transport by rope ways and development oI
industrial areas are entitled to get assistance Irom this institution. SFCs
generally provide loans secured by way oI legal mortgage oI Iixed assets and
executed in Iavour oI the institution. Forty per cent margin is usually maintained
on loans. However, SFC`s policy in this respect has been very Ilexible. In certain
cases particularly those coming up in less developed regions, they lend without
any margin.
Unit Trust of India (UTI)
The UTI was established in 1964 in public sector Ior the purpose
oI mobilisation oI savings oI the community and redirection oI these pooled
savings in proIitable outlets. During 25 years oI its operations UTI provided
attractive saving opportunities to the community through sale oI units under
various schemes and thereby mobilise savings oI the community. The UTI
utilises these resources in assisting diverse needs oI business orgnaisations.
The Trust assists an enterprise by investing in its shares and
debentures and underwriting the security issues. In recent years Iollowing an
amendment the UTI has been empowered to grant term loans, rediscount bills,
undertake equipment leasing, hire purchase Iinancing and Iinancing oI housing
projects.
The major considerations inIluencing the UTI`s investment are
saIety oI Iunds and reasonable return including capital appreciation on its units.
In order to translate these considerations into action, the Trust diIIuses its
investible resources over diIIerent types oI securities oI numerous units
belonging to diIIerent industry groups.
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(B) Intermediate-Term Financing :
Intermediate-term debt is deIined as borrowings with maturity
period greater than 1 year and less than 7 to 10 years. Debts with maturities oI
less than 1 year are classiIied as short-term; debts with maturities in excess oI
7 to 10 years are considered long term. Many analysts and accountant ignore
the distinction between intermediate and long-term debt. They view that debts
are oI only two types : Short-term Ior maturities oI 1 year or less and long-
term Ior maturities in excess oI 1 year. When intermediate term debt is
identiIied as a separate category, the Iollowing types are common :
(a) Term Loans : This is a loan Irom a bank, non-Iinance company,
insurance company or other Iinancial institutions Ior a period ranging between
1 to 7 years. Such loans are generally employed to Iinance more a permanent
portion oI working capital requirements. As a result, most oI these loans are
paid in regular, and periodic installments, although there are exceptions to the
rule.
Term loans may take the Iorm oI an ordinary loan or a revolving
credit. In ordinary term loan lender lends Iunds and as per the agreement
outright Ior a period oI more than a year and upto 10 years. On the other hand,
a revolving credit, is a Iormal commitment by a lender to lend a certain amount
oI money to a Iirm over a speciIied period oI time.
In India, term loans are being provided mainly by Commercial
banks. Industrial Development Bank oI India, Industrial Finance Corporations,
State Finance Corporations, State Industrial Development Corporations,
Industrial Development Corporation oI India, Unit Trust oI India, and several
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Iinancial and investment corporations.
Commercial Bank Loans :
Commercial banks are primary medium-term lenders to business
Iirms. The loans are generally made Ior periods upto 7 years, although
occasionally loans with longer maturities are also considered. Some Ieatures
oI commercial bank loans are as Iollows :
1. Colateral : Term loans are more Irequently secured than short-term
loans due to greater risks involved in term lending. Usually, a Iixed assest
such as a vehicle, a ship, or a piece oI machinery, is pledged as collateal Ior
the loan.
2. Fixed versus Floating Rate : The interest that is due on term loan with
a commercial bank is determined in advance, using one oI the two methods. A
Iixed-rate loan has a single interest rate Ior the entire period much more
common, a Iloating-rae loan has interest charge that is tied to current money
market rate and varies with changes in interest levels. For example, a rate oI
"2.5 per cent above prime quarter" would vary as the prime rate varies.
Commercial bank loans oIIer advantages and disadvantages to the
Iirm. The advantages include establishing a working relationship with a bank
that can result in advice and Iinancial expertise Irom the bank`s oIIicers. The
disadvantages include disclosure oI conIidential inIormation and the
restrictions that may be imposed as part oI the loan agreement.
Commercial banks in India have been pumping in growingly large
amount oI Iunds to meet Iinancial needs oI industrial enterprises. The total
amount oI loans granted by commercial banks at the end oI 1949 aggregated to
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Rs. 133 crores. The amount has now swelled to as high as Rs. 1,05,450 crores
by the end oI 1990 and to Rs. 1,71,42,492 crores by the end oI March 1993.
Insurance Companies :
A number oI LiIe Insurance Companies make term loans to
business. While commercial banks make loans to Iirms oI varying size and
credit risk, insurance companies concentrate on low-risk loans to large and
Iinancially viable companies. Because oI the high credit standing oI their
customers, insurance companies are willing to oIIer maturities oI 10 or more
years, oIIer loans that are large than those available Irom commercial banks,
and in some cases even oIIer unsecured loans. The major diadvantage oI term
loans extended by insurance companies is higher interest rate, and major
advantage is larger loans and higher amount oI money as compared to
commercial bank Iinancing.
Pension Funds :
A minor source oI medium-term Iinancing is the employees`
Pension Iunds that make secured loans to business. These loans are generally
secured by mortgages oI property and carry terms and conditions similar to
loans made by LiIe Insurance Companies.
(b) Lease Financing :
A lease is a contract whereby the owner oI an asset (the lessor)
grants to another party (the lessel) the exclusive right to use the asset, usually
Ior an agreed period oI time, in return Ior the payment oI rent. Most oI us are
Iamiliar with leases oI houses, oIIices, or telephone. Recent decades have seen
an enormous growth in the leasing oI business assets such as cars and trucks,
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and manuIacturing plants. An obvious advantage to the lessor is the use oI an
asset without having to buy it. Because oI the contractual nature oI a Iinancial
lease obligation, it must be regarded as a Iorm oI Iinancing. It is used in place
oI other methods oI Iinancing to acquire the use oI an asset.
(c) Public Deposits :
Industrial and business concerns accept direct term deposits Irom
the public upto a period oI 5 years. In India, in cotton textile industry this
system has been very popular. But now almost all types oI business concerns
are accepting public deposits. This system has been very popular during last 7-
10 years. The Reserve Bank oI India has enacted rules Ior regularising these
Iixed deposits.
Short -term Finance :
In India two important sources Ior mobilising short-term Iunds
Ior Iinancing working capital requirements have been commercial banks and
trade credit apart Irom support being provided through equity base. But, highly
stringent credit polices oI the banks on one hand and the growing complexities
and ever tightening discipline and other controls attached with bank credit and
institutional Iinance on the other have paved way Ior the companies to go in
Ior new and innovative sources other than traditional bank credit. Such a move
oI more reliance oI corporate sector on capital market and money market
resources has helped it to meet ever increasing and dynamic quest Ior working
capital Iinance. Some oI the money market instruments like commercial papers,
customer advances, corporate deposits and inter-corporate loans are brieIly
described in the subsequent pages along with trade credit and commercial bank
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as sources oI Iinance.
1. Trade Credit :
Trade credit is a Iorm oI short-term Iinancing common to almost
all business. In Iact, it is the largest source oI short-term Iunds Ior business
Iirms collectively. In an advanced economy, most buyers are not required to
pay Ior goods upon delivery but are allowed a short deIerment period beIore
payment is due. During this period, the seller oI the goods extends credit to
the buyer. It is because suppliers are generally more liberal in the extension oI
credit than are Iinancial institutions. Most oI the small companies in rely on
trade credit.
There are three types oI trade credits : open account, notes
payable, and trade acceptances. Among these the most common type is the
open-account arrangement, and are known as accounts payable. The seller ships
goods to the buyer and sends an invoice that speciIies the goods shipped, the
price, the total amount due, and the terms oI sale. There is no Iormal agreement
nor there is speciIic document recognizing the buyer`s liability to the seller.
The only evidence with the seller is that credit has been intended on the buyer`s
order and shipping invoices. Open-account credit is ordinarily extended only
aIter the seller conducts a Iairly extensive investigation oI the buyer`s credit
standing and reputation.
In some situations, promissory notes are employed instead oI
open-account credit. The buyer signs a note that evidences a debt to the seller.
The note itselI calls Ior the payment oI obligation at some speciIied Iuture
date. Promissory notes have been used in business such as those dealing in
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Iurs and jewelry. Promissory notes are generally an interest-bearing instrument.
They appear on the seller`s balance sheet as notes receivable.
In some lines oI business the trade acceptances are used in place
oI open account. This Iorm oI credit also involves a Iormal recognition oI the
debt. Under this arrangement oI credit, the buyer will not receive the delivery
oI goods until the buyer accepts a draIt written by the seller. The draIt is an
order oI payment at some date in Iuture. When the buyer accepts the draIt he
designates a bank where draIt will be paid on due date.
The trade credit is a source oI capital that arises naturally in the
course oI business because the customers generally do not pay Ior merchandise
until some time aIter they are delivered. Another beneIit oI trade credit as a
source oI Iinancing is `its liberality`. Many business Iirms, particularly smaller
and newly set-up orgnaisations, whose access to diIIerent sources oI money-
market is limited and, thereIore, experience enormous problems in acquiring
needed Iunds can obtain trade credit. Suppliers are willing to oIIer credit
liberally Ior a number oI reasons. Basically, they regard credit as a sales aid.
Trade credit is also liberal because the supplier does not examine credit
worthiness oI his customers with the same degree oI care than a banker would.
Prompt availability oI trade credit is another attraction oI this source oI
Iinancing. Customarily there are no Iormal applications to Iill out, no notes to
sign, and no rigid repayment dates particularly in open account. II a customer
is occasionally a little late in paying a supplier his credit reputation is not put
to harm.
2 Commercial Bank`s Assistance :
Commercial banks play an important role in the short-term
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Iinancing oI companies. They provide this help in the Iorm oI overdraIt,
mortgages, cash credit, hypothecation and discounting oI bills and hundies etc.
Loan : In a loan account entire advance is disbursed at one time either in cash
or by transIer to his current account. It is a single advance. Except by way oI
interest and other charges no Iurther withdrawals are allowed in this account.
Since loan accounts are not running accounts like overdraIts and cash credit
accounts, no cheque books are issued.
Overdraft : Under this Iacility, the customers are allowed to withdrawin excess
oI credit balance standing in their Current Deposit Account. AIixed limit is
thereIore granted to the borrowers within which the borrower is allowed to
overdraw his account. Though overdraIts are repayable on demand, they
generally continue Ior long periods by annual renewals oI the limits. Interest
on overdraIt is charged on daily balances.
Cash Credit : Cash credit is an arrangement under which a customer is allowed
an advance upto a certain limit against credit granted by the bank. Under this
arrangement, a customer need not borrowthe entire amount oI advance at once,
but he can only draw to the extent oI his requirements and deposit his surplus
Iunds in this account. The interest is charged not on the Iull amount but on the
amount actually availed by him. Generally the cash credit limits are sanctioned
against the security oI goods by way oI pledge or hypothecation.
3. Sale of Commercial Papers :
Commercial paper (CP) is a short-term money market instrument ideally suited
Ior corporate sector borrowing Irom banks Ior their working capital needs and
investors. Highly rated companies can take advantage oI this source and it
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serves the needs oI investors Ior parking their short-term Iunds. CP as a source
oI short-term Iund is popular in the Western countries and Japan. In U.S.A., it
is in vogue Ior over 100 years whereas its origin in European Countries and
Japan is oI recent one. Reserve Bank oI India (RBI) has recently permited
issue oI CP in our country.
CP is a usance promissory note negotiable by endorsement and delivery
typically with a Iixed maturity between three months and six months and is
issued on a discount basis. It enables companies to raise short-term debt at
attractive rates oI interest. CP is an unsecured instrument and is not tied to
any speciIic business transaction. It does not carry any underlying collateral
security like cash credit advance. However, since CP is carved out oI the working
capital limits being enjoyed by the issuing company with its bankers, it becomes
a substitute source and not an additional source.
Central Government has exempted the acceptance oI deposits by
issue oI commercial paper Irom the provisions oI Section 58A oI the
Companies Act, 1956, subject to the condition that raising oI such deposits
t hrough commerci al paper i s regul at ed by Non-Banki ng Compani es
(Acceptance oI Deposits through Commercial Paper) Directions 1989 which
come into Iorce with eIIect Irom 1 January, 1990. The main requirements oI
the same are as Iollows :
Companies Eligible to issue CP
Only the companies which satisIy the Iollowing requirement are eligible to
issue CP :
i) The tangible net worth oI the company is not less than Rs. 10 crores
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(Rs. 5 crores w.e.I. 24.4.90) as per the latest balance sheet;
ii) The Fund Based Working Capital (FBWC) Iacilities enjoyed by the
company Irom the banking system are not less than Rs. 25 crores (Rs. 15 crores
w.e.I. 24.4.90);
iii) Equity shares oI the company are listed in one or more stock exchanges.
Government companies are exempt Irom this condition.
iv) The company obtains a credit rating Irom an agency approved by RBI Ior
the purpose Irom time to time. The Credit Rating InIormation Services oI India
Ltd. (CRISIL) has been approved by RBI as the agency Ior issuing the credit
rating certiIicate. The minimum credit rating Ior issue oI CP shall be PI (PI
w.e.I. 24.4.90). At the time oI issue oI CP, the rating should not be more than
2 months old.
v) The company`s borrowal account should be classiIied under the health
code I as per the RBI guidelines under Health Coded System by the Iinancing
bank/banks.
vi) As per the latest audited balance sheet, the company maintains a
minimum current ratio oI 1.33:1 based on the classiIication oI current assets
and current liabilities as per the RBI`s guidelines, issued Irom time to time.
4. Commercial Factoring :
A Iirm Iinances its short-terms requirements oI Iunds by selling the account
receivables to specialized dealers known as Iactors. These are brokers or agents
who collect the book debts. Thus, Iirm can get the whole amount in ready cash
and Iactor collects it aIterwards. The Iirm is not required to establish and
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operate a separate credit and collection department.
5. The loans from Directors/Managing Directors or other officers
of the firm :
It is also an important source oI short-term Iinance. The directors or oIIicers
oI the company can give advance to companies to meet the working capital
requirements.
6. Customers advances :
II the Iirm undertakes job or production order on contract basis,
then costomers may be required to deposit some advance with the company.
These advances may be used by the company Ior their working capital
requirements.
Self-Assessment Questions
1. Describe the distinguishing Ieatures oI equity shares.
2. Bring out the distinguishing Ieatures oI preIerence shares. In what
respect does preIerred stock diIIer Irom common stock ?
3. Evaluate the potentiality oI debentures as a source oI raising long-term
capital.
4. Write notes on :
(a) IFCI (b) ICICI (c) UTI (d) SFC
5. What are the various sources oI raising short-term Iunds ? Describe.

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OB1ECTIVES : To Iocus on guiding principles oI Capital Structure decisions.
To provide an understanding oI various Iactors that impact capital
structure decisions.
To discuss various models oI Capital Structure Decisions.
Lesson Structure :Having estimated total Iunds requirements oI an enterprise and
examined the potentiality oI diIIerent sources oI Iinancing and their utility to a company,
Iinance manager has to decide about the Iorms oI Iinancing their requirements and
their relative proportion in total capitalisation so as to maximise the value to the
company. Such type oI decisions are collectively designated as capital structure
decisions. In accomplishing this single overall goal, Iinance manager must aim at taking
advantage oI Iavourable Iinancial leverage without incorporating excessive amount oI
Iinance risk in the company. Thus, Iinance manager must take utmost care and exercise
considerable prudence bearing in mind the cardinal principles oI Iinancing and
environmental Iactors within which the company has to operate, and the speciIic
conditions oI the company. Any negligence in their respect may prove costly to the
company aIIecting adversely its value in the long run. We shall discuss it under the
Iollowing broad heads.
I. Guiding Principles oI Capital Structure Decisions.
CAPITALSTRUCTUREDDECISIONS
(Dr. K. P. Singh)
Lesson : 3
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II. Factors AIIecting the patterns oI Capital Structure.
III. Models oI Capital Structure Decisions.
1. GUIDING PRINCIPLES OFCAPITALSTRUCTUREDECISIONS:
A Iinance manager has to plan the pattern oI capital structure Ior the Iirm in
such a way that owners` interest is maximised. Accordingly, that pattern oI capital
structure should be chosen which may minimise cost oI capital and maximise value oI
stocks. Sometimes, a Iinance manager is swayed by other interests and points oI view
and chooses a pattern that is not best suited to the shareholders. For instance, the
management in its endeavour to continue Ior existence would be more interested in
issuing stock than in bond which might add risks in the company and consequently their
position might be at stake. Likewise, management might be Iorced by lenders to go Ior
equity stock instead oI bonds because that would strengthen the security oI bondholders
in the company. Nevertheless, analysis in the present chapter is based on the premise
that the capital structure decision in primarily governed by wealth maximisation goal.
Broadly speaking, there may be three Iundamental patterns oI capital structure
in a newcompany :
i) Financing oI capital requirements exclusively by equity share/stock;
ii) Financing oI capital requirements by equity, preIerred stocks; and
iii) Financing oI capital needs by equity, preIerred stock and bonds.
Which oI the above patterns would be most suited to the company, should be
decided in the light oI the Iundamental principles laid down Ior this purpose.
While choosing a suitable pattern oI capital structure Ior the company Iinance
manager should keep into consideration some Iundamental principles. These principles
are the guiding Iorce and need to be considered jointly. Agood Iinance manager strikes
golden mean among them by giving weightage to them. Weights are assigned in the
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light oI general state oI the company, speciIic conditions prevdent in the industry and
the circumstance within which the company is running. Management Ireedom to adjust
debt-equity mix is primarily conditioned by availability oI various types oI Iunds in
desired quantity. For example, a Iinance manager decides to raise debenture loan to
meet additional capital requirements oI the company but owing to increased risk in the
company lenders may be ready to lend. Under such a condition he Iinds it diIIicult to
strike a desired adjustment in capital structure. In viewoI this, good sense oI Iinance
management lies in satisIactory compromise between management desire Ior Iunds
and constraints in supply oI Iunds. Let us discuss the Iollowing principles :-
(a) Cost Principle
As per this principle, ideal pattern oI capital structure is one that tends to
minimise cost oI Iinancing and maximise earning per share. Cost oI capital is subject
to interest rate at which payments have to be made to suppliers oI Iunds and tax status
oI such payments. Debt capital is cheaper than equity capital Irom both the points oI
view. In the Iirst instance, cost oI debt is limited. Bond holders do not participate in
superior proIits iI earned, rate oI interest on bonds is usually much less than the dividend
rate. Secondly, interest on debt is deductible Ior income tax purposes whereas no
deduction is allowed Ior dividends payable on stock. Consequently eIIective rate oI
interest which the company has ultimately to bear would be less that rate oI interest at
which bonds are issued. For example, iI bonds carry 10 per cent interest rate and
corporate tax rate is 40 per cent, eIIective cost oI debt would be 6 per cent. Thus, use
oI debt capital in the Iinancial process is signiIicantly helpIul in raising income oI the
company.
(b) Risk Principal
This principle states that such a pattern oI capital structure should be devised by
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which the company does not run the risk oI bringing on a receivership with all its
diIIiculties and losses due to insolvency. Since bond is a commitment Ior a long period,
it involves risk. II the expectations and plans on which the debt was issued change, debt
may prove Iatal to the company. II, Ior example, income oI the the corporation declines
to such a lowlevels that debt service, which is a contractual obligation, cannot be met
out oI current income, the debt may be highly risky Ior the company because the
bondholder in that case may Ioreclose and consequently equity stockholders may lose
part or all oI their assets. Similarly, iI the company issues large amount oI preIerred
stock, residual owners may be leIt with no or little income aIter satisIying Iixed dividend
obligations in the year oI low earnings. Assumption oI large risk by the use oI more
and more debt and preIerred stock aIIects the share values and share prices may
consequently. tend to go down. This would result in capital loss oI the common stock
holders.
As against this since common stock neither entails Iixed charges not the issuer
is under legal obligation to pay dividends, the corporation does not incur risk oI
insolvency though oI course issue oI additional common stock may result in decline in
earnings per share oI the old common stockholders owing to dilution oI earnings.
Also risk principle places relatively greater reliance on common stock Ior
Iinancing capital requirements oI the corporation and Iorbids as Iar as possible the use
oI Iixed income bearing securities.
(c) Control Principle :
While designing appropriate capital structure Ior the company and Ior that matter
choosing diIIerent types oI securities, Iinance manager should also keep in mind that
controlling position oI residual owners remain undisturbed. The use oI preIerred stock
and also bonds oIIers a means oI raising capital without aIIecting control. The
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management desiring to retain control must raise Iunds through bonds.
Since common stock carries voting rights, issue oI new common stock will
reduce the control oI existing shareholders. For example, a company is capitalised
exclusively with equity share capital oI Rs. 2,00,000 dividied in 20,000 shares oI Rs.
10 each. II the management contemplates to issue 10,000 new equity shares, voting
rights oI the old stockholders would be reduced to 67 per cent (20,000/30,000). Now
iI one shareholder holds 60 per cent oI the old shares, his holding would decline to 40
per cent oI the total stock aIter Iloatation oI newstock. Thus, a shareholder, who had
predominant control over the aIIairs oI the company, would lose this position because
new stockholders would share control with him. But this does not mean that the
corporation should be over indebted with heavy doses oI debt because that would
certainly increase the possibility oI the corporation`s bankruptcy and the corporation
might suIIer the consequences oI reorganisation and liquidation. Instead oI Ioregoing
entire business oI the corporation by introducting greater doses oI debt, it would be
more desirable to issue common stock and share control with newstockholders.
(d) Flexibility Principle
According to Ilexibility principle, the management should strive toward
achieving such combinations oI securities that the management Iinds it easier to manage
sources oI Iunds in response to major changes in need Ior Iunds. Not only several
alternatives are open Ior assembling required Iunds but also bargaining position oI the
corporation is strengthened while dealing with the supplier oI Iunds.
For example, iI a company is top heavy with debt and has mortgaged all its Iixed
assets to secure presently outstanding debt it may Iind it diIIicult to obtain loan Iurther,
even though market condition in respect oI availability oI debt is Iavourable because
lenders Ieel shy oI lending money to such highly risky concern.
(57)
Accordingly, the company might be compelled to raise equity share capital at a
time when there is scarcity oI such capital in the market. Thus, Ior sake oI the solvency
the company should not assume more debt. Further, the management should, as Iar as
possible, avoid getting cheaper loan on terms and conditions that limit the company`s
ability to procure additional resources. For example, iI a company borrowed money in
the past on the condition that no Iurther borrowing would be made in Iuture or dividend
payments beyond certain limit would not be made to equity stockholders, it restricts
its manoeuvre-ability in the capital Iunds. Such pledges should be avoided.
(e) Timing Principle :
Timing is always important in Iinancing and more particularly in a growing
company. Manoeuvrability principle is sought to be adhered to in choosing the type oI
Iunds so as to enable the company to seize market opportunity and minimise cost oI
raising capital and obtain substantial savings. Important point that is to be kept in mind
is to make the public oIIering oI such securities as are greatly in demand. Depending
on business cycles, demand oI diIIerent types oI securities oscillates. In times oI boom
when there is all- around business expansion and economic prosperity and investors
have strong desire to invest, it is easier to sell equity shares and raise ample resources.
But in periods oI depression bonds should be issued to attract money because investors
are aIraid to risk their money in stocks which are more or less speculative. Thus timing
may Iavour debt at one time and common stock or preIerred stock at other times.
II. FACTORS AFFECTING THEPATTERNOFCAPITALSTRUCTURE:
It comes Irom the above discussion that the principles determining the
choice oI diIIerent sources oI capital Iunds are antagonistic to each other. For example,
cost principle supports induction oI additional doses oI debt in the business which may
(58)
not be Iavoured Irom risk point oI viewbecause with additional debt the company may
run the risk to bankruptcy. Similarly, control Iactor support strongly issue oI bonds but
manoeuvrability Iactors discounts this step and Iavours the issue oI common stock.
Thus, to design suitable pattern oI capital structure Ior the company, Iinance manager
must bring about a satisIactory compromise among these conIlicting Iactors oI cost,
risk, control and timing. This compromise is to be reached by assigning weight to these
Iactors in terms oI economic and industrial characteristics and also in terms oI speciIic
characteristics oI the company. We shall now discuss as to how signiIicance oI these
principles is inIluenced by diIIerent Iactors.
i) Characteristics of the Economy :
Any decision relating to pattern oI capital structure must be made in the light oI
Iuture developments which are likely to take place in the economy because the
management has little control over the economic environment. The Iinance manager
should, thereIore, make predictions oI the economic outlook and adjust the Iinancial
plan, accordingly. Tempo oI business activity, state oI capital market, state regulation,
taxation policy and Iinancial policy oI Iinancial institutions are some oI the vital aspect
oI the economy which have strong bearing on the capital structure decision.
(a) Tempo oI Business Activities : II the economy is to recover Irom current
depression and the level oI business activity is expected to expand, the management
should assign greater weightage to manoeuvrability so that the company may have several
alternative sources available to procure additional Iunds to meet its growth needs and
accordingly, equity stock should be given more emphasis in Iinancing programmes and
avoid issuing bonds with restrictive covenants.
At a time when Indian economy is looking up and tending towards globalisation,
manoeuvrability principle will receive greater preIerence.
(59)
(b) State oI Capital Market : Study oI trends oI capital market should be
undertaken in depth since cost and availability oI diIIerent types oI Iunds is essentially
governed by them. II stock market is going to be plunged in bearish state and interest
rates are expected to decline, the management may provide greater weightage to
manoeuvrability Iactors in order to take advantage oI cheaper debt later on and postpone
debt Ior the present. However, iI debt will become costlier and will be scarce in its
availability owing to bullish trend oI the market, income Iactor may receive higher
weightage and accordingly, the management may wish to introduce additional doses oI
debt.
(c) Taxation : The existing taxation provision makes debt more advantageous in
relation to stock capital in as much as interest on bonds is a tax deductible expense
whereas dividend in subject to tax. Although it is too diIIicult to Iorecast Iuture changes
in tax rates, there is no doubt that the tax rates will not be adjusted downwards. In view
oI prevailing still high corporate tax rate in India, the management would wish to raise
degree oI Iinancial leverage by playing greater reliance oI borrowing.
(d) Policy oI Term Iinancing Institutions : II Iinancial institution adopt harsh
policy oI lending and prescribe highly restr ictive terms management must give more
weightage to manoeuverability principle and abstain Irom borrowing Irom those
institutions so as to preserve the company`s manoeuverability in capital Iunds. However,
iI Iunds can be obtained in desired quantity and on easy terms Irom the Iinancial
institution it would be in Iitness oI things to assign more weight to cost principle and
obtain Iunds Irom the institution that supplies cheaper Iunds.
ii) Characteristics of the Industry :
(a) Cyclical Variations : There are industries whose products are subject to wider
variations in sales in response to national income. For example, sales oI reIrigerators,
(60)
machine tools and most capital equipment Iluctuate more violently than the income.
As against this, some products have a low income elasticity and their sales do not
change in proportion to variation in national income.
The management should attach more signiIicance to manoeuvrability and risk
principles in choosing suitable sources oI Iunds in an industry dealing in product whose
sales Iluctuate very markedly over a business cycle so that the company may have
Ireedom to expand or contract the resources used in accordance with business
requirements. Further, the management would be averse to secure loan Ior additional
Iunds since this would go against the interests oI them, owners and the company would
run the risk oI bankruptcy during the lean years which could spell death knell oI the
company.
(b) Degree oI Competition : Public utility concerns are generally Iree Irom
intra industry competition. Accordingly, proIits oI these concerns in the absence oI
inroads oI competitors are likely to be relatively more stable and predictable. In such
concerns, the management may wish to provide greater weightage to cost principle to
take advantage oI Iinancial leverage. But where nature oI industry is such that there is
neck to neck competition among concerns and proIits oI the business are, thereIore,
no easy to predict, risk principle should be given greater consideration. Accordingly,
the company should insist on equity stock Iinancing because it would incur the risk oI
not being able to meet payments oI borrowed Iunds in case bonds are issued.
(c) Stage oI LiIe Cycle : Factors inIluencing the pattern oI capital structure are
also inIluenced by stage oI the liIe cycle oI industry to which the company belongs. In
an inIant industry, rate oI Iailure is very high. The main source oI Iunds to such industry
is equity capital obtained through underwriters. Debt should be avoided by the inIant
industry because great risk is already associated with the industry. Thus in the case oI
(61)
newindustry risk principle should be the guideline in selecting sources oI Iunds. During
periods oI rapid growth manoeuvrability Iactors should be given special consideration
so as to leave room open Ior easy and rapid expansion is given on research and
development programmes in order to develop newproducts and to postpone ultimate
decline in sales. These capital expenditure programmes must be Iinanced out oI common
stock because oI greater uncertainty in respect oI improvement in the business earnings.
II level oI business activity is expected to decline in the long run, capital structure
should be designed in such a manner that desired contraction in Iunds used is possible
in Iuture.
iii) Characteristic of Company :
Finally, peculiar characteristics oI the company eIIect the Iactors inIluencing
the choice oI diIIerent source oI Iunds. Accordingly, weights are assigned to diIIerent
principles oI manoeuvrability, cost, risk control and timing in the light oI the peculiar
Ieatures oI the company. Let us conIine our analysis oI these characteristics which are
distinct Irom the industry.
(a) Size oI Business : Smaller companies conIront tremendous problem in
assembling Iunds because oI their poor creditworthiness. Investors Ieel loath investing
their money in securities oI these companies. Lenders prescribe highly restrictive terms
in lending. In viewoI this, special attention should be paid to manoeuvrability principle
so as to assure that as the company grows in size it is able to obtain Iunds when needed
and under acceptable terms. This is why common stock represents major portion oI
capital in smaller concerns. However, management should also give special consideration
to the Iactor oI control because iI the company`s common stock were publicly available
some large concern might buy a controlling interest. In viewoI this, management might
insist on debt Ior Iurther Iinancing so as to maintain control or common stock should
(62)
be sold in closed circle so that control oI the Iirm does not pass in the hands oI
outsiders.
(b) Form oI Business organisation : Control principle should be given higher
weightage in private limited companies where ownership is closely held in a Iewhands.
This may not be so imminent in the case oI public limited companies whose shareholders
are large in number and so widely scattered that it become diIIicult Ior them to organise
in order to seize control. In such Iorm oI organisation manoeuvrability looms large
because a public limited company in viewoI its inherent characteristics Iinds it easier
to acquire equity as well as debt capital.
In proprietorship or partnership Iorm oI organisation manoeuvrability Iactors
may not be helpIul owing to limited access oI proprietory or a Iewpartners.
(c) Stability oI Earnings : With greater stability in sales and earning a company
can insist on leverage principle and accordingly it can undertake the Iixed obligation
debt with low risk. But a company with irregular earnings will not choose to burden
itselI with Iixed changes. Such company should, thereIore, pay greater attention to risk.
(d) Asset Structure oI Company : Acompany, which has invested major portion
oI Iunds in long lived Iixed assets and demand oI whose products is assured, should pay
greater attention to leverage principle to take advantage oI cheaper source. But risk
principle will outweigh leverage principle in company whose assets are mostly
receivables and inventory, value oI which is dependent on the continue proIitability oI
the individual concern.
(e) Age oI Company : Younger companies Iind themselves in diIIicult situation
to raise capital in the initial years because oI greater uncertainly involved in them and
also because they are not known to supplier oI Iunds. It would, thereIore, be worth
while Ior the management to give more weightage to manoeuvrability Iactor so as to
(63)
have as many alternatives as possible in Iuture to meet their growth requirements.
Contrary to this, established companies with good earnings record are always in
comIortable position to raise capital Irom whatever sources they like. Leverage principle
should, thereIore, be insisted upon in such concerns.
(I) Credit Standing : Acompany with high credit standing has greater ability to
adjust sources oI Iunds upwards or downwards in response to major changes in needs
Ior Iunds than the one with poor credit standing. In the Iormer case, the management
should pay greater attention to manoeuvrability Iactor and should aim at improving
credit standing oI the latter by improving its liquidity, and earnings potential.
(g) Attitude oI Management : Attitude oI the persons who are at the helm oI
aIIairs oI the company should also be analysed in depth while assigning weights to
diIIerent Iactors aIIecting the pattern oI capitalisation. The management weights to
diIIerent Iactors aIIecting the pattern oI capitalisation. The management attitude towards
control oI the enterprise and risk in particular have to be minutely analysed. Where the
management has strong desire Ior assured and exclusive control, preIerence with have
to be given to borrowing Ior raising capital in order to be assured to continued control.
Further, iI principle objective oI the management is to stay in oIIice, they would insist
more on risk principle and would be loath in issuing bonds or preIerred stock which
might plunge the company in greater risk and endanger their position.
III. MODELOFCAPITALSTRUCTUREDECISIONS
The present section will address the diIIerent models oI capital structure decision
and an attempt has been made to evaluate these models.
A. DURAND`S MODELTO CAPITALSTRUCTUREANDVALUATIONOF
ENTERPRISE.
Durands has developed two approaches to the valuation oI Iirm, viz., Net Income
(64)
Approach and Net Operating IncomeApproach.
1. Net IncomeApproach (NI Approach) :
According to this approach, there is an optimal structure where the market price
per share oI stock is maximum. The signiIicance oI this approach is that a Iirm can
lower its cost oI capital continually and increase its total valuation by the use oI debt
Iunds. Thus, with increased use oI leverage overall cost oI capital decline and total
value oI the Iirm (value oI stock plus value oI debt) rises. Leverage is, thereIore, an
important variable and debt policy decision has a signiIicant inIluence on the value oI
the Iirm.
The basic assumptions oI NI approach are :
(a) Only two types oI capital are employed - long - term debt and common stock.
(b) The interest cost on debt and the rate at which investors capitalise earnings
available to common shareholders are Iixed, regardless oI the debt-equity ratio.
(c) There is no corporate tax rate.
(d) The borrowing rate is less than the equity capitalisation rate.
(e) The Iirm`s operating earnings oI the Iirm are not expected to grow, i.e. the Iirm`s
expected EBITis the same in all Iuture periods.
(I) The Iirm`s business risk is constant and is independent oI its capital structure
and Iinancial risk.
(g) The Iirm is expect to continue indeIinitely.
This approach works like this :
As the proportion oI cheaper debt Iunds in the capital structure increases, the
weighted average cost oI capital (Ko) decreases and approaches the cost oI debt (Ki).
2
Thus, the optimal capital structure, according to the NI approach, is one at which
the total value oI the Iirm is the highest and the cost oI capital (Ko) is the lowest.
(65)
The NI approach determines the value oI the Iirm by capitalising net income
available to common stock holders and adding to it market value oI debt.
Example - 1
AIirm has Rs. 8 lakhs oI debt at 8 per cent, an expected annual net operating
earnings (EBIT) oI Rs. 18 lakhs and an equity capitalisation rate oI 10 per cent. There
are no corporate income taxes.
Rs.
Net Operating Earnings (EBIT) (O) 18,00,000
Interest on Debt (Rs. 8 lakh 8) (I) 64,000
Earnings Available to Common Stockholders (e) 17,36,000
Market Value oI Equity (Equity capitalisation
rate Xearnings available to
common stockholders) 17,36,000/1.10) 1,73,60,000
Market Value oI Bonds (b) 8,00,000
Total Value oI Firm (v) 1,81,60,000
The overall capitalisation rate (also termed as overall cost oI capital) in the
above example is :
KO O/V
Where,
KO Capitalisation rate
O Net operating income
V Overall value oI the Iirm.
Substituting the Iormula with the Iigures given in the example, implied
capitalisation rate is :
KO
18,00,000
x 100
9.9
Rs. 1,81,60,000
(66)
Let us now examine the impact oI a change in Iinancing mix on the Iirm`s
capitalisation rate and value oI the Iirm.
Example - II
AIirm increases in debt Irom Rs. 8 lakhs to 16 lakhs and uses the cost oI debt
and equity are held constant at 8 percent and 10 per cent, respectivey. The impact oI the
above change in capital structure on value oI the Iirm will be as Iollows :
Rs.
Net Operating Income 18,00,000
Interest on Debt (Rs 16 lakh x 8) 1,28,000
Earnings available to Equity 16,72,000
Stockholders
Market Value oI Equity 1,67,20,000
Market Value oI Debt 16,00,000
Total Value oI Firm Rs. 1,83,20,000
The implied overall capitalisation rate is :
KO
18,00,000
x 100

Rs. 1,83,20,000
9.8
Thus, use oI additional debt has resulted in rise in total value oI Iirm and Iall in
capitalisation rate. As a result oI this, market price per share increases. For example, in
the earlier case when the Iirm had Rs. 8 lakhs debt with 17,360 outstanding shares, the
market price per share was Rs. 1,000 (1,73,60,000/17,360).
(67)
When the Iirm issues additional debt oI Rs. 8 lakhs and uses the same to retire
stock, i.e. 800 stock, the market price per share will be Rs. 1,004 (Rs. 1,67,20,000/
16,560). The NI approach is graphically shown in Fig. The degree oI leverage is plotted
along the horizontal axis, while cost oI equity, debt and overall cost are on the vertical
axis. It is evident Irom the exhibit that cost oI equity (Ke) and cost oI debt (Ki) remain
unchanged regardless oI degree oI leverage. As the percentage share oI debt Iinancing
in total capitalisation increases, the overall cost oI capital (Ko) tends to drop and
approach the cost oI (Ki). The optimal capital structure would be the one at which cost
oI capital is the lowest and the total value oI the Iirm is maximum.
1. Evaluation of NI Approach :
This approach gives idea on the impact the debt has on overall cost oI capital.
Furthermore, the approach emphasises that recourse to debt Iinancing increases net
income beIore tax and hence the value oI equity shares in the market.
B/S
Ki
Ko
Ke
25
20
15
10
5
0
Leverage
(FIGURE)
P
e
r
c
e
n
t
a
g
e
(68)
However, NI approach Iails to recognise that incorporation oI additional doses
oI debt increases the risk in the Iirm. In real world, when a Iirm is heavily indebted, the
equity stockholders would perceive increase in risk. They would dispose oI their stock.
As a result, the market value oI equity stock will decrease. Thus, the very objective oI
maximising the value oI the Iirm will be deIeated. NI approach cannot, thereIore, be
considered adequate Ior capital structure management.
2. Net Operating Income (NOI) Approach : According to NOI approach total
value oI a Iirm remains unaIIected by its capital structure. Whatever beneIits results
Irom debt Iinancing, it will be oIIset by the rise in cost oI equity capital with the result
that overall cost oI capital remains unaIIected Ior all the degrees oI the Iinancial leverage
and thereIore, there is no optimal capital structure and investors are indiIIerent to
change in capital structure.
Operating Ieatures oI this approach are :
i) Total market value oI the Iirm (V) is obtained by capitalising net operating
income (EBIT) at the overall cost oI capital (Ko) which is constant.
Thus,
V EBIT/Ko
ii) Total value oI the stock is Iound by substracting the value oI debt Irom
total market value oI the Iirm.
iii) The cost oI equity (EBIT-F)/s tends to rise in correspondence with an
increase in the degree oI leverage.
iv) The overall cost oI capital is an average oI the costs oI debt and equity.
Thus, the NOI approach states that the real cost oI debt and the real cost oI
equity are the same. These costs are equal to Ko (overall cost oI capital). Ko is based
(69)
on expected return Irom operations oI the Iirm rather than on capital structure.
To illustrate howvalue oI the Iirm is determined under NOI approach, we use
the same data as employed in the NI approach. Thus, the Iirm is assumed to have Rs. 8
lakhs oI debt oI 8 per cent, as expected EBIToI Rs. 19 lakhs and an overall capitalisation
rate oI 10 per cent Total value oI the Iirm is calculated as Iollows :
Example - III
NOI (EBIT) Rs. 18,00,000.00
Total Value oI the FirmEBIT/Ko Rs. 18,00,000.00.10
Rs. 1,80,00,000.00
Market Value oI Debt (B) Rs. 8,00,000.00
Market Value oI Stock (s)
1,72,00,000.00
Given the value oI the stock, we can nowcalculate the cost oI equity capital as below:
Ke EBIT - F Rs. 18,00,000-.08 (Rs. 8,00,000)
S 1,72,00,000
101 or 10.1
The weighted average cost oI capital or overall capitalisation rate can now be
calculated :
Ko Ki (B/V) Ke (S/V)
8 .

172 .
8 (180) 10.1 (180)
10
Thus, the average cost oI capital or overall capitalisation rate is 10 per cent, just
as the NOI approach says it should be. II debt is increased Irom Rs. 8 lakhs to Rs. 16
lakhs and proceeds are used Ior retiring stock, the value oI the Iirm would remain
constant at Rs. 1,80,00,000, the value oI the stock would drop to Rs. 1,64,00,000 and
(70)
cost oI equity capital would rise to 10.2 per cent.
Example - IV
NOI (EBIT) Rs. 18,00,000
Value oI the Firm (V) (EBIT/Ko) Rs. 1,80,00,000
Market Value oI Debt (b) Rs. 16,00,000
Market Value oI Stock (s) Rs. 1,64,00,000
Equity capitalisation rate oI cost oI equity capital will be :
Ke EBIT - F 18,00,000-.8 (16,00,000)
S 1,64,00,000
10.2
Overall cost oI capital or capitalisation rate will remain constant at 10 per cent
as calculated below:
Ko 8 (16/180) (164/180) 10.2
10
We, thus, see that cost oI equity capital (Ke) rises with the degree oI leverage
with the result that it consumes the leverage beneIit Ilowing Irom debt Iinancing. Since
cost oI capital and overall value oI the Iirm remain unaIIected by change in capital and
overall value oI the Iirm remain unaIIected by change in capital structure, market price
per share oI the Iirm when no additional debt is taken, is Rs. 1,72,00,000/17,360
Rs. 991. With induction oI additional debt oI Rs. 8 lakhs, the market price per share
will at Rs. 991 (Rs. 1,64,00,000/16,560) the same as beIore. Thus, all capital structures
are optimal and investors are indiIIerent to change in capital structure.
The NOI approach is clearly identiIied with the theory propounded by Modigliani
and Miller who strongly support NOI on the basis oI their theoretical and empricial
(71)
research.
This approach Iocuses on the role oI net operating income in the determination
oI total value oI the Iirm. NOI approach rightly recommends that net investment
proposals should be accepted on the basis oI the relationship oI NOI to total value and
not on the basis oI the relationship between the source oI Iinancing and the return Irom
an investment project.
However, NOI approach does not accept the existence oI the concept oI optimal
capital structure. This is against the perceived risks oI diIIerent Iinancing mixes. II the
risks and beneIits oI leverage do not exist, then the purpose oI regulating debt-equity
mix is meaningless.
3. Traditional model to capital structure and valuation of enterprise.
Traditional theorist believe that up to a certain point a Iirm can, by increasing
proportion oI debt in its capital structure, reduce cost oI capital and raise market value
oI the stock. Beyond that point, Iuther induction oI debt will cause the cost oI capital
to rise and market value oI the stock to Iall. Thus, through a judicious mix oI debt and
equity the Iirm can minimise overall cost oI capital structure. AIter a certain point
overall cost oI capital begins to rise Iaster than the increase in earnings per share as a
result oI application oI additional debt.
Traditional viewwith respect to optimal capital structure can better be appreciated
by categorising the market reaction to leverage in three stages.
Stage I : The Iirst stage begins with the introduction oI debt in the Iirm`s
capitalisation. As a consequence oI the use oI low cost debt the Iirm`s net income
tends to rise. Cost oI equity capital (Ke) rises with the additional dose oI debt but the
rate oI increase will be less than the rise in the earnings rate. Cost oI debt (Kd) remains
constant or rises only modestly. Combined eIIect oI all these will be reIlected in
(72)
increased market value oI the Iirm and decline in overall cost oI capital (Ko).
Stage II : In the second stage, Iurther application oI debt will enhance cost oI
debt and equity share capital so sharply as to oIIset the gains in net income. Hence, the
total market value oI the Iirm remains unchanged.
Stege III : AIter a critical turning point, any Iurther does oI debt to capitalsation
will prove Iatal. The cost oI both debt and equity will tend to rise as a result oI the
increasing riskiness oI each causing an increase in the overall cost oI capital which
will be Iaster than the rise in earnings Irom the introduction oI additional debt.
Consequent upon this, market value oI the Iirm will showdepressing tendency.
The Iollowing illustration will explain the traditional approach.
Example - V
Following Iinancial data are avaiable about A.B.C. Ltd.
Expected net operating income Rs. 6,00,000
Debt Rs. 16,00,000 12
Equity Capitalisation Rate 15
Equity Share Capital Rs. 24,00,000
What will be the eIIect oI the Iollowing actions on the valuation and
Ko ?
(a) II the Company raises Iurther debt oI Rs. 8,00,000 at 12 and the net
operating income is expected to increase by Rs. 1,20,000 and
(b) With increase in leverage, the equity capitalisation rate increase to 18.
Solution :
(a) (i) Valuation oI the Company with existing capital structure, viz., Rs.
16,00,000 as debt and Rs. 24,00,000 as equity.
(73)
Rs.
NOI 6,00,000
Less : Interest on Debt (24,00,000 x 12) 1,92,000
Earnings Available to Equity Stock Holders 4,08,000
Ke 100/15
Market value oI Equity Stock 27,20,000
Add Market Value oI Debt 16,00,000
Total Value oI Company 43,20,000
Overall Cost oI Capital 6,00,000 x 100
43,20,000
13.89
(ii) Valuation oI the company with new capital structure, viz., Rs. 24,00,000 Rs.
24,00,000 debt equity.
Rs
NOI
Less : Interest on Debt (24,00,000 x 12) 7,20,000
Earnings Available to Equity Stock Holders 2,88,000
Ke 100/15
Market value oI Equity Stock 28,80,000
Add Market Value oI Debt 24,00,000
Total Value oI Company 52,20,000
Overall Cost oI Capital 17,20,000 x 100

52,80,000
13.64
(74)
(b) Valuation oI the Company with increase in equity capitalisation rate to
18 and debt equity ratio oI 1: 1
Rs
NOI
Less : Interest on Debt (24,00,000 x 12) 7,20,000
Earnings Availabel to Equity Stock Holders 2,88,000
Equity Capitalisation Rate 100
18
Market value oI Equtiy Stock 4,32,000 x
100
18
Add : Market Value oI Debt 24,00,000
Total Value oI Comapany 48,00,000
Overall Cost oI Capital 7,20,000 x 100
48,00,000
15
It may be noted Irom the above that with the increase in leverage Irom 40 : 60 to
50:50 the total value oI the Company has gone up Irom Rs. 43,20,000 to Rs. 52,80,000.
This is because the earnings on additional Iunds oI Rs. 8,00,000 is more than Ke,
i.e. 12.
When the Iinancial leverage was increased and Ke

was also increased the value
oI the company decreased Irom Rs. 52,80,000 to Rs. 48,00,000. Thus, with increased
risk exposure, value oI the company decreased even though Iinancial leverage was
Iavourable.
Overall cost oI capital goes down with the increase in Iavourable Iinancial
leverage and without increase in Ke.
Overall cost oI capital tends to rise with an increase in Ke.
(75)
According to the traditional model the cost oI capital would tend to rise and
market value oI the Iirm to decline as the Iirm become more risky consequent upon
Iinancing operations with debt capital. Although there is no convincing empirical
evidence to support the traditional mode, institution and practice, as evidenced by the
behaviour oI suppliers oI capital as well as by Iinance managers, seem to suggest that
there is indeeed a limit to which Iirm can assume debt without increasing its cost oI
capital. To exceed certain limits oI debt an acceptable range tends to increase both the
cost oI debt and cost oI common stock because the Iinancial risks tend to rise.
However, the model has not been explained as statisIactorily as it should have
been. Thus, Ior instance, a little was oIIered by way oI explanation as to why lowcost
debt should be substituted Ior higher cost oI equity up to the point. Furhermore, rigorous
attempts were not made to deIine where the optimal point or range may be located. As
a result, vague rules oI thumb were developed which both Iirms and Iinancial institutions
tended to Iollowblindly.
4. Modigliani-Miller Model (M`M`s model) to capital structure and
valuation of enterprise
Modigliani and Miller supplied rigorous challenge to the traditional model.
According to them, the cost oI capital and so also the value oI the Iirm remain unaIIected
by leverage employed by the Iirm. Thus, Modigliani and Miller says that any rational
choice oI debt and equity would result in the same cost oI capital under their assumptions
and that there is no optimal mix oI debt and equity Iinancing. The independence oI cost
oI capital argument in based on the hypotheses that regardless oI the eIIect oI leverage
on interest rates, the equity capitalisation rate will rise by an amount suIIicient to oIIset
any possible savings Irom the use oI lowcost debt. They contend that cost oI capital is
equal to capitalisation rate oI a pure equity stream oI income class and the market
value is ascertained by capitalising its expected income at the appropriate
(76)
discount rate Ior its risk class.
So long as the business risk remains the same, the capitalisation rate (cost oI
capital) will remain constant. Hence, as the Iirm increases the amount oI leverage in its
capital structure, the cost oI debt capital remains constant the capitalisation rate (cost
oI equity capital) will rise just enough to oIIset the gains resulting Irom application oI
lowcost debt.
The Modigliani and Miller argument is based on a simple switching mechanism
which is simply called `arbitrage`. They contend that market value oI the two Iirms
which are identical except Ior the diIIerence in the pattern oI Iinancing will not vary
because arbitrage process will drive the total values oI the two Iirms together. Rational
investors, according to them, will employ arbitrage in the market to prevent the existence
oI the two assets in the same risk class and with same expected returns Irom selling at
diIIerent prices. For example, shares oI the two Iirms in the same risk class with equal
expected returns cannot to sold at diIIerent prices in the market simply because one
has applied larger doses oI debt than the other. The M-M approach is based on the
Iollowing assumptions :
(i) Personal and corportate leverages are perIect substitutes.
(ii) There does not exist transaction cost.
(iii) Rate oI interest at which company and individuals could borrowis the same.
(iv) Institutional investors are Iree to deal in securities.
(v) There are no taxes.
(vi) Borrowings are riskless.
(vii) Investors are Iully knowledgeable and rational.
The Iollowing example will explain the M-M approach.
(77)
Example-VI
Two Iirms Aand B Ialling in the same risk class have net operating income oI
Rs. 5,00,000 each. Firm Bhas Rs. 10,00,000 oI 5 per cent bonds outstanding and Iirm
Ahas all equity. In the initial situation both Iirms have an equity capitalisation rate oI
10 per cent.
The Iollowing situation will exist.
Firm A Firm B
Net Operating Income (O) Rs. 5,00,000 Rs. 5,00,000
Less : Interest on Debt (E) --- 50,000
Net IncomeAvailable to Equity Rs. 5,00,000 Rs. 4,50,000
Stock Holders (F)
Value oI Stock
(SF/kaF/10 Rs. 50,00,000 Rs. 45,00,000
Value oI Debt (B) 0 10,00,000
(V) BS Rs. 50,00,000 Rs. 55,00,000
Thus, total value oI Iirm B is higher than that oI Iirm A by Rs. 5 lakh. But
Modigliani and Miller argue that this situation will exit no longer. Rational investors
would adjust their portIolios to take advantages to improve their earnings. Thus, an
investor owning 10 per cent oI B`s stock would sell his stock at Rs. 5,50,000 and buy
stock oI Iirm Aworth Rs. 4,50,000 and Iurther pledge the newstock as collateral Ior a
loan oI Rs. 1,00,000 in order to buy additional stock in Iirm A. The investor has thus
introduced the same leverage in his personal account as existed in the corporate account
(78)
Re. 1 oI debt Ior every Rs. 4.50 oI equity. Similarly, other investors will sell shares oI
Iirm B and buy shares oI Iirm A and obtain loan against the new stock Ior Iurther
investments. All this is done just to improve earnings position by assuming the same
degree oI risk as it was in the earlier case, investor`s income position will be as
Iollows :-
Old Income oI Firm B Rs. 4,50,000
NewIncome oI Firm A Rs. 4,50,000
Thus, investor`s stock investment income remains exactly the same as beIore.
Then what was the rationale to switch over to Iirm`s Astock ? DeIinitely investor`s
earning position will improve in substituting B`s stock by A`s stock. Investors have
obtained loan oI Rs. 1,00,000 against the security oI newstock which will be invested
elsewhere to increase existing income. This arbitrage process would continue until
Iirm B`s shares increased in price so that diIIerences in market values oI the two Iirms
are eliminated. At this equilibrium the overall cost oI capital (Ko) oI the two Iirms will
be the same.
Thus, on the basis oI arbitrage, Modigliani and Miller conclude that the Iinancing
decision does not help in any way in maximisation oI market price per share. In their
words, the market value oI any Iirm is independent oI its capital structure and is given
by capitalising its expected return at the rate appropriate to its (risk) class.
Theoretical validity oI the M-M`s proposition is diIIicult to counter. However,
the approach has been criticised bitterly by numerous experts questioning the very
assumptions on which ediIice oI the theory is Iounded.
Limitations of M-MModel :
Limitation oI the M-M approach which have been brought to the Iorce Irom
time to time are as under :
(79)
(i) The M-M model seems to have ignored the vital Iact that business risk is
a Iunction oI the degree oI the Iinancial leverage. II a Iirm Iails to service the debt
during the lean periods, it is very likely to collapse and will, thereIore, not survive to
reap the beneIits oI leverage during the lean periods. Further, bankruptcy involves high
costs and probability oI the Iirm having to bear these costs tends to rise with leverage.
(ii) M-M`s argument that there is no diIIerence between personal and
corporate leverage does not true in actual practice. As a matter oI Iact, investors pereIer
corporate leverage to personal leverage. Higher interest rates on individual than
corporate debt and stiIIer margin regulations in the case oI personal borrowing
encourage the use oI debt Iinancing by companies. This would make the investors loath
towards personal leverage. Modigliani and Miller would make the investors loath towards
personal leverage. Modigliani and Miller have answered these charges by pointing out
that the existing practices justiIy their assumptions. Further, the arbitrage process may
not be conIined to individuals. The Iree entry oI the Iinancial intermediaries in the
market without cost which they do so iI opportunities Ior proIit in respect oI dealing in
securities exist, will assure the eIIicient Iunctioning oI the arbitrage process which, in
turn, will result in the prevalence oI corporate leverage.
(iii) Another objection hailed against the M-M`s proposition is that it would
not be realistic to assume that there are no restrictions on institutional investors with
respect to their dealing in securities. In real liIe situations, many institutional investors
are not allowed to engage in the `home made` leverage. Furthermore, Reserve Bank oI
India regultes margin requirements in respect oI diIIerent types oI loans and has
stipulated the percentage oI advances under a margin loan. As a result, a signiIicant
number oI investors cannot substitute personal leverage Ior corporate leverage.
(iv) It is also unrealistic to presume that there are no transaction costs. In
(80)
actual practice security dealers have to incur brokerage, underwriting commission and
similar other costs in buying and selling corporate securities. Consequently,
eIIectiveness oI the arbitrage mechanism may be impeded. Arbitrage will take place
only upto the limits imposed by transaction costs, aIter which it is no longer proIitable.
As a result, the leverage Iirm could have slightly higher total value.
(v) The assumption oI no corporate tax is basically wrong. Nowhere in the
world, corporate income has remained untaxed. Further, everywhere taxation laws have
provided Ior deductively oI interest payments on debt Ior calculating taxable income.
II this is so, debt becomes relatively much cheaper means oI Iinancing and the Iinancial
manager is naturally encouraged to employ leverage. For that very reason debt may be
preIerred to preIerred and common stocks.
Consideration of Tax Factor in M-MApproach
Following strong objections oI Ezra Solomon and other prominent Iinancial
theoristis, M-M modiIied their earlier stand and agreed with the viewthat Iavourable
Iinancial leverage can lower the overall cost oI capital oI a Iirm iI corporation tax is
there.
M-M demonstrate that the value oI levered Iirm is higher than the value oI
unlevered Iirm because oI the Iact that interest is a tax deductible expense and due to
this more income Ilows to investors.
Example - VII
The expected value oI annual net operating income Ior two Iirms is Rs.4,000
beIore taxes, the corporate tax rate is 50 per cent. The aIter tax capitalisation rate is 10
per cent Ior both Iirms and that Iirm Ahas no debt whereas Iirm Bhas Rs. 16,000 in 5
per cent bonds. According to the M-M position, the total values oI the two Iirms would
be :
(81)
A B
1. Net Operating Income Rs. 4,000 Rs. 4,000
2. Taxes 2,000 2,000
3. ProIit beIore interest but aIter Taxes Rs. 2,000 Rs. 2,000
4. AIter Tax Capitalisation Rate
Ior Debt Free Firm .10 .10
5. Capitalised Value 20,000 20,000
6. Interest on Debt 0 800
7. (I-Tax rate) (6) 0 400
8. Tax Saving on Interest 0 400
9. Interest Rate 5
10. Capitalised Value oI (8) 0 8,000
11. Total Value oI Firm (5) (10) Rs.20,000 Rs.28,000
Thus the higher total value oI Iirm B is due to the deductibility oI interest
payments. Owing to the tax beneIits associated with debt Iinancing Iirm Bcould increase
its total value with leverage even under the M-M approach.
With taxes the value oI a Iirm according to M-M is
V O (I-t)
D
r
Where,
v value oI the Iirm
t Corporate tax rate.
r Capitalisation rate applicable to the unlevered company
O Expected net operating income.
D Market value oI debt.
(82)
It is, thus, evident that M-M model recognises that because oI corporate income
taxes, the Iirm can lower its cost oI capital and raise its value by continually increasing
leverage in its capitalisation. They suggest that in order to achieve optimal capital
structure the Iirm should strive Ior the maximum amount oI leverage. In reIreshing
contrast to this, traditional model pleads that cost oI capital would tend to rise with the
extreme leverage owing to increased Iinancial risk. ThereIore, the optimal capital
structure according to the traditional model, is not the one that calls Ior maximum use
oI debt. The weakest part oI the M-M approach, as is evident Irom the above discussion,
is noticeable when leverage is extreme. The Iirm cannot aIIord to go on borrowing
Iunds, recklessly in its bid to maximise its value as is suggested by M-M because beyond
a certain point oI leverage the Iirm would assume considerable Iinancial risk resulting
in higher interest and bankruptcy cost. In support oI their argument M-M suggest that
the Iirm should adopt a target debt equity ratio so as to keep itselI within the limits on
leverage imposed by creditors. The introduction oI debt limits implies that the cost oI
capital rises beyond a point and the there exists optimal capital structure.
EXERCISEQUESTION
1. "In making capital structure decision Iinance manager Iaces the problem oI
striking compromise among conIlicting but equally important principles oI control,
cost, risk and Ilexibility." Comment upon this statement.
2. Spell out the Iinancial considerations that should be taken into account while
reaching capital structure decision.
3. Should Iinance manager take into consideration environmental Iactors while
taking capital structure decisions ?
4. What sort oI capital structure would you propose Ior a company iI its primary
objectives were :
(83)
(a) To maximise the possible income Ior common stockholders ?
(b) To assure control with a minimum investment ?
(c) To minimise Iluctuations in earnings per share on common stock ?
5. II management agrees that the chances are about 8 out oI 20 that earnings will
remain above the break-even point, should they agree to resort to debt Iinancing ? What
might deter them Irom doing so ?
6. How would the capital structure oI a trading concern diIIerent Irom that oI a
manuIacturer oI trucks ? What are the reasons Ior any diIIerences that might exist ?
7. What diIIerences in typical structures within the industry might you expect to
Iind iI the industry was characterised by greater price competition ?
8. What is traditional approach to the concept oI capital structure ?
9. Explain the position oI M-M approach on the issue oI an optimal capital structure,
admitting to the existence oI the corporate income tax.
10. Evaluate the merits and demerits oI each oI the capital structure model.

(84)
THE COST OF CAPITAL
(Dr. K. P. Singh)
Objectives : To focus on the meaning, definition, classification &
computation of cost of capital.
Lesson Structure : The cost oI capital oI a Iirm represents the minimum rate
oI return required or expected by its investors. It only reIers to the weighted
average cost oI various sources oI Iinance employed by a Iirm. The capital
employed by a Iirm normally comprises equity shares, preIerence shares, debts
borrowed Irom Commercial Banks and Iinancial institutions and also its
retained earnings. The concept oI cost oI capital is very important in the realm
oI Iinancial management. At the same time, it is also one oI the most diIIicult
and disputed topics in the Iinancial management, since conIlicting opinions
have been expressed by the Iinancial experts and wizards as regards the way in
which the cost oI capital can be computed. The discussion is structured as
under :
I. DeIinition and Meaning II. SigniIicance oI Cost oI Capital.
III. ClassiIication and IV. Computation oI Cost oI Capital.
DEFINITIONANDMEANING
"Cost oI Capital", according to Solomon Ezra "is the minimum required
Lesson : 4
(85)
rate oI earning or the cut-oII rate Ior capital expenditures." In the words oI
Milton H. Spencer, "cost oI capital is the minimum rate oI return which a Iirm
requires as a condition Ior undertaking an investment."
It is well known that the Iinal selection oI any capital project Irom among
the various alternatives mainly depends on the cost oI the capital oI a Iirm or
the cut-oII rate representing the minimum rate oI return required on investment
projects. It is the cut-oII or the target or the hurdle rate. In case a Iirm is not
able to achieve the cut-oII or the target or the hurdle rate the market value oI
its shares remains constant at a particular level. Moreover, to achieve the
objective oI the Iinancial management, viz., wealth maximisation, a Iirm has
to necessarily earn a rate oI return more than its cost oI capital. The cost oI
capital in turn depends on the risk involved in the Iirm. Generally, higher the
risk involved in a Iirm, the higher will be the cost oI capital.
SIGNIFICANCE :
a) Criterion in capital budgeting decision :
Any capital budgeting decision involves the consideration
oI the cost oI capital. According to the net present value method oI capital
budgeting, iI the present value oI expected returns Irom the investment
throughout its liIe period is greater than or equal to the cost oI investment,
the project may be accepted; otherwise the project may be rejected. The present
value oI expected returns is calculated by discounting the expected cash inIlows
at the cut-oII rate which is the cost oI capital. It is clear Irom the above that
the cost oI capital serves as a very useIul tool in the process oI making capital
budgeting decisions.
b) Determinant of capital mix in designing of capital structure:
The cost oI capital acts as a determinant oI capital mix in the
(86)
designing oI a balanced and appropriate capital structure. As a rule there should
be a proper mix oI debt and equity capital in Iinancing a Iirm`s assets. While
designing an optimal capital sturcture oI a Iirm, the management has to consider
the objectve oI maximising the value oI the Iirm and minimising the cost oI
capital. Computation oI a weighted average cost oI various sources oI Iinance
is very essential in planning and designing the capital structure oI a Iirm.
c) Basis for evaluating the financial performance :
The cost oI capital can be used as a tool to evaluate the Iinancial
perIormance oI top management. The actual proIitability oI any project is
compared to the actual cost oI capital Iunds raised to Iinance the project. II
the actual proIitability oI the project is on the higher side when compared to
the actual cost oI capital raised, the perIormance can be evaluated as
satisIactory.
b) Basis for making financial decisions :
The cost oI capital can be conveniently employed as a tool in
making other important Iinancial decisions such as dividend policy,
capitalisation oI proIits, rights issue and working capital.
CLASSIFICATION:
Cost oI capital can be clssiIied in many ways. Some oI them are
discussed below :
a) Historical cost and future Cost :
Historical cost represents the cost which has already been incurred Ior
Iinancing a project. It is computed on the basis oI past data collected. Future cost
represents the expected cost oI Iunds to be raised Ior Iinancing a project. Historical
cost is signiIicant since it helps in projecting the Iuture cost and in providing
(87)
an appraisal oI the past Iinancial perIormance by comparing with the standard
or predetermined costs. In Iinancial decisions, Iuture costs are more relevant
than the historical costs.
b) Explicit Cost and Implicit Cost :
Explicit cost reIers to the discount rate which equates the present
value oI cash inIlows with the present value oI cash outIlows. Thus the explicit
cost is the internal rate oI return which a company pays Ior procuring the
required Iinances. The explicit cost oI a speciIic source oI Iinance may be
determined with the help oI the Iollowing Iormula :
Io O
1
O
2
................... O
n
(1k) (1k)
2
(1k)
n

Ot
(1k)
t
t 1
where Io is the net cash inIlow at zero point oI time.
Ot is the outIlow oI cash in periods 1 to n
k is the explicit cost oI capital.
Implicit cost represents the rate oI return which can be earned by investing
the capital in alternative investments. The concept oI opportunity cost gives
rise to the implicit cost. The implicit cost represents the cost oI opportunity
Ioregone in order to take up a particular project. For example, the implicit
cost oI retained earnings is the rate oI return available to the shareholders by
investing the Iunds elsewhere.
c) Specific Cost and Composite Cost :
Capital can be raised by a Iirm Irom various sources and
each source will have a diIIerent cost. SpeciIic cost reIers to the cost oI a
(88)
speciIic source oI capital, while composite cost oI capital reIers to the
combined cost oI various sources oI capital. It is the weighted average cost oI
capital. It is also termed as overall cost oI capital. When more than one type
oI capital is employed in the business, it is the composite cost which should
be considered Ior decision-making and not the speciIic cost oI that capital
alone be considered.
d) Average Cost and Marginal Cost :
Average cost oI capital reIers to the weighted average cost
calculated on the basis oI cost oI each source oI capital Iunds. Marginal cost
oI capital reIers to the average cost oI capital which has to be incurred to
obtain additional Iunds required by a Iirm. Marginal cost oI capital is
considered as more important in capital budgeting and Iinancing decisions.
COMPUTATIONOFCOSTOFCAPITALFORVARIOUS
SOURCES OFFINANCE
For calculating the overall cost oI capital oI a Iirm, the speciIic costs
oI diIIerent sources oI Iinance raised by it have to be computed. These sources
are :
(i) Debt (borrowed) Capital,
(ii) PreIerence Share Capital,
(iii) Equit Share Capital and
(iv) Retained Earnings.
1. Cost of Debt :
It is relatively easy to calculate the cost oI debt. The cost oI debt
is the rate oI interest payable on debt. Debt capital is obtained through the
issue oI debentures. The issue oI debentures involves a number oI Iloatation
charges, such as printing oI prospectus, advertisement, underwriting, brokerage,
etc, Again, debentures can be issued at par or at times below par (at discount)
(89)
or at times above par (at premium). These Iloatation charges and modes oI
issue have an important bearing on the cost oI debt capital.
The Iormula adopted or calculating the cost oI debt capital is given
below:
(i) K
d
I/P
where K
d
cost oI debt (beIore tax)
I Interest
P Principal
In case the debt is raised by issue oI debentures at premium or discount,
one should consider P as the amount oI net proceeds Irom the issue and not
the Iace vale oI debentures. The Iormula may be modiIied as
(ii) K
d
I/NP (where NP New Proceeds)
When debt is used as a source oI Iinance, the Iirm saves
considerable amount in payment oI tax since interest is allowed as a deductible
expense in computation oI tax. Hence, the eIIective cost oI debt is reduced. In
other words, the eIIective cost oI debt, i.e., the aIter-tax cost oI debt would be
substantially less than the beIore-tax cost. The aIter-tax cost oI debt may be
calculated with the help oI the Iollowing Iormula :
(iii) AIter-tax cost oI debt Kd (1-t)
where t is the tax rate.
Example I.
(a) A Ltd. issues Rs. 1,00,000, 8 debentures at par. The tax rate
applicable to the company is 50. Compute the cost oI debt capital.
(b) B Ltd. issues Rs. 1,00,000, 8 debentures at a premium oI 10.
The tax rate applicable to the company is 60. Compute the cost oI debt
capital.
(90)
(c) C Ltd. issues Rs. 1,00,000, 8 debentures at a discount oI 5.
The tax rate is 50. Compute the cost oI debt capital.
(d) D Ltd. issues Rs. 1,00,000, 9 debentures at a premium oI 10.
The costs oI Iloatation are 2. The tax rate applicable is 60. Compute costs
oI debt-capital.
Solution :
(a) Kd
I
(1-t)
NP
8,000 (1-0.5)
1,00,000
8000
x

0.5
1,00,000
4
(b) Kd
I
(1-t)
NP
8,000 (1-0.6)
1,10,000
8,000 0.4
1,10,000
2.95
(c) Kd
I
(1-t)
NP
8,000 (1-0.5)
95,000
4.21
(d) Kd
I
(1-t)
NP
(91)
9,000
0.4
1,07,000
3.34
Usually, the debt issued is to be redeemed aIter the expiry oI a certain
period during the liIe time oI a Iirm. Such a debt issue is known as Redeemable
Debt. The cost oI redeemable debt capital may be computed as :
(iv) BeIore-tax cost oI debt :
Kbd
I 1/n (P-NP)
(P NP)
Where, I Interest
N Number oI years in which debt is to be
redeemed
P Proceeds at par
NP Net Proceeds
(v) AIter-tax cost oI debt, K
d2
K
db
(1-t)

11/n (P - NP)
(1-t)

( P NP)
Example II
XYZ Ltd. issues Rs. 5,00,000, 10 redeemable debentures at a
discount oI 5. The cost oI Iloatation amount to Rs. 15,000. The debentures
are redeemable aIter 5 years. Calculate beIore-tax and aIter-tax cost oI debt
assuming a tax rate oI 50.
Solution :
BeIore-tax cost oI debt,
K
db

1 1/n (P - NP)
( P NP)
(92)

50,000 1/5 (5,00,000 - 4,60,000)

(5,00,000 4,60,000)

50,000 8,000
4,80,000

58,000 100
4,80,000
12.09
AIter-tax cost oI debt,
K
da
K
db
(1 - t)
13.09 ( 1 - 0.5)
12.09 0.5
6.045
Example III.
ABC Ltd. issues 5,000, 8 debentures oI Rs. 100 each at a
discount oI 10 and redeemable 10 years. The expenses oI issues amounted
to Rs. 10,000. Find out the cost oI debt capital.
Solution :
K
db
1 1/n (P - NP)
( P NP)
40,000 1/10 (5,00,000 - 4,40,000)
(5,00,000 4,40,000)
40,000 6,000

4,70,000
46,000 100

4,70,000
9.79
(93)
2. Cost of Preference Capital :
Normally, a Iixed rate oI dividend is agreed payable by a company
on its preIerence shares. Though dividend is declared at the discretion oI the
Board oI directors and there is no legal binding on the payment oI dividend,
yet it does not mean that PreIerence Share Capital is cost Iree. The cost oI
preIerence share capital is the dividend expected by its investors. Moreover,
preIerence shareholders have a priority to dividend over the equity
shareholders. In case dividends are not paid to preIerence shareholders, it will
aIIect the Iund raising capacity oI the Iirm. Hence, dividends are usually paid
regularly on preIerence shares except when there are no proIits to pay
dividends.
The cost preIerence capital can be calculated as :
K
p
D/P
where K
p
Cost oI PreIerence Capital
D Annual PreIerence Dividend
P PreIerence Sahre Capital
(Proceeds)
Further, when preIerence shares are issued at premium or discount or
when cost oI Iloatation is incurred to issue preIerence shares, the nominal or
par value oI preIerence share capital has to be adjusted to Iind out the net
proceeds Irom the issue oI preIerence shares. In such a case, the cost oI
preIerence capital can be computed with the Iollowing Iormula :
K
p
D/NP
When Redeemable PreIerence Shares are issued by a company, they can
be redeemed or cancelled on maturity date. The cost oI redeemable preIerence
share capital can be calculated as :
(94)

2,00,000
100
18,60,000
10.75
Example V.
Coca Cola Ltd. issued 1000 9 perIerence shares oI Rs. 100 each
at a premium oI 10 redeemable aIter 5 years at par. Compute the cost oI
preIerence capital
Solution :
Kpr D 1/n (MV - NP)
100
(MV NP)

9,000 1/5 (1,00,000 - 1,10,000)

100
(1,00,000 1,10,000)
9,000 - 2,000 100
1,05,000
6.7
Example VI.
Azhar Ltd., issued 50,000 10 PreIerence Shares oI Rs. 100 each
redeemable aIter 10 years at a premium oI 5. The cost oI issue is Rs. 2 per
share. Calculate the cost oI preIerence capital.
Solution :

5,00,000 1/10 (52,50,000 - 49,00,000) 100

(52,50,000 49,00,000)
(96)
D MV- NP
N .
Kpr (MV NP)
Where, Kpr Cost oI Redeemable PreIerence Shares
D Annual PreIerence Dividend
MV Maturity Value oI PreIerence Shares
NP Net Proceeds oI preIerence Shares
Example IV.
Pepsi Ltd. issued 20,000 10 PreIerence Shares oI Rs. 100 each.
Cost oI issue is Rs. 2 per share. Calculate cost oI preIerence capital iI
these shares are issued (a) at par (b) at a premium oI 10 and (c) at a
discount oI 5.
Solution :
Cost oI PreIerence Capital, K
p
D/NP
(a) Kp
2,00,000
100
20,00,000 - 40,000

2,00,000
100
19,60,000
10.2
(b) Kp
2,00,000
100
20,00,000 2,00,000-40,000

2,00,000
100
21,60,000
9.26
(c) Kp
2,00,000
100
20,00,000 - 1,00,000-40,000
(95)
5,00,000 35,000 100
50,75,000
5,35,000 100
50,75,000
10.54
3. Cost of Equity Share Capital :
As the payment oI dividend on equity shares is not legally binding
and the rate oI dividend is not predetermined, some Iinancial experts hold the
opinion that equity share capital does not carry any cost. But this is not true.
The share holders invest their surplus in equity shares with an expectation oI
receiving dividends and the comapany must earn this minimum rate so that the
market price oI the shares remains unchanged. ThereIore, the required rate oI
return which equates the present value oI the expected dividends with the
markets value oI share is the cost oI equity capital.
For the purpose oI measuring the cost oI equity capital will be divided
into two parts : (a) the external equity oI the new issues (oI shares) and (b) the
retained earnings because oI the Iloatation costs involved in the Iormer. It is
very diIIicult to measure the cost oI equity in practice, since it is diIIicult to
estimate the Iuture dividends expected by the equity shareholders.
Moreover, the earnings and dividends on equity share capital are
generally expected to grow. The cost oI equity capital can be computed in the
Iollowing ways :
(a) Dividend Yield Method or Dividend Price Ratio Method : Under
this method, the cost oI equity capital is the `discount rate that equates the
present value oI expected Iuture dividends per share with the net proceeds (or
current market price) oI a share.` Symbolically,
(97)
Ke D or D
NP MP
where, Ke Cost oI Equity Capital
D Expected Dividend per share
NP Net Proceeds per share
and MP Market Price per share
The basic assumptions underlying this method are that the investor give
utmost importance to dividends and the risk in the Iirm remains constant.
The dividend price ratio method cannot be considered as a sound one
Ior the Iollowing reasons : (i) it does not consider the growth in dividend (ii)
it does not consider Iuture earnings or retained earnings and (iii) it does not
take into account the capital. It is suitable only when the company has stable
earnings and stable dividend policy over a period oI time.
Example VII.
Maruti Ltd. issues 5,000 equity shares oI Rs. 100 each at a premium oI
10. The company has been paying 20 dividend to equity shareholders Ior
the past Iive years and expects to maintain the same in the Iuture also. Compute
the cost oI equity capital. Will it make any diIIerence iI the market price oI
equity share is Rs. 160 ?
Solution :
Ke D
NP
20
100
110
18.18
iI the market price oI a equity share is Rs. 160.
Ke
D
MP
(98)

20
100
160
12.5
where, Ke Cost oI equity capital
D Expected Dividend per share
Np Net proceeds per share
G Rate oI growth in dividends.
(b) Dividend Yield plus growth in dividend method : When the
dividends oI the Iirm are expected to grow at a constant rate and the dividend
pay out ratio is constant, this method may be the cost oI equity capital is based
on the dividend and the growth rate.
Ke D
G

NP
Further, in case cost oI existing equity share capital is to be calculatedd,
the NP should be changed with MP (market price per share) in the above
equation.
Ke D
G

MP
Example VIII
(a) Hero Honda Ltd. issues 2000 new equity shares oI Rs. 100 each
at par. The Iloatation costs are expected to be 5 oI the share price. The
company pays a dividend oI Rs. 10 per share initially and the growth in dividends
is expected to be 5. Compute the cost oI new issue equity share.
(b) II the current market price oI an equity share is Rs. 160, calculate
the cost soI existing equity share capital.
(99)
Solution :
(a) Ke 10
5 15.33
100-5
(b) Ke D
G
MP
10
5 11.25
160
(c) Earning yield method : Under this method, the cost oI equity
capital is the discount rate that equates the present value oI expected Iuture
earnings per share with the net proceeds (or current marketing price) oI a share.
Symbolically :
K
e
Earning per Share
Net Proceeds
EPS

NP
Where, the cost oI existing capital is to be calculated.
K
e
Earning per Share .
Market Price per Share
EPS
MPS
This method oI computing cost oI equity capital may be employed in
the Iollowing cases :
(a) When the earnings per share are expected to remain unchanged.
(100)
(b) When the dividend pay-out ratio is 100 per cent or when the
retention ratio is zero, i.e., all the available proIits are Iully
distributed as dividends.
(c) When a Iirm is expected to earn an amount oI new equity share
capital, which is equal to the current rate oI earnings.
(d) The market price oI share is inIluenced by the earnings per share
alone.
Example IX.
Jindal Ltd. is considering an expenditure oI Rs. 80 lakhs Ior expanding
its operations. Other particulars are as Iollows :
Number oI existing equity shares 10 lakhs
Market value oI existing share Rs. 60
Net earnings Rs. 90 lakhs
Compute the cost oI existing equity share capital and oI new equity
capital assuming that new shares will be issued at a price oI Rs. 54 per share
and the cost oI new issue will be Rs. 2 per share.
Solution :
Cost oI existing equity share capital
K
e
EPS
MPS
90
EPS, or Earnings per share
10
Rs. 9
9 100
K
e

60
15
Cost oI New Equity Capital
Ke
NP
(101)

9 100
54-2

9 100
52
17.30
(d) Realised Yeild Method : The main drawback oI the dividend yield
method or earnings yield method lies in the estimation oI the investors`
expected Iuture dividends on earnings. It is very diIIicult, iI not impossible, to
estimate Iuture dividends and earnings precisely, since both oI them depend
on many uncertain Iactors. To overcome this shortcoming, realised yield
method which takes into consideration the actual average rate oI return realised
in the past, is employed to computed the cost oI equity share capital. While
calculating the average cost oI return realised, dividends recieved in the past
along with the gain realised at the t ime oI sale oI shares, should be considered .
The cost oI capital is equal to the realised rate oI return by the shreholders.
This method is based upon the Iollowing limitations:
(a) The Iirm will continue to remain and Iace the same risk, over the
period:
(b) The investors`s expectations are based upon the past realised yield;
(c) The investors get the same rate oI return as the realised yield
even when invested elsewhere ; and
(d) The market price oI shares remains unchanged.
4. Cost of Retained Earnings
It is generally misunderstood that retained earnings do not involve
any cost since a Iirm is not required to pay dividends on retained earnings.
However, the shareholders expect a return on retained proIits. Retained earning
(102)
accrue to a Iirm only because oI the sacriIice made by the shareholders in not
getting the dividends declared out oI the available proIits Iully. The cost oI
retained earnings is equal to the rate oI return which the existing shreholders
will obtain by investing the aIter-tax dividends in alternative investments. It
thus represents the opportunity cost oI dividends Ioregone by the shareholders.
Cost oI retained earnings can be computed with the help oI Iollowing
Iormula :
Kr D
G

NP
where, Kr cost oI retained earnings
D Expected Dividend
NP Net proceeds oI equity issue
G Rate oI growth
Further, it important to note that sharehoders, usually, cannot obtain the
entire amount oI retained proIits by way oI dividends even iI there is 100 per
cent pay-out ratio. It is so because the shareholders are required to pay tax.
However, tax adjustment in determining the cost oI retained earnings is a
diIIicult problem because all shareholders do not Iall under the same tax
bracket. Moreover, iI the shareholders wish to invest their aIter-tax dividend
income in alternative invetments securities, they may have to incur some
additional costs towards purchasing the securities such as brokerage. Hence,
the eIIective rate oI return realised by the shareholders Irom the newinvestment
will be somewhat lesser than their present return Irom the Iirm. To make
adjustment in the cost oI retained earnings Ior tax and costs oI purchasing new
securities, the Iollowing Iormula may be adopted :
(103)
K
r
( D G) X(1-t)X(1-b)

NP
or, K
r
Ke (1-t) (1-b)
where
K
r
Cost oI retained earnings
D Expected dividend
G Growth rate
NP Net Proceeds oI Equity Issue
t tax rate
b Cost oI purchasing new securities, or brokerage costs.
k
e
Rate oI return available to shareholders
EXAMPLE X.
A Iirm`s K
e
(return available to shareholders) is 12, the average tax
rate oI shareholders is 50 and it is expected that 2 is brokerage cost that
shareholders will have to pay while investing their dividends in alternative
securities. What is the cost oI retained earnings ?
Solution :
Cost oI Retained Earnings, K
r
K
e
(1-t) (1-b)
where, K
e
rate oI return available to shareholders
t tax rate
b brokerage cost
so, k
r
12 x (1-5) (1-02)
12 x .5 x .98
5.88
Weighted Average Cost of Capital
The term weighted average cost oI capital is generally used in composite
or overall sense,
(104)
especially in Iinancial decision making. It is used only to reIer to the costs oI
speciIic Iources oI capital such as cost oI equity, etc. BeIore implementing
any capital expenditure project, it is common experience to compare the cost
oI the speciIic source oI Iund raised to Iinance a particular project with its
proIitability. But this is rather Iailacious. For, a Iirm`s decision to use debt
capital adversely aIIects its potential using low cost debt in Iuture and also
makes the position oI the existing shareholders more risky. This increases the
risk to the shareholders which is turn increases the cost oI equity. Again, the
Iirm`s decision to use equity capital to Iinance its projects will enlarge its
potential Ior borrowing, in Iuture. Because oI this linkage between the methods
oI Iinancing and their costs, the term cost oI capital should be used in a
composite term. Thus, the composite cost or overall cost oI capital is the
weighted average cost oI various sources oI Iunds, weights being the proportion
oI each source oI Iunds in the capital structure. It should also be remembered
that it is the weighted average concept and not the simple average, which is
more relevant in calculating the overall cost oI capital. As the Iirms do not use
various sources oI Iunds in equal proportion, the simple average cost oI capital
will not be appropriate to use, in the capital structure decision-making.
The Iollowing steps are involved in calculating the weighted average
cost oI capital :
i ) To calculate the cost oI the speciIic sources oI Iunds individually
(i.e., cost oI debt, cost oI equity, cost oI preIerence capital, etc.).
ii) To multiply the cost oI each source by its proportion in the capital
structure and
iii) Add the weighted costs oI all courses oI Iunds to get the weighted
cost oI capital.
(105)
The cost oI capital should always be calculated on the aIter-tax basis, in
Iinancial decision-making. Hence, the component costs one used Ior
calculating the weighted average cost oI capital.
EXAMPLE XI.
The Iollowing is the capital structure oI a TATALtd.
Sources of Finance Amount Proportion Cost
Equity Share capital Rs. 4,00,000 40 14.0
(4000 Share oI Rs. 100/-each)
Retained earnings (Reserves) 2,00,000 20 13.0
PreI. capital 1,00,000 10 12.0
Debt. 3,00,000 30 9.0
Calculate the weighted average cost oI capital oI the company.
Solution
The weighted average cost oI TATALtd. is computed as Iollows :
Source Amt Proportion After-tax Weighted cost
(1) (2) (3) (4) (5)
Equity capital 4,00,000 40 14.0 5.60
(4,000 Share oI
Rs. 100/- each)
Retained Earnings 2,00,000 20 13.0 2.60
PreI. Capital 1,00,000 10 12.0 1.20
Debt 3,00,000 30 9.0 2.70
Weighted Average cost oI capital 12.1
(106)
The weighted average cost oI TATALtd. can also be calculated as Iollows:
Alternative Method
Source Amt, Proportion After-tax
(i ) (2) (3) (4)
Equity Capital 4,00,000 14.0 56,000
Retained earnings 2,00,000 13.0 26,000
PreI, capital 1,00,000 12 12,000
Debt 3,00,000 9.0 27,000
Rs. 10,00,000 Rs.1,21,000
Weighted Average Cost oI Capital
Rs. 1,21,000 x 100
12.1
Rs. 10,00,000
Book Value Vs. Market Value Weights
The weighted cost oI capital can be calculated by using
either the book value or market value weights. II there is any diIIerence between
book value and market value weights, the weighted average cost oI capital would
also diIIer according to the weights used. When the market value oI the share
is higher than book value, the weighted average cost oI capital calculated by
using the book value weight will be much lower and vice versa.
Computation of Weighted Average Cost of Capital (Market Value weight)
Source Amt Proportion After-tax Weighted cost
Equity capital
(4,000 Share oI
Rs. 22.50) Rs.9,00,000 69.2 14.0 9.69
(107)
PreI. capital 1,00,000 7.7 12.0 0.92
Debt 3,00,000 23.1 9.0 2.08
Rs.13,00,000 12.69
It can be observed that the total market value oI the equity shares
outstanding takes into account the retained earnings also. It is obvious that the
market value oI cost oI capital (12.69) is higher than book value cost oI
capital (12.1) since market value oI equity share capital (Rs. 9,00,000) is
higher than its book value (Rs. 6,00,000). From the above it is clear that the
market value weight should be preIerred over the book value weights since the
market values reIlect the expectation oI investors. At the same time, market
value Iluctuates very widely and Irequently and there is diIIiculty in using the
market value weights in the computation oI weighted cost oI capital. In practice,
the use oI the book value weights is always preIerred Ior the Iollowing
reasons :
(a) the Iirm determines the capital strucutre targets in terms oI book value
only.
(b) the book value particulars can be easily obtained Irom the published
statement oI the company.
(c) moreover, the debt-equity ratio based on book values alone are analysed
by the investors to evaluate the risk involed in their investment.
(108)
EXERCISEQUESTIONS
1. How is Cost oI debt computed ?
2. What is mean by opportunity cost ?
3. How is cost oI preIerred stock computed ?
4. How is the weighted average cost oI capital calculated ? What is its
importance ?
5. DeIine the term `Cost oI Capital`.
6. "The equity cost is Iree." Do you agree ? Give reasons.
7. "Debt is the cheapest source oI Iunds". Comment.

(109)
CAPITAL BUDGETING
( Dr. N.S. Malik)
Introduction
The management oI any business organisation has to make two types oI
decision i.e. short-term as well as long-term. Income determination and the
planning and controlling oI operations primarily have a current time-period
orientation, i.e. short-term decisions. On the other hand, a long range planning
has a long-term perspective. These long-range decisions relate to capital
budgeting which implies the budgeting oI expenditure on capital assets. There
is a great deal oI controversy among the Iinancial analysts as to the exact
meaning oI capital expenditure. To some people, iI the returns Irom
expenditures extend beyond a year, it should be treated as capital expenditure.
According to an other point oI view, any expenditure which yields returns
beyond 5 years is a capital expenditure. Whatever may be the time dimension
oI capital expenditure, the decision on capital expenditure has importance
because it aIIects the proIitability oI the organisation Ior a Iairly long period.
Prudence exercise in capital expenditure decisions not only IulIills the short-
term objective oI better proIitability but also caters to the long-term objective
oI stabilised growth. Decisions in this area are among the most diIIicult because
Lesson : 5
(110)
the Iuture is hard to predict. Because the unknowable Iactors are many, it
becomes imperative that they be collected, properly analysed and measured
beIore a decision is made. Capital budgeting helps a lot in the budgeting oI
expenditure on capital assets or Iixed assets in order to maximise the worth oI
the Iirm.
Capital budgeting is applicable to decide whether :
Anew project should be undertaken.
Existing projects should be abandoned.
Certain research and development costs should be undertaken.
Certain existing assets should be replaced with new ones.
An eIIicient allocation oI capital is the most important Iunction in the
modern times. It involves decisions to commit the Iirm`s Iunds to the long
term assets. The capital budgeting decision has a direct impact on determining
how many new proposals or projects the Iirm should undertake. Since these
projects need to be Iinanced, the capital budgeting process also leads to the
identiIication oI the Iirm`s need Ior capital resources. It also assists in
allocating capital among various proposals and projects under consideration
by management. Such decisions are oI considerable importance to the Iirm
since they tend to determine its value size by inIluecing its growth, proIitability
and risk.
Meaning of Capital Budgeting
Capital budgeting is concerned with designing and carrying through a
systematic investment programme. According to Charles T. Horngren, "capital
budgeting is a long-term planning Ior making and Iinancing proposed capital
(111)
outlays."
According to G.C. Philippatos, "capital budgeting is concerned with the
allocation oI the Iirm`s scarce Iinancial resources among the available market
opportunities. The consideration oI investment opportunities involves the
comparison oI the expected Iuture streams oI earnings Irom a project with the
immediate and subsequent stream oI expenditure Ior it."
Thus, the capital budgeting decision may be deIined as the Iirm`s decision
to invest its current Iunds most eIIiciently in long-term activities in
anticipation oI an expects Ilow oI Iuture beneIits over a series oI years. Such
decisions may consist addition, disposition, modiIication, mechanisation or
replacement oI any Iixed asset.
Type of Capital Budgeting Decisions
Broadly speaking, capital budgeting decisions are long-term investment
decisions. They include the Iollowing :
Mechanisation of a Process - A Iirm may intend to mechanise its
existing production process by installing machine. The machine is estimated
to cost Rs. 1,50,000 and expected to save operating expenses oI Rs. 25,000
per annum Ior a period oI ten years. Thus, it is an investment decision involving
cost outlay Ior Rs. 1,50,000 and an annual saving oI Rs. 25,000 Ior 10 years.
The Iirm would be interested in analysing whether it is worth to install the
machine.
Expansion Decisions - Every company wants to expand its existing
business. In order to increase the scale oI production and sale, the company
may think oI acquiring newmachinery, addition oI building, merger or takeover
oI another business etc. This all would require additional investment which be
evaluated in terms oI Iuture expected earnings.
(112)
Replacement Decisions - A company may contemplate to replace an
existing machine with a latest model. The use oI new and latest model oI
machinery may possibly bring down operating costs and increase the production.
Such replacement decision will be evaluated in terms oI savings in operating
costs and increase in annual proIits.
Buy or Lease Decisions - Capital budgeting is also helpIul in making
buying or lease decisions. The Iixed assets can be purchased or arranged on
lease arrangements. Such decisions create a great diIIerent in the demand oI
capital. Hence, a comparative study can be made with reIerence to Iuture
beneIits Irom these two mutually exclusive alternatives.
Choice of Equipment - A company needs an equipment (plant or
machinery) to perIorm certain process. Now a choice can be made between
semi-automatic machine and Iully automatic machine. Capital budgeting
process helps a lot in such selections.
Product and Process Innovation - The research and development
department oI a company may suggest that a new product should be
manuIactured and/or a new process should be introduced. The intrduction oI
new product and/or a new process will involve heavy capital expenditure and
will earn proIits also in the Iuture. So, inIlows (i.e. Iuture operating income)
will be very useIul and the ultimate decision will depend upon the proIitability
oI the product and/or process.
House-Keeping Projects - House-keeping projects are such projects
which exert indirect impact on the production. They are Iinanaced either on
account oI legal necessity or to boost up the morale and motivation level oI
the employees, say :
(i) Health and SaIety Projects.
(113)
(ii) Service Department Projects
(iii) WelIare Projects
(iv) Education, Training and Development Projects
(v) Status Projects
(vi) Research and Development Projects.
The decisions relating to Iinancing oI above-mentioned long-term
projects are not made on the basis oI proIitability. They are approved or rejected
in terms oI their urgency, need, compulsion and desirability. Hence, no
proIitability analysis is made Ior them. The capital budgeting decisions exclude
decisions regarding current assets. The management and investment problems
oI current assets are discussed under the head working capital management.
The capital budgeting decisions are concerned with only those type oI decision
areas which have long-term implications Ior the Iirm in terms oI current
expenditure and Iuture beneIits. Current expenditure constitutes the outIlow
oI cash and is represented by cost. The Iuture beneIits are measured in terms
oI annual cash inIlows. Hence, in capital budgeting, it is the Ilow oI cash-
outIlow and inIlow which is important, not the earnings determined in
accordance with the accrual concept oI accounting.
Importance of Capital Budgeting
Capital budgeting decisions are among the most crucial and critical
business decisions. The selection oI the most proIitable assortment oI capital
investment can be considered a key Iunction oI management. On the other hand,
it is the most important single area oI decision-making Ior the Iinancial
executives. Actions taken by management in this area aIIect the operations oI
the Iirm Ior many years to come. The need and importance oI capital budgeting
(114)
can be numerated as Iollows :-
Heavy Investment - Almost all the capital expenditure projects involved
heavy investment oI Iunds. These Iunds are accumulated by the Iirm Irom
various external and internal sources at substantial cost oI capital. So their
proper planning becomes invitable.
Permanent Commitment of Funds - The Iunds involved in capital
expenditures are not only large but more or less permanently blocked also.
ThereIore, these are long-term investment decisions. The longer the time, the
greater the risk is involved. Hence, a careIul planning is essential.
Long-term impact on profitability - The capital expenditure decisions
may have a great impact on the proIitability oI the Iirm Ior a very long time. II
properly planned, they can increase not only the size, scale and volume oI scales
but Iirm growth potentiality also.
Complicacies of Investment Decisions - The long-term investment
decisions are more complicated in nature. They entail more risk and uncertainly.
Further, the acquistions oI capital assets is a continuous process. So the
management must be giIted ample prophetic skill to peep into Iuture.
Worth Maximisation of Shareholders - Capital budgeting decisions
are very important as their impact on the well-being and economic health oI
the enterprise is Iar reaching. The main aim oI this process is to avoid over-
investment and under-investment in Iixed assets. By selecting the most
proIitable capital project, the management can maximize the worth oI equity
shareholder`s investment.
Thus, the signiIicance oI capital budgeting decisions becomes quite
obvious. The other Iacts Ior its signiIicance can be summarised as Iollows :-
(115)
(a) Management loses its Ilexibility and liquidity oI Iunds in making
investment decisions, so it must consider each proposal very
throughly.
(b) Asset expansion is Iundamentally related to Iuture sales and assets
aquistion decisions are based on capital budgeting.
(c) The Iunds available Ior a Iirm are always in scarcity so they must
be properly planned. Modern industrial organisations are
char act er i sed by l arge scal e pr oduct i on and i nt ensi ve
mechanisation. This all requires balanced and properly planned
allocation oI scarce captial resources to the most proIitable
investment proposals. Hence, the procss oI capital budgeting has
become very signiIicant now a days. ThereIore, the Iinancial
executives plan capital budgets oIten years in advance.
Process of Capital Budgeting
Capital budgeting decisions oI a Iirm have a pervasive inIluence on the
entire spectrum oI entrepreneurial activities. Hence, they require a complex
combination and knowledge oI various disciplines Ior their eIIective
administration, such as, Economics, Finance, Mathematics, Economic
Forecasting, projection Techniques and Techniques oI Financial Engineering
and Control. In order to combine all these elements, a Iinance manager must
keep in mind the three dimensions oI a capital budgeting programme : Policy,
Plan and Programme. These three P`s constitute a sound capital budgeting
programme. However, the important steps involved in the capital budgeting
process are : (i) project generation; (ii) project evaluation, (iii) project
selection; and (iv) project execution. These steps are necessary, but more may
be added to make the process more eIIective. Joel Dean a Iamous economist
has described the speciIic elements in an orderly investment programme which
are as Iollows :
(116)
Creative Search for Profitable Opportunities - The Iirst stage in the capital
expenditure programme should be the conception oI a proIit making idea. It
may be rightly called the origination oI investment proposals. The proposals
may come Irom a rank and Iile worker oI any department or Irom any line
executive. To Iacilitate the origination oI such ideas a periodic review and
comparision oI earnings, costs, procedures and product line should be made
by the management on a continuous basis.
Long-range Capital Plans- When a speciIic proposal is made to
management, its consistency with the long-range plans oI the company must be
veriIied. It requires the determination oI over-all capital budgeting policies
beIore hand based upon the projections oI short and long-rum developments.
Short-range Capital Budget- Once the timelines and priority oI a
proposal have been established, it should be listed on the one-year capital budget
as an indication oI its approval.
Measurement of Project Worth- This stage involves the tentative
acceptance oI the proposal with other competitive projects, within the selection
criteria oI the company. Small projects under a certain rupee amount could be
approved by the departmental head. Larger projects should be ranked according
to their proIitability. Any one or more tests oI proIitability may be used Ior it.
For project evaluation, diIIerent techniques may be used, such as, payback
period, accounting rate oI return and discounted cashIlow techniques.
Screening and Selection - This stage involves the comparision oI the
proposal with other projects according to criteria oI the Iirm. This is done
either by Iinancial manager or by a capital expenditure planning committee.
Such criteria should encompass the supply and cost oI capital and the expected
returns Irom alternative investment opportunities. Once the proposal passes
this stage, it is authorised Ior outlays.
Establishing Priorities - Then comes the stage oI establishing the
priorities. When the accepted projects are put in priority, it Iacilities their
(117)
acquisition or construction, avoids costly delays and serious cost overruns.
This stage is also called the ranking oI projects. It helps in capital rationing
and better utilisation oI capital.
Final Approval - Once the Iinancial manager has reviewed the projects,
he will recommended a detailed programme, both oI capital expenditures and
oI sources oI capital to meet them, to the top management. Possibly, the
Iinancial manager will present several alternative capital-expenditure budgets
to the top management, it will Iinally approve the capital budget Ior the Iirm.
Forms and Procedures - This is a continuous phase that involve the
preparation oI report Ior every other phase oI the capital expenditure
programme oI the company.
Retirement and Disposal - This phase marks the end oI the cycle in
the liIe oI a project. It involves more than the recovery oI the original cost
plus and adjustment Ior replacement programmes. The old assets should be
sold and realised sale price should be used Ior replacement Iinancing.
Evaluation - An important step in the process oI capital budgeting is an
evaluation oI the programme aIter its implementation. The evaluation process
answers such questions, say, was the investment greater than anticipated? Were
the expected net cash inIlows actually realised? Was the proper test oI evaluating
the proIitability oI project applied? Management can improve its capital
budgeting programme Ior the Iuture Irom past experience. Such evaluation has
also the advantage oI Iorcing departmental heads to be more realistic in their
approach and careIul in actual execution oI the projects.
Investment Evaluation Criteria
Because oI the utmost importance oI the capital budgeting decisions, a
(118)
sound appraisal method should be adopted to measure the economic worth oI
each investment project. In most business Iirms, there are more than one
investment proposals Ior a capital project than the Iirm is capable and willing
to Iinance. Here the problem oI ranking them in order oI preIerence arises.
Hence, the management has to select the most proIitable project or to take up
the most proIitable project Iirst. As we know that the ultimate goal oI Iinancial
management is the worth maximisation oI the Iirm, hence, in order to achieve
this objective, the management must select those projects which deserve Iirst
priority in terms oI their proIitability. For evaulating the comparative
proIitability oI capital projects many methods have been evolved. Each method
has its own merits and demertis. However, the method going to be used should,
at least, possess the Iollowing characteristics :
(a) It should provide a means oI distinguishing between acceptable
and unacceptable projects.
(b) It should provide clear cut ranking oI the projects in order oI the
proIitability or desirability.
(c) It should also solve the problem oI choosing among alternative
projects.
(d) It should be a criterion which is applicable to any conceivable
investment projects.
(e) It should emphasize upon early and bigger cash beneIits in
comparision to distant and smaller beneIits.
(I) In the last but not the least, the method should be suitable
according to the nature and size oI capital project to be evaluated.
(119)
Method of Evaluating Investment Proposals
The various methods which are commonly used Ior evaluating the relative
worth oI investment proposals are as Iollwos :
I. Non-discounted cashflowTechniques (NDCF)
(A) Payback Period Method (PB)
(B) Accounting Rate oI Return Method (ARR)
II. Discounted Cashflow Techniques (DCF)
(A) Net Present Value Method (NPV)
(B) Present Value Index Method or BeneIit-Cost Ratio Method (BCR)
or ProIitability Index Method (PI)
(C) Internal Rate oI Return Method (IRR)
It is important to note here that diIIerent methods may give diIIerent
conclusions and diIIerent Iirms may use diIIerent methods. Which method is
appropriate Ior a particular purpose oI the Iirm will depend upon the
circumstances. Alarge sized Iirm may use more than one method to evaluate
each oI its investment projects, while a small Iirm may apply only one technique
which involves minimum Iunds and time. Moreover, these techniques assist
the management only in taking objectively sound decisions. They do not provide
the answer. The management has still to exercise its common sense, intuition
and judgement in making Iinal decisions.
1. Non-discounted cashflowTechniques (NDCF)
(A) Payback Period Method (PB)
This method is also known as pay-oII, pay-out or recoupment period
(120)
method. It gives the number oI years in which the total investment in a particular
capital project pays back itselI. This method is based on the principle that every
capital expenditure pays itselI back over a number oI years. It means that it
generates income regularly during its estimated economic liIe. When the total
cash inIlows Irom investment equals the total outlay, that period is the payback
period oI that project. While comparing between two or more projects, the
project with lesser payback period will be acceptable.
Calculation or Payback Period - The payback period can be calculated
in the Iollwoing manner :-
(a) In the case of even cash inflows :- II the pattern oI annual cash
inIlow is oI conventional character or they are in the Iorm oI annuity, the
computation oI payback period is very simple, as Iollow :
Payback Period
Initial Investment
Annual Cash InIlow
For example, iI an investment oI Rs. 10,000 in a machine is expected to
produce annual cash inIlow oI Rs. 2,500 Ior 6 years, then
Payback Period
Rs. 10,000
4 yrs.

Rs. 2,500
(b) In the case of uneven cash inflows - When a project`s cash Ilows
are not equal, but vary Irom year to year, i.e., they are oI non-conventional
nature, the calculation oI payback period takes a cumulative Iorm oI annual
cash inIlows. In such a situation, payback period is calculated by the process
oI cumulating cash inIlows till the time when cumulative cash inIlows become
equal to the original investment outlay. The Iollowing example will illustrate the point.
Illustration : A project requires an investment oI Rs. 10,000. Its estimated
(121)
annual cash inIlows have been given below :
Year Annual Cash Inflows Cumulative Cash inflows
(ACF) (Rs.) (CCF) (Rs.)
1 2,500 2,500
2 3,500 6,000
3 4,000 10,000
4 5,000 15,000
5 3,000 18,000
Thus, Rs. 10,000 is recovered Iully in 3rd year, hence, payback period
is 3 yrs.
Illustration : Aproject requires an ivestment oI Rs. 10,000 and its estimated
annual cash inIlows are as Iollows :
Year
(ACF) (Rs.) (CCF) (Rs.)
1 2,000 2,000
2 3,000 5,000
3 4,000 9,000
4 2,000 11,000
5 3,000 14,000
Here, payback period will be 3 years
10000 - 9000
3.5 yrs.

2000
Accept-Reject Criterion - The paback period can be used as a decision-
criterion to accept or reject investment proposals. II only one independent
project is to be evaluated its actual payable period should be compared with a
(122)
pre-determined (standard) payback, i.e., the payback set up by the management
in terms oI maximum period during which the initial investment must be
recovered. II the actual payback period is less than the standard payback period,
the project would be accepted, iI not, it would be rejected. Alternatively, the
payback can be used as a ranking method also. When mutually exclusive projects
are under consideration they may be ranked according to the length oI the
payback period. Thus, the project having the shortest payback may be assigned
rank one, Iollowed in that order so that project with the longest payback would
be ranked the lowest.
Merits of Payback Method - The payback period method Ior choosing
among alternative projects is very popular among corporate managers. The chieI
merits oI this method are as Iollows :
(i) It is easy to understand and simple to compute and communicate
to others. Its quick computation makes it Iavourite among
executive who preIer snap answers.
(ii) It gives importance to the speedy recovery oI investment in capital
assets. So, it is a useIul technique in industries where technical
developments are in Iull swing necessitating the replacements at
an early date.
(iii) It is an adequate measure Ior Iirms with very proIitable internal
investment opportunities, whose sources oI Iunds are limited by
internal low availability and external high costs.
(iv) It is useIul Ior approximating the value oI risky investments whose
rate oI capital wastage (economic depreciation and obsolescene
rate) is hard to predict. Since the payback period method weights
only ealry return heavily and ignores distant returns it contains a
built-in hedge against the possibility oI limited economic liIe.
(123)
(v) When the payback period is set at large number oI years and income
streams are uniIorm each year, the payback criterion is a good
approximation to the reciprocal oI the internal rate oI discount.
Demerits of Payback Appr oach - The payback approach, however,
suIIers Irom serious limitations also. Its major shortcomings are as Iollows :
(i) It treats each asset individually in isolation with the other assets.
While assets in actual practice can not be treated in isolation.
(ii) The method is delicate and rigid. Aslight change in the division
oI labour and cost oI maintenance will aIIect the earning and as
such it may also aIIect the payback period.
(iii) It overplays the importance oI liquidity as a goal oI the capital
expenditure decisions. While no Iirm can ignore its liquidity oI
saIeguarding liquidity levels. The overlooking oI proIitability and
overstressing the liquidity oI Iunds can in no way be justiIied.
(iv) It ignores capital wastage and economic liIe by restricting
consideration to the projects` gross earnings.
(v) This approach Iails to take Iully into account the time Iactor in
the value oI money; by measuring how quickly the Iirm recovers
its initial investment, it only implicity considers the timing oI
cash Ilows.
(vi) It overlooks the cost oI capital which is a main Iactor in sound
capital budgeting decisions.
(vii) Another major weakness oI this approach is that it completely
ignores all cash inIlows arising aIter the payback preiod. This
could be very misleading in capital budgeting decisions. It may
be possible that two projects have similar payback period but their
post-payback proIitability diIIers signiIicantly. The Iollowing
(124)
examples will illustrate the point.
Project A Project B
(Rs.) (Rs.)
Cost oI Project 15,000 15,000
Year Annual Cash InIlows
1 5,000 4,000
2 6,000 5,000
3 4,000 6,000
4 0 6,000
5 0 4,000
6 0 3,000
Payback period 3 yrs. 3 yrs.
Thus, project B is certainly advantageous as its post-payback proIitability
is more in spite oI similar payback period oI 3 years.
Look at this example also.
Project x Project y
(Rs.) (Rs.)
Total Investment 10,000 10,000
Year Annual Cash InIlows
1 5,000 3,000
2 5,000 4,000
3 2,000 3,000
4 1,000 4,000
5 500 2,000
Payback period 2 yrs. 3 yrs.
(125)
Thus, the payback period Ior project x is 2 years and Ior project y it is 3
years. Obviously, project x will be preIerable on the basis oI payback period.
However, iI we look beyond the payback period, we see that project x returns
only Rs. 3,500 while project y returns Rs. 6,000. Thus, project y should be
preIerred.
(viii) Another weakness oI this method is that it does not measure
correctly even the cash Ilows expected to be received within the paybak period
as it does not diIIerentiate between projects in terms oI the timing or magnitude
oI cashIlows. It considers only payback period as a whole while the pattern oI
cashIlows may aIIect the value oI Iirm considerably. The Iollowing example
will illustrate the point.
Project O Project P
(Rs.) (Rs.)
Total Cost oI the Project 10,000 10,000
Year Annual Cash InIlows
1 2,000 5,000
2 3,000 3,000
3 5,000 2,000
Payback period 3 yrs. 3 yrs.
Above example shows that both the projects O and P have the same cash
outlays in the zero time period, the same total cash inIlows oI Rs. 10,000; the
same payback period oI 3 years. But intuitively the project P would be
preIerable as it returns cash earlier than Iirst project. Hence, the internal
composition oI cash inIlows is also very important which should not be ignored.
But inspite oI the above-mentioned weaknesses, the payback method can
(126)
Thus, this method considers whole earnings over the entire economic
liIe oI an asset. The project with highest return will be acceptable.
(i i ) Earnings Per Unit of Money Invested - As per this method, we Iind
out the total net earnings (aIter taxes) and then divide it by the total investment.
This gives us the average rate oI return per unit oI amount invested in the project,
as Iollows :
Earnings Per Unit oI Investment
Total Earnings (aIter taxes)

Total Outlay oI the Project
Higher the earnings per rupee, the project deserves to be selected.
( i i i ) Average Return on Average Investment - Under this method the
percentage oI average return on average amount oI investment is calculated.
To calculate the average investment, the outlay oI the project is divided by
two. ARR is calculated as Iollows :
Averae Rate oI Return
Average ProIits (aIter taxes)
x 100

Average Investment
The average profits after taxes - Average proIits aIter taxes are Iound
by taking the sum oI the expected aIter-tax proIits oI the project during its liIe
and dividing the sum by the number oI years oI its liIe. In the case oI an annuity,
the average aIter-tax proIits are equal to any year`s proIits.
The average investments - Any oI the Iollowing three Iormulae may
be applied to calculate average investment :
(a) Initial Investment

2
(b) Initial Investment Scrap V alue
2
(128)
be gainIully employed under certain circumstances. In a politically unstable
economy, a quick return oI investment is a must. Shortest payback period is
the only answer to such investments. In case oI Ioreign investments, the Iirms
experiencing sever shortage oI liquidity, Ior assessing short-run and medium
term capital projects, the payback period is the only good technique Ior
assessing their proIitability. In Iact, the payback period is a measure oI liquidity
oI investment rather than their proIitability. Thus, the payback period should
more appropriately be treated as a constraint to be satisIied than as a
proIitability measure to be maximised.
(B) Accounting Rate of Return Method (ARR)
This method is also known as Financial Statement Method, Return on
Investment Method or Unadjusted Rate oI Return Method. It is based on
operating earnings computed in the ProIit & Loss Account, hence, no separate
calculations are necessary to compute annual cash inIlows. Finding the average
rate oI return is a quite popular approach Ior evaluating proposed capital
expenditures. Its appeal stems Irom the Iact that the average rate oI return is
typically calculated Irom accounting data (i.e. proIits aIter taxes). According
to this method, capital projects are ranked in order oI their rate oI earnings.
Projects which yield the highest earnings are selected and others are ruled
out. This return on investment can be expressed in several ways as below :
(i ) Average Rate of Return on Total Investment - This method established
the relationship between the average annual proIits to total outlay oI capital
project, as Iollows :
Average Rate oI Return
Average ProIits (aIter taxes)
x 100

Total Outlay oI the Project
(127)
(c) Recovered Capital
Scrap Value

2
The averaging process outlined above assumes that the Iirm is using straight
line method oI depreciation.
Merits of ARR Method
The approach has the Iollowing merits :
(1) Like payback method it is also simple and easy to understand.
(2) It is based on the accounting concept oI operating income and
accounting proIit Iigures are used in analysing the proIitability
oI alternative capital projects, hence no separate calculations are
required.
(3) It takes into consideration the total earnings Irom the project
during its entire economic liIe.
(4) This approach gives due weight to the proIitability oI the project.
(5) In investments with extremely long lives, the simple rate oI return
will be Iairly close to the true rate oI returns. It is oIten used by
Iinancial analysts to measure current perIormance oI a Iirm.
Demerits of ARR Method
This method has a Iollowing demerits :
(1) One apparent disadvantage oI this approach is this that its results by
diIIerent methods are inconsistent.
(2) It is simply an averaging technique which does not take into account the
impact oI various external Iactors on over all proIits oI the Iirm.
(129)
(3) The method ignores the time Iactor oI Iuture cash streams which is
crucial in business decisions as the amount oI interest and discount is
substantially aIIected by it.
(4) This method does not determine the Iair rate oI return on investments.
It is leIt at the discreation oI the management. Hence, the use oI this
arbitrary rate oI return may cause serious distortions in the selection oI
proIitable projects.
II. Discounted Cash Flow Techniques (DCF)
Although, return on investment has been considered a satisIactory
technique oI capital budgeting in accounting circles Ior long. Next came the
payback approach which is based on cash Ilow technique. But the lacuna oI the
above methods is that they do not take the time Iactor oI the income into
account. The earlier receipts are certainly more important than the income to
be received in later years. Abird in hand is worth than the two in the bush, is
aptly applicable to the management oI capital. Accordingly, a rupee in the hand
has more worth than a rupee to be received Iive year later, because the use oI
money has a cost (interest) just as the use oI building or an automobile may
have a cost (rent). The DCF techniques take care oI these both aspects, i.e.,
time value oI money and cost oI capital. As a capital project yields returns
spread over a number oI years, correct assessment oI its proIitability can be
made only iI the annual returns oI the Iuture years are brought to their present
value aIter applying a discounting rate (i.e. cost oI capital or interest rate).
Similarly, iI the investment is to be made over a number oI years, the cash
outIlows have to be brought down to their present value. Thus these techniques
recognise time-adjusted rate oI return as well as the cost oI capital. The
aggregate oI Iuture cash Ilows discounted at a given rate oI cost oI capital is
called the present value oI those cash inIlows.
(130)
The calculation oI present value consists oI the Iollowing steps :
(a) Estimating Iuture cash inIlows Irom the project.
(b) Selecting a discount rate which is commonly known as opportunity
cost or cost oI capital also.
(c) Discounting those cash inIlows with the discount Iactors or
present value Iactors picked up Irom the present value tables
according to the rate oI cost oI capital.
There are three methods to judge the proIitability oI diIIerent proposals on
the basis oI discounted cashIlow technique. These are as Iollows :
(A) Net Present Value Method (NPV)
The calculation oI net present value (NPV) oI project is one oI the most
commonly used capital budgeting techniques. This method is also known as
Excess Present Value oI Net Gain Method. The deIinition oI net present value
can be expressed as Iollows :
NPV Total Present value oI Future Cash inIlows - Initial Investment.
The total present value oI Iuture cash inIlows is calculated with the help
oI the Iollowing Iormula :
P
S
1
S
2

..............

S
n
(1i)

(1i)
2
(1i)
n
where, P Present Value oI Iuture cash inIlows.
S Future Value oI cash inIlows Ior n years.
i Rate oI interest
n number oI years (1,2,3,...........)
(131)
Based on the above equation, the present value Iactors tables have been
prepared. In these tables, the present value oI Re. 1 at diIIerent rates oI interest
have been given. The second type oI present value tables provide us the
cumulative amount oI an annuity oI Re. 1 Ior a given rate oI interest. II the
annual cash inIlows are oI even nature, the compound present value Iactor should
be used and iI it is oI uneven nature, the simple present value Iactor should be
applied. II the NPV is in positive the project should be accepted. II it is in
negative, it should be rejected. In mutually exclusive projects, the project with
higher NPVshould be preIerred.
The Iollowing example will explain the procedure.
Illustration : Suppose a project costs Rs. 5,000. Its estimated economic liIe
is 2 years. The Iirm`s cost oI capital is estimated to be 10. The estimated
cash inIlows Irom the project are Rs. 2,800 p.a. Calculate its NPV.
Solution : As the Iirm`s cash inIlows are oI conventional pattern (i.e. even
amount), the compound value Iactor can be used Ior calculating thier NPV.
Rs.
Total Present Value Rs. 2,800 x 1.813 5,272
Less Cost oI the Project 5,000
Net Present Value 272
Merits of NPV Method
(1) The NPV method takes into consideration the time Iactor oI
earnings as well as cost oI capital.
(2) It is very easy to calculate, simple to understand and useIul Ior
simply "accept" or "reject" type oI projects.
(3) It can be applied to both types oI cash inIlows patterns - even and
uneven cash inIlows.
(132)
(4) The NPV method is generally preIerred by economists. II one
wishes to maximise proIits, the use oI NPV always Iinds the
correct decisions.
(5) It takes care oI entire earnings.
(6) The concept oI the present value oI series oI cash Ilows is an
important Ieature in the analysis oI diIIerent investment
potentialities. The net present worth technique analyses the merit
oI relative capital investments in a nice and exact manner.
Demerits of NPV Method
(1) It involves a good amount oI calculations. Hence, it is a
complicated method.
(2) The use oI this method requires the knowledge oI cost oI capital.
II it is unknown, the method can not be used.
(3) It leads to conIusing and contradictory answers Ior the ranking oI
complicated projects.
(4) Keeping in view the substantial diIIerence in time-span and
involved risk in various capital projects, the use oI one common
rate oI cost oI capital Ior discounting cash inIlows is not
desirable.
B. Profitability Index Method
This method is also known as BeneIit-Cost Ratio. One major demerit oI
NPVmethod is that it can not be applied to compare those mutually exclusive
projects which diIIer in costs substantially. To compare and evaluate such
projects, the proIitability index should be calculated. The proIitability index
(133)
is the relationship that exists between the present values oI net cash inIlows
and cost outlays oI the projects. It can be calculated in two manners :
(i) Gross BCR
Total Present Values oI Cash InIlows

Intial Investment
(ii) Net BCR
Net Present Values oI Cash InIlows
Intial Investment
(where NPVoI cash inIlows in Total Present value oI cash inIlows minus
initial investment)
These both can be expressed in percentage also. Their expression in
percentage helps in comparing the relative proIitability oI capital projects.
The higher the proIitability index, the more desirable is the investment.
(C) Internal Rate of Return (IRR) Method
The third DCF technique is the Internal Rate oI Return Method which is
commonly known as Time-adjusted Rate oI Return method also. Like the present
value method, the IRR method also considers the time value oI money by
discounting the annual cash inIlows. But present value method can be applied
only when the discount rate (i.e. cost oI capital) is known to us. On the other
hand, in IRR technique we Iind out that rate oI return which will equate the
present value oI Iuture cash streams to the present cash outlay oI the project.
It is usually the rate oI return that the project earns. "It may be deIined as the
discount rate (r) which equates the aggregate present value oI the net cash
inIlows with the aggregate present value oI cash outIlows oI a project". In other
words, "IRR is the maximum rate oI interest that could be paid Ior the capital
employed over the liIe oI an investment without loss on the project". Thus, it
is that rate which gives the projects NPV oI zero.
(134)
Assuming conventional cash inIlows, mathematically, the IRR is
represented by that rate, r, such that,
ACF
1
ACF
2
ACF
3
ACF
n
SW
n
C -------- -------- -------- ......... --------- ------

(1r)
1
(1r)
2
(1r)
3
(1r)
n
(1r)
n
Here :
C Cost oI the Project
ACF Annual Cash InIlows
S Scrap Value oI the Project
W Working capital involved and recovered
r estimated rate oI interest
Fortunately tabular values oI present values oI Iuture earnings are readily
available. So, usually these tables are used Ior this purpose.
Computation of IRR
(a) In the case of even cash inflows - II the cash inIlows are uniIorm
each year then the computation oI IRR involves the Iollowing two steps :
(i) Calculate Present Values Factor by applying the Iollowing Iormula :
P.V. Factor
Initial Investment
Annual Cash InIlow
(ii) Locate the Iactor calculated in (i) in the compount Present Value
Table on the line corresponding the liIe span oI investment in
years. The interest rate oI the line oI that Iactor will be the
required IRR.
It is to be noted that the present value oI cash inIlows at this computed
(135)
rate must be equal to the present value oI cash outIlows.
Illustration : A project costs Rs. 10,000 and is expected to generate cash-
inIlows oI Rs. 1,750 annually Ior 10 years. Its salvage value is nil. Calculate
its IRR
Solution :
P.V. Factor Investment Annual Cash InIlow
10,000 1,750 5.714
Locating this Iactor in the compound present value table on the line
corresponding to the 10th year. we Iind that this Iactor is most close to the
Iactor in the table at 12. Hence, the approximate rate oI return is 12.
As the Iactor given in the table is less than the Iactor computed above,
actual rate will be a bit less than 12. It can, however, be ascertained by applying
the interpolation technique as Iollows :

V
1
-V
Where,
IRR r
1
------------- (r
2
-r
1
) r
1
lower rate oI return

V
1
-V
2
r
2
higher rate oI return

6.145 - 5.714
V
1
Present value Iactor at lower rate oI return
10 ------------------------ x (12 - 10) v
2
Present value Iactor at higher rate oI retun

6.145 - 5.652
V Present value Iactor Ior which IRR is to be
10 1.74 11.74 interpolated
Alternative Formula :

V- V
2
IRR r
2
- ----------- (r
2
-r
1
)

V
1
- V
2
5.714 - 5.650
12 - ---------------------- x (12 - 10)
6.145 - 5.650
0.064
12 - ------------ x 2
0.495
12 - 0.26 11.74
(b) In the case of uneven cash inflows - Here the computation oI
(136)
IRR involves a trial and error procedure. To Iind the rate oI interest that equates
the cash inIlows with the cash outIlows, we start with an assumed rated and
calculate the NPV. This NPV may be more than zero, less than zero or just
equal to zero. II more than zero, a higher rate oI interest should be tried to
calculate NPV. Conversely, when the NPVis less than zero, a lower rate would
be used. The procedure will go on till we Iind the rate which gives zero Ior the NPV.
Under IRR approach, the calculated IRR (i.e. actual rate) is compared
with the required rate oI return, also known as the cut-oII rate or hurdle rate
(i.e. the cost oI capital or interest rate on which the Iunds will be available). II
the actual IRR is higher than the cut-oII rate, the project is accepted, iI lower
it is rejected.
II the IRR and cut-oII are just equal, the Iirm will be indiIIerent as to
whether to accept or reject the project.
Illustration : Aproject requires an initial outlay oI Rs. 32,400. Its estimated
economic liIe is 3 years. The cash streams generated by it are expected to be
as Iollows :
Years Estimated ACF
(Rs.)
1 16,000
2 14,000
3 12,000
Computed its IRR. II the cost oI capital to the Iirm is 12 Advise the
management whether the project should be accepted or rejected.
Solution : To compute IRR, we have to Iollow the trial and error procedure
with various rate oI interest. The Iollowing table presents the calculations :
(137)
Table showing calculations of IRR for unequal cash inflows
Total Present Values at diIIerent rate oI interest
Year ACF DF at 14 P.V. DF at 16 P.V. DF at 15 P.V.
(Rs.) (Rs.) (Rs.) (Rs.)
1 16,000 0.877 14,032 0.862 13,795 0.870 13,920
2 14,000 0.769 10766 0.743 10,402 0.756 10,584
3 12,000 0.675 8100 0.641 7,692 0.658 7,896
32,898 31,886 32,400
Less Cost oI Project 32,400 32,400 32,400
498 -514 0
Since NPV is zero at 15 discount rate, it is its IRR. II the cost oI
capital is 12, the project must be accepted as its internal return is 15 while
cost oI Iunds is only 12. The project will contribute 3 to the value oI the
Iirm.
Merit of Discount Cashflow Techniques
(1) This method takes into account the entire economic liIe oI an investment
and income thereIrom. It gives the true rate oI return oIIered by a new
project.
(2) It gives due weight to time Iactor oI Iinancing. It is more suitable Ior
long-term planning. In the words oI Charles Horngren. "Because the
discounted cashIlow method explicity and routinely weights the time
value oI money, it is the best method to use Ior long-range decisions.
(3) It permits direct comparison oI the projected returns on investments
with the cost oI borrowing money which is not possible in other methods.
(138)
(4) It makes allowance Ior diIIerence in the time at which investments
generate their income.
(5) This approach by recognising the time Iactor makes suIIicient provision
Ior handling uncertainly and risk. It oIIers a good measure oI relative
proIitability oI capital expenditures by reducing the earnings to their
present value.
The concept oI "discounted cash Ilow" has evoked considerable interest in
regular commercial enterprises as well as among Iinancial institutions. The
World Bank and other Iinancial institutions use the DCF techniques extensively
while measuring the success oI new development ventures in order to arrive at
sound capital expenditure decisions.
Demerits and Criticism of Discounted Cashflow Techniques
This method is criticised on the Iollowing grounds :
(1) It involves a good amount oI calculations. Hence, it is a diIIicult and
complicated one. But this criticism has no Iorce, particularly with the
advent oI very sophisticated and speedy calculating and other aiding
machanisations.
(2) It is very diIIicult to Iorecast the economic liIe oI any investment
exactly.
(3) The selection oI cash-inIlow is based on sales Iorecasts which is in itselI
an interminable element.
(4) The selection oI an appropriate rate oI interest is also diIIicult.
(5) The DCF approaches do not consider the impact oI an investment on
accounting proIits. The investment may generate a low, or even a negative
(139)
net cash inIlowin early years, but produce high cash inIlows in subsequent
years. In such cases, the accounting proIits oI a Iirm are adversely
aIIected.
But despite these deIects, this approach aIIords an opportunity Ior making
valid comparisons between several long-term competing capital projects. J.
Batty has very rightly remarked - "Allowing Ior these apparent deIects there is
still a very strong case Ior using the present value concept. Values and costs
should be shown at their true worth, only then can the management accountant
say that he is truely representing Iacts which represent economic realities and
not simply a list oI unrelated Iigures. The process oI discounting brings them
all into present day terms allowing valid comparisons to be made."
Limitations of Capital Budgeting
(1) Various data such as investment, return, estimated economic liIe oI the
asset , t o a great ext ent , are onl y est i mat es. Even wi t h al l t he
"knowledgeable Iactors" collected and duly analysed, there are many
unknown Iactors which can not be Ioreseen and which can not be avoided
or controlled.
(2) Financial planning Ior liquidity and proIitability is Iraught with many oI
the same risks that apply to other phases oI business activity. The risks
oI Iaulty projections oI Iinancial requirements are particularly great in
the planning oI capital expenditures Ior long-term Iixed-asset expansion.
(3) Capital Budgeting process does not take into consideration various non-
Iigure aspects oI the project while they play an important role in
successIul and proIitable implementation oI them. Hence, non-
proIitability considerations should also be considered by the management
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while taking a Iinal decision.
(4) It is also not correct to assume that mathematically exact techniques,
always produce highly accurate results.
Standard Questions :
(1) What is capital Budgeting? Explain the relevance oI capital budgeting
decisions Irom the point oI view oI an industrial concern.
(2) Examine various methods oI ranking investment proposals in respect to
their relative merits & demerits.
(3) "The investment alternative yielding the highest discounted rate oI return
is the most acceptable". Will this always be true?
(4) What do you understand by the term "return on investment"? Do you
consider it a yard stick Ior measuring eIIiciency? Discuss the various
purposes Ior which this yardstick could be used.
Suggested Reading :
(1) Khan & Jain : Financial Management-Text and Problems.
(2) I.M. Pandey : Financial Management
(3) Prasana Chandra : Financial Management-Theory & Practice
(4) John J. Hempton : Financial Decisions Making

(141)
WORKING CAPITAL MANAGEMENT
( Dr. N. S. Malik)
Introduction
This chapter is aimed to take up issues relating to the management oI
current assets. The management oI current assets is similar to that oI Iixed
assets as Iar as their analysis oI eIIects on their return and risk is concerned.
However, the management oI current assets diIIers Irom that oI Iixed assets
on account oI time involved, liquidity position and its Ilexibility, as the current
assets can be adjusted with sales Iluctuations in the short sun. Hence, the
Iirm has a greater degree oI Ilexibility in managing current assets.
Concepts of Working Capital
Working capital or circulating capital indicates circular Ilow oI Iunds
in the day-to-day or routine activities oI business. However, this term is used
in two ways; in the gross and in the net concept.
In the broad sense, the term `working capital is used to denote the `total
current assets`. The Iollowing are some deIinitions oI this group.
(1) "Working Capital means current assets". -Mead, Baker, Malott.
(2) "The sum oI the current assets is working capital oI a business".
-J.S. Mill.
Lesson : 6
(142)
(3) "Any acquistion oI Iunds which increases the current assets increases
working capital also, Ior they are one and the same". - Bonneville
(4) "Working capital reIers to a Iirm`s investment in short-term assets-cash,
marketable securities, acounts receivable and inventories".
- Wston & Brigham
In the narrowsnse, the working capital is regarded as the excess oI current
assets over current liabilities. This has bene the most commonly used concept
by Iinancial experts and authors emphasizing the accounting phase oI Iinance.
They include the name oI E.E. Lincoln, E.A. Saliers, C.W. Gerstenbergh, etc.
Gerstenbergh deIines it as Iollows : "It has ordinarily been deIined as the excess
oI current assets over current liabilities". According to Hoagland, "Working
capital is description oI that capital which is not Iixed. But the more common
use oI the working capital is to consider it as the diIIerence between the book
value oI the current assets and the current liabilities". Likewise, "It is that
portion oI a Iirm`s current assets which is Iinanced by long-term Iunds".
Thus, there is no diIIerence in these viewpoints over the true concept oI
working capital. The true diIIerence is on its quantity. The total capital assets
approach reIers to the gross working capital while current assets minus current
liabilities approach reIers to net working capital. The total current assets
approach has a broader application and it is more inviting to the Iinancial
management. It takes into consideration all the current resources oI the
enterprise, Irom whatever source derived and their application to the current
and Iuture activities oI the enterprise. In the words oI Walker and Baughn, "A
good current ratio may mean a good umbrella Ior creditors against `rainy day`,
but to the management it reIlects Iaulty Iinancial planning or presence oI ideal
assets or over capitalisation". Actually speaking, a successIul Iinancial
executive is interested not in maintaining a good current ratio but in maintaining
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an ajustable account oI current assets so that the business may operate smoothly.
That`s why, iI the term `working capital` is used without Iurther qualiIication, iI
reIers to the gross working capital.
Types of Working Capital
Working capital can be classiIied either on the basis oI its concept or
on the basis oI periodicity oI its requirements.
(a) On the Basis of Concept. On the basis oI its concept, it may be either
gross working capital or net working capital. Gross working capital is represented by
the total current assets. The net working capital is the excess oI current assets over
current liabilities.
(i) Gross Working Capital Total Current Assets
(ii) Net Working Capital CA-CL (Current Assets-Current
Liabilities)
(b) On the Basis of Requirements. According to Gerstenbergh, the
working capital can be classiIied into two categories on the basis oI time and
requirement:
(i ) Permanent Working Capital. It reIers to the minimum amount
oI investment which should be there in the Iixed or minimum current assets
like inventory, accounts receivable, or cash balance etc., in order to carry out
business smoothly. This investment is oI a regular or permanent type and as
the size oI the Iirm expands, the requirement oI permanent working capital
also increases. Tandon Committee has reIerred to this type oI working capital
as "hard core working capital".
(i i ) Variable Working Capital. The excess oI working capital over
permanent working capital is known as variable working capital. The amount oI
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such working capital keeps on Iluctuating Irom time to time on the basis oI
business activities. It may again be sub-divided into seasonal and special working
capital. Seasonal Working Capital is required to meet the seasonal demands oI
busy periods occuring at stated intervals. On the other hand, special working
capital is required to meet extra-ordinary needs Ior contingencies. Events like
strike, Iire, unexpected competition, rising price tendencies or initiating a big
advertisement campaign require such capital.
The Iollowing diagram illustrates the diIIerence between permanent and
variable working capital.
Operating Cycle
Every business undertaking requires Iunds Ior two prupose-investment
in Iixed assets and investment in current assets. Funds required to invest in
inventories, debtors and other current assets keep on changing shape and
volume. For example, a company has some cash in the beginning. This cash
may be paid to the suppliers oI raw-materials, to meet labour costs and other
overheads. These three combined would generate work-in-progress which will
be converted into Iinished goods on the completion oI the production process.
On sale, these Iinished goods get converted into debtors and when debtors pay,
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Diagram showing permanent
and working capital
Variable W.C.
Permanent W.C.
Time
A
m
o
u
n
t

o
I

w
o
r
k
i
n
g

c
a
p
i
t
a
l
(
I
n

R
s
.
)
the Iirm will again have cash. This cash will again be used Ior Iinancing raw
materials, work-in-progress, Iinished goods and debtors etc. So the cycle is
completed on the conversion oI these currents assets into cash. This time period
is simply known as the working capital cycle oI the Iirm. In other words,
Working Capital Cycle indicates the length oI time between a Iirm`s paying Ior
materials entering into stock and receiving the cash Irom the sale oI Iinished
goods. In a manuIacturing Iirm, the duration oI time required to complete the
sequence oI events is called operating cycle.
In case oI a manuIacturing company, the operating cycle is the length oI
time necessary to complete the Iollowing cycle oI events :-
(i) Conversion oI cash into raw materials.
(ii) Conversion oI raw materials into work-in-progress;
(iii) Conversion oI work-in-progress into Iinished goods;
(iv) Conversion oI Iinished goods in accounts receivable, and
(v) Conversion oI accounts receivable into cash.
This cycle is repeated again and again. This operating cycle is clear Irom
the Iollowing chart :
Chart Showing Operating Cycle of a manufacturing business
Accounts
Receivable
Cash Finished Goods
Raw Materials Work-in-Progress

(146)
Hard Core Working Capital
"Hard Core" working capital represents the minimum amount oI
investment in raw materials, work-in-progress, Iinished goods, stores and
spares, accounts receivable and cash balance which an indusrial undertaking is
required to carry on a certain level oI activity. This part oI the the investment
in current assests is as permanent as the investment in Iixed assets. In other
words, this is the irreducible minimum amount oI current assets required
throughout the year Ior maintaining the circulation oI current assets. For
example, every industrial undertaking is required to maintain a minimum stock
oI raw materials, work-in-progress, Iinished goods, loose tools and spares etc.
It has to invest in accounts receivable and carry some cash balance to make
payment Ior wages, salaries and other expenses throughout the year. Thus, `hard
core working capital` is the permanent working capital which is required to
produce goods and services necessary to satisIy their demand at the lowest
point. It is always gainIully employed in the business. The permanent working
capital possesses the Iollowing important characteristics :
First, unlike Iixed assets, it keeps on changing its Iorm Irom one asset to another.
Second, it cannot be substantially reduced as long as Iirm is a going concern.
Third, with the growth oI business, the size oI this component oI working
capital also grows.
The quantum oI `hard core` working capital is determined by taking into
consideration the sales/production volume, technology oI production process
and diIIerent operating policies oI the Iirm. At diIIerent levels oI sales, diIIerent
levels oI inventory, receivables and cash balance are required. AIast production
process may process raw material at a Iaster rate and this may decrease the
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level oI inventory on permanent basis. The Iirm`s policies also have direct impact
on the quantum oI working capital. For example, iI a Iirm changes its credit
period Irom 30 days to 60 days the amount oI working capital will go up
permanently. Similarly, iI as a policy measure the Iirm changes the level oI its
saIety stock or cash balance, permanent working capital level will also be
aIIected. The Tandon Committee has laid down norms Ior the various
components oI working capital in major industries. These may be oI great help
in the determination oI `hard core` working capital.
The identiIication oI permanent working capital is very signiIicant Irom
the point oI its Iinancing. The supplier oI hard core working capital should not
expect its return untill the business ceaeases to exist. ThereIore, the `hard core`
component oI working capital should be Iinanced Irom long term sources oI
Iunds. For this purpose, besides ploughing back oI proIits, shares and
debentures can be issued to raise necessary Iunds. In Iact, all long-term sources
oI Iunds are suitable Ior the purpose oI Iinancing oI hard core working capital.
Importance of Working Capital
Working Capital is just like the heart oI business. II it becomes weak,
the business can hardly prosper and survive. It is an index oI the solvency oI a
concern. Its proper circulation provides to the business the right amount oI
cash to maintain regular Ilow oI its operations. The Iollowing are a Iew
advantages oI adequate working capital Iunds in the business:
Cash Discount - II proper cash balance is maintained the business can
avail oI the cash discounts Iacilities oIIered to it by the suppliers.
Liquidity and Solvency - The proper adminsitration oI working capital
enhances the liquidity in Iunds, solvency and credit - worthiness oI the concern.
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Meeting Contingencies - It provides Iunds Ior unIorseen emergencies
so that a business can successIully sail through the periods oI crisis.
High Morale - The provision oI adequate working capital improves the
morale oI the executives and their eIIiciency leads it to higher climax.
Good Bank Relations - Good relations with banks can also be
maintained. The enterprise by maintaining an adequate amount oI
working capital is able to maintain a sound bank credit, trade credit
and can escape inslovency.
Fixed Assets Productivity is Increased - Fixed assets oI the Iirm
cannot work without proper amount oI working capital. Without it Iixed
assets are like guns which cannot shoot as there are no cartridges.
Somebody has aptly commented that the Iate oI large scale investment
in Iixed assets is largely determined by the manner in which its current
assets are managed.
Research and Innovation Programmes - No research programme,
innovation and technical developments are possible to be undertaken
without suIIicient amount oI working capital.
Expansion Facilitated - The expansion programme oI a Iirm is highly
successIul, iI it is Iinanced through own working capital.
Profitability Increased - The proIitability oI a concern also depends,
in no small measure, on the right proporation oI Iixed assets and current
assets. Every activity oI the business directly or indirectly aIIects the
current position oI the enterprise, hence, its need should be properly
estimated and calculated.
(149)
Thus, the need Ior maintaining an adequate working capital can hardly be
questioned. Just as circulation oI blood is very necessary in the human body to
maintain liIe, smooth Ilow oI Iunds is very necessary to maintain the health oI
the enterprise. The importance oI working capital can be very well explained
in the words oI Husband and Dockery, "The prime object oI management is to
make a proIit. Whether or not this is accomplished in most businesses depends
largely on the manner in which the working capital is administered".
Factors Affecting Working Capital
There are numerous Iact ors whi ch aIIect t he worki ng capi t al
requirements oI a concern. Their appraisal assists the management in
Iormulating its sound working capital policies and estimating its requirements.
The important Iactors are as Iollows :
Nature of Business - The eIIect oI the general nature oI the business
on working capital requirements can not be exaggerated. Rail, roads and other
public utility services have large Iixed investment so they have the lower
requirements Ior current assets. Industrial and manuIacturing enterprises, on
the other hand, generally require a large amount oI working capital. A rapid
turnover oI capital (sales divided by total assets) will inevitably mean a larger
proportion oI current assets. However, the authors diIIer as regards to its impact
on working capital requirements. As Husband and Dockery opine, "The working
capital position is aIIected more by business conditions and trends than by the
nature or the size oI the company".
Production Policies - The nature oI production policy also exercise its impact
on capital needs. Strong seasonal movements have special working capital
problems and requirements. Ahigh level production plan also involves higher
investment in working capital.
(150)
The Proportion of the Cost of Raw Materials to total costs - In those
industries where cost oI materials is a large proportion oI the total cost oI the
goods produced or where costly raw materials are used, requirements oI
working capital will be comparatively large. But iI the proportion oI raw
materials is small, the requirements oI working capital will naturally be small.
Length of Period of Manufacture - The time which elapses between the
commencement and end oI the manuIacturing process has an important bearing
upon the requirements oI working capital. II it takes long to manuIacture the
Iinished product, naturally a large sum oI money will have to kept invested in
the Iorm oI working capital.
Rapidity of Turnover - Turnover represents the speed with which the working
capital is recovered by the sale oI goods. In certain businesses, sales are made
quickly so that stocks are soon exhausted and new purchases have to be made.
In this manner, a small sum oI money invested in stocks will result in sales oI
a much large amount. It will reduce the requirements oI working capital.
Terms of Purchases - II continuous credit is allowed by suppliers, payment
can be postponed Ior some time and can be made out oI the sale proceeds oI
the goods produced. In such a case, the requirements oI working capital will
be reduced. The period oI credit received and allowed also determines the
working capital requirements oI the enterprise.
Growth and Expansion of Business - As a company grows, it is logical to
expect that the larger amount oI working capital will be required. Growing
concerns require more working capital that those that are static. The
requirement oI working capital also varies with economic circumstances and
corporate practices.
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Business Cycles - Requirement oI working capital also varies with the business
cycles. When the price level is up due to boom conditions, the inIlationary
conditions create demand Ior more working capital. During depression also a
heavy amount oI working capital is needed due to the inventories being locked
unsold and book debts uncollected.
Requirement of Cash - The working capital requirements oI a company are
also inIluenced by the amount oI cash required by it Ior various pruposes.
The greater the requirement oI cash, the higher will be working capital needs
oI the company.
Dividend Policy of the Concern - II a conservative dividend policy is Iollowed
by the management the needs oI working capital can be met with the retained
earnings. OIten variations in need oI working capital bring about an adjustment
in dividend policy. The relationship between dividend policy and working capital
is well established and mostly comapnies declare dividend aIter a careIul study
oI their cash requirements.
Other Factors - In addition to the above considerations there are a number oI
other Iactors aIIecting the requirements oI working capital, Ior example, lack
oI co-ordination in production and distribution policies, the Iiscal and tariII
policies oI the government, etc.
Fixed Capital Vs. Working Capital
The proportion oI Iixed and working capital required Ior an enterprise
varies Irom industry to industry. There are no hard and Iast rules as regards to
Iixing their respective sizes. II the working capital is high, the Iixed capital
will be low or vice-versa. The presence oI high working capital can be
ascertained Irom the large carry-over oI raw materials, ratio oI indirect ccosts
to the total costs and lack oI control over perIormance. For eIIicient conduct
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oI an enterprise a proper balance has to be maintained between the Iixed capital
and current capital.
The proportion between Iixed and working capital depends to a large extent
upon the nature oI business. In transportation and engineering the proportion oI
Iixed capital is high while in public utilities, advertising agencies and manuIacturing
industries the proportion oI working capital is high. Initially, a business requires
more working capital, but later on as the cycle oI production, selling, and collection
starts, the requirements oI working capital diminish comparatively. As the output
goes up the need Ior investment in current assets enhances. However, the
relationship between output, Iixed assets and current assets is not linear, current
assets increase at a decreasing rate with output.
The relationship between Iixed and working capital may diIIer Irom
country to country, Irom industry to industry in the same country, even Irom
unit to unit in the same industry. High degree oI mechanisation, shortage oI
man-power and technical advancement these all Iactors contribute to the high
proportion oI Iixed capital. That is why, in less advanced countries the proportion
oI Iixed capital may not be so high.
With regard to industries, the degree oI mechanisation and automation
as also the size oI unit generally determine the proportion oI Iixed and working
capital. The iron and steel, hydro-electric, mining and heavy engineering
industries are usually organised on a large scale, hence they require a greater
proportion oI Iixed capital an account oI higher degree oI mechanisation and
automation. On the other hand, in consumer goods industries like cotton
textiles, the value oI raw materials and labour is so substantial that the
proportion oI working capital is much greater than that oI the Iixed capital.
Similarly, in a mail order business concern where the operations consist entirely
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oI simple oIIice accommodation, Iurniture and Iixtures, warehousing and
packing Iacilities, the Iixed capital is very small in relation to the working
capital. The capital intensive industries like cement, paper and chemicals, etc.
have the Iixed capital two or three times or even more oI the working capital.
The main reason oI a higher proportion oI Iixed capital in such cases is the use
oI costly machine oI huge size requiring spacious premises and costly building
accommodation.
Working Capital Forecasing
The Iorecast oI working capital requirements oI a concern is not an easy
task. As the concept oI working capital is closely related to that oI current
assets, so a number oI Iinancial experts suggest that in estimating the working
capital requirements, the total current assets requirements should be
Iorecasted. But, however, this contention is not not justiIied on logic as the
short-term needs oI the Iunds, are vitally aIIected by the nature and composition
oI Iixed assets. Hence, the problem oI working capital Iorecast should be dealt
within the overall Iinancial requirements and Iinancing policies oI the concern.
Forecasting Techniques of Working Capital
II the working capital is to be estimated Ior the ensuing year, then the
current requirement oI the assets and cashIlow Ior that period are to be
estimated. The study oI cashIlows will reveal how much cash is available to
meet the current assets requirements. The basic object oI Iorecasting working
capital needs is either to measure the cash position oI the enterprise or to
exercise control over the liquidity position oI the concern. But, the circular
Ilow oI working capital does not occur automatically and it is the essential
responsibility oI management to guide it in proper proportions through the
production machine.
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There are many popular methods available Ior Iorecasting the working
capital requirements which are as Iollows :
( i ) Cash Forecasting Method. In this method the position oI cash
at the end oI the the period is shown aIter considering the receipts and
payments to be made during that period. Its Iorm assumes more or less a
summary oI cash book. This shows the deIiciency or surplus oI cash at the
deIinite point oI time.
(i i ) The Balance Sheet Method. In the balance sheet method oI
Iorecasting, a Iorecast is made oI the various assets and liabilities oI the
business. AIterwards, the diIIerence between the two is taken which will
indicate either cash surplus or cash deIiciency.
( i i i ) Profit and Loss Adjustment Method. Under this method the
Iorecasted proIits are adjusted on cash basis. That means, cash Irom operations
is taken, as not that proIit Iigure as shown by proIit & loss account, but the
Iigure oI proIit as adjusted in the light oI non-cash items such as depreciation,
loss on sale oI capital assets, preliminary expenses written oII Irom proIit &
loss account etc. Since these items do not aIIect cash position, though they
have been charged to the proIit & loss account, they are added back or deducted
Irom loss, as the case may be. Similarly, increase in current asets and decreased
in current liabilities will mean decrease in cash resources and vice-versa.
(iv) Per Cent-of-Sales Method. Having determined the sales accurately,
steps can be taken to Iorecast the working capital oI concern, It is a traditional and
simple method oI determining the volume oI working capital and its components,
sales being a dominant Iactor. In this method, working capital is determined as a
per cent oI Iorecasted sales. It is decided on the basis oI past observations. II over
the year, relationship between sales and working capital is Iound to be stable then this
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relationship may be taken as a standard Ior the determination oI working capital in
Iuture also. This relationship between sales and working capital and its various
components may be expressed in three ways : (i) as number oI days oI sales; (ii) as
turnover; and (iii) as percentage oI sales.
The per cent oI sales method oI determining working capital is simple
and easy to understand and is useIul in Iorecasting the working capital
requirements, particularly, in the short-term. However, the greatest drawback
oI this method is the assumption oI linear relationship between sales and
working capital. ThereIore, this method can not be recommended Ior universal
application. It may be Iound suitable by individual companies in speciIic
situations.
(v) The Operational Cycle Method. This method oI working capital
Iorecast is based on the operational cycle concept oI working capital. The
operational cycle reIers to the period that a business enterprise takes in
converting cash back into cash. As an example, a manuIacturing Iirm uses cash
to acquire inventory oI materials that is converted into semi-Iinished goods
and then into Iinished goods. When Iinished goods are disposed oI to customers
on credit, accounts receivable are generated. When cash is collected Irom these
customers (trade debtors), we again have cash. At this stage one operating cycle
is completed. Thus, a circle Irom cash back to cash is called the `Operating
Cycle`. Each oI the above operating cycle stage is experessed in terms oI
number oI days oI relevant activity and requires a level oI investment to support
it. The sum total oI these stage-wise investments will be the total amount oI
working capital oI the Iirm.
The Iollowing Iormulae may be used to express the Iramework oI the
operating cycle.
t(r-c) wIb
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Where t stands Ior the total period oI the operating cycle in number oI days;
r stands Ior the number oI days oI raw material and stores consumption
requirements held in raw materials and stores inventory;
c stands Ior the number oI days oI purchases in trade creditors;
w stands Ior the number oI days oI cost oI production held in work-in-
progress.
I stands Ior the number oI days oI cost oI sales held in Iinished goods
inventory; and
g stands Ior the number oI days oI sales in book debts.
The compuations may be made as under :
r
Average inventory oI raw materials and store
Average per day consumption oI raw materials and stores
c
Average trade creditors

Average credit purchases per day
w
Average work-in progress

Average cost oI production per day
I
Average inventory oI Iinished goods
Average cost oI sales per day
b
Average book debts
Average sales per day
The average inentory, trade creditors, work-in-progress, Iinished goods
and book debts can be computed by adding the opening and closing balances at
the end oI the year in the respective accounts and dividing the same by two.
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The average per day Iigures can be obtained by dividing the concerned annual
Iigures by 365 or the number oI days in the given period.
The operat i onal cycl e met hod oI det ermi ni ng worki ng capi t al
requirements gives only an average Iigure. The Iluctuations in the intervening
period due to seasonal or other Iactors and their impact on the working capital
requirements cannot be judged in this method. To identiIiy these impacts,
continuous short run detailed Iorecasting and budgeting exercises are necessary.
(vi) Regression Analysis Method. The regression technique is a very useIul
statistical technique oI working capital Iorecasting. In the sphere oI working
capital management, it helps in making projection aIter establishing the average
relationship in the past years between sales and working capital (current assets)
and its various components. The analysis can be carried out through the graphic
portrayals (scatter diagrams) or through mathematical Iormula.
The relationship between sales and working capital oI various
component s may be si mpl e and di rect i ndi cat i ng compl et e l i neari t y
between the two or may be complex in diIIering degrees involving simpler
l i near r egr essi ons; or si mpl e cur vi l i near r egr essi on, and mul t i pl e
regression situations.
This method with the range oI techique suitable Ior simple as well as
complex situations, is an undisputed reIinement on traditional approaches oI
Iorecasting and determining working capital requirements. It is particularly
suitable Ior long-term Iorecasting.
Illustration. From the Iollowing inIormation, prepare a statement showing
the average amount oI working capital required by Sony Ltd., taking 360
days in a year.
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Annual sales are estimated at 5,000,000 units at Rs. 2 per unit.
Production quantities coincide with sales and will be carried on evenly
throughout the year and the production cost is :
Materials Re. 1 per unit.
Labour Re. 0.40 per unit
Overheads Re. 0.35 per unit
Customers are given 45 days credit and 60 days credit is taken Irom
suppliers, 36 days` supply oI rawmaterials and 15 days` supply oI Iinished goods
are kept.
Product i on cycl e i s 18 days and al l mat eri al i s i ssued at t he
commencement oI each production cycle.
And cash balance equivalent to one-third oI the average oI other working
captial requirement is kept Ior contingencies.
Solution :
Statement of working capital requirements forecast
Current Account Rs.
1. Stock oI Raw Materials 36 x5,00,000 50,000.00
360
2. Stock oI Finished Goods 15 x8,75,000 36,458.33
360
3. Work-in Progress 18 x8,75,000 43,750.00
360
4. Debtors 45 x 8,75,000 1,09,375.00
360
(159)
Total current Assets excluding cash 2,39,583.33
Less Current Liabilities :
Creditors oI Raw Materials 60 x 5,00,000 83,333.33
360
Other Working capital requirement 1,56,250.00
Add cash Ior contingencies (1/3) 52,083.33
Working Capital Required 2,08,333.33
Standard Questions
1. What are the diIIerent techniques oI Iorecasting the working capital oI
a concern ? Explain and illustrate.
2. DiIIerentiate between permanent working capital and temporary working
capital.
3. Explain the Iactors that you would take into consideration Ior assessing
the amount oI working capital Ior diIIerent kinds oI business enterprises
oI various sizes.
4. What is meant by working capital ? Howwould you determine the working
capital requirements ?
5. BPL Ltd. is desirous to purchase a business and has consulted you and
one point on which you are asked to advise them is the average amount
oI working capital which will be required in the Iirst year`s working.
You are given the Iollowing estimates and are instructed to add 10 to
your computed Iigure to allow Ior contingencies.
(160)
Figures for the year
Rs.
(i) Average amount locked up Ior stocks :
Stock oI Iinished product 5,000
Stock oI stores, materials etc. 8,000
(ii) Average credit given :
Inland Sales-6 weeks credit 3,12,000
Export Sales 1 weeks credit 78,000
(iii) Lag in payment oI wages and other outgoings:
Wages 1 weeks 2,60,000
Stores, materials etc. - 6 months 48,000
Rent, Royalties etc. - 6 months 10,000
Clerical staII - month 62,400
Manager - month 4,800
Miscellaneous expenses - 1 months 48,000
(iv) Payments in advance :
Sundry expenses (paid quarterly in advanced) 8,000
(v) Undrawn proIits on the average throughout the year 11,000
Set up your calculations Ior the average amount oI working capital
required.
Suggested Reading :
(1) Khan & Jain : Financial Management - Text and Problems.
(2) I.M.Pandey : Financial Management
(3) Prasana Chandra : Financial Management - Theory & Practice
(4) John J.Hempton : Fiancial Decisions Making

(161)
MANAGEMENT OF CASH
AIter reading this lesson, you will be conversant with
* Motives Ior holding cash
* Methodology oI cash planning
* Various methods oI accelerating cash inIlows and slowing cash outIlows
* Determination oI optimum cash Ilows
* Need Ior investing surplus cash in marketable securities.
Cash is a vital component oI working capital because it is the cash which
keeps a business going. It is the hub around which all other Iinancial matters centre.
There is no denying the Iact that cash is the very liIe-blood oI a business enterprise.
The steady and healthy circulation oI cash throughout the entire business operation
is the basis oI business solvency. Cash is the basic input needed to keep the business
running on a continuous basis. At the same time, it is also the ultimate output
expected to be realised by selling the services or products manuIactured by the
Iirm. Ultimately, every transaction in a business results in either an inIlow or
outIlowoI cash. ThereIore, eIIective management oI cash is the key determinant
oI eIIicient working capital management. There should be suIIicient cash with a
Iirm all the time to meet the needs oI the business. Both excess and inadequate
Lesson : 7
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cash situations are undesirable Irom the point oI viewoI proIitability and liquidity.
Inadequate cash may degenerate a Iirm into a state oI technical insolvency and
even lead to its liquidation. It will eventually disturb the Iirm`s manuIacturing
operation. On the other hand, excessive cash remains idle, without contributing
anything towards the Iirm`s proIitability. Moreover, holding oI cash balance has an
implicit cost in the Iorm oI its opportunity cost. The larger the idle cash, the
greater will be its opportunity cost in the Iorm oI loss oI interest which could have
been earned either -by investing it in some interest-bearing securities or by reducing
the burden oI interest charges by paying oII the loans taken previously. II the cash
balance with a Iirm at any time is surplus or deIicit, it is obvious that the Iinances
are mismanaged. Today, when cash, like any other asset oI the company, is a tool
Ior proIits, the emphasis is on right amount oI cash at the right time, at the right
place and at the right cost.
The term cash with reIerence to cash management is used in two senses. In a nay.
owsense, it includes coins, currency and cheques in hand and balances in bank account.
And in a broader sense, it also .Includes 'near-cash assets such as marketable securities
and time deposits with banks which can be immediately sold or converted into cash.
Cash management is concerned with the management oI collection and
disbursement oI cash, determination oI optimum amount oI cash and investment
oI surplus cash. Various -techniques are used Ior the management oI cash which
are Explained later in the lesson.
MOTIVES FOR HOLDING CASH
Adistinguishing Ieature oI cash as an asset, irrespective oI the Iorm in
which it is held, is that it does not earn any substantial return Ior the business,
In spite oI this Iact, cash is held by the enterprises with the Iollowing motives.
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1. Transactions motive
One oI the important motives Ior maintaining cash is to Iacilitate
business transactions. Business needs cash Ior making various payments in
ordinary course oI its operation. It includes payment Ior purchase oI material,
and payment oI wages, salary, interest, dividend, taxes and other expenses.
Similarly, business gets cash Irom its selling activities and other investments.
Thus, the receipts and payments constitute a continuous two-way Ilow oI cash.
Since the inIlows and outIlows oI cash do not perIectly synchronize, an adequate
or a minimum cash balance is required to uphold the operations iI outIlows
exceed the inIlows. ThereIore, in order to meet the day-to-day transactions,
the requirement oI cash is known as transaction motive. So, it reIers to the
holding oI cash to meet anticipated obligations when timing is not perIectly
synchronised with the inIlows oI cash. Although, a major part oI transactions
balances is held in. cash, a part may also be held in the Iorm oI marketable
securities whose maturity conIorms to the timing oI the anticipated payments,
such as payment oI taxes, dividends, etc.
2. Precautionary Motive
This motive Ior holding cash has to do with maintaining a cushion or
buIIer to meet unexpected contingencies. The unexpected cash needs at short
notice may be the result oI :
(i) incontrollable circumstances, such as Iloods. strikes, droughts, etc.;
(ii) bills which may be presented Ior settlement earlier than expected
(iii) unexpected delay in collection oI trade dues;
(iv) rejection oI orders by customers due to their dissatisIaction; and
(v) increase in the cost oI material, labour, etc.
(164)
Precautionary balances are the cash balances which are held as reserve Ior
random and unIoreseen Iluctuations in cash Ilows, i.e., this motive implies the need
to hold cash to meet unpredictable obligations. The more predictable the cash
Ilows, the less precautionary balances that are needed and vice-versa. Moreover,
the need Ior this types oI cash balance may be reduced iI there is a ready borrowing
power in order to meet the emergency cash outIlows. Sometimes, a portion oI
such cash balances may be held in marketable securities.
3. Speculative Motive
The speculative motive reIers to the desire oI a Iirm to take advantage
oI Iavourable business opportunities which are typically outside the normal
course oI operations. The speculative motive helps to take advantages oI :
(i) an opportunity to purchase raw materials at a reduced price against
immediate payment- i.e. beneIit oI cash discounts-
(ii) a change to speculate oI interest rate movements by purchasing securities
when rates oI interest are expected to decline;
(iii) the purchase at Iavourable prices.
4. Compensating Motive :
An enterprise has to compensate banks and other institutions Ior
providing certain services and loans. Such services include clearance oI
cheques, supply oI credit inIormation, transIer oI Iunds, etc. For some
services, the banks charge commission or Iee. but Ior other services they seek
indirect compensation. We know that banks require their clients to maintain a
minimum balance oI cash in their accounts in the bank. While the customers
cannot withdrawbelowthis minimum balance. the banks oI their own can utilise
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this balance to earn a return. In this way, the banks are compensated Ior the
services rendered by them to the Iirms. Such minimum required balances are
called compensating balances.
The Iour motives oI holding cash discussed above are not oI equal
importance. Transaction motive and compensating motive are the most
important ones. This is so because the enterprises normally do not speculate
and so they need not have speculative balances. As regards the requirements
oI precautionary balances, the Iirms can use short term Iinancing pattern Ior
the same.
OB1ECTIVES OF CASH MANAGEMENT
The main objective oI cash management is to bring equilibrium between
liquidity and proIitability oI business to maximise its long term proIits. The
greater the amount oI cash balance, more will be the liquidity oI the Iirm and
lesser will be its proIitability. On the other hand, lesser the amount oI cash
balance, more will be the proIitability and lesser will be the liquidity oI business.
This is true to a certain limit. AIter this limit, lesser liquidity will reduce the
proIitability. The Iollowing are two main objectives oI cash management:
1. to meet the cash disbursement needs as per the payment schedule.
2. to minimise the amount locked up as cash balances.
As a matter oI Iact, both the objectives are mutually contradictory and
thereIore, it is a challenging task Ior the Iinance manager to reconcile them
and have the best in this process.
1. Meeting cash disbursement needs
The Iirst basic objective oI cash management is to meet the payments
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schedule. In other words, the Iirm should have suIIicient cash to meet the various
requirements oI the Iirm at diIIerent periods oI time. The business has to make
payment Ior purchase oI raw materials, wages, taxes, purchase oI plant, etc. The
business activity may come to a grinding halt iI the payment schedule is not
maintained. Cash has, thereIore, been aptly described as the 'oil to lubricate the
ever-turning wheels oI the business, without it the process grinds to a stop.
2. Minimising funds locked up as cash balances
The second basic objective oI cash management is to minimise the
amount locked up as cash balances. In the process oI minimising the cash
balances, the Iinance manager is conIronted with two conIlicting aspects. A
higher cash balance ensures proper payment with all its advantages. But this
will result in a large balance oI cash remaining idle. Low level oI cash balance
may result in Iailure oI the Iirm to meet the payment schedule. The Iinance
manager should, thereIore, try to have an optimum amount oI cash oI balance
keeping the above Iacts in view.
STRATEGIES TO DEALWITH VARIOUS FACETS OFCASH
MANAGEMENT
In order to solve the uncertainty about cash Ilow prediction and lack oI
synchronisation between cash receipts and payments, the Iirm should develop
appropriate strategies Ior cash management. The Iirm should evolve strategies
regarding the Iollowing Iour Iacets oI cash management
1. Cash planning
2. Managing the cash Ilows
3. Optimum cash level
4. Investing surplus cash
(167)
CASH PLANNING
Cash planning is a technique to plan and control the use oI cash. It is a
process predicting cash inIlows and outIlows oI the Iirm over the Iorthcoming
period so as to determine surplus or shortage oI cash. In case oI excess cash
inIlows, the Iirm can invest it most proIitably and in case oI dearth oI cash, the
Iirm can make adequate provision Ior the same. Thus, with the help oI cash
planning, the Iirm can anticipate discrepancies between inIlows and outIlows
oI cash and thereby reduce the possibility oI idle cash balances (that adversely
aIIect the return) and cash deIicits (that can cause illiquidity crisis).
Cash planning is done on the basis oI the present operations and the
likely changes therein over a stipulated plan period. The basic tool which a
Iinance manager employs to Iorecast the predictable discrepancies between
cash inIlows and outIlows is the cash budget. The cash budget reveals the timing
and magnitude oI net cash outIlows as well as the periods during which surplus
cash may be available Ior temporary investment.
Cash Iorecasts are needed to prepare cash budgets. Cash Iorecasting may be
done on short-term and long-term basis. Short-term cash Iorecasting is made Ior a
period oI less than one year to determine operating cash requirements oI the Iirm.
This will help the Iirm to ascertain howmuch cash balance will be held in balance,
to what extent the Iirm will have to rely on bank Iinancing and amount oI surplus
cash that would be available Ior investment in marketable securities. Thus, short-
term cash Iorecasting enables the Iirm to adjust discrepancies between cash outIlows
and inIlows Iavourably. With prior knowledge oI timing oI cash requirements, the
Iinance manager will experience no problem in negotiating with banks Ior short-
term Iunds. A careIully and skilIully developed cash Iorecast helps the Iinance
manager choose such securities Ior investment oI idle cash as may satisIactorily
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trade-oII risks and return. The important uses oI careIully developed short term
cash Iorecasts are :
a) they help to determine operating cash requirements.
b) they help to anticipate short-term Iinancing.
c) they help in guiding ;redit policies.
There are two methods oI Iorecasting short-term cash requirements, viz.,
the receipt and disbursement method and the adjusted net income method. In
receipt and disbursement method Iorecast Ior each time oI cash receipts and
cash payments has to be made. All cash receipts oI income and non-income
nature are considered. Thus, cash inIlows Irom sales, liquidation oI assets,
dividend and interest Iorm part oI cash receipts Likewise, cash disbursements,
such as payment on account oI purchase oI materials, wages and salaries to
employees, payments oI taxes to the Government and other payments oI revenue
and non-revenue nature have to be prognosticated. AIter anticipating cash
receipts and disbursements periodically, the Iirm can integrate them in tabular
Irom (known as cash budget) to Iind out net cash inIlow or outIlow Ior each
month.
Illustration I : Rama Industries wishes to arrange overdraIt Iacilities with its
Bankers during the period April to June, 1999 when it will manuIacturing mostly
Ior stock. Prepare a cash budget Ior the above period Irom the Iollowing data,
indicating the extent oI the bank Iacilities the company will require at the end
oI each month
(a) 1999 Sales(R.s.) Purchases (Rs.) Wages (Rs.)
February 1,80,000 1,24,800 12,000
March 1,92,000 1,44,000 14,000
(169)
April 1,08,000 2,43,000 11,000
May 1,74,000 2,46,000 10,000
June 1,26,000 2,68,000 15,000
(b) 50 per cent oI credit sales are realised in the month Iollowing the sales
and remaining 50 per cent in the second month Iollowing. Creditors are paid
in the month Iollowing the month oI purchase.
(c) Cash at Bank on 1.4.1999 (estimated) Rs. 25,000
Solution
Cash Budget for Three Months from April to 1une, 1999
(a) Receipts April May June
Rs. Rs. Rs.
Opening Balance 25,000 53,000 -51,000
Sales (last to last month) 90,000 96,000 54,000
Sales (last month) 96,000 54,000 87,000
Total Receipts 2,11,000 2,03,000 90,000
(b) Payments :
Purchases 1,44,000 2,43,000 2,46,000
Wages 14,000 11,000 10,000
Total. Payments 1,58,000 2,54,000 2,56,000
Closing Balance (a-b) 53,000 (-) 51,000 (-) 1,66,000
Note : Workers are paid on lst oI the Iollowing month.
In the adjusted net income method only those receipts and payments
are predicted which are oI revenue in nature. Thus, receipts Irom sale oI
shares and debentures and Iixed assets would not Iorm part oI the Iorecast
under this method. In the same way, disbursements in respect oI purchase oI
(170)
Iixed assets or dividend distribution would not be considered. Further,
adjusted net income method considers all receipts and payments on accrual
basis. Finally, all appropriations, such as depreciation and amortization oI
patents have to be Iorecast under this method. Forecast prepared on adjusted
net income method helps in anticipating the working capital requirements.
The preparation oI cash budget, according to this method, can be understood
with the help oI Iollowing illustration
Illustration 2
From the Iollowing inIormation prepare a cash budget under the adjusted
proIit and loss method
Balance Sheet
as on Ist 1anuary, 1998
Liabilities Rs. Assets Rs.
Share Capital 1,25,000 Land and Building 75,000
Capital Reserve 12,500 Plant and Machinery 50,000
ProIit and Loss A/c 22,500 Furniture and Fixtures 12,500
Debentures 25,000 Closing Stock 10,000
Creditors 72,000 Debtors 65,000
Accrued expenses 500 Bank 45,000
2,57,500 2,57,500
Projected Trading and Profit and Loss Account
for the year ending 31st December, 1998
Particulars Rs. Particulars Rs.
To Opening stock 10,000 By sales 2,00,000
To Purchases 1,50,000 By Closing Stock 25,000
(171)
To Gross ProIit c/d 65,000
2,25,000 2,25,000
To Salary and wages6,250 By Gross ProIit b/d 65,000
Add outstanding 1250 7,500 By Interest received 250
To Depreciation:
Plant & Machinery 5,000
Furniture & Fixture 2,500
To AdministrationExpenses 8,750
To Selling Expenses 6,250
To Net ProIit c/d 35,250
65,250 65,250
To Dividend paid 25,000 By Balance B/d 22,500
To Balance c/d 32,750 By Net ProIit b/d 35,250
57,750 57,750
The Iollowing is the additional inIormation Ior the year 1998 Shares
were issued Ior Rs. 25,000 and debentures were issued Ior Rs. 5,000. On 3 1
st December, 1998, the accrued expenses were Rs. 1,250, Debtors Rs. 50,000,
Creditors Rs. 75,000 and Land & Building Rs. 1,00,000.
Solution :
Cash Budget-Adjusted Profit and Loss Method
Rs. Rs. Rs.
Cash balance on 1. 1. 1998 45,000
Additions to Cash:
Net proIit Ior the year 35,250
(172)
Depreciation :
Plant & Machinery 5,000
Furniture & Fixture 2,500 7,500
Accrued expenses (DiIIerence) 750
Decrease in Debtors 15,000
Increase in Creditors 3,000
Issue oI Share Capital 25,000
Issue oI Debentures 5,000 48,750 91,500
Total Cash Available 1,36,500
Deductions Irom Cash
Dividend paid 25,000
li-icrease in Stock 15,000
Purchase oI Land & Building 25,000 65,000
Cash Balance as on 31.12.1998 71,500
In addition to short-term cash Iorecasting, a Iinance manager has to
predict long-term cash requirements Ior the Iirm. Long-term cash Iorecast
serves as an objective tool to evaluate the impact oI new product market
strategy on the Iirm`s Iinancial position in the long run. Besides, it also helps
in prognosticating working capital needs Ior the Iirm. Long-term cash Iorecasts
are also useIul in steamlining corporate planning. Such Iorecasts Iorce each
division to plan Ior Iuture and to Iormulate project careIully Long-term
Iorecasts can be made either by the receipts and disbursements method or by
the adjusted net income method.
MANAGING THE CASH FLOWS
The cash budget is a Iorerunner Ior controlling the cash Ilows eIIectively
The crux oI eIIective cash management lies in synchronizing the cash inIlows
with cash outIlows. This is done by preparing periodical cash reports. The
cash budget is the planning oI Iorecasting instrument. whereas cash report
(173)
makes a comparison oI actual cash Ilows with estimated cash Ilows. II variations
are Iound, complete analysis Ior the deviations is made. On the basis oI such
analysis, corrective steps are taken and whenever necessary, Iuture cash budgets
are revised. II it is Iound that deviations are due to an ineIIective or a wrong
policy, action is taken to correct it. AIirm having minimum variations in cash
Ilows is considered to have managed its cash more eIIiciently. For eIIective
control oI cash Ilows, preparation oI daily cash reports is advised by Iinancial
experts.
Besides, cash management eIIiciency will have to be improved through
a proper control oI cash collection and disbursement. The inIlowoI cash should
be accelerated while, as Ior as possible, the outIlow oI cash should be
deaccelerated.
Methods of Accelerating cash inflows
1. Prompt payment by customers
In order to accelerate cash inIlows, the collections Irom customers should
be prompt. This will be possible by prompting billing. The customers should be
promptly inIormed about the amount payable and the time by which it should be
paid. It will be better iI selI addressed ei-tvelope is sent alongwith the bill and
quick reply is requested. Another method Ior prompting customers to pay earlier.
is to allow them a cash discount. The availability oI discount is a good saving Ior
the customer and in an anxiety to earn it then,- make quick payments.
2. Quick deposit of customer cheques
One way oI shortening the time lag between the date when a customer sings
a cheque and the date when the Iunds are available Ior use is to make an arrangement
Ior quick deposit oI the cheques in the banks the moment they are received. Special
(174)
attention should be given to large remittances. For example, these may be deposited
individually or air mail services should be used Ior such remittances.
3. Concentration Banking
To speed up collections, collections should be decentralised as Iar as
possible. II, instead oI one collection centre, there are a number oI collection
centres Ior the purpose, collections would certainly be speeded up. This
procedure is named as concentration banking. Through this procedure, the
mailing time oI the customers is reduced. Customers oI a particular region
may be directed to deposit/remit their payments to a collection centre
established at the central place oI that region. The collection centre will deposit
the payments received in the local bank account. Surplus (over the minimum
balance to be kept) Is transIerred to a concentration bank regularly (may be
daily), which is generally at the Iirm`s head oIIice. This concentration bank or
central bank can get the payments by telegraphic transIer or telex, as per the
instructions given by the Iirm. The collection centres may themselves collect
the cheques or the cash payment Irom the customers, instead oI customers
remitting the payments to the collection centre. It Iurther accelerates the
process oI collection because oI the reduction in the mailing time. The
advantage oI decentralised collection is two-Iold :
(a) The mailing time is reduced, because the bills are prepared by the local
collection centres and sent by them to the customers. Further, iI the
collection centres collect the payments by themselves, the time requires
Ior mailing is reduced on this account also.
(b) Collection time is reduced, since the payments collected are deposited
in the local bank accounts. The Iunds become usable by the Iirm
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immediately on hearing Irom the collection centre about ihe amount being
deposited in the local bank account.
4. Lock Box System
Under the concentration banking, the cheques or draIts received by the
collection centres are deposited in the local banks. ThereIore, some time is
wasted beIore the cheques or draIts are sent Ior collection. Under the lock
box system, this time gap can be reduced. Under this system, Iirm takes on
rent a lock box Irom the post oIIice at important collection centres. Customers
are instructed to send their cheques/draIts in the lock box. Firm authorises
the local banks to withdraw these cheques/draIts Irom the lock box and credit
the same to the Iirm account. Bank operates this lock box several times a day.
Local banks are also instructed to transIer Iunds exceeding a particular level
to the head oIIice. This system is considered better to concentration banking
because in this system, time involved in receiving cheques in the collection
centres, their accounting in the books and the deposit oI these cheques or draIts
in the bank is saved. All these clerical tasks are perIormed by banks at lower
costs. The collection oI cheques starts immediately aIter their receipt.
5. Collections through messengers
Certain Iirms like to send messageners at the places oI customers to
collect the payments. It certainly reduces the mailing time but increases the
costs oI collection in terms oI the travelling costs oI messengers.
To conclude, whatever system oI speeding up collections is adopted,
the costs are to be compared with the beneIits derived thereIrom. In case the
beneIits oI a particular system exceed the costs on a comparative basis, the
(176)
same may be recommended by the Iinance manager Ior adoption by the Iirm.
Methods of Slowing Cash Outflows
In order to optimise cash availability in the Iirm, the Iinance manager
must employ devices that could slow down the speed oI payments outward in
addition to accelerating collection. The Iollowing methods can be used to
delay disbursements
1. Paying on Last Date
The disbursements can be delayed on making payments on the last due
date only. II the credit is Ior 10 days then payment should be made on 10th day
only. It can help in using the money Ior short periods and the Iirm can make
use oI cash discount also.
2. Centralised Disbursements
The payments should be centralised and made through cheques or draIts.
When the cheques are issued Irom the head oIIice then it will take time Ior the
cheques to be cleared through post. Moreover, Iirms will have to maintain
lesser cash balances as against decentralised disbursement where each branch
will have to maintain some cash. In this method, greater time will be involved
in the presentation and collection oI cheques. Control over payments will also
become easier.
3. Using Float
Float is the diIIerence between the company`s cheque book balance and
the balance shown in the bank`s books oI account. When a Iirm writes a cheque,
it will reduce the balance in its books oI account by the amount oI the cheque.
But the bank will debit the account oI its customers when the cheque is
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collected usually aIter a week. Thus, there is no strange iI the Iirm`s books
show a negative balance while the bank`s books show positive balance. The
Iirm can make use oI the Iloat iI the magnitude oI the Iloat can be accurately
estimated.
In all these methods oI delaying payments, the company`s credit
reputation is likely to be damaged. The cost that would, thus, result must be
taken into account.
4. Inter-bank transfer
Another method oI making eIIicient use oI cash resources is to transIer
Iunds quickly Irom one bank to another bank where disbursement is to be made.
This would prevent building up oI excess cash balances in one bank. This
procedure could be adopted by a company having accounts with several banks.
OPTIMUMCASH LEVEL
One oI the primary responsibilities oI the Iinancial manager is to maintain
a sound liquidity position oI the Iirmso that obligations may be settled well in
time. The test oI liquidity is really the availability oI cash to meet the Iirm`s
obligations as and when they become due. For this purpose, liquid balance
(balance oI cash and marketable securities) must be maintained at the optimun
level. It is the level which gives the minimum cost oI holding the cash balance.
Determination oI such a level is very important Ior an eIIicient cash
management. II the liquid balance exceeds the required balance, it remains
idle and, thereIore, it involves opportunity cost in the sense that the amount
could have been put to more eIIective use. None-the-less, liquidity position
oI the enterprise becomes more sound. On the other hand, iI liquid balance is
short oI the requirements, the Iirm may have to incur shortage costs. The Iirm
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may be required to sell its Iixed investments or it may have to resort to Iresh
borrowings. It may have to Iorego cash discounts and pay higher rates oI
interest on borrowings. There is a danger oI losing goodwill and a risk oI
insolvency even. Thus with increasing liquid balances, opportunity or holding
costs increase, but the `shortage` costs go down, and vice-versa. The
combination oI opportunity costs and shortage costs gives the total cost oI
maintaining liquid balances at various levels. The point which gives the
minimum total cost is the point oI optimun liquidity balance - representing a
trade-oII oI shortage cost against opportunity cost.
Optimum Liquid Balance
Cash management model
Anumber oI cash management models have been developed to decide the
optimal level oI cash balance. These models are based on such major Considerations
as the demand Ior cash, the interest rate on marketable securities and the cost oI
(179)
Opportunity
Costs
Total
Cost
Minimum
Cost
Shortage
Costs
C
o
s
t
s
Optimum liquid balance
Cash and Marketable Securities
transIers between marketable securities and cash. There are two important models
which lead to the determination oI the optimum balance oI cash.
(a) Inventory Model
The economic order quantity (EOQ) Iormula, basically used in inventory
decision, has now come to be popularly employed to determine the optimal
level oI cash holding Ior the Iirm. William Baumol was the Iirst man who
applied the inventory model to the problem oI cash management.
According to the EOQmodel, optimum level oI cash should be determined
by balancing the carrying cost oI holding cash (the interest Ioregone on marketable
securities) against the Iixed cost oI transIerring marketable securities to cash or
vice-versa so as to minimize total costs. The level oI cash at which the sum oI
carrying costs and the Iixed costs associated with transIerring marketable securities
is minimum, will be the optimum cash balance oI the Iirm. The Iollowing Iormula
is used to determine this optimum level.
Q

2CB
K
Where Q stands Ior optimum size oI cash inventory.
C stands Ior average Iixed cost oI securing cash Irom market.
B stands Ior- the total amount oI transaction demand Ior cash over
the period oI time involved.
K stands Ior the cost oI carrying the inventory oI cash, i.e., interest
rate on marketable securities Ior the period.
Illustration 3 : Ramesh Company Limited estimated cash payments oI Rs. 4
lakhs Ior a one month period. The average Iixed cost Ior securing capital Irom
the market is Rs. 1000 and the interest rate on marketable securities is 12 per
cent per annum or 1.0 percent Ior the one month period. Calculate EOQ.
(180)
Solution :
Economic order size oI cash in this instance will be :

2 Rs. 1,000) (Rs. 4,00,000)

.01
Rs. 2,82,843
The optimal transaction size oI the company is Rs. 2,82,843 and the
average cash balance is Rs. 1,41,421 (Rs. 2,82,843/2).
b) Stochastic Model :
This model is based on the basic assumption that cash balances change
randomly over a period oI time both in size and direction and Iorm a normal
distribution as the number oI periods observed increase. The model prescribes
two control limits-upper limit and lower limit. When cash balances reach the
upper limit, a transIer oI cash to investment account should be made and when
cash balances reach the lower point, a portion oI securities constituting
investment account oI the Iirm should be liquidated to return the cash balances
to its return point.
The upper and lower limits oI control are set aIter taking into account
Iixed cost associated with converting securities into cash and the vice-versa,
and the cost oI carrying stock oI cash.
Miller - Orr model is one oI the most important Stochastic Models. It
is designed to determine the time and size oI transIers between an investment
account and cash account. In this model, control limits are set Ior cash balances.
It speciIies two control limits - h` the upper control limit and o` the lower
control limit. The limits have been explained through a graph shown below.
(181)
When cash balance reaches the upper control limit, h-z`rupees oI cash
are converted into marketable securities so that the new cash balance is at
`z ` level. When cash balance is reduced to the level `zero` , O-Z`., i.e.
`z `rupees oI marketable securities are sold, so that the new cash balance is
again at`z` level. II the cash balance remains Iluctuating between the two control
limits, no transaction takes place (no conversion Irom cash to marketable
securities or vice versa is required). The lower control limit may be set at a
level higher than `zero` point. The optimum value oI h`is -3z. Average cash
balance is (zh)/3 approximately. The optimum value oI z`, the return point
Ior security transactions can be calculated by applying the Iormula :
Z
3

3b
2

4j
Where z Return Point
b Fixed cost associated with a security transaction

2
Variance oI daily net cash Ilows
i Interest rate per day on marketable securities
(182)
Upper Control Limit
Return
Point
Lower Control Limit
Time
C
a
s
h

B
a
l
a
n
c
e

(
R
s
.
)
MILLER-ORR MODEL
h
z
0
The high and low limits oI cash balance are set up on the basis oI Iixed
cost associated with the securities transactions, the opportunity cost oI holding
cash and the degree oI likely Iluctuations in cash balances. These limits satisIy
the demands Ior cash at the lowest possible total cost. More variability oI
cash Ilows and higher Iixed costs oI a security transaction lead to higher control
limits and vice versa.
The total costs oI holding cash, i.e., Iixed costs and opportunity costs
are minimised within these control limits in case oI uncertainty.
INVESTING SURPLUS CASH
Investing surplus cash involves two basic problems
(a) Determining the amount oI surplus cash
(b) Determining the channels oI investment
(a) Determining of surplus cash
Surplus cash is the cash in excess oI the Iirm`s normal cash requirements.
While determining the amount oI surplus cash, the Iinance manager has to take
into account the minimum cash balance that the Iirm must keep to avoid risk or
cost oI running out oI Iunds. Such minimum level may be termed as saIety
level Ior cash`.
Determining safety level for cash : The Iinance manager determines the saIety
level oI cash separately both Ior normal periods and peak periods. In both the
cases, he has to decide about the Iollowing two basic Iactors :
(i) Desired days of cash. It means the number oI days Ior which cash
balance should be suIIicient to cover payments.
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(ii) Average daily cash outflows. This means the average amount oI
disbursements which will have to be made daily.
The 'desired days oI cash and 'average daily cash outIlows are
separately determined Ior normal and peak periods. Having determined them,
saIety level oI cash can be calculated as Iollows
During normal periods
SaIety level oI cash Desired days oI cash x Average daily cash outIlows
For example, iI the Iinance manager Ieels that a saIety level should
provide suIIicient cash to cover cash payments Ior seven days and the Iirm`s
average daily cash outIlows are Rs. 6,000, the saIety level oI cash will be Rs.
42,000 (i.e. 7 x 6,000).
Duing peak periods
SaIety level oI cash Desired days oI cash at the busiest period x
Average oI highest daily cash outIlows.
For example, during the three busiest days in the month oI December,
the Iirm`s cash outIlows were Rs. 7,000 Rs. 8,000, and Rs. 9,000. The average
cash outIlows comes to Rs. 8,000. II the Iinance manager desires suIIicient
cash to cover cash payments Ior 5 days during the peak periods, the saIety
level would be Rs. 40,000 (i.e. Rs. 8,000 x 5).
The above ratios are helpIul in monitoring level oI cash balances. The
actual cash balance is compared with the daily cash outIlows to determine the
number oI days Ior which cash is available. Such number oI days is then
compared with the desired days oI cash to ascertain whether the Iirm is below
or above the saIety level.
(184)
Illustration 4 : From the Iollowing data ascertain whether the Iirms has surplus
or deIiciency oI cash.
Normal periods Peak periods
Desired days oI cash 6 4
Average daily outIlows 30,000 50,000
Actual cash balance 1,00,000 1,20,000
Solution :
During normal periods: The Iirm has a cash balance Rs. 1,00,000. The
average daily cash outIlows are Rs. 30,000. It means the Iirm has cash available
only Ior 3.3 days as compared to required Ior 6 days. Hence, the Iirm has
deIiciency oI cash.
During peak periods : The Iirm has a cash balance oI Rs. 1,20,000. The
average daily outIlows are estimated at Rs. 50,000. It means the Iirm cash has
available only Ior 2.4 days as compared to that required Ior 4 days. Hence, the
Iirm has deIiciency oI cash.
(b) Determination of channels of investment
The Iinance manager can determine the amount oI surplus cash, by
comparing the actual amount oI cash available with the saIety or minimum level
oI cash, as explained in preceding pages. Such surplus cash may be either oI a
temporary or a permanent nature. Temporary cash surplus consists oI Iunds
which are available Ior investment on a short-term basis (maximum 6 months),
since they are required to meet regular obligations, such as those oI taxes,
dividends, etc. Permanent cash surplus consists oI Iunds which are kept by the
Iirm to avail oI some unIoreseen proIitable opportunity oI expansion or
(185)
acquisition oI some asset. Such Iunds are, thereIore available Ior investment
Ior a period ranging Irom six months to a year.
Criteria for investment : In most oI the companies there are usually no Iormal
written instructions Ior investing the surplus cash. It is leIt to the discretion
and judgement oI the Iinance manager. While exercising such discretion oI
judgement, he usually takes into consideration the Iollowing Iactors :
(i) Security : This can be ensured by investing money in securities whose
price remain more or less stable.
(ii) Liquidity : This can be ensured by investing money in short-term
securities including short-term Iixed deposits with bank.
(iii) Yield : OI course most corporate managers give less emphasis to yield
as compared to security and liquidity oI investment. They, thereIore,
preIer short-term Government securities Ior investing surplus cash.
However, some corporate managers Iollow aggressive investment
policies which maximise the yield on their investments.
(iv) Maturity : Surplus cash is available not Ior an indeIinite period. Hence,
it will be advisable to select securities according to their maturities
keeping in view the period Ior which surplus cash is available. II such
selection is done careIully, the Iinance manager can maximise the yield
as well as maintain the liquidity oI investments.
For example, a Iirm can divide the surplus cash available with It in three
categories.
(i) Surplus cash, which is to be made available Ior meeting unIoreseen
disbursements. Such cash should, thereIore, be invested in securities
(186)
which can be immediately sold without much loss. In case oI such cash,
liquidity is more important than vield.
(ii) Surplus cash, which is to be made available on certain deIinite dates Ior
making speciIic payments, such as those on account oI tax, dividends
capital expenditure, etc. Such cash should, thereIore, be invested in
securities whose maturities coincide with the dates oI payments.
(iii) Surplus cash, which is a sort oI general reserve and not required to meet
any speciIic payment. Such cash can, thereIore, be invested in securities
with relatively longer maturities and more Iavourable yields.
Types of short-term investment opportunities
The Iollowing short-term investment opportunities are available to
companies in India to invest their temporary cash surplus :
1. Treasury bills
Treasury bills (TBs) are short-term government securities. The usual
practice in India is to sell treasury bills at a discount and redeem them at par
on maturity. The diIIerence between the issue price and the redemption price,
adjusted Ior the time value oI money, is return on treasury bills. They can be
bought and sold any time, thus, they have liquidity. Also, they do not have the
deIault risk.
2. Commercial papers
Commercial papers (CPs) are short-term unsecured securities issued
by highly credit worthy large companies. They are issued with a maturity oI
three months to one year. CPs are marketable securities and, thereIore,
liquidity is not a problem.
(187)
3. Certificates of deposits
CertiIicates oI deposits (CDs) are papers issued by banks acknowledging
Iixed deposits Ior speciIied period oI time. CPs are negotiable instruments
that make them marketable securities.
4. Bank deposits
A Iirm can deposit its temporary cash in a bank Ior a Iixed period oI
time. The interest rate depends on the maturity period. For example, the current
interest rate Ior a 16 to 30 days deposit is about 5 per cent and Ior 180 days to
one year is about 8 per cent. The deIault risk. oI the bank deposits is quite low
since most banks in India are owned ,by the Government.
5. Inter-corporate deposits
Inter-corporate lending/borrowing or deposits (ICD) is a popular short-
term investment alternative Ior companies in India. Generally a cash surplus
company will deposit (lend) its Iunds in a sister or associate companies or
with outside companies with high credit standing. In practice, companies can
negotiate inter-corporate borrowing or lending Ior very short periods. The
risk oI deIault is high, but returns are quite attractive.
6. Money market mutual funds
Money market mutual Iunds (MMMF) Iocus on short-term marketable
securities such as TBs, CPs or call money. They have a minimum lock-in period oI
30 days, and aIter this period, an investor can withdrawhis or her money any time
at a short notice or even across the counter in some cases. They oIIer attractive
yields; yields are usually 2 per cent above than on bank deposits oI same maturity.
MMMFs are oI recent origin in India, and they have become quite popular with
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institutional investors and some companies. MMMFs have been recently oIIered
by Kothari Pioneer, Unit Trust oI India (UTI) and Industrial Development Bank oI
India (IDBI). UTI`s MMMF schemes are most successIul so Iar.
7. Badla Financing
Badla Iinancing is used in stock exchange transactions when a broker
wants to carry Iorward his transactions Irom one settlement period to another.
Badla Iinancing is done through operators in stock exchange. It is the Iinancing
o I` transactions oI a broker who wants to carry Iorward this deal to the other
settlement period. The badla rates are decided on the day oI settlement. Badla
transaction is Iinanced on the security oI shares purchased whose settlement
is to be carried Iorward. Sometimes, this Iinancing Iacility may be extended
Ior a particular share only. For example, a company may provide badla Iinance
to a broker Rs. 10 crore Ior purchasing ACC shares in Iorward market. Badla
rates vary with demand and supply position oI Iunds.
Badla Iinancing oIIers attractive interest rates. However, it becomes
risky iI the broker deIaults in his commitment. Even the wide Iluctuation in
prices oI shares may also aIIect the value oI security. An investor in this type
oI Iinancing should be careIul about Iollowing things :
(i) The selection oI a broker should be on the basis oI reputation.
(ii) The share with a sound intrinsic value should be selected.
(iii) The margin should be adequate.
(iv) The possession oI securities should be taken.
8. Bill Discounting
Abill arises out oI credit sales. The buyer will accept a bill drawn on
him by the seller. In order to raise Iunds the seller `may get the bill discounted
(189)
with his bank. The bank will charge discount and release the balance amount to
the drawer. These bills normally do not exceed 90 days.
A company may also discount the bills as a bank does this, using its
surplus Iunds. The bill discounting is considered superior to intercorporate
deposits. The company should ensure that the discounted bills are (a) trade
bills (resulting Irom a trade transaction) and not accommodation bills (helping
each other). (b) the bills backed by the letter oI credit oI a bank will be most
secure as these are guaranteed by the drawee`s bank.
Do Yourself:
1. Explain the principal motives Ior holding cash.
2. Illustrate with example the modus operandi oI preparing a cash budget.
3. Discuss the techniques that can be used to accelerate the Iirm`s
collections ?
4. What are the objectives oI a Iirm in controlling its disbursements ? How
can the disbursements be slowed down ?
5. How can be appropriate level oI operating cash balance be determined?
6. Explain the criteria that a Iirm should use in choosing the short-term
investment alternatives in order to invest surplus cash.

(190)
MANAGEMENT OF RECEIVABLES
This lesson will make you conversant with
* Meaning and cost oI maintaining receivables
* Objectives oI receivables management
* Formulation oI credit policies
* Execution oI credit policies
* Formulation oI collection policy and its execution
Receivables represent an important component oI current assets.
They occupy the second important place aIter inventories and constitute a
substantial portion oI current assets in manuIacturing concerns. Trade credit
is considered to be an important marketing tool, acting as a bridge Ior the
movement oI goods Irom production and distribution stages to customers
Iinally. A Iirm grants trade credit to maintain its sale Irom the hands oI
competitors and at the same time, to attract the potential customers to purchase
its product at Iavourable terms. Trade credit arises only when the Iirm sells its
products to the customers but does not receive immediate cash, i.e., at the
time oI sales. The trade credit, thus, creates receivables, which the Iirm is
expected to collect in the near Iuture. Receivables are also known as accounts
receivable, trade receivables, customer receivables, debtors or book debts.
The term `receivables`, in the strict accounting sense is deIined as debt owed
Lesson : 8
(191)
to the Iirm by customers arising Irom sale oI goods or services in the ordinary
course oI business and include :
(a) book debts or accounts,
(b) notes and bills, and
(c) accrued receivables.
The receivables arising out oI credit have got three basic distinct
characteristics :
1. They involve an element oI risk which should careIully be studied since
cash sales are riskless, whereas at the time oI credit sales, cash is yet to
the received.
2. They are based on present economic value. At the time oI sale the
economic value oI goods passes immediately, whereas the seller excepts
an equivalent beneIit at a later date.
3. It implies Iuturity. The value oI goods or services received by the buyer
will be payable by him at a Iuture date.
Objectives of maintaining receivables
The purpose oI granting credit is to Iacilitate sales. It is valuable
to customers as it augments their resources. It is particularly appealing to those
customers who cannot borrow Irom other sources or Iind it very expensive or
cumbersome to do so. In brieI, the main objectives oI maintaining receivables
are :
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(a) Achieving growth in sales : II a Iirm sells goods on credit, it will
generally be in a position to sell more goods than iI it insisted sells on
immediate cash payment. This is because many customers are either not
prepared or not in position to pay cash when they purchase the goods. They
have, thereIore, to be encouraged with the oIIer oI credit terms. In the absence
oI such an oIIer, a Iirm may not be able to sell goods at a desired level.
Receivables enable it to push its sales eIIectively in the market.
(b) Increasing profits : Increase in sales results in higher proIits Ior the
Iirm not only because oI increase in the volume oI sales but also because oI
the Iirm charging a higher margin oI proIit on credit sales as compared to cash
sales.
(c) Maintaining liquidity : The concept oI operating cycle explains the
Iact that receivables are one step ahead oI inventories. So, it Iacilitates the
task oI maintaining liquidity in business because it can be easily converted
into cash.
(d) Meeting competition : AIirm may have to resort to granting oI credit
Iacilities to its customers because oI similar Iacilities being granted by the
competing Iirms to avoid the loss oI sales Irom customers who would buy
elsewhere iI they did not receive the expected credit.
The overall objective oI committing Iunds to accounts receivable
is to generate a large Ilow oI operating revenue and hence proIit than what
would be achieved in the absence oI no such commitment.
Cost of maintaining receivables
The allowing oI credit to customers means giving oI Iunds Ior the
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customer`s use. The concern incurs the Iollowing costs oI maintaining
receivables :
1. Additional fund requirement for the company/capital cost
When a Iirm maintains receivables, some oI the Iirm`s resources
remain blocked in them because there is a time lag between the credit sale to
customer and receipt oI cash Irom them as payment. To the extent that the
Iirm`s resources are blocked in its receivables, it has to arrange additional
Iinance to meet its own obligations towards its creditors and employees, like
payments Ior purchases, salaries and other production and administrative
expenses. Whether this additional Iinance is met Irom its own resources or
Irom outside, it involves a cost to the Iirm in terms oI interest (iI Iinanced
Irom outside) or opportunity costs (iI internal resources which could have
been put to some other use are taken).
2. Administrative costs
When a company maintains receivables, it has to incur additional
administrative expenses in the Iorm oI salaries to clerks who maintain records
oI debtors, expenses on investigating the credit worthiness oI debtors, etc.
3. Collection costs
These are costs which the Iirm has to incur Ior collection oI the
amounts at the appropriate time Irom the customers.
4. Defaulting costs
When customers make deIault in payments, not only is the
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collection eIIort to be increased but the Iirm may also have to incur losses
Irom bad debts.
Factors determining size of investment in receivables
It has already been pointed out that receivables are the major
component oI total current assets. Besides sales, a number oI other Iactors
also inIluence the size oI investment in receivables. These Iactors are :
1. Size of credit sales :
The primary Iactor in determining the volume oI receivables is
the volume oI credit sales, Needless to mention that increase in credit sales
causes a corresponding increase in receivables and vice-versa. No doubt, the
level oI sales can be used to Iorecast changes in receivables, i.e., iI a Iirm
predicts an increase oI 50 in its credit sales Ior the next period, it will
experience probably also an increase oI 50 in receivables.
2. Credit policies
The term `credit policy` reIers to those decision variables that
inIluence the amount oI trade credit, i.e., the investment in receivables. These
variables include the quality oI trade accounts to be accepted, the length oI the
credit period to be extended, the cash discount to be given and any special
terms to be oIIered depending upon particular circumstances oI the Iirm and
the customer. AIirm`s credit policy, as a matter oI Iact, determines the amount
oI risk the Iirm is willing to undertake in its sales activities. II a Iirm has a
lenient or a relatively liberal credit policy, it will experience a higher level oI
receivable as compared to a Iirm with a more rigid or stringent credit policy.
(195)
3. Terms of Trade
The size oI receivables also depends upon the terms oI trade on
which goods are sold on credit to the customers. Under the terms oI trade,
credit period, period oI cash discount and rate oI cash discount are determined.
Credit period is the period Ior which the goods are sold on credit to customers.
II Iirm allows greater credit period, it will lead to increase in the amount oI
receivables. Cash discount is oIIered to the costumers Ior encouraging them
to pay their dues beIore the expiry oI the credit period.
OB1ECTIVES OFRECEIVABLES MANAGEMENT
Receivables management is the process oI making decisions relating to
investment in trade debtors. We know that certain investment in receivables is
necessary to increase the sales and the proIits oI a Iirm. But at the same time
investment in this asset involves cost considerations also. Further, there is
always a risk oI bad debts too. Thus, the main objective oI receivables
management is to maximise the returns on investment in receivables and to
minimise risk oI bad debts. To put it otherwise, it may be said that the basic
objective oI receivables management is to achieve a trade-oII between their
liquidity and proIitability aspects. In Iact, the receivables in a Iirm should be
managed in a way that the sales are expanded to an extent where risk remains
within the acceptable limits. In brieI, the objectives oI receivables management
are enumerated as Iollows :
(a) to maintain an optimum level oI investment in receivables,
(b) to obtain the optimum volume oI sales,
(c) to keep down the average collection period, and
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(d) to control the cost oI credit allowed and to keep it at the minimum
possible level.
As the above objectives seem to be a little contradictory, only a
balanced approach in conIlicting aspects can help to achieve the desired results.
According to S.E. Bolton, the objective oI receivables management is to
promote sales and proIits until that point is reached (i.e., optimum point) where
the return on investments in Iurther Iunding oI receivable is less than the cost
oI Iunds raised to Iinance that additional credit (i.e. cost oI capital).
Dimensions of Receivables Management
The Iollowing aspects must receive attention oI a Iinance manager
desirous oI improving eIIiciency oI receivables management :
1. Formulation oI credit policies,
2. Execution oI credit policies, and
3. Formulation oI collection policy and its execution.
FORMULATIONOFCREDITPOLICIES
Credit policy is an important part oI the overall strategy oI a Iirm
to market its products. Credit policy reIers to such Iactors which aIIect the
amount oI investment in receivables and about which management has to take
decision. The level oI receivables in a Iirm depends on its credit policies
alongwith other Iactors. AIirm may Iollow a liberal or stringent credit policy.
This aspect oI receivables management is concerned with deciding about :
1. Credit standards or the quality oI trade accounts to be accepted.
(197)
2. Length oI credit period.
3. Cash discount.
4. Discount period.
The above Iacets oI credit polices striving to Iind ways and means
oI reducing the volume oI receivables without impeding the Iirm`s sales
potential are discussed below in the Iollowing paragraphs :
1. Credit standards
The basic criterion Ior extension oI credit to customers is known
as credit standard. On the basis oI credit standards, it is determined to whom
the goods are to be sold or not to be sold. When the credit standards oI an
enterprise are loose, the level oI sales and receivables are likely to be high.
As against this, when credit standards are relatively tight, the sales and
receivables are likely to be relatively low. There are Iive C`s oI credit that
inIluence the credit standard oI an enterprise. These are character, capacity,
capital, collateral and condition.
Character is the ingredient which is concerned with the
probability that a customer will try to honour obligations. Capacity evaluation
means judgement oI the customer`s ability to pay, gauged mainly by the
customer`s past business perIormance record. Capital is measured by the
general Iinancial position oI the Iirm, indicated by ratio analysis. Collateral
is represented by assets the costumer is ready to pledge as security Ior the
credit extended. Condition means the impact oI general economic scene on
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the Iirm or the impact oI special development in certain areas oI the economy
on the customer`s ability to meet the obligation. InIormation about these Iactor
is gathered Irom internal and external sources. The Iirm`s previous experience
with the customer is the main guide in this connection. Regarding a new
customer, outside agencies such as banks, other dealers with whom the
customer has his business terms can provide useIul inIormation. The credit
manager can send a short questionnaire to the reIerees seeking the relevant
inIormation. Normally, bankers in India reIuse to give detailed and unqualiIied
credit reIerence. In some cases, the associations Ior speciIic industries
maintain credit bureau which provides useIul and authentic credit inIormation
Ior their members. Sometimes, the published Iinancial statements can be
examined to see the creditworthiness oI a customer. Also many companies
evaluate the credit worthiness oI their customers by consulting salesmen or
sales representatives. For this, salesman should also ascertain the potential
sales which the company can make to the ultimate customers.
When an enterprise plans to liberalise its credit standards
it should strive to strike a balance between the proIits arising due to increased
sales and the costs to be incurred on the increased sales caused thereby. The
implication oI credit standards relaxation can be explained with the help oI
the Iollowing illustration :
Illustration I : The current annual credit sales oI an enterprise amount to Rs.
9,00,000 and the proIit margin to 15 oI sales. There is a proposal to lower
down the credit standards that is likely to result in a slowing in the average
collection period Irom 30 days to 60 days. With this relaxation the sales are
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expected to increase by 15 per cent. At the present level oI sales the production
and selling costs amount to 80 per cent oI sales. The variable production and
selling cost oI increased volume oI sales will be 60 per cent oI sales. Advise
whether the company should relax its credit standards?
Solution
To enable the company to take a right decision in this case a trade-
oII is to be Iound between the added proIits and the required return on the
additional investment in receivables. The Iollowing table gives us the required
inIormation :
Relaxation of Credit Standards : Profits vs. Required Returns
Rs.
ProIits on additional sales (Rs. 1,35,000x15) 20,250
Current average investment in receivables (cost)
(Rs. 9,00,000 12) x 80 60,000
Average investment in receivables aIter credit standard
relaxation (cost)
(Rs. 9,00,000 6) x 80
(Rs. 1,35,000 6) x 80 1,38,000
Additional Investment in receivables (Rs. 1,38,000-60,000) 78,000
Required return on additional investment (Rs.78,000x15) 11,700
The above table reveals that the proIits on additional sales amount
to Rs. 20,250 and the amount oI required return comes to Rs. 11,700. Thus, it
will be desirable Ior the enterprise to resort to the proposed relaxation in its
credit standards.
(200)
2. Length of credit period
The credit period reIers to the length oI the time allowed to
customers to pay Ior their purchases. The decision regarding the length oI
credit period directly aIIects the volume oI investment in receivables and
indirectly the networth oI the concern. Longer credit period may boost sales
but it also increases investment in receivables and lowers the quality oI trade
credit. The credit period varies Irom industry to industry and in the same
industry diIIerent Iirms, sometimes, oIIer diIIerent credit periods to diIIerent
customers. While determining the credit period, a Iirm may take into account
various Iactors, such as buyers` rate oI stock turnover, competitors` approach,
the nature oI the commodity, margin oI proIit and availability oI Iunds.
A Iirm in its hope Ior stimulating sales and so also its proIits
may oIIer more liberal credit Iacilities by lengthening credit period. But
lengthening oI credit period involves the cost. The cost that usually associated
with lengthening credit period is a cost involved in tying up investment in
receivables Ior a longer period oI time that would otherwise have been invested
elsewhere to earn income. Besides, the Iirm may experience increase in both
its collection costs and bad debt losses. II additional cost associated with
lengthening credit period is less than the increased earnings, the Iinance
manager should liberalise credit policy by increasing credit period. There is
no prudence in lengthening credit period iI this involves more cost than
revenue. The Iinance manager should strive Ior locating that period where
additional earnings equate additional costs. This would be an optimal credit
period Ior the Iirm. The Iollowing illustration will make the point more clear :
(201)
Illustration 2 : Reliance Industries, which currently sells goods on a net 30
days terms, is considering the possibility oI lengthening its credit period to
60 days. The current year sale is anticipated to be oI the order oI 2,00,000
units at a selling price oI Rs. 10 each, with an average total unit cost at this
volume oI Rs. 9.50. Lengthening credit period is expected to boost sales by
25 per cent to 2,50,000 units. The company anticipated to produce additional
units oI sale at Rs. 9.00 per unit because it is hoped that overhead costs would
be spread over higher volume oI production resulting in cost reduction by 0.50
paise per unit. Management anticipates that as a result oI increase in credit
period Irom one month to two months collections costs would increase Irom
Rs. 6,000 to Rs. 8,000 annually and bad debt losses would increase Irom 2 per
cent to 2.5 per cent oI sales. The Iinance manager oI the company Ieels that
any additional investment in receivable should earn to least 14 per cent beIore
selling and administrative costs.
Should be Company lengthen its credit period ?
Solution : The policy decision regarding lengthening oI credit period Irom
30 days to 60 days calls Ior, in the Iirst instance, calculation oI average
investment in receivables.
At the estimated sales oI 2,50,000 units total manuIacturing cost
and average cost are :
Current sales (units) x average total costs 2,00,000x Rs.9.50
Rs. 19,00,000
Increased sales x variable costs 50,000 x Rs. 9.00
(202)
Rs. 4,50,000
Total costs Ior manuIacturing 2,50,000 units Rs. 23,50,000
Average cost per unit Rs. 9.40
The average investment in receivables may be computed with the
help oI the Iollowing equation :
Average investment in receivables Annual sales Average cost
Turnover oI Selling price
receivables
When the above equation is substituted by Iigures given in Reliance
Industries, the average investment in receivables is :
Rs. 20,00,000 Rs. 9.50
12 Rs. 10.00
The average investment in receivables under the proposed credit
policy is Rs. 25,00,000 x Rs. 9.40
6 Rs. 10.00
Rs. 3,91,667
We are now in a position to compare the expected proIits under
each credit policy
Net 30 days Net 60 days
Sales (units) 2,00,000 2,50,000
Sales (Rs.) Rs. 20,00,000 Rs. 25,00,000
Cost oI goods sold Rs. 19,00,000 Rs. 23,50,000
Gross proIit Rs. 1,00,000 Rs. 1,50,000
Less collection costs 6,000 8,000
Less bad debt losses 40,000 62,500
Net proIit Rs. 54,000 Rs. 89,500
(203)
(exclusive oI selling
and administrative expenses)
Thus, the additional investment necessary to generate Rs. 35,500
additional proIits would be Rs. 2,33,334. The expected return on this investment
is, thereIore, 15.2 per cent. Since the rate oI return is higher than the minimum
expected return oI 14 per cent, the company can aIIord to oIIer liberal credit
terms by lengthening credit period Irom 30 days to 60 days.
3. Cash Discount
Acreditor grants cash discount to induce a debtor to make payment
beIore the expiry oI credit period. In Iact, it is a premium on payment oI debts
beIore the date, and not a compensation Ior the so called prompt payment. The
cash discount term indicates the rate oI discount and the period Ior which the
discount has been oIIered. Sometimes, a Iirm allows cash discount instead oI
extending the period oI credit. Cash discount, iI availed oI, besides being
proIitable to a debtor, is beneIicial to a creditor. It increases the turnover rate
oI working capital and enables the creditor Iirm to operate a higher volume oI
business with less investment in working capital. Cash discount prevents debtors
Irom using trade credit as a source oI working capital.
Illustration 3 : Reliance Industries adopts net 60 days terms and desires to
determine whether cash discount 2 per cent should be oIIered on payment
within 10 days oI the date oI invoice. The Iinance manager hopes that this
would result in reduction oI collection period Irom two months to one month,
and about 50 per cent oI the customers would take advantage oI cash discount.
Should the Company oIIer cash discount ?
(204)
Solution : At this instance decision to oIIer cash discount involves matching
oI expected earnings on investment oI Iunds Ireed up by speedy collections
with cost oI discount.
Cost oI discount in this case will be Rs. 25,00,000 x 0.50 x 0.02
Rs. 25,000
The average investment in receivables will decrease by
Rs. 1,16,667 (2,33,334/2)
II Rs. 1,16,667 thus Ireed up by speedy collections is invested to
earn desired rate oI return oI 14 per cent, the additional earnings will be Rs.
1,16,667 x 0.14 Rs. 16,333. Since the cost oI discount is higher than the
additional earnings, it would be desirable to oIIer cash discount to customers.
4. Discount Period
Period oI discount also inIluences average collection period oI
receivables. Thus, by lengthening discount period many customers who were
not taking advantage oI cash discount may be tempted to avail oI this beneIit.
This would, thereIore, shorten the collection period. However, there may be
some customers who were availing oI discount Iacility and making payment
within discount period, will now postpone the payment until the expiry oI
lengthened discount period. Consequently, the Iirm`s average collection period
would increase. For example, iI the Iirm allowing cash discount Ior payments
within seven days now extends it to payments within IiIteen days. There may
be more customers availing discount and paying early but there will be those
(205)
also who were paying earlier within seven days will now pay in IiIteen days. It
will increase the collection period oI the concern. Hence, this decision involves
matching oI the eIIect on collection period with the increased cost associated
with additional customers availing the discount.
EXECUTIONOFCREDITPOLICIES
AIter Iormulation oI credit policies, the Iinance manager should
execute these policies properly. Execution oI credit policies calls Ior
evaluation oI credit applicants and Iinancing oI investment in receivables.
1. Evaluation of Credit Applicants
Mere determination oI appropriate credit policy will not help to
accomplish the overall objective oI minimizing investment in receivables and
reducing bad debt losses unless credit worthiness oI applicants is evaluated to
ensure that they conIorm to the credit standards prescribed by the Iirm. Credit
evaluation process involves three steps, viz, gathering credit inIormation about
the credit applicants, determining the credit worthiness oI the applicants on
the basis oI inIormation so collected and Iinally, taking decision to grant credit
Iacilities.
(a) Collecting credit information
The Iirst step in implementing credit policy will be to gather
credit inIormation about the customers. Two important Iactors that should be
kept in mind while searching Ior credit inIormation are cost and time. AIirm
cannot aIIord to spend a lot oI money in investigation oI some credit applicants
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particularly smaller ones and in such case the Iinance manager should take
decision on the basis oI limited inIormation about the applicant. It is true that
with larger expenditure on gathering inIormation, there is greater possibility
Ior the Iirm to reach better judgement oI the credit worthiness oI the applicant
causing reduction in bad debt losses. But beyond a certain point additional
costs in investigation outweigh the expected gains caused by reduction in bad
debt losses. This again is a matter oI matching incremental costs and revenues.
Further, how much time credit department oI the Iirm will spend
on analysis oI credit applicant must also be considered by the Iinance manager.
Spending a lot oI time in investigation may be justiIied in case oI new credit
customers. It must, however, be remembered that the customer may not wait
Ior long pending detailed credit investigation and turnover elsewhere Ior his
requirements.
The sources Irom which credit inIormation will be available
should be ascertained. There are number oI sources oI credit inIormation that
lend insight into credit worthiness oI the potential borrowers. It includes:
(i) Banker`s enquiry : Since the customer maintains account in a bank,
necessary inIormation can be taken iI, oI course, the bank so allows. Normally,
banks do not provide inIormation directly to the inquirer. The same task can be
done with the help oI Iirm`s bank. In India, practically, this source oI
inIormation is not very useIul because oI the indiIIerence oI banks in providing
inIormation, i.e., bankers may be reluctant to disclose its customer`s position.
(ii) Trade Reference : The Iirm may insist on the proposed customers to
give the names oI such Iirms as he has current dealings Ior the purpose oI
(207)
getting inIormation about his creditworthiness. This is, no doubt, a useIul
source oI credit inIormation without cost. The Iirm should take prompt and
proper steps to seek inIormation Irom the reIerences whenever the trade
reIerences have been Iurnished. It may be contacted personally to obtain all
relevant inIormation required by the Iirm.
(iii) Credit bureau reports : In advanced countries, credit bureau
organisations are employed in order to get comprehensive and correct
inIormation. They are specialised in providing credit inIormation. No doubt,
these are valuable sources Ior assessing the creditworthiness oI proposed
customers. There is an urgent need Ior such organisations in our country.
(iv) Financial Statements : Scrutinising the published Iinancial statements
(viz., ProIit and Loss Account and Balance Sheet) oI the proposed costumers,
the Iinancial condition and the creditworthiness can be assessed. For example,
liquidity and solvency position can be judged with the help oI accounting ratios,
viz., Current Ratio, Liquid Ratio, etc. Creditors turnover ratio may also be
tested.
(v) Bazar Reports : The inIormation about the customers can also be
obtained Irom the Iirms or individuals associated with the same type oI trade
or industry. Sometimes, a Iew traders may give wrong inIormations too.
ThereIore, this source should be used careIully.
(vi) Other sources : Other sources oI credit inIormation, especially Ior
the large business ones, might be trade journals, periodicals, newspapers, trade
directories, public records, such as income tax statements, sales tax returns,
reports about auctions and decrees in Government gazette, registration, revenue
(208)
and municipal records.
(b) Credit Investigation
The credit inIormation collected through above given methods
gives an idea about the customer. There are certain things which need Iurther
investigation. With the added inIormation the decision can be taken with
conIi dence regardi ng credi t ext ensi on t o t he cust omer. The Iurt her
investigation as has been detailed by V.E. Ramamoorthy, can be had in the
Iollowing areas :
(i) The type oI customer to ascertain whether new or existing.
(ii) Business line oI the customer, background and the trade risk related
with the business.
(iii) Kind oI product dealing in whether it is perishable, seasonal, durable,
etc.
(iv) Size oI the order given by the customer alongwith the Iuture volume oI
business expected to be had with him.
(v) Credit policies and the practices oI the company.
It should be noted that there is a component oI cost involved in
credit investigation. However, iI a decision is taken without such an
investigation, it may prove more expensive because oI excessive oI collection
costs and likely losses caused by bad debts. From this it can be convincingly
said that such an investigation should be conducted as long as the resultant
speedy collections and prevention oI bad debt losses are in excess oI costs
involved in such investigation.
(209)
AIter gathering the required inIormation, the Iinance manager
should analyse it to Iind out the credit worthiness oI potential costumers and
also to see whether they satisIy the standards oI the concern or not. The credit
analysis will determine the degree oI risk associated with the account, the
capacity oI the customer to borrow and his ability and willingness to pay.
ThereIore, proper evaluation oI the creditworthiness oI a customer is very
vital, and in the ultimate analysis, it determines the success or Iailure oI the
credit policy. In selecting the credit risk the Iive C`s character, capacity,
collateral, capital and conditions play a very important role. II customer
does not bear the desired credit character, the Iirm may incur a loss even in
the case oI a contract to sell on C.O.D. (cash on delivery) term. The selection
oI credit risk is, thus, a preventive measure and prevention is better than cure
as the old adage goes.
(c) Credit decision
AIter determining credit worthiness oI the applicant, the Iinance
manager has to decide whether or not credit Iacilities should be provided to
him. He will match the creditworthiness oI the customer with the credit
standards oI the company. II the applicant is above or upto the standards,
naturally credit Iacilities would be provided otherwise not. It is only in the
marginal cases that such decisions are diIIicult to be made. In such cases, the
beneIit oI extending the credit should be compared to the likely bad debt losses
and then a decision should be taken. In case the customer`s are below the
company`s credit standards, they should not be outrightly reIused. Rather they
should be oIIered some alternative Iacilities. A customer may be oIIered to
(210)
pay on delivery oI goods, invoices may be sent through bank and released aIter
collecting dues or some third party guarantee may be insisted. Such a course
may help in retaining the customers at present and their dealings may help in
reviewing their requests at a later date.
2. Financing Investments in receivables
Since Iunds are tied in receivables, attempt should be made by
the Iinance manager to reduce the amount oI receivables and the period oI its
holding. In addition, the Iinance manager should make eIIorts to get receivables
Iinanced so that working capital needs are met in time. The banks allow raising
oI loan against security oI receivables. While providing loans against accounts
receivable the banks lay considerable emphasis on the quality oI receivables
and their size so as to determine the amount oI loan that can be granted to the
borrower. The banks usually stipulate which oI the accounts are oI suIIicient
quality to serve as collateral Ior a loan. Depending upon the quality oI the
receivables accepted and the Iinancial strength oI the borrower, a lender decides
the percentage advance against the Iace value oI pledged receivable. Generally,
banks supply between 60 to 80 per cent oI the amount oI receivables as loans
against their security . Another method oI getting Iunds against receivables is
their outright sale to the bank.
The bank will credit the amount to the party aIter deducting
discount and will collect the money Irom the customers later. Here too, the
bank will insist on quality receivables only. Besides banks, there may be other
agencies which can buy receivables and pay cash Ior them. This Iacility is known
as factoring. The Iactor will purchase only the accounts acceptable to him and
(211)
may reIuse purchase in certain cases. The Iactoring may be with or without
recourse. II it is without recourse then any bad debt loss is taken up by the
Iactor but iI it is with recourse then bad debts losses will be recovered Irom
the seller. The Iactor may suggest the costumers Ior whom he should extend
this Iacility.
Illustration 4 : A company wants to adopt strict collection policies. While
going through its books the Iollowing details are revealed :
The enterprise is at present selling 20,000 units on credit at a
price oI Rs. 30 each, the variable cost per unit is Rs. 23 while the average cost
per unit is Rs. 27. Average collection period is 56 days and the collection
expenses amount to Rs. 8,000 and bad debts are 3 per cent.
II the policy oI collection is tightened, a sum oI Rs. 15,000 more
will be required as collection charges. Bad debts will come down to 1 per cent
and collection period will reduce to 40 days. Sales volume is expected to reduce
by 400 units.
Advise the company whether is should implement the decision
or not. Assume 20 per cent rate oI return on investments.
Solution :
The decision on the issue should be given aIter undertaking cost-
beneIit analysis oI the policy. The beneIits in this case are accruing in the
shape oI reduced bad debts and reduced collection period. But the costs oI
implementing the suggestion are decrease in sales volume and additional
collection charges. Thus, we will Iirst Iind out the beneIits and then costs to
(212)
enable a comparison between the two :
Benefits :
(i) Bad Debts :
Under existing plant : 3 oI Rs. 6,00,000 Rs. 18,000
Under proposed plan : 1 oI Rs. 5,88,000 Rs. 5,880
BeneIits by way oI reduced bad debts Rs. 12,120
(ii) Average Collection Period/Average Investment in Receivables :
Cost oI Sales
Average Investment
Receivable turnover
20,000 x Rs. 27
Under Existing Plan Rs. 84,000
360 56
Under Proposed Plan
(20,000 x 27) - (400x23)
360 40
BeneIits in Average Investment Rs. 25,022
With 20 rate oI return on investments the company will be able
(213)
to earn Rs. 5,004 on savings.
Costs :
(i) Sales Decline :
There is a decline oI 400 units. This will result in a loss oI
Rs. 7 x 400 Rs. 2,800
(ii) Enhancement oI collection charges :
Additional collection charges are likely to be Rs. 15,000
Thus, iI the tightening oI the collection policy is Iollowed there
will be a beneIit oI Rs. 17,124 i.e. (Rs. 12,120 Rs. 5,004). At the same time
the costs will increase to Rs. 17,800 i.e. (Rs. 2,80015,000). ThereIore, iI
the policy is Iollowed it will result in a loss oI Rs. 676 i.e. (Rs. 17,800 - Rs.
17,124). So the policy should not be adopted as it involves more costs than
beneIits accruing thereIrom.
FORMULATIONOFCOLLECTIONPOLICYANDITS EXECUTION
The purpose oI every collection policy is to speed up the
collection oI dues. II collection are unnecessarily delayed, alternative sources
oI Iinance Ior sustaining production and sales are to made and amount oI bad
debts will also increase. The collection procedures should always be well-
administrated and established in clear-cut terms.
The collection policy should also devise the steps to be Iollowed
in collecting overdue amounts. The objective is to collect the dues and not to
annoy the customer. The steps should be like (i) sending a reminder Ior
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payments, (ii) personal request through telephone, etc., (iii) personal visits to
the customers, (iv) taking help oI collecting agencies, and lastly (v) taking
legal action. The last step should be taken only aIter exhausting all other means
because it will have a bad impact on relations with customers. The genuine
problems oI customers should never be ignored while making collections. The
aim should be to make collections and keep amiable relations with customers.
The collection oI book debts can be monitored with the use oI
average collection period and aging schedule. The actual average collection
period may be compared with the stated collection period to evaluate the
eIIiciency oI collection so that necessary corrective action can be taken iI the
need be. The aging schedule Iurther highlights the debtors according to the
age or length oI time oI the outstanding debtors.
Illustration 5 : Bharat Ltd.. decides to liberalise credit to increase its sales.
The liberalised credit policy will bring additional sales oI Rs. 3,00,000. The
variable costs will be 60 oI sales and there will be 10 risk Ior nonpayment
and 5 collection costs. Will the company beneIit Irom the new credit policy?
Solution :
Rs.
Additional sales Revenue 3,00,000
Less : Variable Cost (60) 1,80,000
Incremental Revenue 1,20,000
(215)
Less : 10 Ior nonpayment risk 30,000
90,000
Less : 5 Ior costs oI collection 15,000
Additional Revenue Irom increased sals due to liberal
credit policy 75,000
The company will be beneIited Irom the newcredit policy because
the increase in revenue is more than the costs oI providing additional credit.
In Iact, the proIit oI the company will increase by Rs. 75,000.
Do Yourself :
1. Discuss the Iactors that determine the Iirm`s investment is receivables.
2. What is the basic reason Ior oIIering cash discount? Discuss the Iactors
which should be taken into account while Iormulation suitable discount
policy Ior the Iirm.
3. What are the Iive `Cs` oI credit analysis ? How do they relate to the
process oI evaluating credit risk ?
4. What do you mean by credit evaluation ? Discuss the diIIerent steps oI
credit evaluation.
5. What is the principal objective oI collection policy? Bring out the Iactors
which should be kept its mind while designing collection policy oI Iirm.
6. Diamond Steel Ltd.. has at present credit sales oI Rs. 16 lakh. The sale
price per unit is Rs. 50; the variable cost is Rs. 40 per unit and the average
(216)
cost per unit is Rs. 45. The Iirm`s average age oI accounts receivable is
60 days.
The management is planning to tighten credit standards. It will
result in drop in sales volume to Rs. 14 lakhs and the average age oI
accounts receivable to 30 days.
Assume a 20 rate oI return, should be management adopt the
new policy ?
7. The Relax Indian Ltd. is thinking to liberalise its credit policy. It sells
at present 10,000 units at a price oI Rs. 200 per unit. The variable cost
per unit is Rs. 176 and the average cost per unit is Rs. 194. The company`s
entire sales is on credit. The average collection period is 45 days.
Aliberal credit policy is likely to augment sales by 20 and the
average collection period will go up to 60 days. Assuming 20 return,
should the Iirm liberalise its credit standards ?

(217)
1. Kolb R. W. and Rodriguez R. J., Financial Management, Black well Publishers Limited,
Cambridge, U.K., 1996, P. 239.
INVENTORY MANAGEMENT
(Author : Prof. Dr. R.K. Mittal)
"Inventories are assets oI the Iirm, and as such they represent an
investment. Because such investment requires a commitment oI Iunds,
managers must ensure that the Iirm maintains inventories at the correct
level. II they become too large, the Iirm loses the opportunity to employ
those Iunds more eIIectively. Similarly, iI they are too small, the Iirm
may lose sales. Thus, there is an optimal level oI inventories and there is
an economic order quantity model Ior determining the correst level oI
inventory"
1
.
Inventories, like receivables, are a signiIicant portion oI most Iirms` assets
and, accordingly, require substantial investments. To keep these investments
Irom becoming unnecessarily large, inventories must be managed eIIiciently.
In this lesson, we shall discuss how to do that and how eIIicient management
oI inventory is related to Iinancial management.
Types of Inventories
Inventories are goods held Ior eventual sale by the Iirm and the raw materials
or other components being used in the manuIacturing oI such goods. Aretailer
keeps an inventory oI Iinished goods to be oIIered to customers whenever
demanded by them. On the other hand, a manuIuring concern has to keep a
stockpile oI not only the Iinished goods it is producing, but also oI all physical
Lesson : 9
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ingredients being used in the production process.
The common types oI inventories Ior most oI the business Iirms may be
classiIied as Iinished goods, work-in-progress and raw materials.
(i) Finished goods : These are completed products awaiting sale. They are
the Iinal output oI the production process in a manuIacturing Iirm. In
case oI wholesalers and retailers, they are generally reIerred to as
merchandise inventory.
(i i ) Work-in-process : It reIers to the raw materials engaged in various
phases oI production schedule. The degree oI completion may be varying
Ior diIIerent units. The work-in-progress reIers to partially produced
goods. The value oI work-in-process includes the raw material costs,
the direct wages and expenses already incurred and the overheads, iI
any.
( i i i ) Raw materials : These are goods which have not yet been committed
to production process in a manuIacturing concern. They may consist oI
basic raw materials or Iinished components.
The quantity and value oI the above three kinds oI inventories diIIer
depending upon the nature oI the business. For example, a manuIacturer will
have levels oI all the three kind oI inventories. While a retailer or a wholesaler
will have a high level oI inventories oI Iinished goods but will have no
inventories oI raw materials or work-in-process. Moreover, depending upon
the nature oI the business, inventories may be durable or non-durable, valuable
or inexpensive, perishable or non-perishable etc.
Benefits of Holding Inventories
Holding oI inventories has costs as well as beneIits associated with it.
(219)
While determining the optimal level oI inventories, the Iinancial manager must
consider the necessity oI holding inventory and costs thereoI. The Iollowing
are some oI the beneIits or reasons Ior holding inventories.
1. Quick Service : Customers desire a prompt IulIilment oI orders. A
Iirm will have to make the goods available Ior sale. In the event oI its
not being able to oIIer quick service to customers, the latter are likely
to get their orders executed by competitors.
2. Uninterrupted production schedule : Every manuIacturing Iirm must
have suIIicient stock oI raw materials in order to have the regular and
uninterrupted production schedule. II there is stock out oI raw material
at any stage oI production process, then the whole production process
may come to a halt. This may result in customer dissatisIaction as the
goods cannot be delivered in time. Moreover, the Iixed costs will
continue to be incurred even iI there is not production.
3. Discounts : AIirm is in a position to take advantage oI trade discounts
by placing bulk orders with suppliers. Aproper proportion will have to
be maintained between the cost oI maintaining inventories and the
discount that is likely to be gained.
4. Reduction in Order Costs : Each order oI supply oI goods or materials
carries certain costs. II the number oI orders is reduced, it is possible
to economise on these costs as the procedure involving each order need
not be repeated each time.
5. Protection against shortages : Adequate inventories protect a Iirm
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against the shortages that would result in production stoppages and considerable
losses.
Risks and Costs Associated with Inventories :
The costs oI holding inventories can be put as Iollows :
1. Materials Cost : This includes the cost oI purchasing the goods,
transportation and handling charges less any discount allowed by the
supplier oI goods.
2. Ordering cost : The cost oI ordering include the cost oI acquisition oI
inventories. It is the cost oI preparation and execution oI an order,
including cost oI paper work and communicating with the supplier. There
is always minimum cost involved whenever an order Ior replenishment
oI goods is placed. The total annual cost oI ordering is equal to the cost
per order multiplied by the number oI orders placed in a year. The number
oI orders determines the average inventory being held by the Iirm
ThereIore, the total order cost is inversely related to the average
inventory oI the Iirm.
3. Carrying Costs : This includes the expenses Ior storing the goods. It
comprises storage costs, insurance costs, spoilage costs, costs oI Iunds
tied up in inventories, etc. The Iunds used in the purchase/production oI
inventories have an opportunity cost i.e., the income which could have
been earned by investing these Iunds elsewhere. The ordering cost may
be reIerred as the "cost oI acquiring" while the inventory carrying cost
as "cost oI holding" inventory. The cost oI acquiring decreases while
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the cost oI holding increases with very increase in the quantity oI purchase
lot. Abalance is thereIore struck between the two opposing Iactors.
4. Costs of Stock-outs : A stock-out is a situation when the Iirm is not
having units oI an item in store but there is a demand Ior that either
Irom the customers or the production department. The stock-out reIers
to demand Ior an item whose inventory levle has already reduced to zero
or insuIIicient level. It may be noted that the stock out does not appear
iI the item is not demanded even iI the inventory level has Iallen to
zero. There is always a cost oI stock-out in the sense that the Iirm Iaces
a situation oI lost sales or orders not honoured. II the item demanded is
not in stock, the customer may buy the item/good someone else. This
result in loss oI goodwill too.
Objectives of Inventory Management
Inventory management covers a large number oI issues including Iixation oI
minimum and maximum levels; determining the size oI the inventory to be
carried; deciding about the issue price policy; setting up receipt and inspection
procedure; determining the economic order quantity; and providing proper
storage Iacilities. However, the Iirm is Iaced with the problem oI meeting two
conIlicting needs while dealing with these issues.
1. To maintain a large size oI inentory Ior eIIicient and smooth production
and sales operations.
2. To maintain a minimum investment in inventories to maximise
proIitability.
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Both `excessive` and `inadequate` inventories are not desirable. There are two
danger points which the Iirm should operate. The objective oI inventory
management should be to determine and maintain optimum level Io inventory
investment. This level oI inventory will lie between two danger points oI
excessive and inadequate inventories. More speciIically, the Iollowing are the
objectives oI inventory management.
(i) To have stocks available as and when they are required;
(ii) To utilise available store space, but prevent stock levels Irom exceeding
space availability;
(iii) To meet a high percentage oI demand without creating excess stock
levels. In other words, "Neither to over-stock nor to run out" is the best
policy;
(iv) To provide, on item-by-item basis, Ior re-order points and order such
quantity as would ensure that the aggregate results conIorm with the
constraints and objectives oI inventory control;
(v) To decide which item to stock and which item to procure on demand;
(vi) To ensure an adequate supply oI materials, stores, spares, etc, minimise
stockouts and shortages; and avoid costly interruption in operations;
(vii) To enable the managemnt to make costs and consumption comparisions
between operations and periods;
(viii) Minimising the inventory carrying costs; and
(ix) To ensure investment in inventories at the optimum level.
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Techniques of Inventory Management
EIIective inventory management requires an eIIective control over inventories.
Inventory control reIers to a system which ensures supply oI required quantity
and quality oI inventories at the required time and prevent unnecessary
investment in inventories. The techniques oI inventory control/inventory
management are as Iollows :
1. Determination of Economic Order Quantity : Determination oI the
quantity Ior which the order should be placed is one oI the important problems
concerned with eIIicient inventory management. II the Iirm is buying raw
materials, it has to decide lots in which it has to be purchased on each
replenishment. Determining an optimum inventory level involves two types oI
costs : (a) ordering costs and (b) carrying costs. The economic order quantity
is that inventory level which minimises the total oI ordering and carrying costs.
(a) Ordering costs : It has been already discussed that the cost oI placing
an order and securing the supplies is termed as ordering cost. They
include costs incurred in the Iollowing activities : requisitioning,
purchase ordering, transporting, receiving, inspecting and storing.
Ordering costs increase in proportion to the number oI orders placed.
The clerical and staII costs, however, do not have to vary in proportion
to the number oI orders placed, and one view is that so long as they are
committed costs, they need not be reckoned in computing ordering cost.
II the number oI orders are drastically reduced, the clerical and staII
Iorce released now can be used in other departments. Thus, these costs
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may be included in the ordering costs.
(b) Carrying Costs : They are costs oI keeping a given level oI inventory
in stock. They include storage, insurance, taxes, deterioration and
obsolesence. The storage costs comprise cost oI storage space
(warehousing cost), stores handling costs and clerical and staII service
costs incurred in recording and providing special Iacilities such as
Iencing, lines, racks, etc. Carrying costs vary with inventory size. The
behaviour is contrary to that oI ordering costs which decline with
increase in inventory size. The economic size oI inventory would thus
depend on trade-oII between carrying costs and ordering costs. Actually,
the economic order quantity is determined at a level Ior which the
aggregate oI two costs is the minimum.


Formula Ior determining EOQ

2U x p
S
where,
EOQ Economic ordering quantity
U Quantity (units) purchased in a year (month)
P Cost oI placing an order
S Annual (Monthly) cost oI storage oI one unit.
Illustration 9.1. Sumit, a colour television manuIacturer, purchases 1,600
units oI a certain component Irom Amit. His annual usage is 1,600 units. The
order placing cost is Rs. 100 and cost oI carrying one unit Ior a year is Rs. 8.
Calculate the Economic Ordering Quantity (EOQ) and tabulate your results.
(225)
EOQ

2U x p
S



2 x 1,600 x 100

40,000 200 units
8
Table 9.1 : Economic Order Quantity
Annual order per Units per Order Average Carrying Total annual
requirement year order placing costs inventory costs (Rs.) cost
1,600 1 1,600 100 800 6,400 6,500
2 800 200 400 3,200 3,400
3 533 300 267 2,136 2,436
4 400 400 200 1,600 2,000
5 320 500 160 1,280 1,780
6 267 600 134 1,075 1,672
7 229 700 115 920 1,620
8 200 800 100 800 1,600
9 178 900 89 762 1,612
10 160 1000 80 640 1,640
It is obvious Irom the above table that total cost is the minimum when
each order is oI 200 units. ThereIore, economic ordering quantity is 200 units
only.
The economic order quantity can also be presented graphically. Figure 9.1,
gives a graphical presentation oI EOQ on the basis oI data given in Table 9.1.
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Assumptions
The EOQ
2
model, as a technique to determine the economic order quantity, is
based on three restrictive assumptions, namely :
(i) The Iirm knows with certainty the annual usage (consumption) oI a
particular item oI inventory.
(ii) The rate at which the Iirm uses inventory is steady over time.
(iii) The orders placed to replenish inventory stocks are received at exactly
that point in time when inventories reach zero. In addition, it may also
be assumed that ordering and carrying costs are costant over the range
oI possible inventory levels being considered.
2. Determination of Optimum Production Quantity : The use oI the
EOQ model can be extended to production runs to determine the optimum size
oI manuIacture. Two costs involved are ordering costs (set-up costs) and
carrying costs. Production costs or set-up costs will reduce with bulk
production runs, but carrying costs will increase as large stocks oI manuIactured
inventories will be held. The economic production size will be the one where
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Orders in a year
Total cost oI inventory management
EOQ 200 units
Minimum Total Cost
Ordering cost
Carrying cost
C
o
s
t
s

(
i
n

2
0
0
0

R
s
.
)
1 2 3 4 5 6 7 8 9 10
8
7
6
5
4
3
2
1
0
the total oI set-up and carrying costs is minimum.
The Iormula Ior EOQcan also be used Ior determining the optimum production
quantity as given below :


2U x P
EPQ
S
Where EPQ is economic production quantity, U is Annual (monthly) output, P
is set-up cost Ior each production run and S is the cost oI carrying inventory
per unit per annum (per month).
Illustration 9.2 : Calculate the optimum production quantity per production
run Irom the Iollowing inIormation :
Estimated annual production 40,000 units
Set-up cost per production run Rs. 50
Carrying cost per unit per annum Rs. 1
Solution :


2U x P
EPQ
S

2 x 40,000 x 50

1
2000 units per production run.
Determination of Re-order Level : The EOQ provides an answer to the
question : how much inventory should be ordered in one lot ? Anbother
important question pertaining to eIIicient inventory management is : when
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should the order to procure inventory be placed ? This aspect oI inventory
management is covered under the re-order point problem.
The re-order point is stated in terms oI the level oI inventory at which
an order should be placed Ior replenishing the current stock oI inventory. In
other words, re-order point may be deIined as that level Io inventory when
Iresh order should be placed with the suppliers Ior procuring additional
inventory equal to the economic order quantity.
In order to determine reorder level, inIormation is required about two things -
(i) the lead time and (ii) the usage rate.
The term Lead Time reIers to the time normally taken in receiving the delivery
oI inventory aIter the order has been placed. In case there is no uncertainty
about the usage rate and the lead time, the order level can be determined by
simply applying the Iollowing Iormula :
Re-order level Average usage x Lead Time
For example, iI the lead time is 3 weeks and the average usage is 50 units per
week, the reorder level can be computed as Iollows :
Reorder level : Lead time x Average usage
3 weeks x 50 units
150 units.
You may note that iI the economic order quantity in the above case is 500
units and there is no lead time, the economic order quantity would have been
suIIicient Ior 10 weeks and the order would have been placed only at the end
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oI the 10th week- the time when the recorded quantity reaches the zero level.
Since in the above problem, the lead time is three weeks and, thereIore, the
order should be placed at the end oI the 7th week when only 150 units are leIt.
Safety Stock
The re-order point is computed under the assumption oI certainty. But it is
diIIicult to predict usage and lead time accurately. The demand Ior material
may Iluctuate Irom day to day or Irom week to week. Similarly, the actual
delivery time may be diIIerent Irom the normal lead time. II the actual usage
increases or the delivery oI inventory is delayed, the Iirm can Iace a problem
oI stock-out. ThereIore, in order to guard against the stock-out, the Iirm may
maintain a saIety stock-some minimum or buIIer inventory as cushion against
expected increased usage and/or delay in delivery time. The level oI saIety
stock can be calculated by applying the Iollowing Iormula :
SaIety Stock Average Usage x Period oI SaIety Stock.
For example, iI the usage rate is 100 units per week, and the Iirm wants to hold
suIIicient inventory Ior at least one week oI production the amount oI saIety
stock would be 100 units.
The Iormula Ior determining the reorder level when saIety stock is maintained
will be as Iollows :
Reorder level Lead Time x Average usage saIety stock
Illustration 9.3 : From the Iollowing data determine (a) SaIety Stock, (b)
Reorder level and (c) Maximum level in respect oI material `M`.
Economic Order Quantity 1000 units
(230)
Lead Time 3 weeks
Weekly usages 100 units
Weeks oI saIety stock desired by the Iirm 2 weeks
Solution :
(a) SaIety Stock level Average usage x period oI saIety stock
100 units x 2 200 units
(b) Reorder level Lead time x Average Usage SaIety stock
(3 x 100) 200 500 units
(c) Maximum inventory EOQ SaIety Stock
1000 units 200 units 1200 units.
3. ABC Classification : An ABC analysis oIIers an important solution to
the problem oI a scientiIic planning and control oI inventories, and is an
important technique oI inventory management. It is based upon the value oI
diIIerent items constituting an inventory. It may be concerned with several
items - raw materials, purchases and selI-Iabricated component parts, sub-
assemblies, Iactory supplies, oIIice supplies, tools, machinery and handling
equipment items. An inventory may be diIIerentiated on the basis oI bulk, size,
weight, usage, value, durability, availability, etc., and should be controlled with
due weightage to diIIerential characteristics. The idea underlying an ABC
analysis is in this recognition oI the principle that some items oI inventory
are more important than others. Thus, items are classiIied under broad
categories -A, B and C. The ABC technique enables an enterprise to keep its
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investment lowand avoid stock- outs oI critical items. Its objective is to reduce
the minimum stock as well as the working stock.
Items under category Aconstitute a small percentage oI the total volume, but
account Ior a large percentage oI the product value oI a unit. Alarge glossary
oI items entering a bulk oI the total volume and accounting Ior an insigniIicant
product value is placed under class C. Items under class B constitute a moderate
class which are neither substantial nor insigniIicant in relation to the product
value oI a unit. Thus, B group stands mid-way. It deserves less attention than A
but more than C. It can be controlled by employing less sophisticated
techniques.
The Iunction oI inventory management is to properly classiIy all the inventory
items into one oI these three groups. Inventory surveys in general have shown
the Iollowing trends regarding the components oI inventory oI manuIacturing
organisations :
Category of total value No. of items ()
A 70 10
B 20 35
C 10 55
The advantages oI ABC analysis are as Iollows :
(i) It ensures closer control on costly items in which a large amount oI
capital has been invested.
(232)
(ii) It helps in developing a scientiIic method oI controlling inventories,
clerical costs are reduced and stock is maintained at optimum level.
(iii) It helps in achieving the main objective oI inventory control at minimum
cost. The stock turnover rate can be maintained at comparatively higher
level through scientiIic control oI inventories.
However, the ABC system suIIers Irom a serious limitation. Under this system,
the items are analysed according to their value and not according to their
importance in the production process. It may create sometimes problems. For
instance, an item may not be very costly and hence it may have been put in
category C. But this item may be very important Ior production process because
oI its scarcity. This type oI item rquires utmost attention oI the management
though according to ABC system it is not advisable to do so. ThereIore, the
technique oI ABC analysis should be Iollowed cautiously not blindly.
Illustration 9.4 : From the Iollowing inIormation pertaining to inventory items
oI a Iirm, draw a plan oI ABC classiIication
Item Average no. of Average Cost
units in inventory per unit (Rs.)
1 11500 7.10
2 24000 3.00
3 38000 1.50
4 7000 5.00
5 4100 6.20
6 40000 0.50
7 1,500 10.00
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8 600 22.00
9 60,000 0.20
10 29,000 0.40
11 3000 3.50
12 300 8.00
Solution : The required plan oI ABC selective control is presented in Table
Table 9.2 : ABC Classification
Item Units of total Unit Cost Total cost of total Category
1 11500 5.3 7.10 81650 23.0
2 24000 10.9 33.6 3.00 72000 20.2 59.2A
3 38000 17.4 1.50 57000 16.0
4 7000 3.2 5.00 35000 9.8
5 4100 1.9 6.20 25420 7.1
6 40000 18.3 24.1 0.50 20000 5.6 26.8B
7 1500 0.7 10.00 15000 4.2
8 600 0.3 22.00 13200 3.7
9 60000 27.4 0.20 12000 3.4
10 29000 13.2 42.4 0.40 11600 3.3 14.1C
11 3000 1.4 3.50 10500 3.0
12 300 0.1 8.00 2400 0.7
219000 100.0 3,55,770 100.0
4. Ratio Analysis in Inventory Management : Inventory turnover ratios
are also calculated to minimise the investment in inventories. Turnover
ratio can be calculated regarding each item oI inventory on the basis oI
the Iollowing Iormula :
Cost oI goods consumed/sold during the period
Inventory Turnover Ratio
Average inventory held during the period
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For example, iI the annual sales is oI 208000 units and the average inventory
held during the year is 20000 units, the inventory turnover ratio comes to 10.4.
Ahigh turnover ratio is usually indcative oI eIIicient operations, provided that
the unproIitable out-oI-stock conditions do not result Irom a Iast rate oI sales
at a dangerously low level oI inventory. The turnover ratio aIIect a number oI
areas oI a business. First, a satisIactory turnover ratio reduces "markdowns"
oI damaged merchandise which has been "lying around". Secondly, a product
which has a good turnover rate is comparatively Iresh product Ior the customer.
Thirdly, items which turnover Iast cost less in storage. Last but not the least
use oI calculating a turnover ratio is in the area oI sales. The selling cost per
unit on Iast turnover items is low. This maniIests in a greater contribution to
net proIit.
5. Aging Schedule : ClassiIication oI the inventories according to age
also helps in identiIying inventories which are moving slowly into production
oI sales. This requires identiIying the data oI purchase/manuIacture oI each
item oI the inventory and classiIying them as shown in the table below :
Table 3: Aging schedule of Inventories as on 31, Dec. 1999
Age Date of purchase/ Amount Percentage to
(in days) manufacture (Rs.) total
0-15 Dec. 18 8,000 20
16-30 Dec. 14 4,000 10
31-45 Nov. 27 2,000 5
46-60 Nov. 10 20,000 50
61 and above Oct. 26 6,000 15
Total 40,000 100
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The above table shows that 50 oI the inventory is oI the age group oI
46-60 days. In case steps are not taken to clear the inventories, it is possible
that more than 50 inventories may suIIer deterioration in its value or may
even become obsolete.
Problems in Inventory Management :
The techniques oI inventory management, discussed above, are very useIul in
determining the optimum level oI inventory and Iinding answer to the problems
oI the economic order quantity, the re-order point and the saIety stock. These
techniques are very essential to economise the use oI resources by minimising
the total inventory cost. The inventory management involves a number oI
problems. Some oI these are given below :
(i) Knowledge oI demand, certainty, risk and uncertainty;
(ii) Method oI obtaining a commodity;
(iii) The decision process; and
(iv) Time lag in receiving on order : Constant time lag or probability
distribution.
An analysis oI inventory problems is Iundamentally based on a very simple,
common sense observation - that in any genuine inventory problem whatsoever,
there mut be `opposing costs`. By this we may think simply that there is a cost
associated with doing "too large" and there is a cost associated with doing "too
little". Sometime there are several such costs, but there must always be at least
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one in each direction.
Financial Manager and Inventory Management : Although the Iinancial
manager is not directly concerned with inventory policies, yet he cannot ignore
them since they directly aIIect the Iinancial needs oI the Iirm to a signiIicant
extent. It is, thereIore, necessary Ior the Iinancial manager to get Iamiliar
with ways to control inventories eIIectively so that there can be eIIicient
allocation oI Iunds. He should make all-out eIIorts to reduce lead time, regulate
usage and minimise the saIety stock. In case he does so, he will be in a position
to reduce investment in inventories to the optimum level and leave suIIicient
Iunds Ior more proIitable channels which will ultimately result in maximisation
oI the shareholders` wealth.
Questions
1. "There are two dangerous situations that management should usually avoid
in controlling inventories". Explain.
2. Why is inventory management important ? Explain objectives oI
inventory management.
3. DeIine the economic order quantity. How is it computed ?
4. What are ordering and carrying costs ? What is their role in inventory
control ?
5. Write notes on the Iollowing :
(a) SaIety stock (b) Reorder point (c) Lead time (d) Aging Schedule oI
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inventories.
6. Illustrate with an example and graph the ABC analysis.
7. The Iinance department oI a corporation provides the Iollowing
inIormation :
(i) The carrying costs per unit oI inventory are Rs. 10
(ii) The Iixed costs per order are Rs. 20
(iii) The number oI units required is 30,000 per year.
Determine the economic order quantity (EOQ), total number oI orders
in a year and the time gap between two orders.
(Ans : EOQ 346 units, No. oI orders 87, Time gap 4 days)
8. ABC company buys an item costing Rs. 125 each in lots oI 500 boxes
which is a 3 month supply and the ordering cost is Rs. 150. The inventory
carrying cost is estimated at 20 oI unit value. What is the total annual
cost oI the existing inventory policy ? How much money could be saved
by employing the economic order quantity ?
|Ans. : Total annual cost oI existing policy Rs. 6850 and EOQ 155 units
and saving in annual cost 2863 (i.e. 6850-3887)|
9. Suggest a break-down oI the items into A, B, and C classiIication Irom
the Iollowing details regarding inventory oI a Iirm :
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Item number Average no. of units Average cost per unit (Rs.)
1 20,000 60.80
2 10,000 102.40
3 32,000 11.00
4 28,000 10.28
5 60,000 3.40
6 30,000 3.00
7 20,000 1.30

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DIVIDENDDECISIONS
(Author : Dr. Chandra Shekhar)
AIter reading this lesson, you should know about :
* Meaning oI Dividend.
* Nature oI Dividend decision.
* Determinants oI Dividend Policy.
The lesson is divided into the Iollowing sections :
1. Introduction and meaning oI Dividend.
2. Nature oI Dividend decision : Long term Iinancing or wealth
maximization.
3. Determinants oI Dividend Policy.
4. Dividend Policy - AClassiIication
4.1 Regular Dividend Policy.
4.2 Stable Dividend Policy.
Lesson : 10
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5. Summary.
1. INTRODUCTIONANDMEANING OFDIVIDEND:
The term dividend reIers to that part oI proIits oI a Iirm which is
distributed by the company among its shareholders. It is the reward oIIered by
the company to its shareholders Ior the investments made by them in the shares
oI the company. The investors are interested in earning the maximum return on
their investments and to maximise their wealth. Acompany, on the other hand,
needs to provide Iunds to Iinance its longterm growth. II a company pays out
as dividend, most oI what it earns, then Ior business requirements and Iurther
expansion it will have to depend upon outside resources such as issuing oI
debt or new shares. Since dividend is the right oI share holders oI a company
to participate in the proIits and surplus oI the company Ior their investment in
the share capital oI the company, the company should thereIore distribute a
reasonable amount as dividends to its members and retain the rest Ior its growth
and survival.
2. NATURE OF DIVIDEND DECISION : LONG TERMFINANCING
ORWEALTH MAXIMISATIONDECISION:
When dividend decision is treated as a Iinancing decision, the net earnings
oI the Iirm may be considered as a source oI long-term Iunds. With this
approach, dividends will paid only when the Iirm does not have proIitable
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investment opportunities. The Iirm grows at a Iaster rate when it accepts highly
proIitable investment projects. External equity could be raised to Iinance
investments. But the retained earnings are preIeable because, unlike external
equity, they do not involve any Iloatation cost. The distribution oI cash
dividends causes a reduction in internal Iunds available to Iinance proIitable
investments opportunities, and thus, either constrains growth or requires the
Iirm to look Ior other costly sources oI Iinancing.
One may argue that capital markets are not perIect, ThereIore,
shareholder are not indiIIerent between dividends and retained earnings.
Because oI the market imperIections and uncertainty, shareholders may give a
higher value to near dividends than the Iuture dividends and capital gains. Thus
the payment oI dividends may signiIicantly aIIect the market price oI the shares.
Higher dividends increase the value oI the shares and low dividends reduce
this value. In order to maximise the wealth under uncertainty, the Iirm must
pay enough dividends to satisIy investors.
The management oI a Iirm while evolving a dividend policy, must strike
a proper balance between the above mentioned two approaches. When the Iirm
increases the retained portion oI net earnings. Shareholders` dividends decrease
and consequently the market price may be adversely aIIected. But the use oI
retained earnings to Iinance proIitable investments will increase the Iuture
earnings per share. On the other hand, when dividends are increased, though
there may be a Iavorable reaction in the stock markets, bu the Iirm may have to
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Iorego some investment opportunities Ior want oI Iunds and consequently, the
Iuture earnings per share may decrease. ThereIore, management should develop
such a dividend policy which divides the net earnings into dividends and retained
earnings in an optimum way to achieve the objective oI maximisation the wealth
oI the share holders. The development oI such a policy will be greatly
inIluenced by investment opportunities available to the Iirm and the value oI
dividends as against capital gains to the shareholders. The other possible aspect
oI the dividend policy relates to the stability oI dividends, the constraints on
paying dividends and the Iorms oI dividends.
3. DETERMINANTS OFDIVIDENDS POLICY:
The payment oI dividend involves some legal as well as Iinancial
considerations. It is diIIicult to determine the general dividend policy which
can be Iollowed by diIIerent Iirms at diIIerent times because the dividend
decision has to be taken considering the special circumstances oI an individual
case. The Iollowing are the important Iactors which determine the dividend
policy oI a Iirm :
3.1 Legal Provisions :
Legal Provisions in relation to the dividends as laid down in sections,
93, 205, 205A, 206 and 207 oI the Companies Act, 1956 are signiIicant because
they lay down a Iramework within which dividend policy is Iormulated. These
provisions require that dividend can be paid only out oI current proIits or past
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proIits aIter providing Ior depreciation, or out oI the moneys provided by the
Government, Ior the Companies Rules, 1975 require that a company providing
more than ten percent oI dividend should transIer certain percentage oI the
current year`s proIits to reserves. Companies Act, Iurther provides that
dividends cannot be paid out oI capital, because it will amount to reduction oI
capital, thus adversely aIIecting the security oI its creditors.
3.2 Level of Earnings :
The amount and trend oI earnings is an important aspect oI dividend
policy. Rather, it would not be an exaggeration iI we consider it as the starting
point oI the dividend policy, as dividends can only be paid iI the company is
earning proIits. The dividend, should generally, be paid out oI current years
earnings only or less a part oI permanent investment in the business to earn
current proIits. The past trend oI the company`s earnings should also be kept
in consideration while making the dividend decision.
3.3 Shareholders` Preferences :
Although, legally the discretion as to whether to declare dividend or not
has been leIt with the Board oI Directors, the directors should give due
importance to the desires oI shareholders in the declaration oI dividends as
they are the representatives oI shareholders. Desire oI shareholders Ior
dividends depends upon their economic status. Investors, such as retired
persons, windows and other economically weaker persons view dividends as a
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source oI Iunds to meet their day-to-day living expenses. To beneIit such
investors, the companies should pay regular dividends.
3.4 Type of Industry :
The nature oI industry, with which company is engaged, also considerably
aIIects the dividend policy. Certain industries have a comparatively steady and
stable demand irrespective oI the prevailing economic conditions. For instance,
people are used to consuming liquor both in boom as well as recession. Such
Iirms expect regular earnings and hence can Iollowa consistent dividend policy.
On the other hand, iI the earnings are uncertain, as in the case oI luxury goods,
a conservative policy should be Iollowed. Such Iirms should retain a substantial
part oI their current earning during in the recession periods. Thus industries
with steady demand Ior their products can Iollows a higher dividend payout
ratio while cyclical industries should Iollow a lower payout ratio.
3.5 Tenure of the Company :
The tenure oI the company also inIluences the dividend decision oI a
company. Anewly established concern has to limit payment oI dividend and
retain a substantial part oI earnings Ior Iinancing its Iuture growth and
development, while other companies which have established suIIicient reserves
can aIIord to pay liberal dividends.
3.6 Requirement of Funds in Future :
The management oI a concern has to reconcile the conIlicting interests
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oI share holders and those oI the companys`s Iinancial needs. II a company has
highly proIitable investment opportunities it can convince the shareholders oI
the need Ior limiting the dividend in order to increase the Iuture earnings and
stabiles its Iinancial position. But when proIitable investments opportunities
do not exist, then the Company may not be justiIied in retaining a substantial
part oI its current earnings. Thus, a concern having Iew internal investment
opportunities should Iollow high payout ratio as compared to the one having
more proIitable investment opportunities.
3.7 Taxation Policy :
The taxation policy oI the government also aIIects the dividend decision
oI a Iirm. Alight or low rate oI business taxation aIIects the oI high proIits, a
policy oI constant dividend per share is most suitable to concern whose
earnings are expected to remain stable over a number oI years or those who
have built up suIIicient reserves to pay dividends in the years oI low proIits.
The policy oI constant lowdividend per share plus some extra dividend in years
oI high proIits is suitable Ior the Iirms having Iluctuating earnings Irom year
to year.
3.11 Liquidity Position :
The dividend policy oI a Iirm is also inIluenced by the availability oI
liquid resources. Although, a Iirm may have suIIicient available proIits to
declare dividends, yet it may not be desirable to pay dividends iI it does not
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have suIIicient liquid resources. Hence the liquidity position oI a company is
an important consideration in paying dividends.
II a company does not have liquid resources, it is better to declare stock
dividend, i.e. issue oI bonus shares to the existing shareholders. The issue oI
bonus shares also amounts to distribution oI a Iirm`s earnings amount the exiting
shareholders without aIIecting its cash position.
4. DIVIDENDPOLICY: ACLASSIFICATION
The various types oI dividend policies are discussed as Iollows :
4.1 Regular Dividend Policy :
Payment oI dividend at the usual rate is termed as regular dividend policy
oIIers the Iollowing advantages :
(a) It establishes a proIitable record oI the company.
(b) It creates conIidence among the shareholders.
(c) It aids in long-term Iinancing and renders Iinancing easier.
(d) It stabilizes the market value oI shares.
(e) The ordinary shareholders view dividends as a source oI Iunds to
meet their day-to-day living expenses.
(I) II the proIits are not distributed regularly and are retained, the
shareholders may have to pay a higher rate oI tax in the years when
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accumulated proIits are distributed.
4.2 Stable Dividend Policy :
The term stable dividends means consistency or lack oI variability in
the streams oI dividend payments. In more precise terms it means payment oI
certain minimum amount oI dividend regularly. Astable dividend policy may
be established in any oI the Iollowing three Iorms.
a) Constant Dividend :
Some companies Iollow a policy oI paying Iixed dividend per share
irrespective oI the level oI earnings year aIter year. Such Iirm usually create a
`Reserve Ior Dividend Equalization` to enable them to pay the Iixed dividend
even in the year when the earnings are not suIIicient or when there are losses.
Apolicy oI constant dividend per share is most suitable to the concerns whose
earnings are not expected to remains stable over a number to years.
b) Constant Pay-out Ratio :
A constant payout ratio means payment oI a Iixed percentage oI net
earnings as dividends every year. The amount oI dividend in such a policy
Iluctuates in direct proportion to the earnings oI the company. The policy oI
constant pay-out ratio is preIerred by the Iirms because it is related to their
ability to pay dividends.
c) Stable rupee dividend plus extra dividend :
Some companies Iollow a policy oI paying constant low dividend per
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share plus an extra dividend in the years oI high proIits. Such a policy is most
suitable to the Iirms having Iluctuating earnings Irom year to year.
What the investors expect is that they should get an assured Iixed amount
as dividends which should gradually and consistently increase over the years.
The most commendable Iorm oI stable dividend policy is the constant dividend
per share policy. There are several reasons why investors would preIer a stable
dividend policy and pay a higher price Ior a Iirm`s shares which observes stability
in dividend payments.
i ) Desire for Current Income :
A Iactor that Iavours a stable dividend policy is the desire Ior current
income by some investors. Investors such as retired persons and windows, Ior
example, view dividends as a source oI Iunds to meet their current living
expenses. Such expenses are Iairly constant Irom period to period. ThereIore,
a Iall in dividend will necessitate selling shares to obtain Iunds to meet current
expenses and, conversely, reinvestment oI some oI the dividend income iI
dividends signiIicantly rise.
Moreover, either oI the alternatives involves, inconvenience cost apart,
transaction costs in terms oI brokerage, and other expenses. These cost are
avoided iI the dividend stream is stable and predictable.
i i ) Information :
Another reason Ior pursuing a stable dividend policy is that investors
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are thought to use dividends and changes in dividends as a source Iirm will
change dividends only iI the management Ioresees a permanent earnings change,
then the level oI dividends inIormas investors about management`s expectations
concerning the company`s earnings. Accordingly, the market views the changes
in dividends oI such a company as oI a semi-permanent nature. Acut in dividend
implies poor earnings expectation; no change, implies earnings stability; and a
dividend increase, signiIies management`s optimism about earnings. On the other
hand, a company that pursues an erratic dividend payout policy does not provide
any such inIormation, thereby increasing the risk associated with the shares.
i i i ) Institutional Investor`s Requirements :
A third Iactor encouranging stable dividends is the requirements oI
institutional like liIe insurance companies, general insurance companies, unit
trusts and so on, to invest in companies which have a record oI continuous and
stable dividend. These Iinancial institutions owing to the large size oI their
investible Iunds, represent a signiIicant Iorce in the Iinancial markets and their
demand Ior the comapany`s securities can have an enhancing-eIIect on its price
and, thereby on the shareholder`s wealth. A stable dividend policy is a pre-
requisite to attract the investible Iunds oI these institutions. One consequent
impact oI the purchase oI shares by them is that there may be an increase in
the general demand Ior the company`s shares. Decreased marketability risk,
coupled with decreased
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DO YOURSELF
1. What is dividend " Why is it necessary Ior a company to pay dividends ?
2. Comment on the nature oI dividend plicy decision.
3. Write a detailded note on the Iactors inIluencing dividend policy.
4. As a decision maker, whether you would decide in Iavour oI regular
dividend policy or stable dividend policy ? Why ? Explain.

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BUSINESS FAILURES AND MERGERS
AIter reading this lesson, you should knowabout :
Amalgamation, Merger, Acquisition & Takeover
Type oI mergers
Motives oI mergers
Examples oI Mergers and Acquisitions
The lesson is divided into Iollowing sections
1 Introduction
2 DeIinition oI Merger
3 Type oI Merger
3.1 Horizontal Merger
3.2 Vertical Merger
3.3 Conglomerate Merger
4. Merger Motives
4.1 Sellers Motives
4.2 Buyers Motives
5. Financial Frame work
6. Target Companies
7. Hostile Takeovers
8. Merger and Growth
9. Merger and Acquisition by multinationals
10. Corporate Restructuring
11. Mergers in recent past - AIewexamples.
Lesson : 11
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1. INTRODUCTION
The Indian business environment has altered radically since 1991
with the changes in the economic policies & introduction oI newinstitutional mecha-
nisms. The Indian corporate world, while beneIitting Irom decontrol and deregulation,
has now begun to Ieel the eIIect oI theses changes. Those most aIIected are the pro-
moters who are today threatened by hostile takeovers. At the same time, Iinancial
institutions which have signiIicant stake in many companies, have started demanding
better corporate governance. Change in the mode oI governance oI a company can be
brought about by mergers & acquisitions (M & A), activities which are yet not so
pervasive in India. Pharmaceuticals and ad-agencies would be the Iront runners as well
as the primary target oI M&Aactivities in India. On the other hand, Iamily businesses
and single units are consolidating their positions to avoid possible hostile takeovers.
2. DEFINITIONOFMERGER
From the point oI viewoI Iinancial management, given its
objective oI maximisation oI wealth oI shareholders, the overall desirability and ac-
ceptability oI the proposed merger scheme depends on its tax implications Ior the
companies involved and their shareholders. Unlike the Companies Act and MRTPAct,
the term merger/amalgamation is explicitly deIined in the Income Tax Act. Section
2(IA) oI theAct provides:
Amalgamation, in relation to companies, means the merger oI one or more
companies with another company or the merger oI two or more companies to Iorm
another company (the companies which so merge being reIerred to as the amalgamat-
ing companies and the company with which they merge or which is Iormed as the result
oI merger, as the amalgamated company) in such a manner that -
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(i) All the property oI amalgamating company(ies) immediately beIore the amal-
gamation becomes the property oI amalgamated company, by virtue oI amal-
gamation ;
(ii) Shareholders holding not less than nine-tenths in value oI the shares in amal-
gamating company(ies) become shareholders oI the amalgamated company, by
virtue oI amalgamation.
Accordingly, diIIerent provisions oI theAct are attracted, depending on the Iact
whether the proposed scheme IulIils all the three conditions mentioned above
or not.
Acquisition or takeover is diIIerent Irom merger. Acquisition implies that a
company unilaterally relinquishes its independence and adapts to another Iirm`s
plans, while in merger, all combining Iirms relinquish their independence, re-
sulting in a common corporation.
TYPEOFACQUISITIONS
Amalgamation and Merger : In amalgamation, a newcorporation is created by unit
uniting the companies voluntarily. Merger does create a newcorporation.
Acquisition and Takeovers : One company acquires another company`s total or con-
trolling interest. Subsequently, the acquired company operates as a separate division
or subsidiary.
holding company acquisition : This is quasi Iorm oI merger. It involves the acquisi-
tion oI either the total or the majority oI a Iirms stock by a company. The purpose is
only to acquire the management and control oI other companies.
3. TYPES OFMERGERS
Mergers can assume various Iorms, depending upon the need oI the company.
Abroad classiIication oI mergers is presented below:
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3.1 HorizontalMergers
Ahorizontal merger involves two Iirms operating and competing in the same
kind oI business activity. Thus, the acquisition in 1987 oI American Motors by Chrysler
represented a horizontal combination or merger. Forming a larger Iirm may have the
beneIit oI economies oI scale. Horizontal mergers are also believed by many as
potentially creating monopoly power on the part oI the combined Iirm enabling it to
engage in anticompetitive practices.
3.2 Vertical Merger
Vertical merger occurs between Iirms in diIIerent stages oI production operation.
In the oil industry, Ior example, distinctions are made between exploration and
production, reIining and marketing to the ultimate consumer. In the pharmaceutical
industry one could distinguish between research and the development oI new drugs,
the production oI drugs and the marketing oI drugs product through retail drugstores.
There are many reasons why Iirms might want to be vertically integrated between
diIIerent stages. There are technological economies such as the avoidance oI reheating
and transportation costs in the case oI an integrated iron & steel producer. Transaction
within a Iirm may eliminate the cost oI searching Ior prices, contracting payment
collecting and advertising and may also reduce the cost oI communicating and
coordinating production.
3.3 Conglomerate Mergers
Conglomerate mergers involve Iirms engaged in unrelated types oI business
activity. Thus, the merger between Mobile Oil and Montgomery Ward was generally
regarded as a conglomerate merger. Among conglomerate mergers, three types have
been distinguished. Product-Extention mergers broaden the product lines oI Iirms in
related business activities mergers. AGeographic Market-Extention merger involves
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the Iirms whose operations have been conducted in non overlapping geographic
areas.
Finally, the other conglomerate mergers which are oIten reIerred to as pure
conglomerate mergers involve unrelated business activities.
4. MERGERMOTIVES
Mergers and acquisitions can be motivated by either the shareholder`s wealth-
maximising approach or the widening share ownership. The shareholders wealth-
maximising approach hypothesizes that managers try to pursue those M&Aactivities
which oIIer positive net present value. In the latter case, as the ownership and control
oI a Iirm are seperate, managers seek to maximize their own interests. Sometimes,
managers oI Iinancially poor companies seek a merger partner to avoid liquidation
proceedings. The basic pattern oI M&Aactivities is that the divesting company moves
Irom a diversiIying strategy to concentrate on core activities is that the divesting
company moves Irom a diversiIying strategy to concentrate on core activities in order
to increase competitiveness. On the other hand, the acquiring company tries to
complement its existing activities. Both patterns are based on an attempt to create
value Ior shareholders. The primary objective oI M&Aactivities are diversiIication,
market expansion, improving competitive position, and immunity against depression.
4.1 Seller Motives
Sellers opt Ior M&Abecause:
(a) Owners oI small companies may like to diversiIy their personal investments.
Selling out to a diversiIied company could mean more income than
continuing as a separate unit, providing an opportunity to improve the
investment position oI owners.
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(b) Financial limitations due to restriction on working capital Iinancing may lead to
Selling the unit.
(c) An attractive oIIer may trigger the selling oI the company.
(d) Small companies may desire to connect with large ones.
4.2 Buyers Motives
The motivations Ior buyers are as Iollows
(a) Acquiring a newproduct, newplant capacity or newproduction Organization.
(b) Greater degree oI vertical integration, synergy and growth.
(c) Increased market control, desire to achieve economies oI scale and multiunit
operations.
(d) Possibility oI economies oI scale in distribution and advertising.
(e) Greater control oI patents, acquisition oI technological skills and maintenance
oI proIits through a bigger operation.
(I) Acquistion oI Iinancial resources, tax advantages and gains Irom sales oI securities.
(g) Gains to promoters, personal ambition and desire to limit competition.
5. FINANCIAL FRAMEWORK
This section discusses the Iinancial Iramework oI a merger decision. It covers three
inter-related aspects : (i) determining the Iirm`s value, (ii) Iinancing techniques in
merger, and (iii) analysis oI merger as a capital budgeting decision.
5.1 Firm`s Value
To determine an acceptable price Ior a corporation, a number oI Iactors,
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quantitative as well as qualitative, are relevant. However, placing a value on
qualitative Iactors is diIIicult such as managerial talent, strong sales staII, excellent
production department, and so on. ThereIore, the Iocus relate to (a) the value oI the
assets and (b) the earnings oI the Iirm. Based on the assets values and earnings, these
Iactors include book value, appraisal value, market value and earnings per share.
Book Value
The book value oI a Iirm is based on the balance sheet value oI the owners` equity.
It is determined by dividing net worth by the number oI equity shares outstanding. The
book value, as the basis oI determining a Iirm`s value, suIIers Irom a serious limitation
as it is based on the historical costs oI the assets oI the Iirm. Historical costs do not
bean a relationship either to the value oI the Iirm or to its ability to generate earnings.
Nevertheless, it is relevant to the determination oI a Iirm`s value Ior several reasons :
(i) it can be used as a starting point to be compared and complemented by other analyses,
(ii) in industries where the ability to generate earnings requires large investments in
Iixed assets, the book value could be a critical Iactor where especially plant and
equipment are relatively new, (iii) in industries where the ability- to generate earnings
requires large investments in Iixed assets, the book value could be a critical Iactor
where especially plant and, equipment are relatively new, (iii) a study oI Iirm`s working
capital is particularly appropriate and necessary in mergers involving a business
consisting primarily oI liquid assets such as Iinancial institutions.
Appraisal Value
Appraisal value is another measure oI determining, a Iirm`s value. Such a value is
acquired Irom an independent appraisal agency. This value is normally based on the
replacement cost oI assets. The appraisal value has several merits. In the Iirst place, it
is an important Iactor in special situations such as in Iinancial companies, natural -
resources enterprises or organisations that have been operating at a loss. For instance,
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the assets oI a Iinancial company largely consist oI securities. The value oI the individual
securities has a direct bearing on the Iirm`s earning capacity. Similarly, a company
operating at a loss may only be worth its liquidation value which would approximate
the appraisal value. Secondly, the appraisal by independent appraisers may permit the
reduction in accounting good will by increasing the recopised worth oI speciIic assets.
Goodwill results when the purchase price oI a Iirm exceeds the value oI the individual
assets. Third, appraisal by an independent agency provide a test oI the reasonableness
oI results obtained through methods - based upon the going-concern concept. Further,
the appraiser may identiIy strengths and weaknesses that otherwise might not be
recopised such as in the valuation oI patents, partially completed research and
development expenditure. On the other hand, this method oI analysis is not adequate
by itselI since the value oI individual assets may have little relation to the Iirm`s over-
all ability to generate earnings and thus the going concern out in conjunction with
other evaluation processes. In speciIic cases, it is an important instrument Ior valuing
a Iirm.
Market value
The market value, as reIlected in the stock market quotations comprises another approach
Ior estimating the value oI a business. The justiIication oI market value as an
approximation oI true worth oI a Iirm is derived Irom the Iact that market quotations
by and large indicate the consensus oI investors as to the Iirm`s earning potentials and
the corresponding risk. The market value approach is one oI the most widely used in
determining value, specially oI large listed Iirms. The market value oI Iirm is determined
by investment as well as speculative Iactors. This value can change abruptly as a result
oI change not in the analytical Iactors but also purely speculative inIluences and is
subject to market sentiments and personal decisions. Nevertheless, the market value
provides a close approximation oI the true value oI a Iirm. In actual practices certain
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percentage premium, above the market- price is oIten oIIered as an inducement Ior
the` current owners to sell their shares.
Earnings Per Share
Yet another basis to place a value on a Iirm is the earnings per share (EPS).
Accordingly to this approach, the value oI a prospective acquisition is considered to be
a Iunction oI the impact oI the merger on the EPS. In other words, the analysis would
Iocus on whether the acquisition will have a positive impact on-the EPS aIter merger
or it will have the eIIect oI diluting. The Iuture EPS will aIIect the Iirm`s share prices
which is a Iunction oI price earnings (P/E) ratio and EPS.
Financial Techniques
The choice oI Iinancial instruments and techniques in acquiring a Iirm usually
has an eIIect on the purchasing agreement. The payment take the Iorm oI either cash
or securities, i.e. ordinary shares, convertible security, deIerred payment plans and
tender oIIers.
Ordinary Shares
When a company is considering to use common shares to Iinance a merger, the
relative price-earnings (P/E) ratios oI two Iirms are an important consideration. For
instance, Ior a Iirm having a high P/E ratio, ordinary shares represent an ideal method
Ior Iinancing mergers and acquisitions. Similarly, the ordinary shares are more
advantageous Ior both companies when the Iirm to be acquired has a lowP/E ratio.
Debt and Preference Shares
Since, some Iirms may have a relatively lower P/E ratio as also the requirement
oI some investors might be diIIerent, the other types oI securities, in conjunction
with/in lieu oI equity shares may be used Ior the purpose.
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In an attempt to tailor a security to the requirement oI investors who seek
dividend/interest income in contrast to capital appreciation/ growth, convertible
debentures and preIerence shares might be used to Iinance merger. the use oI such
sources oI Iinancing has several advantages, namely, (i) Potential earning dilution may
be partially minimized by issuing a convertible security. For example, suppose the
current market price oI the shares oI an acquiring company is Rs. 50 and the value oI
the acquired Iirm is Rs. 50,00,000. II the merger proposal is to be Iinanced with
equity 1,00,000 additional shares will be required to be issued. Alternatively, convertible
debentures oI the Iace value oI Rs. 100 with conversion ratio oI 1.8, which would
imply conversion value oI Rs. 90 (Rs.50 x 1.8), may be issued. To raise the required
Rs. 50,00,000 & 50,000 debentures convertible into 90,000 equity shares would be
issued. Thus, the number oI shares to be issued would be reduced by 10,000 thereby -
reducing the dilution in EPS that could ultimately result, iI convertible security in
place oI equity shares was not resorted. to; (ii) A convertible issue might serve the
income objectives oI the shareholders oI target Iirm without changing the dividend
policy oI the acquiring Iirm; (iii) Convertible security represents a possible way oI
lowering the voting power oI the target company; (iv) Convertible security may appear
more attractive to the acquired Iirm as it combines the protection oI Iixed security
with the growth potential oI ordinary shares. In brieI, Iixed income securities are
compatible with the needs and purpose oI mergers and acquisitions. The need Ior
changing the Iinancing leverage and Ior a variety oI securities is partly resolved by the
use oI senior securities.
Deferred Payment Plan
Under this method, the acquiring Iirm, besides making initial payment also
undertakes to make additional payment in Iuture years to the target Iirm in the event oI
the Iormer being able to increase earnings consequent to merger. Since the Iuture
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payment is linked to the Iirm`s earning, this plan is also known as earn-out plan.
There are several advantages oI adopting such a plan to the acquiring Iirm; (i) It emerges
to be an appropriate outlet Ior adjusting the diIIerence between the amount oI shares
the acquiring Iirm is willing to issue and the amount the target Iirm is aggreable to
accept Ior the business; (ii) In view oI the Iact that Iewer number oI shares will be
issued at the time oI acquisition, the acquiring Iirm will be able to report higher EPS
immediately; (iii) There is built-in cushion/protection to the acquiring Iirm as the total
payment is not made at the time oI acquisition; it is contingent to the realisation oI the
potential projected earnings aIter merger.
Notwithstanding the above beneIits, there are certain problems oI this mode oI
payment. The important ones are : (i) The target Iirm must be capable oI being operated
as an autonomous business entity so that its contribution to the total projects may be
determined; (ii) There must be Ireedom oI operation to the management oI the newly
acquired Iirm; (iii) On the part oI the management oI the acquiring Iirm, there must be
willing co-operation to work towards the success and growth oI the target Iirm, realising
that only by this way the two Iirms can gain Irom merger.
5.24 Tender Offer
An alternative approach to acquire another Iirm is the tender oIIer. Atender
oIIer, as a method oI acquiring Iirms, involves a bid by the acquiring Iirm Ior controlling
interest in the acquired Iirm. The essence oI this approach is that the purchaser
approaches the shareholders oI the Iirm rather than the management to encourage them
to sell their shares generally at a premium over the current market price.
Since, the tender oIIer is a direct a peal to the shareholders, prior approaval oI
the management oI the target Iirm is not required. In case, the management oI the
target Iirm does not agree with the merger move, a number oI deIensive tactics can be
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used to counter tender oIIers. These deIensive tactics includeWHITE KNIGHTS
and PAC-MANS. Awhite knight is a company that comes to the rescue oI a Iirm that is
being targeted Ior a take-over. Such a company makes its own oIIer at a higher price.
Under Pac-mans Iorm oI tender oIIer the Iirm unclear under attack- becomes the
attacker.
As a Iorm oI acquiring Iirms, the tender oIIer has certain advantages and
disadvantages. The disadvantages are : (i) II the target Iirm`s management attempts to
block it, the cost oI executing oIIer may increase substantially; (ii) the purchasing
company may Iail to acquire a suIIicient number oI shares to meet the objective oI
controlling the Iirm. The major advantages oI acquisition through tender oIIer include
: (i) II the oIIer is not blocked, it may be less expensive than the normal route oI
acquiring a company. This is so because it permits control by purchasing a smaller
proportion oI the Iirm`s shares; (ii) The Iairness oI the purchase price is not questionable
as each shareholder individually agrees to part with his shares at the negotiated price.
5.3 PROBLEMEXERCISE
ALtd. wants to acquire Ltd.. by exchanging 0.5 oI its shares Ior each share
oI Ltd. Relevant Iinancial data are as Iollows:
ALtd. TLtd.
EAT Rs. 18,00,000 Rs. 3,60,000
Equity Shares outstanding 6,00,000 1,80,000
EPS Rs. 3, Rs. 2
P/E ratio 10 times 7 times
Market Price per Share Rs. 30 (Rs. 3xlO) (Rs. 14 (Rs. 2x7)
Required:
(i) The number oI equity shares required to be issued by ALtd. Ior acquisition oI T
Ltd.
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(ii) What is the EPS oI ALtd. aIter the acquisition ?
(iii) Determine the equivalent earnings per share oI TLtd.
(iv) What is the expected market price per share oI A Ltd.. aIter the acquisition,
assuming its P/E multiple remains unchanged ?
(v) Determine the market value oI the merged Iirm.
Solution :
(i) 1,80,000 shares oI T Ltd. x 0.5 exchange Ratio 90,000 shares
(ii) Rs. 18,00,000 Rs.3,60,000

Rs. 21,60,000
3. 13 app.
6,00,000 90,000 6,90,000
(iii) Rs.3.13xO.5Rs.1.565app.
(iv) Rs. 3.13 x 10 times Rs. 31.30 app.
(y) Rs. 31.30 x 6,90,000 sharcs Rs. 2,15,97,000 app.
6. TARGETCOMPANIES
Normally the companies targeted Ior takeover are those which are under valued
and whose replacement costs are high. Indian companies normally target those
companies which are not in competition with multinationals.
The tentative evaluation oI the target company involves the Iollowing:
(a) Extent oI the market,
(b) Quality oI Product/services,
(c) Extent oI competition,
(d) Size oI Mark-up,
(e) Condition oI equipment,
(I) Geographical location,
(g) Fringe beneIits Ior employees,
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(h) Motive Ior merging,
(i) Personality Iactor.
7. HOSTILETAKEOVERS
All mergers and acquisitions are not Iriendly. Sometimes, an aggressive Iirm
tries to acquire a Iirm against its desire, resulting in a hostile takeover. Some oI the
warning signs Ior hostile takeovers are as Iollows
(a) Abrupt jump in share prices.
(b) Sudden rise in trading volumes.
(c) Share transIer to same owner.
(d) Disclosure oI acquisition as per legal requirement.
Hostile takeovers are linked with poor management and perIormance. Large
Iuture gains are however expected aIter takeover and this is reIlected in high bid
premiums paid to target shareholders.
8. GROWTH THROUGH ACQUISITIONS
The empire builders have been involved in M&Aactivities Ior more than a decade
and are nowtrying to restructure their acquisitons. Restructuring has in turn meant a
Iocussing oI business through mergers. Some oI the empire builders are the Murugappa
Group,, RPG group..`and UB Group. The Murugappa Group is trying to expand its
diversised business. Asimilar attempt is being made by the RPGgroup which is trying
to consolidate its various businesses into a IewIocused groups. On the other hand, the
UBgroup tried to diversiIy its activities and soon realised that the diversiIied activities
were not giving the expected results. It then started to, Iocus on a Iew areas and
divested many oI its acquired business.
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9. M& ABYMULTINATIONALS
AIter liberallisation many oI the MNCs were responding to
distinct changes : Iirst, the restructuring oI parent companies through M& Aactivities,
and second, India began the process oI liberaiisation and the take over code was
introduced in the 1990s. These two Iactors inIluenced the behaviour oI MNCs in
India.
The Iast-moving consumer goods (FMCG) industry and pharmaceuticals
dominated M&Aactivities.
The Iollowing sections give a brieI account oI M&Aactivities in various industry
groups.
9.1 FMCG (FASTMOVING CONSUMERGOODS) INDUSTRY:
Hindustan Lever (HLL)
HLL has been acquiring new companies since 1993. Since then, it has been
trying to takeover companies and brands. In 1995 it acquired Kwality & MilkIood and
then acquired Lakme subsequently. It also
merged with TOMCOin 1993.
HLL`s acquisitions are as Iollows :-
I) 1992-Acquired Kothari Foods.
2) 1992 1 -Acquired Dollops Ice Cream, merged with Doom Dooma Tea Estates,
acquired Kisan Irom UB`group, merged with Brooke Bond & Lipton
3) 1993-HLLmerged with TOMCO
4) 1995-Acquired MilkIood I 00 Ior marketing& distribution.
1995-HLL had an alliance with Lakme and Iormed Lakme Lever Ltd. HLL and its
subsidiary Stepan Chemicals restructured their business.
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9.2 Beverages Industry
Coca-Cola
The history oI Coca-Cola in India is as Iollows
I) In 1977, Coke was Iorced to close its business in India.
2) In 1993, Coke acquired the Parle Brands and got access to 53 bottling
Iranchisees.
3) In 1994, t here was a dispute between Coke and Parle over breach oI contract.
9.3 Pharmaceuticals Industry
The Indian pharmaceutical sector has witnessed diverse attempts. While some
MNCs are trying to restructure`, Iollowing their parent companies actions, other are
divesting their operations in India. A Iew such as Smithkline Beecham (SKB) are
trying to acquire brands. SKBhas acquired the crocin brand Irom Duphar Inter Ian.
Bayer:
Since 1995, Bayer in India has signed a series oI joint ventures and divested
business to achieve Iocus. It also plans to invest heavily in newhigh-growth. ventures.
The areas it is working at, include siliconpolymers; Synthetic rubber, Engineering
Plastics and Polyurelthane.
Glaxo:
Following the world wide merger oI Welcome Pic and Glaxo Plc in 1995, the
boards oI their Indian subsidiaries were integrated. The management integration saw
several top executives oI Glaxo India moving to Burroughs Welcome India.
9.4 AutomobileIndustry
Honda:
Siel oI the Sriram group is selling a 30 stake out oI its total 40 holding in
Honda Siel Cars Ltd., Honda`s share in the Car venture will now go up 60 to 90
(267)
However, it retains the option to buy back its share Irom Honda within 2 years.
DCM- Daewoo
Earlier in 1996, Daewoo Motor Corporation increased its stake in DCM-
Daewoo Irom 5 1 to 75. Daewoo holds 75 oI the equity,the DCM group 3.22
and the remaining 2 1 is with others including Toyota.
VOLVO
Volvo has been talking with to Bharat Earth Motors Ltd. (BEML) to pick up a 5-
10 stake in the state run company. The Central Govt. owns a majority (60) stake in
BEML. The rest is with the public.
9.5 Tekcom Industry:
AT& TAnd Tata Telecom:
AT&Tswitching systems is a joint venture between Lucent
Technological and Tata Industries. This is being merged with Tata Telecom, bringing
all the telecom activities under it.
9.6 FinancialServicesIndustry:
ITC
ITCClassic Finance was promoted by three wholly owned subsidiaries oI ITC.
All the group Iinancial service companies are being merged into ITCclassic, including
ITCAgrotech, VSTInvestment Ltd., ITCReal Estate Finance Ltd., and Classic Credit.
9. 7- AD Agencies
Indian Ad agencies have opted out oI the Iirst wave oI globalization. They are
giving up controlling stakes to Ioreign ad agencies O&M,J. Walter Thompson, MC
Cann Erickson, & Euro RSCBalready have controlling interests in their Indian opera-
tions. Leo Barnett increased its equity stakes to 30 in Chaitra. DDBNeedham World
(268)
9.2 Overall ProIitability Ratios
10. Capital Structure oI Company
11. DU-PONT Control Chart
1. MEANING ANDDEFINITIONOFARATIO :
A ratio is a simple arithmetical expression oI the relationship oI one
number to another. It may be deIined as the indicated quotient oI two
mathematical expressions. According to Accountant`s Handbook by Wixon,
Kell and Bedbord, 'a ratio is an expression oI the quantitative relationship
between two numbers. In simple language ratio is one number expressed in
terms oI the other and can be worked out by dividing one number into the other.
A Iinancial ratio is the relationship between two accounting Iigures
expressed mathematically. For example, iI the current assets oI a Iirm on a
given date are Rs. 5,00,000 and the current liabilities are Rs. 2,50,000 then
t he rat i o oI current asset s t o current l i abi l i t i es wi l l work out t o be
5,00,0002,50,000 or 2. It is also expressed as a proportion. Considering the
same example, ratio Ior current assets to current liabilities is, say 5,00,000 :
2,50,000 or 2 : 1. Similarly, it can also be expressed as a percentage by simply
multiplying the ratio by 100. As in above example, the ratio is 2 x 100 or
200 or say current assets are 200 oI current liabilities.
2. NATURE OFRATIO ANALYSIS:
Ratio Analysis is a technique oI analysis and interpretation oI Iinancial
statements. It is a process oI establishing and interpreting various ratios Ior
helping in making certain decisions. However, ratio analysis is not an end in
itselI. It is only a means oI better understanding oI Iinancial strengths and
weaknesses oI a Iirm. Calculation oI mere ratios does not serve any
(272)
wide wants to increase its stake in Mudra Communications. It has increased its
stake Irom 3 to 5. Even WPP increased its stake in O&M Irom 40 to 51.
FCB(Foote, cone & Belding) had 40 stake in UlkaAdvertising. This may rise
to 30 in near Iuture but presently it has acquired 51 equity and FCBor UlkaAdver-
tising is nowknown as FCBUlka.
10. CORPORATERESTRUCTURING
Corporate restructuring is a broad term to denote signiIicant reorientation or
realignment oI the assets, investments structure oI any company through conscious
management actions with aviewto drastically alter the quality and quantity oI its Iuture
cash Ilowstreams.
This includes mergers, acquisitions, divestiture,. spin oIIs, and all other internal
management upgradation. Restructuring has gained added importance due to intersiIying
competition, globalisation & technological changes. However a detailed discussion
oI restructuring methods lies beyond the scope oI this lesson.
11. AFEWMERGERSINRECENTPAST
1. Pechiney (French) Alcan (Canadian) and Algroup have merged. The merged
group, called APA` will Iorm the world`s largest aluminium companies.
2. Master card to merge Maestro and Cirrus into a single brand. Master Card
International plans to merge two oI its products, Maestro and Cirrus, into a
single brand. The payments service provider has decided to bring both product
under a single brand since they oIIer similar services.
3 Royal Holdings Services Ltd. (listed on NASDAQ), will acquire 54 stake in
Modi LuIt Ior Rs. 75 crore as a part oI the I.atter`s revival package.
4 . French Oil Company, Total FINA signed a Iriendly merger deal with ElI
Acquintaine, bringing an end to their takeover Iight and creating world`s Iourth
largest oil company.
(269)
5 . Mr. Vijay Mallaya (UB Group) inked a deal to acquire Traditioral beer invest-
ment (a S.A. bear giant subsidiary).
11.1 RecentAcaquisitionandMergersinIndia
March, 1998 : Ciba Geigy and Sandoz merged to Iorm Novartis with a share swap
ration oI 1:17.
May, 1998 : BPLgroup acquired majority holding in Uptron Colour Picture Tubes.
Electric lamp manuIactures (India) has been merged with Phillips India.
Aug., 1998 : VNUthe dutch multinational into multimedia acquired 26 stake in
ORGMARG.
Dec. 1998.: SCICI planned to merge with ICICI.

(270)
RATIO ANALYSIS
AIter reading this lesson, you should understand the Iollowing:
* Meaning & nature oI ratio Analysis.
* Importance and Limitations oI ratio analysis.
* Types oI ratios and their interpretation.
The lesson is divided into the Iollowing sections :
1. Meaning and DeIinition oI a Ratio.
2 . Nature oI Ratio Analysis.
3 . Interpretation oI Ratio.
4. SigniIicance oI Ratio Analysis.
5. Drawbacks oI Ratio Analysis
6. ClassiIication oI Ratios
6.1 Statement Ratios
6.2 Functional ClassiIication
7. Financial position oI a company : Short-term analysis.
7.1 Liquidity Ratios
7.2 EIIiciency Ratios
8. Financial position oI a company: Long-Term analysis
9. ProIitability oI a company
9.1 General ProIitability Ratios
Lesson : 12
(271)
purpose, unless several appropriate ratios are analysed and interpreted. The
Iollowing are the Iour steps involved in the ratio analysis;
(i) Selection oI relevant data Irom the Iinancial statements depending
upon the objective oI the analysis.
(ii) Calculation oI appropriate ratios Irom the above data.
(iii) Comparison oI the calculated ratios with the ratios oI the same
Iirm in the past, or the ratios developed Irom projected Iinancial
statements or the ratios oI some other Iirms or the comparison
with ratios oI industry to which the Iirm belongs.
(iv) Intrepretation oI the ratios.
3. INTERPRETATIONOFRATIOS:
The interpretation oI ratios is an important Iactor. Though calculation
is also important but it is only a clerical task whereas interpretion needs skills,
intelligence and Ioresightedness. The interpretation oI the ratios can be done
in the Iollowing ways :
1. Single Absolute Ratio : Generally speaking one cannot draw
meaningIul conclusions when a single ratio is considered in isolation. But
single ratios may be studied in relation to certain rules oI thumb which are
based upon well proven contentions, as Ior example 2 : 1 is considered to be a
good ratio Ior current assets to current liabilities.
2. Groups of Ratio : Ratios may be interpreted by calculating a
group oI related ratios. A single ratio supported by related additional ratios
becomes more understandable and meaningIul.
(273)
3. Historical Comparisons : One oI the easiest and most popular
ways oI evaluating the perIormance oI the Iirm is to compare its present ratios
with the past ratios called comparison over time.
4. Projected Ratios : Ratios can also be calculated Ior Iuture
standard based upon the projected Iinancial statements. Ratio calculation on
actual Iinancial statements can be used Ior comparison with the standard ratios
to Iind out variance, iI any. Such variance helps in interpreting and taking
corrective action Ior improvement in Iuture.
5. Inter-firm Comparison : Ratios oI one Iirm can also be
compared with the ratios oI some other selected Iirms in the same industry at
the same point oI time.
3.1 Guidelines for Interpretation
Following guidelines or Iactors may be kept in mind while interpreting
various ratios :
1. Accuracy of Financial Statements : The ratios are calculated
Irom the data available in Iinancial statements. The reliability oI ratios is linked
to the accuracy oI inIormation in these statements. Thus, one should see
whether proper concepts and conventions have been used Ior preparing them
and also whether they are properly audited by a competent auditor.
2. Objective or Purpose of Analysis : The type oI ratios to be
calculated will depend upon the purpose Ior which these are required. DiIIerent
objects may require the study oI diIIerent ratios.
4. SIGNIFICANCE OFRATIO ANALYSIS :
Ratio analysis is used as a device to analyse and interpret the Iinancial
(274)
health oI an enterprise. Its use is not conIined to a Iinance manager only.
There are diIIerent parties interested Ior diIIerent purposes. The creditors,
bankers, Iinancial institutions, investors, shareholders and management, all
make use oI ratio analysis as a tool oI evaluating the Iinancial position and
perIormance oI a Iirm Ior granting credits, providing loans or making
investment in the Iirm. Thus, ratios have a wide application and are oI
immense use today.
4.1 Managerial uses :
1. Help in Decision-Making : Financial statements are prepared
primarily Ior decision-making. But inIormation provided in Iinancial
statements is not an end in itselI and no meaningIul decisions Irom these
statements can be taken.
2. Help Financial Forecasting & Planning : Ratio analysis is oI
much help in Iinancial Iorecasting and planning. Planning is looking ahead and
the ratios calculated Ior a number oI years work as guide Ior Iuture.
3. Help In Communication : The Iinancial strength and weakness oI a
Iirm are communicated in a more easy and understandable manner by use oI ratios.
4. Selection of Ratio : It means the ratios should match the purpose
Ior which these are required. Calculation oI large numbers oI ratios without
determining their need in the present context may conIuse the things instead
oI solving them.
5. Use of Standards : The ratios will give an indication oI the
Iinancial position only when discussed with reIerence to certain standards.
These standards may be a rule oI thumb as in case oI current ratio (2 : 1) and
acid-test ratio (1:1) or may be an industry standard.
(275)
6. Calibre of Analyst : The ratios are only the tools oI analysis and
their interpretation will depend upon the calibre and competence oI the analyst.
He should be Iamiliar with various Iinancial statements and the signiIicance oI
changes etc. The utility oI ratios is linked to the expertise oI the analyst.
7. Ratios Provide Only a Base : The ratios are only guidelines Ior
an analyst. He should not base his decisions entirely on them. He should
study any other relevant inIormation, situation in the concern, general economic
environment, etc. beIore reaching Iull conclusions.
8. Helps in Co-Ordination : Ratios even help in co-ordination
which is oI utmost importance in eIIective management oI business. Better
communciation oI eIIiciency and weakness oI an enterprise results in better
co-ordination in an enterprise.
9. Helps in Controlling : Ratio analysis even helps in making
eIIective control oI business. Standard ratios can be based upon perIorma
Iinancial statements and deviations, iI any, can be Iound by comparing the actual
with the standard, so as to take a corrective measure in time.
4.2 Utility to Shareholders/Investors :
An investor in the company will like to assess the Iinancial position oI
the concern beIore investment. His Iirst interest will be the security oI his
investment and then a return in the Iorm oI dividend/interest. He will Ieel
satisIied only iI the concern has large assets. Long term solvency ratios will
also be oI help. ProIitability ratio on the other hand, will be useIul to determine
the proIitability position.
(276)
4.3 Utility to Creditors :
The creditors/suppliers extend short-term credit only iI the Iinancial
position oI the concern warrants their payments. Thus by looking at current &
acid-test ratios, creditors can establish the short-term solvency oI the concern.
4.4 Utility to Employees
The employees are also interested in Iinancial position, especially
proIitability. Their wages increase and amount oI Iringe beneIits are related
to volume oI proIits earned. Various proIitability ratios relating to gross
proIit, operating proIits, net proIits etc. enable employees to know reality.
4.5 Utility to Government:
Government is interested to know the overall strength oI concern. It
may base its Iuture policies on the basis oI industrial inIormation available
Irom various units. The ratios may be used as indicators oI overall Iinancial
strength oI public as well as private sector.
5. DRAWBACKS OFRATIO ANALYSIS:
Though ratios are simple to calculate and easy to understand, they suIIer
Irom some serious limitations :
1. Limited use of Single Ratio : A single ratio, usually, does not
convey much oI a sense. For better interpretation, a number oI ratios have to
be calculated which is likely to conIuse the analyst than help him in making
any meaningIul conclusions.
2. Lack of Adequate Standards : There are no well accepted
standards or a rule oI thumb Ior all ratios which can be accepted as norms. It
renders interpretation oI ratios diIIicult.
(277)
3. I nherent Li mi t at i on of Account i ng : Li ke I i nanci al
statements, ratios also suIIer Irom the inherent weakness oI accounting
records such as t hei r hi st ori cal nat ure. Rat i os oI t he past are not
necessarily indicators oI the Iuture.
4. Change in Accounting Procedure : Change in accounting
procedures by a Iirm oIten makes ratio analysis misleading e.g., a change in
the valuation methods oI inventories, Irom FIFO to LIFO increases the cost oI
sales and reduces the value oI closing stock which makes turnover ratio
lucrative but leads to an unIavorable gross proIit ratio.
5. Window Dressing : Financial statements can easily be window
dressed to present a better picture oI its Iinancial and proIitability position to
outsiders. Hence one has to be careIul while making decision on the basis oI
ratios calculated Irom such window dressing made by a Iirm.
6. Personal Bias : Ratios are only means oI Iinancial analysis and
is not an end in itselI. Ratios have to be interpreted careIully because the
same ratio can be looked at, in diIIerent ways.
7. Uncomparable : Not only industries diIIer in their nature but
also the Iirms oI the similar business widely diIIer in their size and accounting
procedures. It makes comparisons oI ratios diIIicult and misleading.
8. Absolute Figures Distortive : Ratios devoid oI absolute Iigures
may prove distortive as ratio analysis is primarily a quantitative analysis and
not a qualitatative analysis.
9. Pri ce Level Changes : Whi l e maki ng rat i o anal ysi s, no
consideration is made to the changes in price levels and this makes the
interpretation oI ratios invalid.
(278)
10. Ratios No Substitutes : Ratio analysis is merely a tool oI
Iinancial statements. Hence, ratios become useless iI separated Irom the
statements Irom which they are computed.
6. CLASSIFICATIONOFRATIOS :
Various accounting ratios can be classiIied as Iollows :
RATIOS
(A) (B) (C)
Traditional ClassiIication Functional ClassiIication SigniIicance Ratio
or or or
Statement Ratios ClassiIication According Ratios According
To Test To Importance
(A) Statement Ratios
Balance Sheet Revenue/Income Composite/Mixed
Statement Ratio Statement Ratio Statement Ratios
6.1 Statement Ratios:
1. Balance Sheet Statement Ratio :
Balance sheet ratios deal with the relationship between two balance sheet
times e.g., the ratio oI current assets to current liabilities, or the ratio oI proprietor`s
Iunds to Iixed assets. Both items must belong to same balance sheet.
2. Profit and loss account or revenue/income ratio :
These ratios deal with the relationship between two proIit and loss
(279)
account items e.g. the ratio oI gross proIit to sales, or the ratio oI net proIit to
sales. Both the items must, however, belong to the same proIit and loss
account. The various proIit and loss account ratios, commonly, used are named
in the Iollowing chart.
3. Composite/mixed ratios or inter statement ratio :
These ratios exhibit the relation between a proIit and loss account or income
statement item and a balance sheet item, e.g.. stock turnover ratio, total assets to sales
etc. The most commonly used inter-statement ratios are given as under:
Table 1
Statement Ratios
Balance Sheet ProIit & Loss Account Composite Ratios
Current & liquid ratio Gross ProIit ratio Stock Turnover Ratio
Absolute Liquidity-Ratio Operating Ratio DebtorsTurnover Ratio &
Return on Equity
Debt Equtiy Ratio Operating ProIit Ratio Payable turnover Ratio
Proprietory Ratio Net ProIit Ratio Fixed Assets Turnover
Capital Gearing Ratio Expense Ratio Return on Capital
Assets-Proprietory Ratio Interest Coverage Ratio Capital Turnover Ratio
The Iollowing Iigure gives the Iunctional classiIication oI ratio :
Fig.1
6.2 Functional Classification of Ratios
Liquidity Ratios Activity Ratios Levarage Ratios
current ratio Inventory turnover ratio Capital Gearing Ratio
(280)
Quick/Acid Ratio Debtor turnover ratio Debt. Equity
Absolute Liquid Ratio Working capital Creditors Turnover ratio
Turnover Ratio. Total investment to long term
liabilities, Fixed assets to
Iunded Debt ratio, current
liabilities to proprietor`s
Iunds Ratio, reserves to
equity capital ratio.
Solvency Ratios Profitability Ratios
Debt equity ratio Funded-debt General gross proIit Overall net worth ratio,
to total capitalisation ratio, ratio, operating ratio, Return on equity capital
proprietory ratio, Operating proIit ratio, earning per share, Return on
Solvency ratio, proprietor`s Expenses ratio, Net Capital employed, capital
Iund ratio, Fixed assets ratio proIit ratio. turnover ratio, Dividend
Current assets to Proprietor`s yield ratio, Earning
Iund ratio, Debt-service ratio. yield ratio.
7. FINANCIALPOSITIONOFACOMPANY: SHORTTERMANALYSIS:
The short-term creditors oI a company like suppliers oI goods on credit
and commercial banks providing short-term loans are primarily interested in
knowing the company`s ability to meet its current or short-term obligations as
and when these become due. Even a very high degree oI liquidity is not good
Ior a Iirm because such a situation represents unnecessarily excessive Iunds
oI the Iirm being tied up in current assets. ThereIore, it is very important to
have proper balance in regard to the liquidity oI the Iirm. Two types oI ratios
can be calculated Ior measuring short-term Iinancial position or short-term
solvency oI a Iirm.
(281)
(A) Liquidity Ratios
(B) Current Assets Movement or eIIiciency ratios.
Liquidity Ratios :
Liquidity reIers to the ability oI a concern to meet its current obligations
as and when they become due. II current liabilities are not easily met out oI
current assets then liquidity position will be bad. The bankers, suppliers oI
goods and other short-term creditors are interested in liquidity oI the concern.
So to measure the liquidity oI a Iirm, the Iollowing ratios can be calculated :
(i) Current Ratio; (ii) Quick/acid test or liquid ratio; and (iii) absolute
Liquid Ratio
Current Ratio
Current ratio may be deIined as the relationship between current assets
and current liabilities. This ratio, also known as working capital Ratio is a
measure oI general liquidity and is most widely used to make the analysis oI
short-term Iinancial position or liquidity oI a Iirm.
It is calculated by dividing the total oI current assets by total oI the
current liabilities.
Thus,
Current Ratio
Current Assets

Current liabilities
Or, Current Assets : Current liabilities
The two basic components oI this ratio, current assets and current
liabilities, include items listed below.
(282)
Table-2
Components of Current Ratio
Current Assets Current Liabilities
Cash-in-hand, cash-at-bank, O/s Expenses, B/P, Sundry Creditors,
Marketable Securities, Short Term Short-term Advances, Income-Tax
Investments, B/R, Sundry Debtors payable, Dividends Payable & Bank
Invertories, Work-in-Progress & OverdraIt.
Prepaid Expenses.
Significance and Limitations
Current ratio is a general & quick measure oI liquidity oI a Iirm. It
represents the margin oI saIety`, or cushion` available to the creditors and
other current liabilities. But it suIIers Irom the Iollowing limitations:
(a) Crude Ratio :
It is a crude ratio because it measures only the quantity and not
the quality oI current assets.
(b) Window Dressing :
Current assets and liabilities are manipulated in such a way that
current ratio loses its signiIicance. Window dressing may be indulged in the
Iollowing ways :
(I) Over-valuation oI closing stock
(ii) Obsolete or worthless stock are shown in the closing inventory at
their costs instead oI writing them oII.
(iii) Recording in advance, cash receipts applicable to next year `s sales.
(iv) Omission oI a liability Ior merchandise included in inventory.
(283)
(v) Treating a short term obligation as long term liability.
(vi) Inadequate provision Ior bad and doubtIul debts.
(vii) Inclusion in debtors oI advance payment Ior purchase oI Iixed assets.
Quick or Acid Test or Liquid Ratio
Liquid Ratio is more rigorous test oI liquidity than the current ratio. It
may be deIined as the relationship between quick/liquid assets and current
liabilities. It can be calculated by dividing the total oI the quick assets by total
oI current liabilities. Thus,
Quick/Liquid or Acid Test Ratio
Quick or liquid Assets

Current liabilities
Quick assets can also be calculated as :
Current Assets - (InventoriesPrepaid Expenses)
The two basic components oI this ratio, quick assets and current
liabilities, includes items which are as Iollows :
Table -3
Components of Quick Ratio
Quick/Liquid Assets Current Liabilities
Cash-in-hand Outstanding/Accrued Expenses
Cash-at-Bank Bills payable
Bills Receivable Sundry Creditors
Sundry Debtors Short-term Advances
Marketable Securities Income-tax Payable
Temporary Investment Dividends Payable
Bank OverdraIt
(284)
Absolute liquid Ratio Creditors Turnover Ratio
Working Capital Turnover Ratio
Inventory Turnover or Stock Turnover Ratio :Inventory ratio, also known as
stock velocity, is normally calculated as sales/average inventory or cost oI
goods sold/average inventory. It would indicate whether the inventory is
eIIiciently used or not. Inventory Turnover Ratio (I.T.R.) indicates the number
oI times the stock has been turned over during the period and evaluates the
eIIiciency with which a Iirm is able to manage its inventory.
The ratio is calculated by dividing the cost oI goods sold by the amount
oI average inventory at cost.
Inventory Turnover Ratio
Cost oI goods sold

Average inventory at cost
Generally, the cost oI goods sold may not be known Irom the published
Iinancial statements. In such circumstances, the inventory turnover ratio may
be calculated in any oI the Iollowing manner depending upon the availability
oI inIormation.
Inventory Turnover Ratio
Net Sales

Average inventory at cost
Inventory Turnover Rate
Net Sales

Average inventory at selling price
Inventory
Turnover Rate
Net Sales

Inventory
Interpretation
It measures the velocity oI conversion oI stock into sales. Usually, a
high inventory turnover/stock velocity indicates eIIicient management oI
inventory and vice-versa. Alowinventory turnover ratio indicates an ineIIicient
(288)
Interpretation of quick Ratio : Usually, a high quick ratio is an
indication that the Iirm is liquid and has the ability to meet its current or liquid
liabilities in time and on the other hand a low quick ratio represents that the
Iirm`s liquidity position is not good. As a rule oI thumb, or as a convention,
quick ratio oI 1 : 1 is considered satisIactory.
Significance of Quick Ratio : The quick ratio is very useIul in measuring
the liquidity position oI a Iirm. It measures the Iirm`s capacity to pay oII
current obligations immediately and is a more rigorous test oI liquidity than
liquid current ratio.
ABSOLUTE LIQUID RATIO: Although receivables, debtors and bills
receivable are generally more liquid than inventories yet there may be doubts
oI realisation into cash immediately. Hence some authorities think that the
absolute liquid ratio should be calculated so as to exclude even receivables
Irom the current assets and Iind out the absolute liquid assets.
Absolute Liquid Assets Cash-in-handBankmarketable Securities
Absolute Liquid Ratio
Absolute liquid Assets

Current liabilities
PROBLEMEXERCISE 1:
The Iollowing is the Balance sheet oI NewIndia Ltd. Ior the year ending Dec. 31,
Liabilities Rs. Assets Rs.
9 PreIerence share capital 5,000,00 Goodwill 1,00,000
Equity share capital 10,00,000 Land Building 6,50,000
8 Debentures 2,00,000 Plant 8,00,000
Long-term loan 1,00,000 Furniture & Iixtures 1,50,000
(285)
Bills payable 60,000 Bills recievables 70,000
Sundry creditors 70,000 Sundry Debtors 90,000
Bank overdraIt 30,000 Bank Balance 45,000
Outstanding expenses 5,000 Short-term investment 25,000
Prepaid expenses 5,000
Stock expenses 5,000
Stock 30,000
19,65,000 19,65,000
From the balance sheet calculate
(a) Current Ratio (b) Acid Test Ratio
(c) Absolute liquid Ratio
Solution :
(a) Current Ratio
Current Assets

Current liabilities
Current Assets Rs. (70,000 90,000 45,000) (25,000 5,000 30,000)
Rs. 2,65,000
Current liabilities Rs. (60,00070,00030,0005,000)
Rs. 1,65,000
Current Ratio
2,65,000
1.61
1,65,000
(b) Acid-Test Ratio
Liquid Assets

Current liabilities
Liquid Assets Rs. (70,00090,00045,00025,000) Rs. 2,30,000
(286)
Stock and prepaid expenses have been excluded Irom current assets in
order to arrive at liquid assets.
Current liabilities Rs. 1,65,000
Acid-Test Ratio
Rs. 2,30,000
1.39
Rs. 1,65,000
(c) Absolute Liquid Ratio
Absolute liquid Assets

Current liabilities
Absolute liquid Assets Rs. (45,000 25,000) 70,000
Absolute liquid Ratio
70,000
0.42

1,65,000
Current Assets Movement or Efficiency Ratios:
Funds are invested in various assets in the business to make sales and
earn proIits. The eIIiciency with which assets are managed directly aIIects
the volume oI sales. The better the management oI assets, the larger is the
amount oI sales and the proIits. Activity ratios measure the eIIiciency or
eIIectiveness with which a Iirm manages its resources or assets. These ratios
are also called turnover-ratios because they indicate the speed with which assets
are converted or turned over into sales.
Table-4
Analysis of Short-Term Financial Position
Liquidity Ratios Efficiency Ratios
Current Ratio Inventory/Stock Turnover Ratio
Quick/Acid Test Ratio Debtors Turnover Ratio
(287)
management over-investment in inventories, dull business, poor quality oI
goods, stock accumulation, accumulation oI obsolete and slow moving goods
and low proIits as compared to total investment.
Debtors or Receivable Turnover Ratio :
The volume oI sales can be increased by Iollowing a liberal credit policy.
But the eIIect oI a liberal credit policy, may result in tying up substantial Iunds
oI a Iirm in the Iorm oI trade debtors. Hence, the liquidity oI a concern to pay
its short term obligations in time depends upon the quality oI its trade debtors.
Two kinds oI ratios can be computed to evaluate the quality oI debtors.
(a) Debtors Turnover or Debtor. Velocity : It indicates the velocity oI
debt collection oI Iirm. In simple words, it indicates the number oI times
average debtors (Receivables) are turned over during the year. Thus
Debtors (Receivable) Turnover Ratio
Net Credit Annual Sales

Average Trade Debtors
Here,
Trade Debtors Sundry Debtors B/R and A/c Receivable;
and Average Trade Debtors
Op. Trade Debtos Cl. Trade Debtors
2
This ratio can also be calculated as
Debtors Turnover Ratio
Total Sales

Debtors
Interpretation : Generally, the higher the value oI debtors turnover, the
more eIIicient is the management oI debtors/sales or more liquid are the
debtors and vice-versa. But, a very high debtors turnover ratio is not good
(289)
because a very high ratio may imply a Iirm`s inability due to lack oI
resources to sell on credit thereby losing sales and proIits. There is no
'rule oI thumb which may be used as a norm as it diIIers Iirm to Iirm,
depending upon the nature oI business.
(b) Average Collection Period : It represents the average number oI days
Ior which a Iirm has to wait beIore its receivables are converted into cash.
This ratio can be calculated as :
Average collection period Average Trade Debtors (Drs B/R)
Sales per Day
Sales per Day
Net Sales

No. oI working Days
Interpretation of Average Collection Period Ratio : This ratio
represents the average number oI days Ior which a Iirm has to wait beIore its
receivables are converted into cash. Generally, the shorter the period the better
is the quality oI debtors and vice-versa. But interpreting a very short collection
period needs precaution because it may imply a Iirm`s conservatism to sell on
credit or its inabilty to allow credit to its customers and thereby losing sales
and proIts. There is no `rule oI thumb` as `standard` which may be used as a
norm. It depends upon a Iirm`s credit policy, nature oI business and business
conditions. The Iigure oI trade debtors should be taken beIore deducting bad
and doubtIul debts or provision Ior bad debts and doubtIul debts.
Creditors/payables Turnover Ratio : Asupplier oI goods i.e. creditor,
is naturally interested in Iinding out how much time the Iirm is likely to take
in paying its trade creditors. The analysis Ior creditors turnover is basically
the same as oI `debtors turnover ratio except that in place oI trade debtors, the
(290)
trade creditors are taken as one oI the components oI ratio and in place oI
daily sales, daily purchases are taken. Thus it is calculated as
(a) Creditors/Payable Turnover Ratio
Net Credit Annual Purchases

Average Trade Creditors
II inIormation about credit purchases is not available, it can be
calcuatated as Iollows
Creditors Turnover Ratio
Total Purchases

Trade Creditors
(b) Average Payment period
Average Trade Creditors (Crs. B/P)

Average Daily Purchases
or Average Payment period
Annual Purchases

No. oI Working Days in a year
or Average Payment period.
Trade Creditors x No. oI Working Days

Net Annual Purchases
or Average Payment period
No. oI Working Days

Creditors Turnover Ratio
Interpretation : Generally, lower the ratio, the better is the liquidity position
oI a Iirm and vice-versa. Ahigher payment period also implies greater credit period
enjoyed by the Iirm and consequently larger the beneIit reaped Irom credit suppliers.
But one has to be careIul, as a higher ratio may also imply lesser discount Iacilities
or higher price paid Ior goods purchased on credit.
Working Capital Turnover Ratio :Working Capital oI a concern is
directly related to sales. The current assets like debtors, bills receivables,
cash, stock, etc. change with the increase or decrease in sales, the working
capital in taken as :
(291)
Working Capital Current Assets - Current Liabilities
Working Capital Turnover Ratio indicates the velocity oI the utilization
oI net working capital. This ratio indicates the number oI times the working
capital is turned over in course oI a year. This ratio measures the eIIiciency
with which the working capital is used. Alow ratio indicates low eIIiciency &
vice-versa. But a very high working capital turnover ratio is not a good situation
Ior any Irm and hence care must be taken while interpreting the ratio.
This ratio can be calcualated as :
Working Capital Turnover Ratio
Cost oI sales

Average Working Capital
or Working Capital Turnover Ratio
Costs oI Sales

Net Working Capital
Problem Exercise: The Iollowing inIormation is given about M/ s S.P.
Ltd. Ior the year ending Dec. 31, 1995;
(i) Stock turnover ratio 6 times
(ii) Gross ProIit Ratio 20 on sales
(iii) Sales Ior 1995 Rs. 3,00,000
(iv) Closing stock is Rs. 10,000 more than the opening stock
(v) Opening Creditors Rs. 20,000
(vi) Closing Creditors Rs. 30,000
(vii) Trade debtors at the end Rs. 60,000
(viii) Net working capital - Rs. 50,000
(292)
Find out :
(a) Average stock; (b) Purchases;
(c) Creditors turnover ratio; (d) Average payment period;
(e) Average collection period (I) Working capital turnover ratio
Solution :
Cost oI goods, sold Sales - Gross ProIit
3,00,000 - (20 oI sales)
3,00,000 - 60,000
Rs. 2,40,000
(a) Average Stock
Stock Turnover ratio
Costs oI Goods sold

Average stock
6
2,40,000
Average stock
or, Average Stock
2,40,000
Rs. 40,000

6
(b) Cost oI goods sold Opening stock Purchases - Closing Stock
or, Cost oI goods sold - Opening Stock Closing Stock
Average share
Opening Stock Closing Stock

2
Since, Closing stock is Rs. 10,000 more than opening stock or,
Rs. 40,000
Opening Stock (Rs. 10,000 Opening Stock)

2
Rs. 80,000 2 Opening Stock Rs. 10,000
(293)
words used in this ratio-are (i) Funded Debt & (ii) Total Capitalisation.
Funded Debt DebenturesMortage LoansBondsOther longterm loans.
Total capitalisationEquity share capital PreIerence share Capital
Reserves and Surplus Other Undistributed Reserves Debenturs
Mortgage loans Bonds Other Long term loans.
Funded debt is that part oI total capitalisation which is Iinanced by outsiders.
Funded debt to total capitalisation Ratio
Funded Debt
x100

Total capitalisation
Though there is no `thumb rule but still the lesser the reliance on
outsiders the better it will. be. II this ratio is smaller, better it will be.
Upto 50 or 55, this ratio may be to tolerable but not beyond.
8.3 Proprietary Ratio Or Equity Ratio
Avariant to the debt-equity ratio is the proprietary ratio which is also
known as equity ratio or shareholder `s to total equities ratio or net worth
to total assets ratio. This ratio establishes the relationship between
shareholder `s Iunds to total assets oI the Iirm. This ratio can be
calculated as under :
Proprietary Ratio/Equity Ratio
Shareholder`s Iunds

Total Assets
Intrepretation
As equity ratio represents the relationship oI owner `s Iunds to total
assets, higher the ratio or the share oI the shareholder `s in the total
capital oI the company, better is the long-term solvency, position oI the
(296)
Opening Stock
70,000
35,000

2
Closing Stock 35,000 10,000 Rs. 45,000
Purchases Rs. 2,40,000 + Rs. 45,000 - Rs. 35,000 Rs. 2,50,000
(c) Creditors turnover ratio
Net annual credit purchase

Average Trade creditors
All purchases are taken as credit purchases.
Creditors Turnover Ratio
Rs. 2,50,000 Rs. 2,50,000 10

(20,00030,000)/2 25,000
(d) Avg. Payment period
Avg. Trade Creditors x No. oI Working days

Net Annual Purchases

25,000 x 365
36.5 37 days

2,50,000
(e) Average Collection Period
Average Trade Debtors x No. oI working Days

Net Annual Sales

60,000 x 365
73 days

3,00,000
(I) Working Capital Turnover Ratio
Cost oI Goods sold

Net working Capital
Rs. 2,40,000 4.8 times

Rs. 50,000
8. FINANCIALPOSITIONOFACOMPANY: LONG TERM ANALYSIS:
The term`solvency` reIers to the ability oI a concern to meet its long
term obligations. The long term creditors oI a Iirm are primarily
interested in knowing the Iirm`s ability to pay regular interest on long-
(294)
term borrowings, repayments oI the principal amount at the maturity and
the security oI their loans. Accordingly, long-term solvency ratios
indicate a Iirm`s ability to meet the Iixed interest costs and repayment
schedules associated with its long-term borrowings.
8.1 Debt-Equity Ratio : It is also known as External-Internal Equity ratio.
It is calculated to measure the relative claims oI outsiders and the owners
(i.e. shareholders) against the Iirm`s assets. This ratio indicates the
relationship between the external equities or the outsiders Iunds and
the internal equities or the shareholders` Iunds. Thus :
Debt-Equity Ratio
Outsider Funds
Shareholders Funds
or Debt to Equity Ratio
External Equities

Internal Equities
Interpretation : The debt-equity ratio is calculated to measure the extent
to which debt Iinancing has been used in business. The ratio indicates the
proportionate claims oI owners and the outsiders against the Iirm`s assets. The
purpose is to get an idea oI the cushion available to outsiders on the liquidation
oI the Iirm. As a general rule, there should be an appropriate mix oI owner `s
Iunds and outsider `s Iunds in Iinancing the Iirm`s assets. However the owner
wants to do business with maximum oI outsider `s Iund in order to take lesser
risk oI his investment and to increase his earnings (per share)by paying a lower
Iixed rate oI interest to outsiders. Thus, interpretation oI ratios depends upon
the purpose oI analysis, Iinancial policy and the nature cI business oI the Iirn.
8.2 Funded Debt to Total Capitalisation Ratio
This ratio establishes a link between the long-term Iunds raised Irom
outsiders and total long-term Iunds available in the business. The two
(295)
company. This ratio indicates the extent to which the assets oI the company can
be lost without aIIecting the interest oI the creditors oI the company.
8.4 Solvency Ratio
This ratio is a small variant oI equity ratio and can be simply calculated
as 100-equity ratio i.e. the ratio indicates the relationship between the
total liabilities to outsiders to total assets oI a Iirm and can be calculated
as Iollows
Solvency Ratio
Total liabilities to outsiders

Total Assets
Interpretation
Generally, lower the rate oI total liabilities to total assets, more
satisIactory or stable is the long-term solvency position oI a Iirm.
8.5 Ratio of Fixed Assets to Proprietor`s Funds
The ratio establishes the relationship between Iixed assets and
shareholder `s Iunds i.e. share capital.plus reserves, surpluses and retained
earnings. The ratio can be calculated as Iollows
Fixed Assets to Net Worth Ratio
Fixed Assets (AIter Depreciation)

Shareholder `s Funds
Interpretation
The ratio oI Iixed assets to net worth indicates the extent to which
shareholder `s Iunds are sunk into the Iixed assets. Generally, the
purchase oI Iixed assets should be Iinanced by shareholder `s equity
including reserves, surpluses and retained earnings. II the ratio is less
than 100, it implies that owner `s Iunds are more than total Iixed
(297)
assets and a part oI the working capital is provided by the shareholders.
There is no rule oI thumb` to interpret this ratio but 60 to 65 per cent is
considered to be a satisIactory ratio in case iI industrial undertakings.
8.6 Fixed Assets Ratio
A variant to the ratio oI Iixed assets to net worth is the ratio oI Iixed
assets to total long-term Iunds which is calculated as :
Fixed Assets Ratio
Fixed Assets (AIter depreciation)

Total long-term Iunds
Interpretation
The ratio indicates the extent to which the total oI Iixed assets are
Iinanced by long-term Iunds oI the Iirm. Generally, the total oI the Iixed
assets should be equal to total oI the long-term Iunds or say the ratio
should be 100. And iI total long-term Iunds are more than total Iixed
assets, it means that part oI working capital requirement is met out.
8.7 Ratio of Current Assets to Proprietary`s Funds
The ratio is calculated by dividing the total oI current assets by the amount
oI shareholder `s Iunds. For example, iI current assets are Rs. 2,00,000
and shareholder `s Funds are Rs. 4,00,000, the ratio oI current assets to
proprietors Iunds in terms oI percentage would be

Current Assets
x 100

Shareholders Funds
2,00,000 x 100 50 4,00,000
Interpretation
The ratio indicates the extent to which proprietors Iunds are invested
in current assets. There is no rule oI thumb` Ior this ratio and
(298)
depending upon the nature oI the business there may be diIIerent ratios
Ior diIIerent Iirms.
8.8 Debt-Service Ratio
Net income to debt service ratio or simply debt service ratio is used to
test the debt-servicing capacity oI a Iirm. The ratio is also known as
interest coverage ratio or coverage ratio or Iixed charges cover or times
interest earned. This ratio is calculated by dividing the net proIit beIore
interest and taxes by Iixed interest charges.
Debt Service or Interest Coverage Ratio Net ProIit (beIore interest and taxes)

Fixed Interest Charges
Interpretation
Interest coverage ratio indicates the number oI times interest is covered
by the proIits available to pay the interest charges. Longterm creditors
oI a Iirm are interested in knowing the Iirm`s ability to pay interest on
their long-term borrowings. Generally, higher the ratio, more saIe are
long term creditors because even iI earnings oI the Iirm Iall, the Iirm
shall be able to meet its commitment oI Iixed interest changes. But a
too high interest coverage ratio may not be good Ior the Iirm because it
may imply that Iirm is not using debt as a source oI Iinance so as to
increase the earnings per share.
9. PROFITABILITYOFACOMPANY
A business enterprise can discharge its obligations to the various
segments oI the society only through earning proIits. ProIits are, thus,
a useIul measure oI overall eIIiciency oI a business. ProIits, to the
(299)
management, are the test oI eIIiciency and a measure oI control, to
owners, a measure oI worth oI their investment; to the creditors, the
margins oI saIety; to employees, a source oI Iringe beneIits; to
government, a measure oI tax-paying capacity and the basis oI legislative
action; to customers, a hint to demand Ior better quality and price cuts
to an enterprise, less cumbersome Iinance Ior growth and existence to
the country. Generally, the various proIitability ratio are :
Table 5
Profitability Ratios
General Profitability Ratios Overall Profitability Ratios
Gross ProIit Ratio Return on Shareholder`s Investment
Operating Ratio Return on Equity Capital
Operating ProIit Ratio Earning Per Share
Expense Ratio Return on Capital Employed
Net ProIit Ratio Capital Turnover Ratio
Dividend Yield Ratio
Earning Yield Ratio
9.1 General Profitability Ratios
GrossProfit Ratio : Gross proIit ratio measures the relationship oI
gross proIit to net sales and is usually represented as a percentage. Thus,
it is calculated by dividing the gross proIit by sales.
Gross proIit Ratio
Gross proIit
x 100

Net Sales

Sales-cost oI goods sold

x 100
Sales
(300)
Interpretation
The gross proIit ratio indicates the extent to which selling prices oI
goods per unit may decline without resulting in losses on operations oI
a Iirm. It reIlects the eIIiciency with which a Iirm produces it products,
as the gross proIit is Iound by deducting cost oI goods sold Irom the net
sales. Highest the gross proIit ratio (GP Ratio) better the result.
Operating Ratio
Operating ratio establishes the relationship between cost oI goods sold
and other operating expenses on the one hand and the sales on the other.
The ratio is calculated by dividing operating cash with net sales and it is
generally represented as a percentage.
Gross proIit Ratio
Operating Cost
x 100

Net Sales

Cost oI goods sold Operating exp. x 100

Sales
Interpretation
Operating ratio indicates the percentage oI net sales that is consumed
by operating cost. Obviously higher the operating ratio, the less
Iavourable it is, because, it would have a small margin (Operating proIit)
to cover interest income-tax dividend and reserves. There is no rule oI
thumb` Ior this ratio as it may diIIer Irom Iirm. to Iirm depending upon
the nature oI its business and its capital structure.
Operating Profit Ratio
This, ratio is calculated by dividing operating proIit by sales. Operating proIits
are calculated as :
(301)
To Administrative Exp. 20,000 By Gross proIit b/c 2,01,000
To selling & distribution exp. 89,000 To interest on inv. 10,000
To non-operating exp. 30,000 To proIit on sale oI investment 8,000
To net proIit 80,000
2,19,000 2,19,000
You are required to calculate
1. Gross proIit Ratio. 2. Net ProIit Ratio
3. Operating Ratio 4. Operating ProIit Ratio &
5. Administrative expenses Ratio
Solution
1. Gross ProIit Ratio
Gross ProIit x 100
Net sales

2,01,000 x 100
35.9

5,60,000
2. Net ProIit Ratio
Net ProIit (aIter tax) x 100

Net sales

80,000 x 100
14.3

5,60,000
3. Operating Ratio
Cost oI goods sold Operating exp.

Net Sales
Cost oI goods sol d Op. st ock pur chase wages- cl osi ng st ock
1,00,0003,50,0009,000-1,00,000 Rs. 3,59,000
Operating exp. Adm. Selling & Distribution expenses
(304)
Operating ProIit Net sales - Operating Cost
or Net Sales (Cost oI goods sales Adm. & oIIice exp. Selling and
distributive expenses.
Also, Operating ProIit Net ProIit Non Operating expenses-Non Operating incomes.
So, Operating proIit Ratio
Operating ProIit x 100

Sales
Also,
Operating ProIit Ratio 100 - Operating Ratio
Expenses Ratio
Expenses ratio indicates the relationship oI various expenses to net sales. The
operating ratio reveals the average total variations in expenses. The lower the
ratio, the greater is the proIitability and higher the ratio, lower is the
proIitability. While, interpreting the ratio, it must be taken care that Ior a
Iixed expense like rent, the ratio will. Iall iI the sales increases and Ior a variable
expense, the ratio in proportion to sales shall remain nearly the same.
Particular expense Ratio
Particular expense x 100

Net sales
It can also be calculated as
cost oI goods sold ratio
Cost oI goods sold x 100

Sales
Non-Operating expense Ratio
Non-Operating Expenses x 100

Sales
Net Profit Ratio
Net proIit ratio establishes a relationship between net proIit (aIter taxes) and
sales, and indicates the eIIiciency oI the management in manuIacturing, selling
(302)
administrative and other activities oI the Iirm. This ratio is the overall measure
oI Iirm`s proIitability and is calculated as
(i) Net ProIit Ratio Net ProIit aIter T ax x 100
Net Sales
(ii) Net ProIit Ratio
Net Operating proIit x 100

Net Sales
Interpretation
The ratio is very useIul because iI the proIit is not suIIicient, the Iirm
shall not be able to achieve satisIactory return on its investment. This
ratio also indicates the Iirm`s capacity to Iace adverse economic
conditions such as price competition, low demand, etc.
Obviously, higher-the ratio, the better is the proIitability. But while
interpretaring the ratio, it should be kept in mind that the perIormance
oI proIits must also be seen in relation to investment on capital oI the
Iirm and not only in relation to sales.
Problem Exercise
Following is the proIit and loss account oI Electro matrix Ltd. Ior the
year ended 31 st Dec., 1995
Dr. Rs. Rs.
To Opening Stock 1,00,000 By Sales 5,60,000
To Purchases 3,50,000 By Closing Stock 1,00,000
Wages 9,000
To Gross ProIit c/d 2,01000
6,60,000 6,60,000
(303)
Rs. 20,000 89,000
Rs. 1,09,000
Operating Ratio
3,59,000 1,09,000 x 100

5,60,000

4,68,000 x 100
83.65

5,60,000
4. Operating ProIit Ratio I00-Operating Ratio 100-83.6 16.4
5. Administrative exp. Ratio
Administrative expenses x 100

Net Sales

20,000 x 100
3.6

5,60,000
9.2 Overall Profitability Ratios
Return On Investment Ratio
Return on shareholder investment, popularly known as ROI or Return on
shareholder Iunds is the relationship between net proIits and proprietors Iunds.
Thus,
Return on investment
Net ProIit (aIter tax & interest)

Shareholders Iunds
Interpretation
This is the most important ratio used Ior measuring the overall eIIiciency
oI a Iirm as the primary objective oI the business is to maximise its
earnings. This ratio indicates the extent to which this primary objective
oI business is being achieved. As this ratio reveals how well the
resources oI a Iirm are being used, higher the ratio, better are the results.
(305)
Return On Equity Capital
The rate oI dividend varies with the availability oI proIits in case oI
ordinary shares only. Thus, ordinary shareholders are more interested
in the proIitability oI a company and the perIormance oI a company
should be judged on the basis oI return on equity capital oI the company.
Return on equity capital which is the relationship between proIits oI a
company and its equity capital, can be calculated as
Return on Equity Capital
Net ProIit aIter Tax - PreIerence Div

Pais up equity share capital
Earning Per Share (E.P.S.)
Earning per share is a small variation oI return on equity capital and is
calculated by dividing the net proIit aIter taxes and preIerence dividend
by the total number oI equity shares. Thus,
E.P.S.
Net ProIit (aIter tax) - preIerence dividend

No. oI equity shares
The earning per share is good measure oI proIitability and when compared
with E.P.S. oI similar companies, it gives a viewoI the comparative earnings
or earnings power oI a Iirm. E.P.S., calculated Ior a number oI years indicates
whether or not earnings power oI the company has increased.
Return on Capital Employed
Return on capital employed establishes the relationship between proIits
and the capital employed.
It can be calculated as
Return or Gross Capital Employed
Adjusted Net ProIits x 100

Gross Capital Employed
(306)
Return on Net Capital Emp.
Adjusted Net ProIits x 100

Net Capital Employed
The terms `capital employed` reIers to the total oI investment made in a
business and can be deIined in a number oI ways. The three most widely
used oI deIinitions oI this term are :
(a) Gross capital employed
(b) Net capital employed
(c) Proprietors net capital employed.
(a) Gross Capital Employed : The terms Gross Capital Employed`.
usually comprises oI Iixed assets as well as current assets used in
business Numerically, Gross capital employed Fixed Assets Current
Assets.
(b) Net Capital Employed : The term `net capital employed`
comprises oI the total assets used in a business, less its current
liabilities. Numerically,
Net capital employed Total Assets - Current liabilities.
(c) Proprietor`s Net Capital Employed : Proprietor `s net capital
employed means shareholders Iunds or investment in the business. This
term is the same as return on shareholders investment and it has been
discussed in detail in previous pages. Numerically, Proprietors net
capital employed Fixed Assets Current Assets - Outside liabilities.
Significance of Return on Capital Employed
The return on capital employed is the prime ratio which measures the
eIIiciency oI the business. It is signiIicant due to the Iollowing reasons:
(307)
1 . It is a prime test oI the eIIiciency oI business.
2. The perIormance oI the enterprise can be assessed by making inter Iirm
and. intra-Iirms comparisons.
3. By this ratio, outsiders like bankers, creditors etc. Iind the concern`s
viability Ior giving credit or extending loans.
4. Return on capital employed may help in devising Iuture business policies
Ior expansion or diversiIication, etc.
5 . It helps in providing Iair remuneration to various Iactors oI production.
Capital Turnover Ratio
Capital turnover ratio is the relationship between cost oI goods sold
and the capital employed. It can be calculated as
Capital Turnover Ratio
Cost oI Goods Sold

Capital Employed
Since capital employed in a business consists oI investment in
(i) Iixed assets and (ii) working capital, Capital turnover ratio can be
classiIied as
(a) Fixed Assets Turnover and
(b) Working capital turnover
Fixed Assets Turnover is the relationship between sales or cost oI goods
sold and Iixed capital assets employed in a business. Working capital
turnover ratio indicates the velocity oI the utilisation oI net working
capital.
Fixed Assets Turnover Ratio
Cost oI Goods sold

Fixed capital employed
(308)
Working Capital Turnover Ratio
Cost oI Goods Sold

(Avg.) working capital
Dividend Yield Ratio
Shareholders are the real owners oI a company and they are interested
in real sense in the earnings distributed and paid to them as dividends.
ThereIore, dividend yield ratio is calculated to evaluate the relationship
between dividend per share paid and the market value oI the share.
Dividend yield Ratio
Dividend per share

Market value per share
Earnings Yield Ratio
Price earning ratio is the ratio between market price per equity share
and earnings per share. The ratio is calculated to make an estimate oI
appreciation in the value oI a share oI a company and is widely used by
investors to decide whether or not to buy shares in a particular company.
This ratio is calculated as :
Price Earning Ratio
Market Price Per Equity share

Earnings Per Share
Generally, higher the price-earnings ratio, the better it is. II the P/E
ratio Ialls, the management should look into causes that may have
resulted into the Iall oI this ratio.
Problent Exercies 4
The capital oI Star Co. Ltd. is as Iollows :
Rs.
80,000 Equity shares oI Rs. 10 each 8,00,000
9 30,000 preIerence shares oI Rs. 10 each 3,00,000
11,00,000
(309)
The Iollowing inIormation has been obtained Irom the books oI the
company:
ProIit aIter tax at 60 Rs. 2,70,000
Depreciation Rs. 60,000
Equity Dividend Paid 20
Market Price oI Equity Shares Rs. 40
You are required to calculate :
(a) Dividend yield on equity, share
(b) Cover Ior preIerence dividend
(c) Cover Ior equity dividend
(d) Earnings Per share
(e) The Price-Earnings Ratio & Net Cash Flow
Solution
(a) Dividend yield on equity share
Dividend Y ield Per Share x 100

Market Price Per Share

2(i.e. 20 oI Rs. 10)

0.05 or say, 5

40
(b) Cover Ior PreIerence Dividend

ProIits AIter Tax

PreIerence Dividend

2,70,000
10 times
27,000 (i.e. 9 oI 3,00,000)
(c) Cover Ior Equity Dividend

ProIits aIter tax & PreIerence Dividend

Equity Dividend
(310)

2,70,000 - 27,000 .
1,60,000 (i.e. 20 oI 8,00,000)

2,43,000
1.52 times
1,60,000
(d) Earning Per Share
ProIit aIter tax & PreIerence Dividend

Number oI Equity shares

2,43,000 (i.e. 2,70,000 - 27,000)

3.04

80,000
(e) Price-earning Ratio
Market Price Per Share

Earning Per Share

40
13.1
3.04
Also, Net Cash Flow Total Cash Flow - Dividend
(Net ProIit Depreciation - Dividend)
(2,70,00060,000) - (27,0001,60,000)
3,30,000 - 1,87,000 Rs. 1,43,000
10. CAPITALSTRUCTUREOFACOMPANY
The term capital structure` reIers to the relationship between various
long-term Iorms oI Iinancing such as debentures (longterm), preIerence
share capital and equity share capital including reserves and surplus.
Financing the Iirm`s assets is a very crucial problem and as a general
rule, there should be proper structure ratios. They are calculated to test
the long-term Iinancial position oI a Iirm.
Following ratios are generally calculated to analyse the capital structure
oI a Iirm.
(311)
10.1 Capital Gearing Ratio
The term capital gearing` is used to describe the relationship between
equity share capital including reserves and surpluses to preIerence share
capital and other Iixed interest-bearing loans. II preIerence-share capital
and other Iixed interest bearings loans exceed the equity share capital
including reserves, the Iirm is said to be highly geared. The Iirm is said
to be in a low gear iI preIerence share capital and other Iixed interest-
bearing loans are less then equity capital and reserves.
Capital Gearing Ratio
Equity Share Capital Reserves & Surplus

PreIerence Capital Long-term debt bearing Iixed interest
10.2 Debt-Equity Ratio
This ratio has been discussed earlier under the analysis oI longterm
solvency position
10.3 Total Investment to Long-Term Liabilities
This ratio is calculated by dividing the total oI long-term Iunds by the
long term liabilities. Thus,
Ratio oI Total Inv. to long-term liabilities

Shareholders Fund Long-term Liabilities

Long-term liabilities
10.4 Ratio of Fixed Assels to Funded Debt
The ratio measures the relationship between the Iixed assets and the
Iunded debt and is very useIul to the long-term creditors. This ratio can
be calculated as below :
Ratio oI Iixed assets to Iunded debt
Fixed Assets

Funded Debt
(312)
10.5 Ratio of Current Liabilities to Proprietors Funds
The ratio oI current liabilities to proprietors Iund indicates the amount
oI long-term Iunds raised by the proprietors as against short-term
borrowings.
10.6 Ratio of Reserves to Equity Capital
It establishes a relationship between reserves & equity share capital.
Ratio oI Reserve to Equity Capital
Reserves x 100

Equity Share Capital
11. Du-pont Control Chart
A system oI management control designed by an American company
named DU-PONT COMPANYis popularly known as DUPONT CHART.
This system uses the ratio inter-relationship to provide charts Ior
managerial attention. The standard ratios oI the company are compared
to present ratios and changes in perIormance are judged. The chart is
based on two elements i.e. Net ProIit and Capital Employed. Net proIit
is related to operating expenses. II the expenses are under control then
proIit margin will increase. The earnings as a percentage oI sales or
earnings divided by sales give us percentage oI proIitability. Earnings
can be calculated by deducting cost oI sales Irom sales. Cost oI sales
includes cost oI goods sold plus oIIice and administrative expenses and
selling, and distributive expenses. Capital employed, on the other hand,
consists oI current assets and net Iixed assets. Current assets includes
debtors, stock, bills receivable etc. Fixed assets are taken aIter
deducting depreciation. So proIit margin is divided by capital employed
(313)
and is multiplied by 100. The ratio will be

ProIit Margin
x 100
Capital Employed
DU-PONTCHART
Return on Investment
(Net ProIit x 100)
Capital Employed
Profit Investment Turnover
Operating Profit + Sales Sales Investment
Sales-operating Expenses]
Cost of goods sold office and selling + distributive
administrative expenses
expenses
Fixed assets Working Capital
Current Assets Current liabilities
The eIIiciency oI a concern depends upon the working operation oI the concern.
The return on investment becomes a yardstick to measure eIIiciency because
return inIluences various operations. The proIit margin will show the
(314)
eIIiciency with which assets oI the business have been used. The eIIiciency
can be improved either by a better relationship between sales and costs or
through more eIIective use oI available capital. The proIitability can be
increased by controlling cost and/or increasing sales. The investments turnover
can lie raised by having a control over investments in Iixed asses and working
capital without adversely aIIecting sales. The sales may also be increased with
the help oI same capital. The management is able to pinpoint weak spots and
take corrective measures. The perIormance can be better judged by having inter-
Iirm comparison. The ratios oI return on investment, assets turnover and proIit
margins oI comparable companies can be calculated and these can be used as
standards oI perIormance.
DO YOURSELF
1 What is ratio analysis ? How is it beneIicial to the management ?
2 . What are the Iactors which must be considered white interpreting ratios?
3 . How can ratios be classiIied ? Explain
4. Write a note on merits and demerits oI ratio analysis.
5 . From the Iollowing details, prepare the balance sheet oI the Iirm
concerned :
Stock velocity 6
Capital turnover ratio 2
Fixed assets turnover ratio 4
Gross proIit 20
Debt collection period 2 months
(315)
Creditors payment period 73 days
The gross proIit was Rs. 60,000. Closing stock was Rs. 5,000 in excess
oI the opening stock.
6. The Iinancial statements oI Good Luck ltd. Ior the current year-end
reveal the Iollowing inIormation :
Ratio oI current assets to current liabilities 1.75 to 1.0
Liquidity ratio (debtors and bank balances to current liabilities) 1.25 to 1.0
Issued capital in equity shares oI Rs. 10 each Rs. 1,20,000
Net current assets (as over current liabilities) RS-. 60,600
Fixed assets (Net blocks) - Percentage oI shareholder`s
equity as on the closing date 60
Gross proIit-Percentage oI turnover 20
Annual rate oI turnover oI stock (based on cost at 31 st Dec.) 5.2 6
times
Average age oI outstanding debtors Ior the current year 2 months Net proIit-
Percentage on issued share capital 16
On 31st December, Co`s current assets consisted oI stock, debtors and
bank balances.
You are required to reconstruct, in as much detail as possible :
(1) The balance sheet as on 31 st December, current year, and
(2) The trading and proIit and loss account, Ior the current year ended 31 st
December.
(Working should be clearly shown -to Iorm a part oI the answer).
(316)
7 From the ratios and other data set Iorth below Ior the Auto Accessories
Ltd. indicate your interpretation oI the company`s Iinancial condition
Year 3 Year 2 Year I
Current ratio 302 278 265
Acid-test ratio 99 110 155
Working capital turnover (times) 3.25 3.00 2.75
Receivables turnover 7.2 8.41 9.83
Collection period (days) 50 43 37
Inventory to working capital 110 100 95
Inventory turnover (times) 5.41 6.01 6.11
Income per equity share Rs. 2.5 4.05 5.10
Net income to net worth 7 8.5 1 1.07
Operating expenses to net sales 25 23 22
Sales increase during the year 23 16 10
Cost oI goods sold to net sales 73 71 70
Dividends per share Rs.3 Rs.3 Rs.3
Fixed assets to net worth 22.7 18.0 16.4
Net proIit on net sales 2.0 5.09 7.03

(317)
FUNDS FLOWSTATEMENT
AIter going through this lesson, you should know about:
*Meaning and nature oI Iunds Ilow statement.
*Preparation oI a Iunds Ilow statement.
The lesson is organized into Iollowing sections.
1. Introduction.
2. Funds Ilow statement
2.1 Meaning and concept oI Iunds.
2.2 Meaning and concept oI Ilow oI Iunds.
2.3 Current and Non-Current Accounts.
2.4 Detecting the Ilow oI Iunds.
2.5 Meaning and deIinition oI Iunds Ilow statement.
2.6 Uses, SigniIicance and importance oI Iunds Ilow statement.
2.7 Limitation oI Iunds Ilow statement.
3. Preparation oI a Iunds Ilow statement.
3.1 Statement or schedule oI changes in working capital.
3.2 Statement oI sources and applications oI Iunds.
3.21 Sources oI Iunds.
3.22 Applications oI Iunds.
Lesson : 13
(318)
4. Problem Exercieses
1. INTRODUCTION:
The basic Iinancial statements i.e. the balance sheet and and proIit or
loss account or income statement oI business, reveal the net eIIect oI the
various transactions on the operations and Iinancial position oI the company.
The balance sheet gives a static view oI the resources (liabilities) oI a business
and the uses (assets) to which these resources have been put at a certain point
oI time. It does not disclose the cause Ior changes in the assets and liabilities
between two diIIerent points oI time. The proIit or loss account, in a general
way indicates the resources provided by operations. But there are many
transactions that take place in an undertaking and which do not operate through
proIit or loss account. Thus, another statement has to be prepared to show the
change in the assets and liabilities Irom the end oI one period oI time to the
end oI another period. AIunds Ilow statement, in simple words is a statement
oI sources and application oI Iunds.
2. Funds Flow Statement :
BeIore knowing about `Funds Flow statement` it is important to know
the meaning oI Iunds and howa IlowoI Iunds takes place. The ensuing sections
are devoted towards this discussion.
2.1 Meaning And Concept of Funds :
The term Iunds has been deIined in a number oI ways:
(a) In a narrow sense, it means cash only and a Iunds Ilow sttement is
prepared on this basis.
(b) In a broader sense, the term `Iunds` reIers to money values in whatever
Iorm it may exist. Here `Iunds` means all Iinancial resources used in
(319)
business whether in the Iorm oI men, material, money etc.
(c) In a popular sense, the term `Iunds` mean working capital, i.e. excess oI
current assets over current liabilities. The working capital concept oI
Iunds has emerged due to the Iact that total resources oI a business are
invested partly in Iixed assets in the Iorm oI Iixed capital and partly
kept in the Iorm oI liquid or near liquid Iorm as working capital. In this
lesson `Iunds` are reIerred to as working capaital and a Iunds Ilow
statement as a statement oI sources and application oI Iunds.
2.2 Meaning And Concept of `Flow of Funds`:
The term `Ilow` means movement and includes both `inIlow` and `outIlow`.
The term `Ilow oI Iunds` means transIer oI economic values Irom one asset to
another. Flow oI Funds is said to have taken place when any transaction makes
changes in the amount oI Iunds available aIter happening oI the transaction. II
the eIIect oI transaction results in an increase oI Iunds, it is called a source oI
Iunds and iI it results in the decrease oI Iunds it is known as an application oI
Iunds and in case the transaction does not change the position oI Iunds it is
said to have not resulted in a Ilow oI Iunds.
RULE : The Ilow oI Iunds occurs when a transaction changes, on the one
hand a non-current account and on the other a current account and vice-versa.
When a change (in a transaction) in a non current account is Iollowed by a
change in another non current account, it does not amount to Ilow oI Iunds. In
simple language Iunds move when a transaction aIIects (i) a current assets and
a Iixed asset, or (ii) a Iixed and a current liability, or (ii) a current asset and a
Iixed liability or (iv) a Iixed liability & liability which is current.
2.3 Current And Non-Current Accounts :
(320)
To understand Ilow oI Iunds it is essential to classiIy various accounts
and balance sheet items into current and non current categories.
Current Accounts can either be current assets or current liabilities.
Current assets are those assets which in the ordinary course oI business can
be or will be converted into cash within a short period
Table-1
List of current or working capital accounts
CURRENTLIABILITIES CURRENTASSETS
1. Bills payable 1. Cash in hand
2. Sundry creditors 2. Cash at bank
3. Accrued or outstanding expenses 3. Bills receivable
4. Dividends payable 4. Sundry debtors or
accounts receivable
5. Bank overdraIt 5. Short term loans &
advances
6. Short-term loans & advances 6. Temporary oI marketable
oI deposits investments
7. Provision against current assets 7. Inventories or stock such
as
8. Provision Ior taxation iI it does not (i) Raw material
amount to appropriation oI proIits (ii) Work-in-progress
(iii) Stores and spares
(iv) Finished goods
9. Proposed dividends (may be a 8. Prepaid expenses
current or a non-current liability 9. Accured Incomes
(321)
Table-2
List of Non-Current or Permanent
Capital Accounts
Non-Current Liabilities Non-Current Assets or
Permanent-Liabilities Permanent-Assets
1. Equity share capital 1. Goodwill
2. PreIerence share capital 2. Land
3. Redeemable preIerence share capital 3. Building
4. Debentures 4. Plant and machinery
5. Long term Loans 5. Furniture and Iittings
6. Share premium account 6. Trade marks
7. Share IorIeited account 7. Patent Rights
8. ProIit or Loss Account`s credit 8. Debit balance or proIit & loss
balance
9. Capital Reserve 9. Long term investment
10. Capital Redemption reserve 10. Discount on issue oI shares
11. Provision Ior depreciation against 11. Discount on issue oI
Iixed assets debentures
12. Appropriation oI proIits :
General Reserve
Dividend equalisation Iund
Insurance Compensation Iund
Sinking Iund
Investment Iluctuation Iund
Provision Ior taxation
Proposed dividend
(322)
oI normally new accounting year. Current liabilities are those liabilities which
are normally intended to be paid in the ordinary course oI business within a
short period oI normally one year out oI current assets or the income oI the
business.
2.4 Detecting the Flow of Funds :
1. Analyse the transaction and Iind out the two accounts involved.
2. Make journal entry oI transaction.
3. Determine whether the accounts involved in the transaction are current
or non current.
4. II both the accounts involved are current or non-current accounts, it
does not result in the Ilow oI Iunds.
5. II the accounts involved are such that one is current account while the
other is non current, it results in a Ilow oI Iunds. There are Iew examples
showing whether there is Ilow oI IundIs or not.
1. Cash collected from debtors : This transaction involves only the
current accounts and hence does not result in the Ilow oI Iunds.
2. Conversion of debenture into shares : This transaction involves only
the non-current accounts and hence it also does not result in the Ilow oI
Iunds.
3. Issue of shares for cash : This transaction involves a current asset and
a current liability. Thus it results in a Ilow oI Iunds.
2.5 Meaning And Definition of Funds Flow Statement :
Funds Ilow statement is a method by which we study changes in the
Iinancial position oI a business enterprise between the beginning and
ending Iinancial statement dates. It is a statement showing sources
(323)
and uses oI Iunds Ior a period oI time. Foulke deIines this statement as" A
statement oI sources and applications oI Iunds is a ... device designed
to analyse the changes in the Iinancial condition oI a business enterprise
between two dates."
In the words oI Anthony,
"The Iunds Ilowstatementm describes the sources Irom which additional
Iunds were derived and the use to which these sources were put".
I.C.W.A. in the golssary oI management accounting terms deIines Iunds
Ilow statemnt as "a statement either prospective or retrospective. setting up
oI resouces and application oI the Iunds oI an enterprise. The purpose oI the
statement is to indicate clearly the requirements oI Iunds and how they are
proposed to be raised and their eIIicient utilisation and application." Funds
Ilow statement is called by various names such as Sources and Application oI
Iunds, Statement oI changes in Iinancial position, Sources and uses oI Iunds,
summary oI Iinancial operations, where came in and where gone out statement,
movement oI working capital statement, movement oI Iunds statement, Funds
received and disbursed statement, Iunds generated and expended statement,
Iunds statement etc.
2.6 Uses, Significance And Importance of Funds Flow Statement :
The basic purpose oI Iunds Ilow statement is to reveal the changes in
the working capital on the two balance sheet dates. it also describes the sources
Irom which additional working capital has been Iinanced and the uses to which
working capital has been applied. Such a statement is particularly useIul in
assessing the growth oI the Iirm, its resulting Iinancial needs and in determining
the best way oI Iinancing these needs. The signiIicance or importance oI Iunds
(324)
Ilow statement can be well Iollowed Irom its various uses given below:
1. It helps in the analysis oI Iinancial operations. The Iinancial statements
reveal the net eIIect oI various transactions on the operational and
Iinancial position oI a concern. A Iunds Ilow statement discloses the
causes Ior changes in the assets and liabilities between two diIIerent
points oI time.
2. It throws light on many preplexing questions oI general interest which
otherwise may be diIIicult to be answered such as;
(i) Why were the net current assets lesser in spite oI high proIits and vice-
versa?
(ii) Why more dividends could not be declared in spite oI available proIits.
(iii) What happened to the net proIits ? Where did they go ?
3. It helps in the Iormation oI a realistic dividend policy.
4. It helps in the proper allocation oI resources. A projected Iunds Ilow
statement constructed Ior the Iuture helps in making manangement
decisions. The Iirm can plan the deployment oI its resources and allocate
them among various applications.
5. It acts as a Iuture guide to the management. The Iirm`s Iuture needs oI
Iunds can be projected will in advance and also the timing oI these needs.
The Iirm can arrange to Iinance these needs more eIIectively and avoid
Iuture problems.
6. It helps in appraising the use oI working capital. AIunds Ilow statement
helps in explaining howeIIiciently the management has used its working
capital and also suggests way to improve working capital position oI the
Iirm.
(325)
7. It helps knowing the overall credit worthiness oI the Iirm. The Iinancial
institutions and banking Iirms such as State Financial Institutions,
Industrial Finance Corporation on oI India, Industrial Development Bank
oI India, etc. ask Ior Iunds Ilow statementsm constructed Ior a number
oI years beIore granting loans. to know the credit worthiness and paying
capacity oI Iirm.
2.7 Limitations of Funds Flow Statement :
Funds Ilow statement has certain limitations which are as Iollows:
1. It should be remembered that a Iunds Ilow statementm is not a substitute
oI an Income statement or a Balance sheet. It provides only some
additional inIormation as regard changes in working capital.
2. It can not reveal continuous changes.
3. It is not an original statement but simply rearrangement oI data given in
the Iinancial statements.
4. It is essentially historic in nature and projected Iunds Ilow statement
can not be prepared with much accuracy.
5. Changes in cash are more important and relevant Ior Iinancial
management than the working capital.
3. PREPARATIONOFAFUNDS FLOWSTATEMENT:
Funds Ilow statement is a method by which we study changes in the
Iinancial position oI a business enterprise between beginning and ending
Iinancial statements dates. The preparation oI a Iunds Ilow statement
consists oI two parts:
a) Statement or Schedule oI changes in working capital, and
b) Statement oI sources and application oI Iunds.
(326)
3.1 Statement for Schedule of Changes in Working Capital.
Working capital means the excess oI current assets versus current
liabilities. Statement oI changes in working capital is prepared to show
the changes in working capital between the two balance sheet dates. The
change in the amount oI any current asset or current liability in the
current date as compared to that oI the previous balance sheet date either
results in increase or decrease in working capital. We know that the
relation is
STATEMENTORSCHEDULE OFCHANGES INWORKING CAPITAL
Effect on
Particulars Previous Current Working Capital
Year Year Increase Decrease
Current Assets :
Cash in hand
Bills receivable
Sundry Debtors
Prepaid Expenses
Stock/Inventories
Accrued Income
Total current assets
Current liabilities :
Bills payable
Sundry creditors
Outstanding Expenses
Bank overdraIt
Short-term advances
(327)
Total Current
Liabilities
Working Capital
(CA-CL)-
Net Increase in Working
Capital or Decrease in
Working Capital
Working Capital Current Assests - Current liabilities
From this relation Iollowing conclusions can be drawn :
(i) An increase in current assets increases working capital ;
(ii) A decrease in current assets decreases working capital ;
(iii) An incrase in current liabilities decreases working capital; and
(iv) A decrease in current liabilities increases working capital.
It is worth noting that schedule oI changes in working capital is prepared
only Irom current assets and current liabilities and the other inIormation is
not oI any use Ior preparing this statement. A typical Iorm oI statement or
schedule oI changes in working capital is as Iollows.
3.2 Statement of Sources and Application of funds :
Funds Ilowstatement is a statement which indicates various sources Irom
which Iunds (working Capital) have been obtained during a certain period and
the uses or applications to which these Iunds have been put during that period.
This statement is prepared in two Iormats :
(a) Report Iorm
(b) T-Iorm or an account Iorm or SelI Balancing type.
(328)
Table 4
SPECIMENOFREPORTFORMOFFUNDS FLOWSTATEMENT
Sources of funds Rs.
Funds Irom operations
Issue oI share capital
Raising oI long term loans
Receipts Irom partly paid shares called up.
Sales oI non-current (Iixed assets)
No trading receipt such as dividends received
Sale oI Investment (long term)
Decrease in working capital
Total
Application of Funds
Funds lost in business
Redemption oI preIerence share capital
Redemption oI Debentures
Repayment oI Long-term loans
Purchase oI non-current (Iixed) assets
Purchase oI long-term investments
Non trading payment.
Increase in working capital.
Total
Table 5
(329)
T-Form or an account form or self balancing type
Funds flow statement
(For the year ended..............)
Sources Rs. Application Rs.
1. Funds Irom operations 1. Funds lost in
operation
2. Issue oI share capital 2. Redemption oI
PreIerence share
capital
3. Issue oI debentures 3. Redemption oI
debentures
4. Raising oI long term loans 4. Repayment oI long
term loans
5. Receipt Irom partly paid, 5. Purchases oI non-
called up shares current (Iixed assets)
6. Sale oI non-current (Iixed) 6. Purchase oI long term
assets investment
7. Non trading receipt such as
dividends
8. Sale oI long-term investment
Net decrease in working capital Net increase in W.C.
3.21 Sources of Funds :
The Iollowing are the sources Irom which Iunds generally Ilow into the
business :
1. Funds from opertions or trading profit : Sales are the main sources
oI inIlow oI Iunds the business as they increase current assets. Thus
trading proIits or proIits Irom opertions oI the business are the most
(330)
important and major source oI Iunds. Basically there are two methods oI
calculation :
(a) The Iirst method is to prepare the P/L Account aIresh by taking into
consideration only Iunds and operational items which invlove Iunds and
are related to the normal operations oI the business.
(b) The Second method is to proceed Irom the Iigure oI net proIit or net loss
as arrived at Irom the proIit and loss account already prepared. Funds
Irom operations by this method are calculated as :
Table 6
Calculation of funds from operations
Closing balance oI P & LA/c or
Retained earnings (as given in the balance sheet)
Add, Non-Iunds & Non-operating items which
have already been debited to P & LA/c.
(1) Depreciation and Depletion
(2) Amortization oI Iictitious and intabgible Assets such as
(i) Goodwill
(ii) Patents
(iii) Trade-marks
(iv) Preliminary expenses
(v) Discount on issue oI shares, etc.
(3) Appropriation oI retained earnings such as :
(i) TransIer to general reserve
(ii) Dividend equalisation Iund
(iii) Transter to sinking Iund
(331)
(iv) Contingency Reserve etc.
(4) Loss on sale oI any non-current (Iixed assets such as :
(i) Loss on sale oI land and building
(ii) Loss on sale oI Iurniture
(iii) Loss on sale oI long term investments etc.
(5) Dividends including
(i) Interim Dividend
(ii) Proposed Dividend (iI it is an appropriation oI proIits and not taken as
current liability)
(6) Provision Ior taxation (iI it is not taken as current liability).
(7) Any other non Iund/non operating item which have been debited to P/LA/c
Total (A)
Less, non-Iund or nor operating items
which have already been credited to P & A/c.
(1) ProIit or gain Irom the sale oI non-current (Iixed) assets such as :
(i) ProIit on sale oI land and building
(ii) ProIit on sale oI plant and machinery.
(iii) ProIit on sale oI long term investments, etc.
(2) Appreciation in the value oI Iixed
assets, such as increase in the value oI
land iI it has been credited to P/LA/c.
(3) Dividend Received
(4) Excess provision retransIerred to P/L
A/c or written oII.
(5) Any other non-operating item which has
(332)
been credited to P/LAc.
(6) Opening balance oI P & LA/c or
retained earnings.
(as given in the balance sheet)
Total B
Total (A) - Total (B) funds generated by operations
Funds Irom operations can also be calculated by preparing adjusted proIit
& loss account as Iollows :
Table 7
Adjusted Profit and Loss Account
To depreciation or Rs. By opening balance Rs.
amortization oI Iictitious (oI P & LA/c).
and intangible assets such as By transIer Irom
goodwill, patent, trade excess provisions.
marks, preliminary expenses By appreciation in the
etc. value oI Iixed assets.
To Appropriation oI By dividends received.
retained earnings such as : By proIit on sale oI
TransIer to general reserve, Iixed or non current
dividend equalisation Iund, assets.
sinking Iund etc. By Iunds Irom operations
(balancing Iig. in)
case debit side exceeds
credit side.)
To loss on sale oI only non
(333)
current or Iixed assets.
To Dividends (including interim
dividend)
To proposed dividend (iI not
taken as a current liability)
To provision Ior taxation
(iI not taken as a current liability)
To closing balance (oI P & LA/c)
To Iunds lost in operations
(balancing Iigure, in case credit
side exceeds the debit side.)
2. Issue oI share capital : iI during the year, there is any increase in the
share capital whether preIerence or equity, it means capital has been raised
during the year. Issue oI shares is a sources oI Iunds as it constitutes inIlow oI
Iunds. Even the calls received Irom partly paid shares constitute an inIlow oI
Iunds into the business.
But some times shares are issued otherwise than in cash. The Iollowing
rules must be Iollowed in such a case :
(i) Issue oI shares Ior making partly paid shares as Iully paid out oI
accumulated proIits in the Iorm oI bonus shares is not a source oI Iunds.
(ii) Issue oI shares Ior consideration other than current assets such as against
purchase oI land, machines etc. does not amount to inIlow oI Iunds.
(iii) Conversion oI debentures or loans into shares also does not amount to
inIlow oI Iunds. In above three cases both the Accounts are non-current.
3. Issue of debentures and Raising of Loans : Issue oI debentures or raising
(334)
oI loan (long term), whether secured or unsecured results in the Ilow oI Iunds
into the business. The inIlow oI Iunds is the actual proceeds Irom the
issue oI such debentures or raising oI loans i.e. including the amount oI
premium or excluding discount, iI any. However, loans raised Ior
consideration other than a current asset such as Ior purchase oI building,
will not constitute inIlow oI Iunds because in that case the accounts
invoved are only Iixed or non-current.
4. Sale of fixed (non-current) assets and long term or trade investments
: When any Iixed or non-current asset like land, building, plant and
machinery, Iurniture, long-term investments etc. are sold, it generates
Iunds and becomes a source oI Iunds. However, it must be remembered
that iI one Iixed asset is exchanged Ior another Iixed asset, it does not
constitute an inIlow oI Iunds because both current asset are involved.
5. Non-trading receipt : Any non-trading receipt like dividend received,
reIund oI tax etc. also increases Iunds and is treated as a source oI Iunds
because such an income is not included in Iunds Irom operations.
6. Decrease in Working Capital : II the working capital decreases during
the current period as compared to the previous period, it means that there
has been a release oI Iunds because it constitutes a source oI Iunds.
3.22 Application or Uses of Funds
(1) Funds lost in operations :
Some times the result oI trading in a certain year is a loss and some Iunds
are lost during that period in trading operations. Such loss oI Iunds in
trading amounts to an outIlow oI Iunds and is treated as an application oI
Iunds.
(335)
(2) Redemption of preference share capital :
II during the year any preIerence shares are redeemed, it will result in
the outIlow oI Iunds and is taken as an application oI Iunds. When the
shares are redeemed at premium or discount, it is the net amount paid
which is taken as an application. However iI shares are redeemed in
exchange oI some other type oI share or debentures, it does not constitute
an outIlow oI Iunds as no current account is involved in that case.
(3) Repayment of loans or redemption of debentures :
In the same way as redemption oI preIerence share capital is an application
oI Iunds, redemption oI debentures or repayment oI loans also constitute
an application oI Iunds.
(4) Purchase of any non-current or fixed asset :
When any Iixed or non-current asset like land, building, plant and
machinery, Iurniture long-term investments etc. are purchased, there is a
Iunds outIlow Irom the business. However, iI Iixed assets are purchased
Ior a consideration oI issue oI shares or debentures or iI some Iixed
asset is exchanged Ior another, it does not involve any Iunds and hence it
is not an application oI Iunds.
(5) Payments of Dividends and Tax :
Payments oI dividends and tax are also applications oI Iunds. It is the
actual payment oI dividend and tax which should be taken as an outIlow
oI Iunds and not the mere declaration oI dividend or creating oI a
provision Ior taxation.
(6) Any other non-trading payment :
Any payment or expense not related to the trading operations oI the
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business amount to outIlow oI Iunds is taken as an application oI Iunds.
The examples could be drawings in case oI sole trader or partnership Iirm,
loss oI cash etc.
4. PROBLEMEXERCISES :
4.1 Problex exercise 1 :
Astatement oI the retained earnings oI Harish Ltd. is given below
Rs. Rs.
Balance oI retained earnings,
July 1, 19X1 41,72,800
Add : Net income aIter taxes 83,26,600
Tax reIund 2,84,300
1,27,83,700
Less : Dividend 58,52,100
Write-oII, cost oI investments
in Ioreign subsidiary 12,23,000
Loss on sale oI plant equipment 1,33,400
72,08,500
Balance oI retained earnings, June 30, 19 X 2 55,75,200
(a) Depreciation oI Rs. 7,95,200 was deducted in arriving at net income Ior
the Iiscal year ; (b) Plant and equipment having a net book value oI Rs.
4,32,100 was sold in August, 19X1; (c) Plant properties were increased
during the Iiscal year at a cost oI Rs. 23,19,000 and the increases were
Iinanced by bonds; (d) PreIerence shares were retired Ior Rs. 7,64,000.
You are required to prepare a statement oI the sources and uses oI net
working capital Ior the year ended June 30, 19X2.
(337)
Solution
STATEMENTOFSOURCES ANDUSES OFFUNDS
Rs. Rs.
Sources :
Funds Irom operations 91,21,800
Sale oI machine 2,98,700
Tax reIund 2,84,300
Total Sources 97,04,800
Uses :
Retirement oI preIerences shares 7,64,000
Payment oI dividends 58,52,100
Total Applications 66,16,100
Net Increase in Working Capital 30,88,700
Notes :
1. Purchase oI plant properties at Rs. 23,19,000 is neither a souce nor an
application. In this case the transaction gives rise to noncurrent asset
and non-current liability, and hence Iunds remain unaIIected by it.
2. Calculation oI Iunds Irom operation :
Net income aIter income tax Rs. 83,26,600
Add : Depreciation 7,95,200
Source Irom operation Rs. 91,21,800
3. Calculation oI source Irom sale oI machine :
Book value oI plant sold Rs. 4,32,100
Less : Loss on sale oI plant 1,33,400
Source Irom the sale oI plant Rs. 2,98,700
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4.2 Problem Exercise 2
From the Iollowing balance sheets oI ALtd. make out : (i) Statement oI changes
in the working capital, and (ii) Iunds Ilow statement.
ALTD
Balance Sheets
Liabilities and Assets 19X1 19X2
Rs. Rs.
Liabilities
Equity share capital 3,00,000 4,00,000
8 Redeemable preIerence share capital 1,50,000 1,00,000
General reserve 40,000 70,000
ProIit and Loss A/c 30,000 48,000
Proposed dividend 42,000 50,000
Creditiors 55,000 83,000
Bills payable 20,000 16,000
Provision Ior taxation 40,000 50,000
Total 6,77,000 8,17,000
Assets
Goodwill 1,15,000 90,000
Land and buildings 2,00,000 1,70,000
Plant 80,000 2,00,000
Debtors 1,60,000 2,00,000
Stock 77,000 1,09,000
Bills receivable 20,000 30,000
Cash in Hand 15,000 10,000
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Cash in Bank 10,000 8,000
Total 6,77,000 8,17,000
Additional InIormation. (i) Depreciations oI Rs. 10,000 and Rs. 20,000
have been charged on plant and land and buildings respectively in 19X2. (ii)
An interim dividend oI Rs. 20,000 has been paid during the year. (iii) Income-
tax Rs. 35,000 has been paid during the 19X2.
Solution :
(a) STATEMENTOFCHANGES INWORKING CAPITAL
19X1 19X2 Changes
Rs. Rs. Rs. Rs.
Assets :
Goodwill 1,15,000 90,000 -25,000
Land and buildings 2,00,000 1,70,000 -30,000
Plant 80,000 2,00,000 1,20,000
Debtors 1,60,000 2,00,000 40,000 -------
Stock 77,000 1,09,000 32,000 -------
Bills receivable 20,000 30,000 10,000 -------
Cash in Hand 15,000 10,000 -5,000 -------
Cash at Bank 10,000 8,000 -2,000 -------
Total 6,77,000 8,17,000 +75,000 +65,000
Liabilities
Equity share capital 3,00,000 4,00,0001,00,000
8 Redeemablem preI- 1,50,000 1,00,000 -50,000
erence share capital
(340)
ProIit and Loss A/c 30,000 48,000 ------- 18,000
Proposed divident 42,000 50,000 ------- 8,000
Creditors 55,000 83,000 28,000 -------
Bills payable 20,000 16,000 -4,000 -------
Provision Ior taxation 40,000 50,000 ------- 10,000
Total 6,77,000 8,17,000
40,000 70,000 ------- 30,000 General Reserve
Net Increase in
Working Capital +51,000 -51,000
Total 75,000 65,000
(a STATEMENTOFSOURCES ANDUSES)
Sources : Rs. Rs. Rs.
Funds Irom operation 2,18,000
Issue oI equity share capital 1,00,000
Sale oI building 10,000
Total Sources 3,28,000
Applications :
Purchase oI Plant 1,30,000
Redemption oI preIerence share 50,000
Payment oI dividend :
(i) OI previous year 42,000
(ii) Interim dividend 20,000 62,000
Payment oI Tax 35,000
Total Application
(341)
Net Increase in Working Capital
Notes : 1. Funds from operations :
Increase in proIit Rs. 18,000
Increase in general reserve 30,000
Provision Ior taxes 45,000
Depreciation 30,000
Increase in ProIit Rs. 18,000
Increase in general reserve 30,000
Provision Ior taxes 45,000
Depreciation 30,000
Provision Ior dividend 50,000
Interim dividend 20,000
Goodwill written oII 25,000
Rs. 2,18,000
2. Provision Ior taxation in the beginning oI the year was Rs. 40,000. Since
Rs. 35,000 were paid during 19X2, a balance oI Rs. 5,000 should have
remained at the end oI the year. As Rs. 50,000 is the actual balance at
the end oI the year, a provision oI Rs. 45,000 would have been created
during the year.
3. It is assumed that provision Ior dividends, Rs. 42,000, created in 19X1
is paid in 19X2. Thus the provision Ior dividends Ior 19X2 is Rs. 50,000
4. Goodwill decreases because it has been written oII. Since the goodwill
written oII is a book entry in ProIit and Loss Account and does not use
any Iunds, it is added to Iunds Irom operations.
(342)
DO YOURSELF
1. In what way the Statement oI Changes in Financial Position is diIIerent
Irom the Financial Statements.
2. Explain the concept oI Ilow oI Iunds and illustrate how this statement
can be prepared.
3. Give an account oI major sources and uses oI Iunds.
4. What are the beneIits & limitations oI a Iunds Ilow statement ? Discuss.
5. The Iollowing are the balance sheets oI Mega Company Ior the years
ending July 31, 19 X 1 and July 31, 19X2.
19X1 19X2