Definition.

Financial management is that managerial activity which is concerned with planning and controlling of firms financial resources.

Objectives of FM.

The main objectives of financial management are:-1. Profit maximization : The main objective of financial management is profit maximization. The finance manager tries to

earn maximum profits for the company in the short-term and the long-term. He cannot guarantee profits in the long term because of business uncertainties. However, a company can earn maximum profits even in the long-term, if:-

A) The Finance manager takes proper financial decisions.B) He uses the finance of the company properly.2. Wealth maximization : Wealth maximization (shareholders' value maximization) is also a main objective of financial management. Wealth maximization means to earn maximum wealth for the shareholders. So, the finance manager tries to give a maximum dividend to the shareholders. He also tries to increase the market value of the shares. The market value of the shares is directly related to the performance of the company. Better the performance, higher is the market value of shares and vice-versa. So, the finance manager must try to maximise shareholder's value.

1. Proper estimation of total financial requirements : Proper estimation of total financial requirements is a very important objective of financial management. The finance manager must estimate the total financial requirements of the company. He must find out how much finance is required to start and run the company. He must find out the fixed capital and working capital requirements of the company. His estimation must be correct. If not, there will be shortage or surplus of finance. Estimating the financial requirements is a very difficult job. The finance manager must consider many factors, such as the type of technology used by company, number of employees employed, scale of operations, legal requirements, etc.

4. Proper mobilisation : Mobilisation (collection) of finance is an important objective of financial management. After estimating the financial requirements, the finance manager must decide about the sources of finance. He can collect finance from many sources such as shares, debentures, bank loans, etc. There must be a proper balance between owned finance and borrowed finance. The company must borrow money at a low rate of interest.

5. Proper utilisation of finance : Proper utilisation of finance is an important objective of financial management. The finance manager must make optimum utilisation of finance. He must use the finance profitable. He must not waste the finance of the company. He must not invest the company's finance in unprofitable projects. He must not block the company's finance in inventories. He must have a short credit period.

6. Maintaining proper cash flow : Maintaining proper cash flow is a short-term objective of financial management. The company must have a proper cash flow to pay the day-to-day expenses such as purchase of raw materials, payment of wages and salaries, rent, electricity bills, etc. If the company has a good cash flow, it can take advantage of many opportunities such as getting cash discounts on purchases, large-scale purchasing, giving credit to customers, etc. A healthy cash flow improves the chances of survival and success of the company.

7. Survival of company : Survival is the most important objective of financial management. The company must survive in this competitive business world. The finance manager must be very careful while making financial decisions. One wrong decision can make the company sick, and it will close down.

8. Creating reserves : One of the objectives of financial management is to create reserves. The company must not distribute the full profit as a dividend to the shareholders. It must keep a part of it profit as reserves. Reserves can be used for future growth and expansion. It can also be used to face contingencies in the future.

9. Proper coordination : Financial management must try to have proper coordination between the finance department and other departments of the company.

10. Create goodwill : Financial management must try to create goodwill for the company. It must improve the image and reputation of the company. Goodwill helps the company to survive in the short-term and succeed in the long-term. It also helps the company during bad times.

11. Increase efficiency : Financial management also tries to increase the efficiency of all the departments of the company. Proper distribution of finance to all the departments will increase the efficiency of the entire company.

12. Financial discipline : Financial management also tries to create a financial discipline. Financial discipline means:-To invest finance only in productive areas. This will bring high returns (profits) to the company.

To avoid wastage and misuse of finance.13. Reduce cost of capital : Financial management tries to reduce the cost of capital. That is, it tries to borrow money at

a low rate of interest. The finance manager must plan the capital structure in such a way that the cost of capital it minimised.

14. Reduce operating risks : Financial management also tries to reduce the operating risks. There are many risks and uncertainties in a business. The finance manager must take steps to reduce these risks. He must avoid high-risk projects. He must also take proper insurance.

15. Prepare capital structure : Financial management also prepares the capital structure. It decides the ratio between owned finance and borrowed finance. It brings a proper balance between the different sources of. capital. This balance is necessary for liquidity, economy, flexibility and stability.

Role of Financial ManagerThe financial manager plays an important role in the functional areas of finance. The assignments of finance functions to the financial manager depend upon size of the business enterprise. The larger the business enterprise the greater degree ofspecialization of tasks is needed. The financial manager is the key persons in any business enterprise. The function of finance manager includes budgeting and investing funds, accounting, products pricing and forecasting. The financial manager is engaged in the analysis, planning and control of the financial activities of the enterprise.FINANCING AND INVESTING: The financial manager performs the financing and investing function of an enterprise. He supervises the cash and other holding of the firm. He arranges for raising additional funds as per the requirement of the enterprise. FINANCIAL ANALYSIS: Financial manager makes analysis of financial condition of the firm. Financial analysis ensures the effective and smooth functioning of any enterprise. Financial analysis is made to judge the propriety of the trend of share market prices, etc. DIVIDEND DECISIONS: The financial manager takes dividend decision. For taking decisions in respect of dividend, the following factors are considered-availability of cash, tax position of the share-holders, trend of earnings, etc. ACCOUNTING AND CONTROL: The financial manager arranges for the maintenance of financial records. He controls the financial activities of the enterprise. He identifies deviations from planned and efficient financial activities. FORECASTING AND LONG-RUN PLANNING: The finance manager forecasts costs and technological changes. He studies the market conditions and forecasts the funds needed for investment. He calculated the estimated returns on proposed investment project and forecasts about the demand for the products of the enterprise. CASH MANAGEMENT: The financial manager arranges for cash management of the enterprise. Through cash management, he ensures the supply of funds to the different dept. of the enterprise. The financial manager arranges for the adequate supply of cash to all sections of the enterprise for its smooth flow of operations.              DECISION REGARDING CAPITAL STRUCTURE: The financial manager takes decision regarding capital structure of the firm. Capital structure indicates the proper mix of different sources of capital. He tries to maintain proper balances between the long-run funds and shorts-run funds. EVALUATION OF FINANCIAL PERFORMANCE: The financial manager evaluates the financial performance for the analysis of financial performance of the enterprise. The financial manager constantly reviews the financial performance to assess the financial health of the business enterprise. The financial manager helps the management to take different decision on the result of the evaluation of the financial performances.

SOURCE OF FINANCE

Business is concerned with the production and distribution of goods and services for the satisfaction of needs of society. For carrying out various activities, business requires money. Finance, therefore, is called the life blood of any business. The financial needs of a business can be categorised as follows:

(a) Fixed capital requirements: In order to start business, funds are required to purchase fixed assets like land and building, plant and machinery, and furniture and fixtures. This is known as fixed capital requirements of the enterprise. The funds required in fixed assets remain invested in the business for a long period of time.

(b)Working Capital requirements: No matter how small or large a business is, it needs funds for its day-to-day operations. This is known as working capital of an enterprise, which is used for holding current assets such as stock of material, bills receivables and for meeting current expenses like salaries, wages, taxes and rent. For financing such requirements short-term funds are needed.

CLASSIFICATION OF SOURCE OF FUNDS.

A. Period Basis.

On the basis of period, the different sources of funds can be categorized into three parts. These are long-term sources, medium-term sources and short-term sources. The long-term sources fulfill the financial requirements of an enterprise for a period exceeding 5 years and include sources such as shares and debentures, long-term borrowings and loans from financial institutions. Such financing is generally required for the acquisition of fixed assets such as equipment, plant, etc. Where the funds are required for a period of more than one year but less than five years, medium-term sources of finance are used. These sources include borrowings from commercial banks, public deposits, lease financing and loans from financial institutions.

Short-term funds are those which are required for a period not exceeding one year. Trade credit, loans from commercial banks and commercial papers are some of the examples of the sources that provide funds for short duration. Short-term financing is most common for financing of current assets such as accounts receivable and inventories.

B. Ownership Basis.

On the basis of ownership, the sources can be classified into ‘owner’s funds’ and ‘borrowed funds’. Owner’s funds means funds that are provided by the owners of an enterprise, which may be a sole trader or partners or shareholders of a company. Apart from capital, it also includes profits reinvested in the business. The owner’s capital remains invested in the business for a longer duration and is not required to be refunded during the life period of the business. Such capital forms the basis on which owners acquire their right of control of management. Issue of equity shares and retained earnings are the two important sources from where owner’s funds can be obtained.

‘Borrowed funds’ on the other hand, refer to the funds raised through loans or borrowings. The sources for raising borrowed funds include loans from commercial banks, loans from financial institutions, issue of debentures, public deposits and trade credit. Such sources provide funds for a specified period, on certain terms and conditions and have to be repaid after the expiry of that period. A fixed rate of interest is paid by the borrowers on such funds. At times it puts a lot of burden on the business as payment of interest is to be made even when the earnings are low or when loss is incurred. Generally, borrowed funds are provided on the security of some fixed assets.

LONG TERM FUNDS

1. Retained Earnings.

A company generally does not distribute all its earnings amongst the shareholders as dividends. A portion of the net earnings may be retained in the business for use in the future. This is known as retained earnings. It is a source of internal financing or self

financing or ‘ploughing back of profits’. The profit available for ploughing back in an organisation depends on many factors like net profits, dividend policy and age of the organisation.

Merits.

The merits of retained earning as a source of finance are as follows:

(i) Retained earnings is a permanent source of funds available to an organisation;(ii) It does not involve any explicit cost in the form of interest, dividend or floatation cost;(iii) As the funds are generated internally, there is a greater degree of operational freedom and flexibility;(iv) It may lead to increase in the market price of the equity shares of a company.

2. Trade Credit.

Trade credit is the credit extended by one trader to another for the purchase of goods and services. Trade credit facilitates the purchase of supplies without immediate payment. Such credit appears in the records of the buyer of goods as ‘sundry creditors’ or ‘accounts payable’. Trade credit is commonly used by business organisations as a source of short-term financing. It is granted to those customers who have reasonable amount of financial standing and goodwill. The volume and period of credit extended depends on factors such as reputation of the purchasing firm, financial position of the seller, volume of purchases, past record of payment and degree of competition in the market. Terms of trade credit may vary from one industry to another and from one person to another. A firm may also offer different credit terms to different customers.

3. Factoring.

Factoring is a financial service under which the ‘factor’ renders various services which includes: (a) Discounting of bills (with or without recourse) and collection of the client’s debts. Under this, the receivables on account of sale of goods or services are sold to the factor at a certain discount. The factor becomes responsible for all credit control and debt collection from the buyer and provides protection against any bad debt losses to the firm. There are two methods of factoring —recourse and non-recourse. Under recourse factoring, the client is not protected against the risk of bad debts. On the other hand, the factor assumes the entire credit risk under non-recourse factoring i.e., full amount of invoice is paid to the client in the event of the debt becoming bad. The organizations, that provide such services include SBI Factors and Commercial Services Ltd., Canbank Factors Ltd., Foremost Factors Ltd.etc.

4. Lease Financing.

A lease is a contractual agreement whereby one party i.e., the owner of an asset grants the other party the right to use the asset in return for a periodic payment. In other words it is a renting of an asset for some specified period. The owner of the assets is called the ‘lessor’ while the party that uses the assets is known as the ‘lessee’ (see Box A). The lessee pays a fixed periodic amount called lease rental to the lessor for the use of the asset. The terms and conditions regulating the lease arrangements are given in the lease contract. At the end of the lease period, the asset goes back to the lessor. Lease finance provides an important means of modernization and diversification to the firm. Such type of financing is more prevalent in the acquisition of such assets as computers and electronic equipment which become obsolete quicker because of the fast changing technological developments. While making the leasing decision, the cost of leasing an asset must be compared with the cost of owning the same.

5. Public Deposits.

The deposits that are raised by organisations directly from the public are known as public deposits. Rates of interest offered on public deposits are usually higher than that offered on bank deposits. Any person who is interested in depositing money in an organisation can do so by filling up a prescribed form. The organisation in return issues a deposit receipt as acknowledgment of the debt. Public deposits can take care of both medium and short-term financial requirements of a business. The deposits are beneficial to both the depositor as well as to the organisation. While the depositors get higher interest rate than that offered by banks, the cost of deposits to the company is less than the cost of borrowings from banks. Companies generally invite public deposits for a period up to three years. The acceptance of public deposits is regulated by the Reserve Bank of India.

6. Commercial Paper (CP).

Commercial Paper emerged as a source of short term finance in our country in the early nineties. Commercial paper is an unsecured promissory note issued by a firm to raise funds for a short period, varying from 90 days to 364 days. It is issued by one firm to other business firms, insurance companies, pension funds and banks. The amount raised by CP is generally very large. As the debt is totally unsecured, the firms having good credit rating can issue the CP. Its regulation comes under the purview of the Reserve Bank of India. 7. Issue of Shares.

The capital obtained by issue of shares is known as share capital. The capital of a company is divided into small units called shares. Each share has its nominal value. For example, a company can issue 1,00,000 shares of Rs. 10 each for a total value of Rs. 10,00,000. The person holding the share is known as shareholder. There are two types of shares normally issued by a company. These are equity shares and preference shares. The money raised by issue of equity shares is called equity share capital, while the money raised by issue of preference shares is called preference share capital.

(a) Equity Shares.

Equity shares is the most important source of raising long term capital by a company. Equity shares represent the ownership of a company and thus the capital raised by issue of such shares is known as ownership capital or owner’s funds. Equity share capital is a prerequisite to the creation of a company. Equity shareholders do not get a fixed dividend but are paid on the basis of earnings by the company. They are referred to as ‘residual owners’ since they receive what is left after all other claims on the company’s income and assets have been settled. They enjoy the reward as well as bear the risk of ownership. Their liability, however, is limited to the extent of capital contributed by them in the company. Further, through their right to vote, these shareholders have a right to participate in the management of the company.

Merits.

The important merits of raising funds through issuing equity shares are given as below:(i) Equity shares are suitable for investors who are willing to assume risk for higher returns;(ii) Payment of dividend to the equity shareholders is not compulsory. Therefore, there is no burden onthe company in this respect;(iii) Equity capital serves as permanent capital as it is to be repaid only at the time of liquidation of a company. As it stands last in the list of claims, it provides a cushion for creditors, in the event of winding up of a company;(iv) Equity capital provides credit worthiness to the company and confidence to prospective loan providers;(v) Funds can be raised through equity issue without creating any charge on the assets of the company. The assets of a company are, therefore, free to be mortgaged for the purpose of borrowings, if the need be;(vi) Democratic control over management of the company is assured due to voting rights of equity shareholders.

Limitations.

The major limitations of raising funds through issue of equity shares are as follows:(i) Investors who want steady income may not prefer equity shares as equity shares get fluctuating returns;(ii) The cost of equity shares is generally more as compared to the cost of raising funds through other sources;(iii) Issue of additional equity shares dilutes the voting power, and earnings of existing equity shareholders;(iv) More formalities and procedural delays are involved while raising funds through issue of equity share.

(b) Preference Shares.

The capital raised by issue of preference shares is called preference share capital. The preference shareholders enjoy a preferential position over equity shareholders in two ways: (i) receiving a fixed rate of dividend, out of the net profits of the company, before any dividend is declared for equity shareholders; and (ii) receiving their capital after the claims of the company’s creditors have been settled, at the time of liquidation. In other words, as compared to the equity shareholders, the preference shareholders have a preferential claim over dividend and repayment of capital. Preference shares resemble debentures as they bear fixed rate of return. Also as the dividend is payable only at the discretion of the directors and only out of profit after tax, to that extent, these resemble equity shares. Thus, preference shares have some characteristics of both equity shares and debentures. Preference shareholders generally do not enjoy any voting rights. A company can issue different types of preference shares.

Types of Preference Shares ;

1. Cumulative and Non-Cumulative: The preference shares which enjoy the right to accumulate unpaid dividends in the future years, in case the same is not paid during a year are known as cumulative preference shares. On the other hand, on non-cumulative shares, dividend is not accumulated if it is not paid in a particular year.

2. Participating and Non-Participating: Preference shares which have a right to participate in the further surplus of a company shares which after dividend at a certain rate has been paid on equity shares are called participating preference shares. The non-participating preference are such which do not enjoy such rights of participation in the profits of the company.

3. Convertible and Non-Convertible: Preference shares that can be converted into equity shares within a specified period of time are known as convertible preference shares. On the other hand, non-convertible shares are such that cannot be converted into equity shares.

Merits.

The merits of preference shares are given as follows:(i) Preference shares provide reasonably steady income in the form of fixed rate of return and safety of investment;(ii) Preference shares are useful for those investors who want fixed low risk;(iii) It does not affect the control of equity shareholders over the management as preference shareholders don’t have voting rights;(iv) Payment of fixed rate of dividend to preference shares may enable a company to declare higher rates of dividend for the equity shareholders in good times;(v) Preference shareholders have a preferential right of repayment over equity shareholders in the event of liquidation of a company;(vi) Preference capital does not create any sort of charge against the assets of a company.

8. Debentures.

Debentures are an important instrument for raising long term debt capital. A company can raise funds through issue of debentures, which bear a fixed rate of interest. The debenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money, which it promises to repay at a future date. Debenture holders are, therefore, termed as creditors of the company. Debenture holders are paid a fixed stated amount of interest at specified intervals. Public issue of debentures requires that the issue be rated by a credit rating agency like CRISIL (Credit Rating and Information Services of India Ltd.) on aspects like track record of the company, its profitability, debt servicing capacity, credit worthiness and the perceived risk of lending.

A company can issue different types of debentures . Issue of Zero Interest Debentures (ZID) which do not carry any explicit rate of interest has also become popular in recent years. The difference between the face value of the debenture and its purchase price is the return to the investor.

Types of Debentures.

1. Secured and Unsecured: Secured debentures are such which create a charge on the assets of the company, thereby mortgaging the assets of the company. Unsecured debentures on the other hand do not carry any charge or security on the assets of the company.2. Registered and Bearer: Registered debentures are those which are duly recorded in the register of debenture holders maintained by the company. These can be transferred only through a regular instrument of transfer. In contrast, the debentures which are transferable by mere delivery are called bearer debentures.3. Convertible and Non-Convertible: Convertible debentures are those debentures that can be converted into equity shares after the expiry of a specified period. On the other hand, non-convertible debentures are those which cannot be converted into equity shares.4. First and Second: Debentures that are repaid before other debentures are repaid are known as first debentures. The second debentures are those which are paid after the first debentures have been paid back.

Merits.

The merits of raising funds through debentures are given as follows:(i) It is preferred by investors who want fixed income at lesser risk;

(ii) Debentures are fixed charge funds and do not participate in profits of the company;(iii) The issue of debentures is suitable in the situation when the sales and earnings are relatively stable;(iv) As debentures do not carry voting rights, financing through debentures does not dilute control of equity shareholders on management;(v) Financing through debentures is less costly as compared to cost of preference or equity capital as the interest payment on debentures is tax deductible.

9. Commercial Banks.

Commercial banks occupy a vital position as they provide funds for different purposes as well as for different time periods. Banks extend loans to firms of all sizes and in many ways, like, cash credits, overdrafts, term loans, purchase/discounting of bills, and issue of letter of credit. The rate of interest charged by banks depends on various factors such as the characteristics of the firm and the level of interest rates in the economy. The loan is repaid either in lump sum or in installments. Bank credit is not a permanent source of funds. Though banks have started extending loans for longer periods, generally such loans are used for medium to short periods. The borrower is required to provide some security or create a charge on the assets of the firm before a loan is sanctioned by a commercial bank.

MeritsThe merits of raising funds from a commercial bank are as follows:(i) Banks provide timely assistance to business by providing funds as and when needed by it.(ii) Secrecy of business can be maintained as the information supplied to the bank by the borrowers is kept confidential;(iii) Formalities such as issue of prospectus and underwriting are not required for raising loans from a bank. This, therefore, is an easier source of funds;(iv) Loan from a bank is a flexible source of finance as the loan amount can be increased according to business needs and can be repaid in advance when funds are not needed.

10. Special Financial Institutions.

After independence a large number of financial institutions have been established in India with the primary objective of providing long-term financial assistance to industrial enterprises. Some of these institutions have been set up on the initiative of the Central Government, while others have been set up in different states on the initiative of the concerned State Governments. Thus there are all-India institutions like Industrial Finance Corporation of India (IFCI), Industrial Credit and Investment Corporation of India (ICICT), Industrial Development Bank of India (IDBI), and Industrial Reconstruction Corporation of India (IRCI). They mainly provide long-term finance for large companies. On the other hand, at the state level there are State Financial Corporations (SFCs) and Industrial Development Corporations (SIDCs). These state level institutions mainly provide long-term finance to relatively smaller companies.

These institutions (both national level and state level) are known as 'Development Banks' because their main objective is to provide financial assistance to industrial enterprises for investment projects, expansion or modernisation of plants in accordance with the priorities laid down in the Five Year Plans.

Besides the development banks, there are several other institutions known as investment companies or investment trusts which subscribe to the shares and debentures offered to the public by companies. For example, the Life Insurance Corporation of India (LIC), General Insurance Corporation of India (GIC), the Unit Trust of India (UTI), etc., come under this category.

Merits.

The merits of raising funds through financial institutions are as follows:(i) Financial institutions provide long term finance, which are not provided by commercial banks;(ii) Besides providing funds, many of these institutions provide financial, managerial and technical advice and consultancy to business firms; (iii) Obtaining loan from financial institutions increases the goodwill of the borrowing company in the capital market. Consequently, such a company can raise funds easily from other sources as well;(iv) As repayment of loan can be made in easy installments, it does not prove to be much of a burden on the business;(v) The funds are made available even during periods of depression, when other sources of finance are not available.

11. International Financing.

In addition to the sources discussed above, there are various avenues for organisations to raise funds internationally. With the opening up of an economy and the operations of the business organisations becoming global, Indian companies have an access to funds in global capital market. Various international sources from where funds may be generated include:

(i) Commercial Banks ( Foreign): Commercial banks all over the world extend foreign currency loans for business purposes. They are an important source of financing non-trade international operations. The types of loans and services provided by banks vary from country to country. For example, Standard Chartered emerged as a major source of foreign currency loans to the Indian industry.

(ii) International Agencies and Development Banks: A number of international agencies and development banks have emerged over the years to finance international trade and business. These bodies provide long and medium term loans and grants to promote the development of economically backward areas in the world. These bodies were set up by the Governments of developed countries of the world at national, regional and international levels for funding various projects. The more notable among them include International Finance Corporation (IFC), EXIM Bank and Asian Development Bank.

(iii) International Capital Markets: Modern organisations including multinational companies depend upon sizeable borrowings in rupees as well as in foreign currency. Prominent financial instruments used for this purpose are:

(a) Global Depository Receipts (GDR’s): The local currency shares of a company are delivered to the depository bank. The depository bank issues depository receipts against these shares. Such depository receipts denominated in US dollars are known as Global Depository Receipts (GDR). GDR is a negotiable instrument and can be traded freely like any other security. In the Indian context, a GDR is an instrument issued abroad by an Indian company to raise funds in some foreign currency and is listed and traded on a foreign stock exchange. A holder of GDR can at any time convert it into the number of shares it represents. The holders of GDRs do not carry any voting rights but only dividends and capital appreciation. Many Indian companies such as Infosys, Reliance, Wipro and ICICI have raised money through issue of GDRs.

(b) Foreign Currency Convertible Bonds (FCCB’s): Foreign currency convertible bonds are equity linked debt securities that are to be converted into equity or depository receipts after a specific period. Thus, a holder of FCCB has the option of either converting them into equity shares at a predetermined price or exchange rate, or retaining the bonds. The FCCB’s are issued in a foreign currency and carry a fixed interest rate which is lower than the rate of any other similar nonconvertible debt instrument. FCCB’s are listed and traded in foreign stock exchanges. FCCB’s are very similar to the convertible debentures issued in India.

SHORT TERM FUNDS.

After establishment of a business, funds are required to meet its day to day expenses. For example raw materials must be purchased at regular intervals, workers must be paid wages regularly, water and power charges have to be paid regularly. Thus there is a continuous necessity of liquid cash to be available for meeting these expenses. For financing such requirements short-term funds are needed. There are a number of sources of short-term finance which are listed below:

1. Trade credit2. Bank credit– Loans and advances– Cash credit– Overdraft– Discounting of bills3. Customers’ advances4.. Loans from co-operatives.5. Indigenous bankers.

1. Trade Credit.

Trade credit refers to credit granted to manufactures and traders by the suppliers of raw material, finished goods, components, etc. Usually business enterprises buy supplies on a 30 to 90 days credit. This means that the goods are delivered but payments are not made until the expiry of period of credit. This type of credit does not make the funds available in cash but it facilitates purchases without making immediate payment. This is quite a popular source of finance.

2. Bank Credit.

Commercial banks grant short-term finance to business firms which is known as bank credit. When bank credit is granted, the borrower gets a right to draw the amount of credit at one time or in installments as and when needed. Bank credit may be granted by way of loans, cash credit, overdraft and discounted bills.

(i) LoansWhen a certain amount is advanced by a bank repayable after a specified period, it is known as bank loan. Such advance is credited to a separate loan account and the borrower has to pay interest on the whole amount of loan irrespective of the amount of loan actually drawn. Usually loans are granted against security of assets.

(ii) Cash CreditIt is an arrangement whereby banks allow the borrower to withdraw money upto a specified limit. This limit is known as cash credit limit. Initially this limit is granted for one year. This limit can be extended after review for another year. However, if the borrower still desires to continue the limit, it must be renewed after three years. Rate of interest varies depending upon the amount of limit. Banks ask for collateral security for the grant of cash credit. In this arrangement, the borrower can draw, repay and again draw the amount within the sanctioned limit. Interest is charged only on the amount actually withdrawn and not on the amount of entire limit.

(iii) Overdraft

When a bank allows its depositors or account holders to withdraw money in excess of the balance in his account upto a specified limit, it is known as overdraft facility. This limit is granted purely on the basis of credit-worthiness of the borrower. Banks generally give the limit upto Rs.20,000. In this system, the borrower has to show a positive balance in his account on the last friday of every month. Interest is charged only on the overdrawn money. Rate of interest in case of overdraft is less than the rate charged under cash credit.

(iv) Discounting of Bill

Banks also advance money by discounting bills of exchange and promissory notes.. When these documents are presented before the bank for discounting, banks credit the amount to cutomer’s account after deducting discount. The amount of discount is equal to the amount of interest for the period of bill.

3. Customers’ Advances.

Sometimes businessmen insist on their customers to make some advance payment. It is generally asked when the value of order is quite large or things ordered are very costly. Customers’ advance represents a part of the payment towards price on the product which will be delivered at a later date. Customers generally agree to make advances when such goods are not easily available in the market or there is an urgent need of goods. A firm can meet its short-term requirements with the help of customers’ advances.

4. Loans from Co-operative Banks

Co-operative banks are a good source to procure short-term finance. Such banks have been established at local, district and state levels. District Cooperative Banks are the federation of primary credit societies. The State Cooperative Bank finances and controls the District Cooperative Banks in the state. They are also governed by Reserve Bank of India regulations. Some of these banks like the Vaish Co-operative Bank was initially established as a co-operative society and later converted into a bank. These banks grant loans for personal as well as business purposes. Membership is the primary condition for securing loan. The functions of these banks are largely comparable to the functions of commercial banks.

5. Indigenous Bankers.

They are private individuals engaged in the business of financing small and local business units. They provide short term and medium term loans. However they charge very high rates of interest and are, therefore, considered only as a last resort of finance.

WORKING CAPITAL MANAGEMENT.

Capital required for a business can be classified under two main heads:

i. Fixed Capitalii. Working CapitalFixed capital / Long term funds is required to meet long term obligations namely purchase of fixed assets such as plant & machinery, land, building, furniture etc. Any business requires funds to meet short-term purposes such as purchase of raw materials, payment of wages and other day-to-day expenses. These funds are called Working capital. In short, Working Capital is the funds required to meet day-to-day operations of a business firm. And hence study of Working capital is considered to be very significant. An inefficient management of working capital leads to not only loss of profits but also to the closure of the business firm.

There are two concepts of Working capital namely,1. Gross Working Capital (GWC)2. Net Working Capital.

Generally working capital refers to the gross working capital and represents funds invested in total current assets of the firm. That means according to this concept working capital means Total Current Assets.Net Working Capital is often referred to as circulating capital and represents the excess of current assets over current liabilities. Current liabilities are short-term obligations which are to be paid in the ordinary course of the business within a short period of one accounting year. Net working capital is positive when current assets exceed current liabilities. It is negative when current liabilities exceed current assets.Working capital management is concerned with the problems that arise in attempting to manage the current assets, current liabilities and the inter relationship that exist between them. The goal of working capital management is to manage firms current assets and current liabilities in such a way that a satisfactory level of working capital is maintained. This is so because, if the firm can’t maintain a satisfactory level of working capital, it is likely to become insolvent.

FACTORS DETERMINING THE WORKING CAPITAL REQUIREMENTS.

The total working capital requirement of a firm is determined by a wide variety of factors. These factors affect different organisations differently and they also vary from time to time. In general the following factors are involved in a proper assessment of the amount of working capital needed.

1. General nature of business.The working capital requirements of an enterprise are basically related to the conduct of those business. Enterprises fall in to some broad categories depending on the nature of their business. For instance, public utilities have certain features which have a bearing on their walking capital needs. The two relevant features are Cash nature of business; and Sale of services than commodities. In view of these features they do not maintain big inventories and have there fore, probably little or least requirement of working capital. At the other extreme are trading and financial enterprises. The nature of their business is such that they have to maintain a sufficient amount of cash, inventories and book debts. They have necessarily to invest proportionately large amount in working capital.

2. Production Cycle. Another factor which affects is production cycle. The term production cycle refers to the time involved in the manufacture of goods. It covers the time span between the purchase of raw materials and the completion of the manufacturing process leading to the production of finished goods. Funds will have to be necessarily tied up during the process of manufacture, necessitating enhanced working capital. The longer the time span (production cycle), the larger will be the funds tied up and there fore, the larger the working capital needed and vice versa. Further even within the same group of industries, the operating cycle may be different due to technological considerations. For economy in working capital, that process should be selected which has a shorter manufacturing process. Appropriate policies concerning terms of credit for raw materials and other supplies and advance payment from customers can help in reducing working capital requirement.

3. Business cycle. The working capital requirements are also determined by the nature of the business cycle. During the boom period the need for working capital is likely to grow to cover the lag between increased sales and receipt of cash as well as to finance purchases of additional material to face the expansion of the level of activity. The decline stage in the business cycle will have exactly an opposite effect on the level of working capital requirement. The decline in the economy is associated with a fall in the volume of sales, which will lead to a fall in the level of inventories and book debts. The need for working capital in recessionary condition is bound to decline.

4. Production policy. The quantum of working capital is also determined by production policy. In the case of certain lines of business, the demand for the product is seasonal ie they will be purchased during certain months of the year. Such companies may either confine their production only to periods when goods are purchased or they follow a steady production policy through out the year. In the former case there will be serious production problems. During slack season the firm will have to maintain its working force and physical facilities with out adequate production and sales. A steady production through out the year will cause large accumulation of finished goods. This will require additional working capital.

5. Credit Policy. The level of walking capital is also determined by the credit policy which relates to sales and purchase. The credit sales will result in higher amount of debtors and more working capital. On the other hand if liberal credit terms are available from the suppliers of goods the need for working capital will be less. The walking capital requirements of a business are, thus, affected by the terms of purchase and sales.

6. Growth and Expansion. As a Co grows it is logical to expect that a larger amount of working capital will be required. It is difficult to determine the relationship between the growth in the volume of business of a Co and the increase in the working capital. Other things being equal, growing Go's need more working capital than those that are static.

7. Availability of Raw Material. The availability of Raw material without interruption would some times affect working capital. There may be some material which cant be procured easily either because their sources are few or irregular. To sustain smooth production the firm might be compelled to purchase and stock them in large quantities. This will result in excessive inventory of such materials.

8 Profit level. Higher profit margin of a Co would generate more internal funds.. Net profit is a source of working capital to the extent that it has been earned in cash. The availability of such funds for working capital would depend upon level of tax, dividend and reserves, and depreciations.a. Level of Tax:- The amount of tax to be paid is determined by the prevailing tax regulations and very often taxes have to be paid in advance. An adequate provision for tax is an important aspect of working capital planning. If tax liability increases, it will lead to an increase in the level of working capital and vice versa.b. Dividend Policy:- The payment of dividend consumes cash resource and affects working capital. If the firm does not pay dividend and but retains the profit, working capital will increase.c. Depreciation Policy. :- as depreciation charges do not involve any cash out flow, the amount so retained can be used as working capital.

9 Price Level Changes. Changes in the price level also affect the requirement of working capital. Rising prices would necessitate the use of more funds for maintaining an existing level of activity. For the same level of materials and assets higher cash out flows are required. The effect of rising prices will be that a higher level of working capital is needed.

Operating Cycle / Need for Working Capial.

Every business needs some amount of working capital. The need for working capital arises dueto the time gap between the production and realization of cash from sales. Thus working capitalis needed for the following purposes.1. For the purchase of raw material, components and spares parts.2. To pay wages and salaries3. To incur day-to-day expenses.

4. To meet the selling costs s packing, advertising.5. To provide the credit facilities to the customers.6. To maintain the inventories of Raw material, work in progress, finished stockThere is an operating cycle involved in the sales and realization of cash. The cycle starts with thepurchase of raw material and ends with the realization of cash from sales of finished foods. Itinvolves purchase of raw material and stores, it conversion in to stock of finished goods throughwork-in- progress, conversion of finished stock in to sales, debtors and receivables andultimately in cash and this cycle continues again from cash to purchase of raw material and soon.The gross operating cycle of the firm = RMCP +WIPCP + FGCP+RCPWhere, RMCP = Raw material conversion periodWIPCP = Work in progress conversion periodFGCP = Finished goods conversion periodRCP = Receivables conversion periodHowever a firm may acquire some resources of credit and thus defer payments fro certain period.In this caseNet operating cycle period = Gross operating cycle period - Payable deferral period.

USERS OF FINANCIAL STATEMENT ANALYSIS.

Analysis of financial statement is an attempt to measure the enterprises liquidity, profitability, solvency and other indicators to assess its efficiency and performance. Analysis of financial statements is linked with the objective and interest of the individual / agency involved. Some of the agencies interested include Management, investors, creditors, bankers, workers, Government, and public at large.

1 MANAGEMENT.Management is interested in the financial performance and financial condition of the enterprise. It would like to know about its viability as an on going concern, management of cash, debtors, inventory and fixed asset and adequacy of capital structure. Management would also be interested in the overall financial position and profitability of the enterprise as a whole and its various departments and divisions.

2. INVESTORSAn investor is interested in the profitability and safety of his investment and would like to know whether the

business is profitable, has growth potential and is progressing on sound lines. The present investors want to decide whether they should hold the securities of the company or sell them. Potential investors, on the other hand, want to know whether they should invest in the shares of the company or not. Investors (Shareholders or owners) and potential investors, thus, make use of the financial statements to judge the present and future earning capacity of the business, to judge the operational efficiency of the business and to know the safety of investment and growth prospects.

3. BANKERS AND LENDERSBankers and lenders are interested in serving of their loans by the enterprise, i.e. regular payment of interest and repayment of principal amount on schedule dates. They also like to know the safety of their investment and reliability of returns.

4. SUPPLIERS/ CREDITORS.Creditors dealing with the enterprise are interested in receiving their payments as and when fall due and would like to know its ability to honor its short-term commitments.

5. EMPLOYEESEmployees interested in better emoluments, bonus and continuance of the business, would like to know its financial performance and profitability.

6. GOVERNMENTGovernment and regulatory authorities would like to ensure that the financial statements prepared are as per the specified laws and rules, and are to safe guard the interest of various concerned agencies. E.g.: Taxation authorities would be interested in ensuring proper assessment of tax liability of the enterprise as per the laws.

Stock exchange uses the financial statements to analyze and thereafter, inform its members about the performance, financial health, etc. of the company. 7. CUSTOMERS

Customers are interested to ascertain continuance of an enterprise. For example, an enterprise may be supplier of a particular type of consumer goods and in case it appears that the enterprise may not continue for a long time, the customer has to find an alternate source.

8.. PUBLIC Enterprises affect members of the public in a variety of ways. For example, enterprises may make a substantial contribution to the local economy in many ways including the number of people, they employ and their patronage of local suppliers. Financial statements may assist the public by providing information about trends and recent developments in the prosperity of the enterprise and the range of its activities.

Different agencies thus look at the enterprise from their respective viewpoint and are interested in knowing about its profitability and financial condition. In short a detailed cause and effect study of profitability and financial condition is the over all objective of financial statement analysis.

CASH FLOW. Every big and small firms performs cash transactions. Cash transaction refers to cash inflows and outflows.Cash inflows and outflows help to review success, failure of a firm and its ability to meet maturing debts. Such review and evaluation are possible if the statement of cash flow is prepared.Accounting standard Board(ASB) at international level in 1996 suggested every firm to publish the statement of cash flow along with the final accounts. Since then the statement of cash flow is getting more recognition than funds flow statement.

The statement that shows cash inflows and outflows of a firm for a specified period is called the cash flow statement. Cash flow statement demonstrates where the cash has come during the period and what the firm has done with the available cash. Therefore, cash flow statement shows a picture of cash movement occurred in and out from a firm during a year in a summarized form. Cash flow statement gives a picture of sources and applications of cash of a firm for a year.

The cash flow statement is not a cash book because it demonstrates inflows and outflows of cash and near to cash items. Cash and near to cash cover entire items of current assets and current liabilities. The cash flow statement reports increase and decrease in cash by listing in meaningful categories in terms of operating,investing and financing activities.

RATIO ANALYSIS.

A companies financial information is contained in 3 basic financial statements- the Balance Sheet, the Trading and P&L Account and the P&L Appropriation Account. These statements are very useful to different partiers concerned such as management, creditors, investors and so on. These statements may be more fruitfully used if they are analysed and interpreted to have an insight into the strengths and weakness of the firm. Analysis of statements means such a treatment of the information contained in the two statements as to afford a diagnosis of the profitability and financial position of the firm concerned. In the analysis of financial statements, the analyst has a variety of tools available from which he can choose those best suited to his specific purpose. The most important tools used now a days are Ratio analysis, Fund flow analysis and Comparative and common size statements.

Ratio Analysis.

Ratios are well known and most widely used tools of financial analysis. A ratio gives the mathematical relationship between one variable and another. Accounting ratios are relationships, expressed in quantitative terms, between figures which have a cause and effect relationship or which are connected with each other in some manner or the other. The analysis of a ratio can disclose the relationships as well as bass of comparison that reveal conditions and trends that cant be detected by going through the individual components of the ratio. The usefulness of ratios is ultimately dependent on their intelligent and skillful interpretation.

Classification of Ratios. Ratios can be grouped into various classes according to financial activity or function to be evaluated. In view of the requirements of the various users of ratios, we can classify them into the following categories.• Liquidity ratios.• Profitability Ratios• Solvency ratios.

Liquidity Ratios.

Liquidity ratios measure the firms ability to meet current obligations; ie the ability to pay its obligations as and when they become due. They show whether the firm can pay its short term obligations out of short term resources or not. They establish a relationship between cash and other current assets to current liabilities. If a firm has sufficient net working capital it is assumed to have enough liquidity. The most common ratios which indicate the extent of liquidity are current ratio and quick ratio.

Current Ratio.It is calculated by dividing the Current Assets by Current Liabilities.

Current AssetCurrent ratio = --------------------------

Current Liabilities.

Current assets include cash, securities, debtors B/R, stock etc and current liabilities include creditors, B/P, accrued expense, short term loan etc. Current ratio is a measure of the firms short term solvency. It indicates the availability of a current asset in rupees for every one rupee of current liability . a ratio greater than 1 means that the firm has more current assets than current claims against them.

As a conventional rule, a Current ratio of 2:1 or more is considered satisfactory. This rule is based on the logic that in a worse situation even the value of CA’s(current assets) becomes half, the firm will be able to meet its obligations. The higher the current ratio, the more will be the firms ability to meet its current obligations. In inter firm comparison, the firm with the higher current ratio has better liquidity or short term solvency.

Quick Ratio. (Acid Test Ratio)

This ratio establishes a relationship between quick or liquid assets and current liabilities. An asset is liquid, if it can be converted in to cash immediately or reasonably soon without a loss of value. Cash is the most liquid asset. QA also include debtors, B/R and securities. Inventories are considered less liquid. They normally require some time for realising in to cash.

Quick assets Quick Ratio = --------------------------

Current Liabilities.

Quick assets = Current Assets – Inventories or stock

Generally a QR of 1:1 is considered to represent satisfactory current financial position.

Cash Ratio (Absolute Liquid Ratio).Since cash is the most liquid asset, a financial analyst may examine the ratio of cash and its equivalent to current

liabilities. Trade investments or marketable securities are equivalents to cash.

Cash / Bank + Marketable securitiesCash Ratio = -----------------------------------

Current Liabilities.

Turn Over Ratio.

The liquidity ratios discussed so far relate to the liquidity of a firm as a whole. Another way of examining the liquidity is to determine how quickly certain current assets are converted in to cash. The ratios to measure these are referred to as turnover ratios.

Inventory Turnover Ratio. It is computed by dividing the cost of goods sold by the average inventory.

Cost of goods soldInventory turnover Ratio = --------------------------

Average inventory.

Cost of goods sold means sales – gross profit. Average inventory refers to the simple average of the opening and closing sock. The ratio indicates how fast inventory is sold. A high ratio is good from the view point of liquidity. A low ratio would signify that inventory does not sell fast.

Debtors Turn over Ratio.

It is determined by dividing the net credit sales by average debtors outstanding during the year.

Net credit salesDebtors turnover Ratio = ------------------------

Average Debtors.

Net credit sales consists of gross sales – sales returns if any from debtors. Average debtors is the simple average of opening balance of debtors and closing balance.

Average debt collection period in days Debtors + B/R =------------------------- X 365 Net credit sales

Average debt collection period in months

Debtors + B/R=------------------------ X 12 Net credit sales

12 monthsOr Debt collection period = --------------------------

Debtors turnover.

Debtors turnover measures how rapidly debts are collected. A high ratio is indicative of shorter time lag between credit sales and cash collection. A low ratio shows that debts are not being collected rapidly.

Creditors Turnover Ratio.

It’s the ratio between net credit purchases and average amount of creditors outstanding during the year. It is calculated as follows.

Net credit purchaseCTR = -------------------------------------------

Average Creditors.

Net credit purchase = Gross credit purchase – returns to suppliers.

Average creditors is the simple average of creditors at the beginning and at the end.

Average debt Payment period in days Creditors + B/P= --------------------------------- x 365 Net credit purchases.

Creditors + B/P= --------------------------------- x 12 Net credit purchases

12 monthsOr Credit payment period = ------------------------

Creditors turnover.

A low turnover reflects liberal credit terms granted by suppliers, while a high ratio shows that accounts are to be settled rapidly. The creditors turnover ratio is an important tool of analysis as a firm can reduce its requirements of current assets by relying on the suppliers credit.

Profitability Ratios.

A measure of profitability is the over all measure of efficiency. The management of the firm is naturally eager to measure its operating efficiency. Similarly is the share holders or owners who invest their funds in the expectation of reasonable returns. The profitability of a firm can be measured by its profitability ratios. Profitability ratios can be determined on the basis of either sales or investments.

Gross profit margin. The gross profit margin ratio is calculated as

Gross profit--------------------------------- X 100.

Sales This ratio shows the profit relative to sales. A high ratio of gross profits to sales is a sign of good management as it implies that the cost of production of the firm is relatively low.

Net Profit margin.This measures the relationship between net profit and sales of a firm. Depending on the concepts of the net profit employed, this ratio can be computed in two ways.

Operating profit Ratio

Earning Before interest and Tax (EBIT) = ---------------------------------------------------X 100

Sales

Earning after Interest and tax (EAIT)Net profit Ratio = --------------------------------------X 100

Sales

Net profitOr Net profit ratio = -------------------------X 100

Sales

The net profit margin is indicative of managements ability to operate the business with sufficient success not only to recover from revenues, but also to leave a reasonable margin to the owners. A high net profit margin would ensure adequate return to the owners as well as enable a firm to face adverse economic conditions.

Expenses ratio.

Another profitability ratio related to sales is expense ratio. It is computed by dividing expenses by sales.

Cost of goods sold Ratio

Cost of goods sold= --------------------------------------X100

Net sales

Administrative expense

Administrative expense ratio = ---------------------------------------X 100

Net sales

Operating expenses

Operating expense Ratio = -------------------------------------- X 100

Net sales

Selling expense Ratio. Selling expense.=--------------------------------------X 100

Net sales

The expense ratio is closely related to the profit margin, gross as well as net. The cost of goods sold ratio shows what percentage share of sales is consumed by cost of goods sold and what proportion is available for meeting expenses such as selling and general distribution expense as well as financial expenses consisting of taxes, interest, dividends and so on. The expense ratio is very important for analysing the profitability of a firm. It should be compared over a period of time with the industry average as well as firms of similar type. A low ratio is favourable and a high ratio is unfavourable.

Profitability ratios related to Investments.

The profitability ratios can be computed by relating the profits of a firm to its investments. Such ratios are popularly known as Return On Investments (ROI). There are 3 different concepts of investments and based on each of them, there are 3 broad categories of ROI’s.

Return on Asset. Here the profitability ratio is measured in terms of the relationship between net profits and assets. It is also called profit – to –asset ratio.

Net profit after tax Return on Asset = --------------------------------- X100

Average total assets.

Return on capital employed.Here the profits are related to total capital employed. The term capital employed refers to long term funds supplied by the creditors and owners of the firm. A comparison of those with similar firms, and with the industry average would provide sufficient insight in to how efficiently the long term funds of owners and creditors are being used. The higher the ratio, the more efficient is the use of capital.

Return on capital employed = Net profit after tax /EBIT

--------------------------------------------- X 100Average total capital employed.

Return on Total shareholders equity.According to this ratio, profitability is measured by dividing the net profits after tax by the average total shareholders equity. The term share holders equity includes (1) preference share capital, (2) ordinary share holder’s equity consisting of equity share capital, share premium, and reserves and surplus less accumulated losses. Return on total shareholders equity

Net profit after tax = ------------------------------------------------ X 100. Average total shareholders equity. The ratio reveals how profitably the owner’s funds have been utilised by the firm. A comparison of this ratio with that of similar firms will show the performance of the firm.

Return on ordinary shareholders equity.(Net worth)

The real owners of the business are the ordinary share holders who bear all the risk, participate in management and are entitled to profit remaining after all outside claims, including preference dividends are met in full.

Return on Equity Fund

Net profit after tax- Preference dividend = ---------------------------------------------------------- Average ordinary shareholders equity.

This is probably the single most important ratio to judge whether the firm has earned a satisfactory return for its equity share holders or not.

Earning Per Share.

EPS measures the profit available to the equity shareholders on a per share basis. – ie the amount that they can get on every share held. The profits available to the ordinary shareholders are represented by the net profits after taxes and preference dividend.

Net profit available to equity shareholdersEPS = ------------------------------------------------------------

Number of ordinary shares outstanding.

Dividend Per Share.

This is the dividend paid to the shareholders on a ‘per share’ basis. It is net distributed profit belonging to the shareholders dividend by the number of ordinary shares.

Dividend paid to equity shareholders DPS = --------------------------------------------------

Number of equity shares.

Dividend Pay –Out Ratio.

This is also known as pay out ratio. It measures the relationship between the earnings belonging to the ordinary shareholders and the dividend paid to them. It can be calculated by dividing the total dividend paid to the owners by the total profits available to them.

Total dividend to equity shareholdersDPR =---------------------------------------------- X 100. Net profit belonging to equity shareholders

Or DPS ------------------ X 100

EPS

Price Earning Ratio

This ratio gives the relationship between the market price of the stock and its earnings by revealing how earnings affect the market price of the firms stock.

Market price of shareP E Ratio = --------------------------------

EPS.

Other important Ratios.

Debt Equity Ratio.

The relationship between borrowed funds and owners capital is a popular measure of the long term financial solvency of the firm. This relationship is shown by the debt equity ratio. It indicates the relative proportion of debt and equity in financing the assets of

Debt Outsiders fundDebt Equity Ratio = --------- or -------------------

Equity. Share holders fund.

The term debt refers to the total outside liabilities. It includes all current liabilities and other outside liabilities like loan debenture etc. The term equity refers to networth or shareholders fund.

Proprietary ratio.

This ratio shows the long term solvency of the business. It is calculated by dividing shareholders funds by total assets.

Share holders fundProprietary ratio = -------------------------------

Total assets.

Capital gearing ratio.

This is also known as Leverage ratio. This is mainly used to analyse the capital structure of a company. The term capital gearing normally refers to the proportion between fixed income bearing securities and non fixed income bearing securities. The former includes preference share capital and debentures and the later includes equity share capital and reserves and surplus.

Capital gearing Ratio =

Fixed interest bearing funds --------------------------------------------------- Equity share capital + Reserves and Surplus.

Working Capital TurnoverThis reflects the turnover of the firm’s net working capital in the course of the year.

Net salesWorking capital turnover Ratio = ---------------------------

Net working capital.

Operating Ratio.It shows the proportion that the cost of sales bears to sales. Cost of sales includes direct cost of goods sold as well as other operating expenses. It is calculated by dividing the total operating cost by net sales. Total operating expenses include all costs like administration, selling and distribution expenses etc, but do not include financing cost and income tax. Lower the ratio, the more profitable are the operations indicating an efficient control over costs and appropriate selling price.

Operating Ratio =

(Cost of goods sold + Operating expense) --------------------------------------------------x 100

Net sales

Question : Are financial ratios relevant in financial decision making ? Answer : A popular technique of analysing the performance of a business concern is that of financial ratio analysis, it, as a tool of financial management is of crucial significance. Its importance lies in the fact that it presents facts on a comparative basis and enables drawing of inferences as regards a firm's performance. It is relevant in assessing the firm's performance in the below mentioned aspects : I) Financial ratios for evaluation of performance : • Liquidity position : Ratio analysis assists in drawing conclusions as regards the firm's liquidity position. It would be satisfactory if the firm is able to meet its current obligations when they become due. A firm can be said to have the ability to meet its short-term liabilities if it has sufficient liquidity to pay interest on its short-maturing debt, usually within a year as also the principal. This ability is reflected in the liquidity ratios of the firm and liquidity ratios are useful in credit analysis by banks and other suppliers of short-term loans. • Long-term solvency : Ratio analysis is equally helpful for assessing a firm's long-term financial viability. This aspect of the financial position of a borrower is of concern to the long-term creditors, security analysts and the present and potential owners of a business. The long-term solvency is measured by the leverage/capital structure and profitability ratios focusing on earning power and operating efficiency and ratio analysis reveals the strength and weaknesses of a firm in respect thereto. The leverage ratios, for example, indicates whether a firm has a reasonable proportion of various sources of finance or whether heavily loaded with debt in which case its solvency is exposed to serious strain. In the same manner, various profitability ratios reveal whether or not the firm is able to offer adequate return to its owners consistent with the risk involved. • Operating efficiency : Ratio analysis throws light on the degree of efficiency in the management and utilisation of its assets. Various activity ratios measure this kind of operational efficiency, a firm's solvency is, in the ultimate analysis, dependent on the sales revenues generated by the use of its assets - total as well as its components. • Over-all-profitability : Unlike outside parties, that are interested in one aspect of the financial position of a firm, the management is constantly concerned about the overall profitability of the enterprise i.e. they are concerned about the firm's ability to meet its short-term and long-term obligations to its creditors, to ensure reasonable return to its owners and secure optimum utilisation of the firm's assets. It is possible if an integrated view is taken and all the ratios are considered together. • Inter-firm comparison : Ratio analysis not only throws light on the firm's financial position but also serves as a stepping stone to remedial measures. It is made possible by inter-firm comparison/comparison with industry average. It should be reasonably expected that the firm's performance is in broad conformity with that of the industry to which it belongs. An inter-firm comparison demonstrates the relative position vis-à-vis its competitors. If the results are at variance either with the industry average or with that of the competitors, the firm can seek to identify the probable reasons and in its light, take remedial measures. Ratios not only perform post-mortem of operations, but also serves as barometer for future, they have predictory value and are helpful in forecasting and planning future business activities and helps in budgeting. II) Financial ratios for budgeting : In this field ratios are able to provide a great deal of assistance, budget is only an estimate of future activity based on past experience, in the making of which the relationship between different spheres of activities are invaluable. It is usually possible to estimate budgeted figures using financial ratios. Ratios also can be made use of for measuring actual performance with budgeted figures and indicate directions in which adjustments should be made either in the budget or in performance to bring them closer to each other.

Question: what are the various ratios based on capital market information? Answer : frequently share prices data are punched with accounting data to generate new set of information, these are: i) Price earning ratio :Price earning ratio (PE ratio) = average or closing share prices/EPS It indicates the payback period to investors or prospective investors. ii) Yield : Yield = dividend/average or closing share price * 100 It indicates return on investment, which may be on average or closing investment. Dividend % indicates return on paid-up value of shares, but, yield % is the indicator of true return in which share capital is taken at its market value. iii) Market value/book value for share : Market value for share/book value per share = average share price/(net worth/number of equity shares) or = closing share price/(net worth/number of equity shares) It indicates market response of shareholders' investment. Higher the ratio better is the shareholders position in terms of return and capital gains. Question: what are the ratios computed for investment analysts ? Answer : Investment analysis are published weekly in economic newspapers, some ratios are used by analysis to report performance of selected companies. Let us discuss the issues highlighted by Economic Times under the caption' performance indicators' : i) Book value per share=(equity capital + reserves and surplus excluding revaluation reserves)/number of equity shares ii) EPS = (net profit - preference dividend)/number of equity shares iii) dividend % iv) yield % = equity dividend/market price * 100 v) payout ratio % = dividend including preference dividend/profit after tax * 100 vi) gross margin/sales (%)where,gross margin = profit before depreciation but after interest and before tax vii) gross margin/capital employed (%)where,gross margin = profit before depreciation but after interest and before taxcapital employed = fixed assets + capital work-in-progress + investments + current assetsi.e. aggregate of fixed assets, capital work-in-progress, investment and current assets but excluding accumulated deficit.

viii) PE ratio = price/earnings ix) current ratio = current assets/current liabilities Explain the meaning of capital budgeting ?

The term capital budgeting means planning for capital assets. Capital budgeting decision means the decision as to whether or not to invest in long-term projects such as setting up of a factory or installing a machinery or creating additional capacities to manufacture a part which at present may be purchased from outside and so on. It includes the financial analysis of the various proposals regarding capital expenditure to evaluate their impact on the financial condition of the company for the purpose to choose the best out of the various alternatives. The finance manager has various tools and techniques by means of which he assists the management in taking a proper capital budgeting decision. Capital budgeting decision is thus, evaluation of expenditure decisions that involve current outlays but are likely to produce benefits over a period of time longer than one year. The benefit that arises from capital budgeting decision may be either in the form of increased revenues or reduced costs. Such decision requires evaluation of the proposed project to forecast likely or expected return from the project and determine whether return from the project is adequate. Also as business is a part of society, it is its moral responsibility to undertake only those projects that are socially desirable. Capital budgeting decision is an important, crucial and critical business decision due to : Importance of Capital Budgeting1. Large Investment: Capital budgeting decision involves large investment of funds. Butthe funds available with the firm are always limited and the demand for funds far exceedsthe resources. Hence it is very important for a firm to plan and control its capitalexpenditure.

2. Long Term Commitment of Funds: capital expenditures involves not only largeamount of funds but also funds for long term or permanent basis. The long terncommitments of funds increases, the financial risk involved in the investment decision.Greater the risk involved, greater is need for careful planning of capital expenditure i.e.Capital Budgeting.

3. Irreversible Nature: The Capital expenditure decision is of irreversible nature. Once thedecision for acquiring a permanent asset is taken, it becomes very difficult to dispose ofthese assets without incurring heavy losses.

4. Long term Effect on profitability: Capital budgeting decisions have a long term andsignificant effect on the profitability of a concern. Not only the present earnings of thefirm are effected by the investments in capital asserts but also the future growth andprofitability of the firm depends upon the investment decision taken today. An unwisedecision may prove disastrous and fatal to the very existence of the concern.

5. Difficulties of investment Decisions: The long tern investment decision are difficult tobe taken because decision extends to a series of years beyond the current accountingperiod, uncertainties of future, higher degree of risk.

6. National Importance: Investment decision though taken by individual concern is ofnational importance because it determines employment, economic activities and

Question : Explain the major considerations in the planning of capital structure ? Answer : The 3 major considerations evident in capital structure planning are risk, cost and control, they assist the management in determining the proportion of funds to be raised from various sources. The finance manager attempts to design the capital structure in a manner, that his risk and cost are least and there is least dilution of control from the existing management. There are also subsidiary factors as, marketability of the issue, maneuverability and flexibility of

capital structure and timing of raising funds. Structuring capital, is a shrewd financial management decision and is something that makes or mars the fortunes of the company. The factors involved in it are as follows : 1) Risk : Risks are of 2 kinds viz. financial and business risk. Financial risk is of 2 kinds as below : i) Risk of cash insolvency : As a business raises more debt, its risk of cash insolvency increases, as : a) the higher proportion of debt in capital structure increases the commitments of the company with regard to fixed charges. i.e. a company stands committed to pay a higher amount of interest irrespective of the fact whether or not it has cash. and b) the possibility that the supplier of funds may withdraw funds at any point of time.Thus, long term creditors may have to be paid back in installments, even if sufficient cash to do so does not exist. Such risk is absent in case of equity shares. ii) Risk of variation in the expected earnings available to equity share-holders : In case a firm has a higher debt content in capital structure, the risk of variations in expected earnings available to equity shareholders would be higher; due to trading on equity. There is a lower probability that equity shareholders get a stable dividend if, the debt content is high in capital structure as the financial leverage works both ways i.e. it enhances shareholders' returns by a high magnitude or reduces it depending on whether the return on investment is higher or lower than the interest rate. In other words, there is relative dispersion of expected earnings available to equity shareholders, that would be greater if capital structure of a firm has a higher debt content. The financial risk involved in various sources of funds may be understood with the help of debentures. A company has to pay interest charges on debentures even in case of absence of profits. Even the principal sum has to be repaid under the stipulated agreement. The debenture holders have a charge against the company's assets and thus, they can enforce a sale of assets in case of company's failure to meet its contractual obligations. Debentures also increase the risk of variation in expected earnings available to equity shareholders through leverage effect i.e. if return on investment remains higher than interest rate, shareholders get a high return and vice versa. As compared to debentures, preference shares entail a slightly lower risk for the company, as the payment of dividends on such shares is contingent upon the earning of profits by the company. Even in case of cumulative preference shares, dividends are to be paid only in the year in which company earns profits. Even, their repayment is made only if they are redeemable and after a stipulated period. However, preference shares increase the variations in expected earnings available to equity shareholders. From the company's view point, equity shares are least risky, as a company does not repay equity share capital except on its liquidation and may not declare dividends for years. Thus, as seen here, financial risk encompasses the volatility of earnings available to equity shareholders as also, the probability of cash insolvency. 2) Cost of capital : Cost is an important consideration in capital structure decisions and it is obvious that a business should be atleast capable of earning enough revenue to meet its cost of capital and also finance its growth. Thus, along with risk, the finance manager has to consider the cost of capital factor for determination of the capital structure. 3) Control : Along with cost and risk factors, the control aspect is also an important factor for capital structure planning. When a company issues equity shares, it automatically dilutes the controlling interest of present owners. In the same manner, preference shareholders can have voting rights and thereby affect the composition of Board of directors, if dividends are not paid on such shares for 2 consecutive years. Financial institutions normally stipulate that they shall have one or more directors on the board. Thus, when management agrees to raise loans from financial institutions, by implication it agrees to forego a part of its control over the company. It is thus, obvious that decisions concerning capital structure are taken after keeping the control factor in view. 4) Trading on equity : A company may raise funds by issue of shares or by borrowings, carrying a fixed rate of interest that is payable irrespective of the fact whether or not there is a profit. Preference shareholders are also entitled to a fixed rate of dividend, but dividend payment is subject to the company's profitability. In case of ROI the total capital employed i.e. shareholders' funds plus long term borrowings, is more than the rate of interest on borrowed funds or rate of dividend on preference shares, the company is said to trade on equity. It is the finance manager's main objective to see that the return and overall

wealth of the company both are maximised, and it is to be kept in view while deciding on the sources of finance. Thus, the effect of each proposed method of new finance on EPS is to be carefully analysed. This, thus, helps in deciding whether funds should be raised by internal equity or by borrowings. 5) Corporate taxation : Under the Income tax laws, dividend on shares is not deductible while interest paid on borrowed capital is allowed as deduction. Cost of raising finance through borrowings is deductible in the year in which it is incurred. If it is incurred during the pre-commencement period, it is to be capitalised. Cost of share issue is allowed as deduction. Owing to such provisions, corporate taxation, plays an important role in determination of the choice between different sources of financing.

6) Government Policies : Government policies is a major factor in determining capital structure. For instance, a change in the lending policies of financial institutions would mean a complete change in the financial pattern followed by companies. Also, rules and regulations framed by SEBI considerably affect the capital issue policy of various companies. Monetary and fiscal policies of government also affect the capital structure decisions. 7) Legal requirements : The finance manager has to keep in view the legal requirements at the time of deciding as regards the capital structure of the company. 8) Marketability : To obtain a balanced capital structure, it is necessary to consider the company's ability to market corporate securities. 9) Maneuverability : Maneuverability is required to have as many alternatives as possible at the time of expanding or contracting the requirement of funds. It enables use of proper type of funds available at a given time and also enhances the bargaining power when dealing with the prospective suppliers of funds. 10) Flexibility : It refers to the capacity of the business and its management to adjust to expected and unexpected changes in circumstances. In other words, the management would like to have a capital structure providing maximum freedom to changes at all times. 11) Timing : Closely related to flexibility is the timing for issue of securities. Proper timing of a security issue often brings substantial savings due to the dynamic nature of the capital market. Intelligent management tries to anticipate the climate in capital market with a view to minimise cost of raising funds and the dilution resulting from an issue of new ordinary shares. 12) Size of the company : Small companies rely heavily on owner's funds while large companies are usually considered, to be less risky by investors and thus, they can issue different types of securities. 13) Purpose of financing : The purpose of financing also, to some extent affects the capital structure of the company. In case funds are required for productive purposes like manufacturing, etc. the company may raise funds through long term sources. On the other hand, if the funds are required for non-productive purposes, like welfare facilities to employees such as schools, hospitals, etc. the company may rely only on internal resources. 14) Period of Finance : The period for which finance is required also affects the determination of capital structure. In case funds are required for long term requirements say 8 to 10 years, it would be appropriate to raise borrowed funds. However, if the funds are required more or less permanently, it would be appropriate to raise borrowed funds. However, if the funds are required more or less permanently, it would be appropriate to raise them by issue of equity shares.

15) Nature of enterprise : The nature of enterprise to a great extent affects the company's capital structure. Business enterprises having stability in earnings or enjoying monopoly as regards their products may go for borrowings or preference shares, as they have adequate profits to pay interest/fixed charges. On the contrary, companies not having assured income should preferably rely on internal resources to a large extent. 16) Requirement of investors : Different types of securities are issued to different classes of investors according to their requirement. 17) Provision for future : While planning capital structure the provision for future requirement of capital is also required to be considered. Explain the relevance of time value of money in financial decisions.Time value of money means that worth of a rupee received today is different from theworth of a rupee to be received tomorrow or in future, The preference of money now, ascompared to future money is known as time preference for money.A rupee today is more valuable than a rupee after a year due to several reasons like:- Risk:- There is uncertainly about the receipt of money in future.

Inflation:- In an inflationary period, a rupee today represents a greater real purchasingpower than a rupee a year later.

Preference for present consumption: - Most of the persons & companies in generalprefer current consumption to future consumption.

Investment opportunities:- Many persons and the companies have a preference forpresent money as there are many opportunities of investment available for earningadditional cash flow.

Capital Budgeting:- While arriving at capital budgeting decisions time value of money isone or utmost important option. In this type of decision money is invested today butreturn is realised over a long period of time. Hence to arrive at a correct decision weneed to consider time value of money.

Objectives and Advantages or Uses of Ratio Analysis.

It helps the reader in giving tongue to mute the mute heaps of figures given in financialstatements. The figures then speak of liquidity, solvency, profitability etc. of the businessenterprise. Some important objects and advantages of accounting ratios are:

a) Helpful in Analysis of Financial Statements: Ratio analysis is an extremely usefuldevice for analyzing the financial statements. It helps the bankers, creditors, investors,shareholders etc. in acquiring enough knowledge about the profitability and financialhealth of the business.

b) Simplification of Accounting Data: Accounting ratio simplifies and summarizes a longarray of accounting data and makes them understandable. It discloses the relationshipbetween two such figures which have a cause and effect relationship with each other.

c) Helpful in Comparative Study: With the help of ratio analysis comparison ofprofitability and financial soundness can be made between one firm and another in thesame industry. Similarly, comparison of current year figures can also be made with thoseprevious years with the help of ratio analysis.

d) Helpful in Locating the Weak Spots of the Business: Current year’s ratios arecompared with those of the previous years and if some weak spots are located, remedialmeasures are taken to correct them.

e) Helpful in Forecasting: Accounting ratios are very helpful in forecasting and preparingthe plans for the future. For example, if sales of a firm during this year are Rs. 10 Lakhsand the average amount of stock kept during the year was Rs. 2 Lakhs, i.e., 20% of salesand if the firm wishes to increase sales in next year to Rs.15 Lakhs, it must be ready tokeep a stock of Rs.3, 00,000, i.e., 20% of 15 Lakhs.

f) Estimate About the Trend of the Business: If accounting ratios are prepared for anumber of years, they will reveal the trend of costs, sales, profits and other importantfacts.

g)Fixation of Ideal Standards: Ratios help us in establishing ideal standards of thedifferent items of the business. By comparing the actual ratios calculated at the end of theyear with the ideal ratios, the efficiency of the business can be easily measured. h) Effective Control: Ratio analysis discloses the liquidity, solvency and profitability of thebusiness enterprise. Such information enables management to assess the changes thathave taken place over a period of time in the financial activities of the business. It helpsthem in discharging their managerial functions, e.g., planning, organizing, directing,communicating and controlling more effectively.

i) Study of Financial Soundness. Ratio analysis discloses the position of business withdifferent view'-points. It discloses the-position of business with the liquidity point ofview, solvency point of view, profitability point of view etc. With the help of such astudy we can draw conclusions regarding the financial health of the business enterprise.

Limitations of Ratio AnalysisFollowing limitations should be kept in mind while making use of the ratio analysis:

a) False accounting Data Gives False Ratios: Accounting ratios are calculated on the basisof data given in profit and loss account and balance sheet. Therefore, they will be only ascorrect as the accounting data on which they are-based. For 'example, if the -closingstock is overvalued, not only the profitability will be overstated but also the financialposition will appear to be better.

b) Comparison not possible if the different Firms Adopt Different Accounting Policies:There may be different accounting policies adopted by different firms with regard toproviding depreciation, creation of provision for doubtful debts, method of valuation ofclosing stock etc.

c) Ratio Analysis Becomes Less Effective Due to Price Level Changes: Price' level overthe years goes on changing; therefore, the ratios of various years cannot be compared. For47 example, one firm sells 1,000 Machines for Rs. 10 Lakhs dunng2002, it again sells 1,500Machines of the same type in 2003 but owing to rising prices the sale price was Rs. 15Lakhs. On the basis of ratios it will be concluded that the sales have increased by 50%,whereas in actual,-sales have not increased at all. Hence, the figures of the past yearsmust be adjusted in the light of price level changes before the ratios for these years arecompared. '

d) Ratios may be Misleading in the Absence of Absolute Data: For example, X companyproduces 10 lakh meters of cloth in 2002 and 15 Lakh meters in 2003, the progress is50%. Y Company raises its production from 10 thousand meters in 2002 to 20 thousandmeters in 2003, the progress is 100%. Comparison of these two firms made on the basisof ratio will disclose that the second firm is more active than the first firm. Suchconclusion is quite misleading because of the difference in the size of the two firms. It is,therefore, essential to study the ratios along with the absolute data on which they arebased.

e) Limited Use of a Single Ratio: The analyst should not merely rely on a single ratio. Heshould study several connected ratio before reaching a conclusion. For example, theCurrent Ratio of a firm may be quite satisfactory, whereas the Quick Ratio may beunsatisfactory.

f) Window-Dressing: Some companies in order to cover up their bad financial positionresort to window dressing, i.e., showing a better position than the one which really exists.

g) Lack of Proper Standards: Circumstances differ fro firm to firm hence no standardratio can be fixed for all the firms. For ex if a firm has such type of relations with itsbankers that it can get necessary credit in case of need, the ideal current ratio for the firmwould be less than generally accepted current ideal ratio of 2:1.

h) Ration alone are not adequate for proper conclusions: They merely indicate theprobability of favorable or unfavorable position. The analyst has to use other tools andtechniques to further carry out the investigation and to arrive at a correct diagnosis.

i) Effect of personal ability and bias of the Analyst: Different person draw differentmeaning of the different terms. For example one analyst may calculate ration on the basisof profit after interest and tax while another may consider profits before interest and Tax.

EVALUATIONS TECHNIQUES OF PROJECTS

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The commonly used methods are following:

1. Traditional Method

a. Pay backs period method or pay out or pay off method

b. Rate of return Method or Accounting Method

2. Time adjusted Method or discounted method

a. Net present value method

b. Internal rate of return method

c. Profitability Index

Traditional Method

Pay Back Period Method: It represents the period in which the total investments in permanent

assts pay backs itself. This method is based on the principal that every capital expenditures pays

itself back within a certain period out of the additional earnings generated from the capital assets

thus it measures the period of time for the original cost of a project to be recovered from the

additional earnings of the project itself.

In case of evaluation of a single project, it is adopted if it pays back itself within a period

specified by the management and if the project does not pay back itself within the period

specified by the management than it is rejected.

92The payback period can be ascertained in the following manner: Calculate annual net

earning (profit) before depreciation and after taxes; these are called the annual cash flows.

Where the annual cash inflows are equal, Divide the initial outlay (cost) of the project by

annual cash flows, where the project generates constant annual cash inflows.

Where the annual cash inflows are unequal, the pat back period can be found by adding up the

cash inflows until the total is equal to the initial cash outlay of project or original cost of the

asset.

Payback period = Cash outlay of the project or original cost of the asset

Annual cash Inflows

Illustration 1. A project costs Rs1, 00,000 and yields annual cash inflow of Rs. 20,000 for 8

years. Calculate its pay back period.

Solution:

Pay back period = Cash outlay of the project or original cost of the asset

Annual cash Inflows

= 1, 00,000 = 5 years

20,000

Advantages of Pay Back Period

1. It is simple to understand and easy to calculate.

2. It saves in cost; it requires lesser time and labor as compared to other methods of

capital budgeting.

3. This method is particularly suited to firm, which has shortage of cash or whose

liquidity position is not particularly good.

Disadvantages of Pay Back Period

1. It does not take into account the cash inflows earned after the pay back period and

hence the true profitability of the project cannot be correctly assessed.

2. It ignores the time value of money and does not consider the magnitude and timing of

cash inflows. it treats all cash flows as equal though they occur in different time

periods.

3. It does not take into consideration the cost of capital, which is very important; factor

in making sound investment decision.

4. It treats each asset individually in isolation with other asset, which is not feasible in

real practice.

5. It does not measure the true profitability of the project, as the period considered under

this method is limited to a short period only and not the full life of the asset.

Rate of Return Method: This method take into account the earnings expected from the

investment over their whole life. It is known as accounting rate if Return method for the reasons

93that under this method, the accounting Concept of profit is used rather than cash inflows.

According to this method, various projects are ranked in order of the rate of earnings or rate of

return. The project with the higher rate of return is selected as compared to the one with the

lower rate of return. This method can be used to make decisions as to accepting or rejecting a

proposal. The expected return is determined and the project with a higher rate of return than the

minimum rate specified by the firm called cut-off rate, is accepted and the one which gives a

lower expected rate of return than the minimum rate is rejected.

The return in investment can be used in several ways as follows:

Average rate of return method (ARR): Under this method average profit after tax and

deprecation is calculated and than it is divided by the total capital outlay or total investment in

the project.

Total Profits (after dep. & taxes) X 100

Net Investment in project x No. Of years of profits

Or

Average annual profit X 100

Net investment in the Project

Illustration 2. A project requires an investment of Rs.5, 00,000 and has a scrap value of Rs.20,

000 After 5 years. It is expected to yield profits after depreciation and taxes during the 5 years

amounting to Rs. 40,000. Rs. 60,000, Rs. 70,000, Rs. 50,000 and Rs.20, 000. Calculate the

average rate of return on the investment.

Solution:

Total profits = Rs. 40,000+60,000+70,000+50,000+20,000 = Rs. 2, 40,000

Average Profit = Rs. 2, 40,000 = Rs.48, 000

5

Net Investment in the project = Rs. 5, 00,000 – 20,000(scrap value)

= Rs 4, 80,000

Average annual profit X 100

Net investment in the Project

48,000 X 100 = 10%

4, 80,000

Return per unit of investment method: This method is small variation of the average rate of

return method. In this method, the total profit after tax and depreciation is divided by the total

investment i.e.

Return per Unit of Investment = Total profit (after depreciation and tax) X 100

Net investment in the project

94Illustration 3. Continuing above illustration, the return per unit of investment shall be:

2, 40,000 X 100 = 50%

4, 80,000

Return on average Investment method: In this method the return on average investment is

calculated. Using of average investment for the purpose of return in investment is referred

because the original investment is recovered over the life of the asset on account of depreciation

charges.

Return on Average Investment = Total profit (after depreciation and tax) X 100

Total Net investment/2

Advantages of Rate of Return Method

1. It is very simple to understand and easy to operate.

2. This method is based upon the accounting concept of profits; it can be readily

calculated from the financial data.

3. It uses the entire earnings of the projects in calculating rate of return.

Dis Advantages of Rate of Return Method

1. It does not take into consideration the cash flows, which are more important than the

accounting profits.

2. It ignores the time value of money as the profits earned at different points of time are

given the equal weighs.

Time Adjusted or Discounted Cash Flows Methods

The traditional methods of capital budgeting suffer from serious limitations that give the equal

weights to present and future flow of income. These do not take into accounts the time value of

money. Following are the discounted cash flow methods:

Net Present Value Method: This method is the modern method of evaluating the investment

proposals. This method takes into consideration the time value of money and attempts to

calculate the return in investments by introducing the factor of time element. It recognizes the

fact that a rupee earned today is more valuable earned tomorrow. The net present value of all

inflows and outflows of cash occurring during the entire life of the project is determined

separately for each year by discounting these flows by the firm’s cost of capital.

Following are the necessary steps for adopting the net present value method of evaluating

investment proposals.

1. Determine appropriate rate of interest that should be selected as the minimum

required rate of return called discount rate.

2. Compute the present value of total investment outlay.

3. Compute the present value of total investment proceeds.

4. Calculate the net present value of each project by subtracting the present value of

cash inflows from the present value of cash outflows for each project.

5. If the net present value is positive or zero, the proposal mat be accepted otherwise

rejected.

Advantages of Net Present Value

1. It recognizes the time value of money and is suitable to be applied in situations with

uniform cash outflows and cash flows at different period of time.

2. It takes into account the earnings over the entire life of the projects and the true

profitability of the investment proposal can be evaluated.

2. It takes into consideration the on\objective of maximum profitability.

Disadvantages of Net Present Value

1. This method is more difficult to understand and operate.

2. It is not easy to determine an appropriate discount rate.

3. It may not give good results while comparing projects with unequal lives and

investment of funds.

Internal Rate of Return Method: It is a modern technique of capital budgeting that takes into

account the time value of money. It is also known as “time adjusted rate of return discounted

cash flows” “yield method” “trial and error yield method”

Under this method, the cash flows of the project are discounted at a suitable rate by hit and trial

method, which equates the net present value so calculated to the amount of the investment.

Under this method, since the discount rate is determined internally, this method is called as the

internal rate of return method. It can be defined as the rate of discount at which the present value

of cash inflows is equal to the present value of cash outflows.

Steps required for calculating the internal rate of return.

1. Determine the future net cash flows during the entire economic life of the project.

The cash inflows are estimated for future profits before depreciation and after taxes.

2. Determine the rate of discount at which the value of cash inflows is equal to the

present value of cash outflows.

3. Accept the proposal if the internal rate of return is higher than or equal to the

minimum required rate of return.

4. In case of alternative proposals select the proposals with the highest rate of return as

long as the rates are higher than the cost of capital.

Determination of Internal Rate of Return:

1. When the annual net cash flows are equal over the life of the assets.

Present value Factor = Initial Outlay

Annual cash Flows

962. When the annual net cash flows care Unequal over the life of the assets.

Following are the steps

i. Prepare the cash flow table using an arbitrary assumed discount rate to

discount the net cash flows to the present value.

ii. Find out the net present value by deducting from the present value of total

cash flows calculated in above the initial cost of the investment

iii. If the NPV is positive, apply higher rate of discount.

iv. If the higher discount rate still gives a positive NPV, increase the discount rate

further the NPV becomes become negative.

v. If the NPV is negative at this higher rate, the internal rate of return must be

between these two rates.

Advantages of Internal Rate of Return Method

1. It takes into account the time value of money and can be usefully applied in situations

with even as well as uneven cash flows at different periods of time.

2. It considers the profitability of the project for its entire economic life.

3. It provides for uniform ranking of various proposals due to the % rate of return.

Disadvantages of Internal Rate of Return Method

1. It is difficult to understand.

2. This method is based upon the assumption that the earnings are reinvested at the

internal rate of return for the remaining life of the project, which is not a justified

assumption particularly when the rate of return earned by the firm is not close ton the

internal rate of return.

3. The result of NPV and IRR method may differ when the project under evaluation

differ their size.

Profitability Index or PI: This is also known as benefit cost ratio. This is similar to NPV

method. The major drawback of NPV method that not does not give satisfactory results while

evaluating the projects requiring different initial investments. PI method provides solution to

this. PI is calculated as:

PI = Present value of cash Inflows

Present value of cash outflows

If PI > 1project will be accepted, if PI<1 then project is rejected and if PI= 1 then decision is

based on non-financial consideration.

Advantages of PI method

1. It considers Time value of money

2. It considers all cash flow during life time of project.

973. More reliable than NPV method when evaluating the projects requiring different initial

investments.

Disadvantages of PI method

1. This method is difficult to understand.

2. Calculations under this method arte complex

Determinants of Dividend Policy

The payment of dividend involves some legal as well as financial considerations. The following

are the important factors which determine the dividend policy of a firm:

1. Legal Restrictions: Legal provisions relating to dividends in the Companies Act, 1956

lay down a framework within which dividend policy is formulated. These provisions

require that:

• Dividend can be paid only out of current profits or past profits after providing for

depreciation or out of the moneys provided by Government for the payment of

dividends in pursuance of a guarantee given by the Government.

• A company providing more than ten per cent dividend is required to transfer certain

percentage of the current year's profits to reserves.

• The dividends cannot be paid out of capital, because it will amount to reduction of

capital adversely affecting the security of its creditors.

2. Magnitude and Trend of Earnings: As dividends can be paid only out of present or

past year's profits, earnings of a company fix the upper limits on dividends. The

dividends should, generally, be paid out of current year's earnings only as the retained

earnings of the previous years become more or less a part of permanent investment in the

business to earn current profits. The past trend of the company's earnings should also be

kept in consideration while making the dividend decision.

3. Desire and Type of Shareholders: Desires of shareholders for dividends depend upon

their economic status. Investors, such as retired persons, widows and other economically

weaker persons view dividends as a source of funds to meet their day-to-day living

expenses. To benefit such investors, the companies should pay regular dividends. On the

other hand, a wealthy investor in a high income tax bracket may not benefit by high

current dividend incomes. Such an investor may be interested in lower current dividends

and high capital gains.

4. Nature of Industry: Certain industries have a comparatively steady and stable demand

irrespective of the prevailing economic conditions. For instance, people used to drink

liquor both in boom as well as in recession. Such firms expect regular earnings and hence

can follow a consistent dividend policy. On the other hand. If the earnings are uncertain,

as in the case of luxury goods, conservative policy should be followed.

5. Age of the Company: The age of the company also influences the dividend decision of a

company. A newly established concern has to limit payment of dividend and retain

substantial part of earnings for financing its future growth and development, while older

companies which have established sufficient reserves can afford to pay liberal dividends.

6. Future Financial Requirements: The management of a concern has to reconcile the

conflicting interests of shareholders and those of the company's financial needs. If a

company has highly profitable investment opportunities it can convince the shareholders

of the need for limitation of dividend to increase the future earnings.

7. Economic Policy: The dividend policy of a firm has also to be adjusted to the economic

policy of the Government as was the case when the Temporary Restriction on Payment of

Dividend Ordinance was in force. In 1974 and 1975, companies were allowed to pay

dividends not more than 33 per cent of their profits or 12 per cent on the paid-up value of

the shares, whichever was lower.

8. Taxation Policy: The taxation policy of the Government also affects the dividend

decision of a firm. A high or low rate of business taxation affects the net earnings of

company (after tax) and thereby its dividend policy. Similarly, a firm's dividend policy

may be dictated by the income-tax status of its shareholders. If the dividend income of

shareholders is heavily taxed being in high income bracket, the shareholders may forego

cash dividend and prefer bonus shares and capital gains.

9. Inflation: Inflation acts as a constraint in the payment of dividends. when prices .rise,

funds generated by depreciation would not be adequate to replace fixed assets, and hence

to maintain the same assets and capital intact, substantial part of the current earnings

would be retained. Otherwise, imaginary and inflated book profits in the days of rising

prices would amount to payment of dividends much more than warranted by the real

profits, out of the equity capital resulting in erosion of capital.

10. Control Objectives: As in case of a high dividend pay-out ratio, the retained earnings are

insignificant and the company will have to issue new shares to raise funds to finance its

future requirements. The control of the existing shareholders will be diluted if they

cannot buy the additional shares issued by the company.

11. Requirements of Institutional Investors: Dividend policy of a company can be affected

by the requirements of institutional investors such as financial institutions, banks

insurance corporations, etc. These investors usually favor a policy of regular payment of

cash dividends and stipulate their own terms with regard to payment of dividend on

equity shares.

12. Stability of Dividends: Stability of dividend simply refers to the payment of dividend

regularly and shareholders, generally, prefer payment of such regular dividends. Some

companies follow a policy of constant dividend per share while others follow a policy of

constant payout ratio and while there are some other who follows a policy of constant

low dividend per share plus an extra dividend in the years of high profits.

13. Liquid Resources: The dividend policy of a firm is also influenced by the availability of

liquid resources. Although, a firm may have sufficient available profits to declare

dividends, yet it may not be desirable to pay dividends if it does not have sufficient liquid

resources. If a company does not have liquid resources, it is better to declare stockdividend

i.e. issue of bonus shares to the existing shareholders. The issue of bonus shares

also amounts to distribution of firm's earnings among the existing shareholders without

affecting its cash position.

Bonus Issue

A company can pay bonus to its shareholders either in cash or in the form of shares. Many a times, a company is not in a position

to pay bonus in cash in spite of sufficient profits because of unsatisfactory cash position or because of its adverse effects on the

working capital of the company. In such cases, if the articles of association of the company provide, it can pay bonus to

its shareholder in the form of shares by making partly paid shares as fully paid or by the issue of fully paid bonus shares. Issue of

bonus shares in lieu of dividend is not allowed as according to

Section 205 of the Companies Act, 1956, no dividend can be paid except in cash. It cannot be termed as a gift because it only

represents the past sacrifice of the shareholders. When a company accumulates huge profits and reserves, its balance sheet does

not reveal a true picture about the capital structure of the company and the shareholders do not get fair return on their capital.

Thus, if the Articles of Association of the company so permit, the excess amount can be distributed among the existing

shareholders of the company by way of issue of bonus shares. The effect of bonus issue is two-fold:

(i) It amounts to reduction in the amount of accumulated profits and reserves. -

(ii) There is a corresponding increase in the paid up share capital of the company.

Objectives of Bonus Issue:

a) To bring the amount of issued and paid up capital in line with the capital employed so as to depict more realistic earning

capacity of the company. .

b) To bring down the abnormally high rate of dividend on its capital so as to avoid labour problems such as demand for higher

wages and to restrict the entry of new entrepreneurs due to the attraction of abnormal profits.

c) To Pay bonus to the shareholders of the company without affecting its liquidity and the earning capacity of the company.

d) To make the nominal value and the market value of the shares of the company comparable.

e) To correct the balance sheet so as to give a realistic view of the capital structure of the company.

Advantages of Issue of Bonus Shares

Advantages from the viewpoint of the company

1. It makes available capital to carry an a larger and more profitable business.

2. It is felt that financing helps the company to get rid of market influences.

3. When a company pays bonus to its shareholders in the value of shares and not in cash, its

liquid resources are maintained and the working capital of the company is not affected.

4. It enables a company to make use of its profits on a permanent basis and increases credit

worthiness of the company.

5. It is the cheapest method of raising additional capital for the expansion of the business.

6. Abnormally high rate of dividend can be reduced by issuing bonus shares which enables

a company to restrict entry of new entrepreneurs into the business and thereby reduces

competition.

7. The balance sheet of the company will reveal a more realistic picture of the capital

structure and the capacity of the company.

Advantages from the viewpoint of investors or shareholders.

The bonus shares are a permanent source of income to the investors.

1. Even if the rate of dividend falls, the total amount of dividend may increase as the

investor gets dividend on a larger number of shares.

2. The investors can easily sell these shares and get immediate cash, if they so desire.

Disadvantages of Bonus Shares

1. The issue of bonus shares leads to a drastic fall in the future rate of dividend as it is only the capital that increases and not the

actual resources of the company. The earnings donot usually increase with the issue of bonus shares.

2. The fail in the future rate of dividend results in the fall of the market price of shares

considerably, this may cause unhappiness· among the shareholders.

3. The reserves of the company after the bonus issue decline and leave lesser security to

investors.

MANAGEMENT OF CASH.

Cash is an important current asset for the operations of business. Cash is the basic input that keeps business running continuously and smoothly. Too much cash and too little cash will have a negative impact on the overall profitability of the firm as too much cash would mean cash remaining idle and too less cash would hamper the smooth running of the operations of the firm. Therefore, there is need for the proper management of cash to ensure high levels of profitability. It is a usual practice to include near cash items such as marketable securities and bank term deposits in cash. The basic characteristics of near cash items is that, they can be quickly and easily converted into cash without any transaction cost or negligible transaction cost.

Motives for Holding Cash. The firm’s need to hold cash may be attributed to the three motives given below: The transaction motive. The precautionary motive. The speculative motive. The Compensation motive.

1.Transaction Motive: The transaction motive requires a firm to hold cash to conduct its business in the ordinary course and pay for operating activities like purchases, wages and salaries, other operating expenses, taxes, dividends, payments for utilities etc. The basic reason for holding cash is non-synchronization between cash inflows and cash outflows. Firms usually do not hold large amounts of cash, instead the cash is invested in market securities whose maturity corresponds with some anticipated payments. Transaction motive mainly refers to holding cash to meet anticipated payments whose timing is not perfectly matched with cash inflows.

2.Precautionary Motive: The precautionary motive is the need to hold cash to meet uncertainties and emergencies. The quantum of cash held for precautionary objective is influenced by the degree of predictability of cash flows. In case cash flows can be accurately estimated the cash held for precautionary motive would be fairly low. Another factor which influences the quantum of cash to be maintained for this motive is, the firm’s ability to borrow at short notice. Precautionary balances are usually kept in the form of cash and marketable securities. The cash kept for precautionary motive does not earn any return, therefore, the firms should invest this cash in highly liquid and low risk marketable securities in order to earn some returns.

3. Speculative Motive. A firm also keeps cash balance to take advantage of un expected opportunities, typically outside the normal course of business. Such motive is, there fore, of purely speculative nature. For e.g., a firm may like to take advantage of an opportunity of purchase raw materials at the reduced price on payment of immediate cash. Similarly it may like to keep some cash balance to make profit by buying securities in times when their prices fall.

4. Compensation Motive. Another motive to hold cash balance is to compensate banks for providing certain services and loans. Banks provide a variety of services to business firms such as clearance of cheque, supply of credit information, transfer of funds and so on. While for some of these services banks charge a commission or fees, for others they seek indirect compensation.

Usually clients are required to maintain a minimum balance of cash at the bank. Since this balance cant be utilised by the firms for transaction purpose, the bank themselves can use the amount to earn a return. Such balances are called as compensating balances.

RECEIVABLES MANAGEMENT.

An efficient control of stocks and liquid resources in conjunction with credit facility is an essential part of management control. Credit and collection policies significantly influence working capital requirements. With proper credit terms, the flow of cash from receivables is synchronised to liquidate current expenses with out requiring additional funds from short term sources.

Accounts receivables constitute a significant portion of the total current assets of the business. They are a direct result of 'trade credit' which has become an essential marketing tool in modern business. When a firm sells goods for cash, payments are received immediately and there fore, no receivables are created How ever when a firm sells goods or services on credit, the payments are postponed to future dates and receivables are created.

Meaning of Receivables. The term receivables is defined as "debt owed to the firm by customers arising from sale of goods or service in the ordinary

course of business." Account receivables represents an extension of credit to customers, allowing them a reasonable period of time to pay for the goods purchased. Receivables are a direct result of credit sales. Credit sale is resorted to, by a firm to push up its sales which ultimately results in pushing up the profits earned by the firm. At the same time, selling goods on credit result in blocking of funds in Accounts Receivables.

Additional funds are, there fore, necessary for the operational needs of the business, which involve extra cost in terms of interest. Moreover increase in receivables also increases the chance of bad debts. Thus creation of account receivable is beneficial as well as dangerous. Management of account receivables may, there fore, be defined as the process of making decisions relating to the investment of funds in this asset which will result in maximising the over all return of the investment of the firm.

Thus the objective of receivables management is to promote sales and profits until that point is reached , where the return on investment in further funding of receivables is less than the cost of funds raised to finance that additional credit.

FACTORS AFFECTING THE SIZE OF RECEIVABLES.

The size of Account Receivables is determined by a number of factors. Some are:

1. Level of sales. This is the most important factor in determining the size of receivables. Generally in the same industry, a firm having a largo volume of sales will be having u larger level of receivables as computed to a firm with a small volume of sales.

2. Credit Policies.The term credit policy refers to those decision variables that influence the amount of trade credit, i.e. investment in receivables. These include total amount of credit to be accepted, the length of the credit period to be extended, and the cash discount to be given. A firms credit policy determines the amount of risk the firm is willing to under take in sales activities. If a firm has a liberal credit policy, it will experience a higher level of receivables as compared to a firm with rigid policy.

3. Terms of Trade. The size of receivables is also affected by the terms of trade (or credit terms) offered by the firm, the two important components are credit period and cash discount.

A. Credit Period - The term credit period refers to the time duration for which credit is extended to the customers. It is generally expressed in terms of "net

date". For eg, if a firms credit terms are 'net 15' it means the customers are expected to pay within 15 days from the date of credit sale.

B. Cash Discount. Most of the firms offer cash discounts to their customers for encouraging them to pay their dues before the expiry of the credit period. Allowing cash discounts results in a loss to the firm because of recovery of less amount than what is due from the customer, but it reduces the volume of receivables and puts extra funds at the disposal of the firm for alternative investment. The amount of loss thus suffered is, there fore, compensated by the income otherwise earned by the firm.'

4 Stability of sales.In the business of seasonal character, total sales and the credit sales will go up in the season and there fore volume of receivables will

also be large. If the firm supplies goods on installment basis its balance in receivables will be high.

Determinants of Dividend Policy.

The payment of dividend involves some legal as well as financial considerations. The followingare the important factors which determine the dividend policy of a firm:1. Legal Restrictions: Legal provisions relating to dividends in the Companies Act, 1956lay down a framework within which dividend policy is formulated. These provisionsrequire that:• Dividend can be paid only out of current profits or past profits after providing fordepreciation or out of the moneys provided by Government for the payment ofdividends in pursuance of a guarantee given by the Government.• A company providing more than ten per cent dividend is required to transfer certainpercentage of the current year's profits to reserves.• The dividends cannot be paid out of capital, because it will amount to reduction ofcapital adversely affecting the security of its creditors.2. Magnitude and Trend of Earnings: As dividends can be paid only out of present orpast year's profits, earnings of a company fix the upper limits on dividends. Thedividends should, generally, be paid out of current year's earnings only as the retainedearnings of the previous years become more or less a part of permanent investment in thebusiness to earn current profits. The past trend of the company's earnings should also bekept in consideration while making the dividend decision.3. Desire and Type of Shareholders: Desires of shareholders for dividends depend upontheir economic status. Investors, such as retired persons, widows and other economicallyweaker persons view dividends as a source of funds to meet their day-to-day livingexpenses. To benefit such investors, the companies should pay regular dividends. On theother hand, a wealthy investor in a high income tax bracket may not benefit by highcurrent dividend incomes. Such an investor may be interested in lower current dividendsand high capital gains.

4. Nature of Industry: Certain industries have a comparatively steady and stable demandirrespective of the prevailing economic conditions. For instance, people used to drinkliquor both in boom as well as in recession. Such firms expect regular earnings and hencecan follow a consistent dividend policy. On the other hand. If the earnings are uncertain,as in the case of luxury goods, conservative policy should be followed.5. Age of the Company: The age of the company also influences the dividend decision of acompany. A newly established concern has to limit payment of dividend and retainsubstantial part of earnings for financing its future growth and development, while oldercompanies which have established sufficient reserves can afford to pay liberal dividends.6. Future Financial Requirements: The management of a concern has to reconcile theconflicting interests of shareholders and those of the company's financial needs. If acompany has highly profitable investment opportunities it can convince the shareholdersof the need for limitation of dividend to increase the future earnings.7. Economic Policy: The dividend policy of a firm has also to be adjusted to the economicpolicy of the Government as was the case when the Temporary Restriction on Payment ofDividend Ordinance was in force. In 1974 and 1975, companies were allowed to paydividends not more than 33 per cent of their profits or 12 per cent on the paid-up value ofthe shares, whichever was lower.8. Taxation Policy: The taxation policy of the Government also affects the dividend

decision of a firm. A high or low rate of business taxation affects the net earnings ofcompany (after tax) and thereby its dividend policy. Similarly, a firm's dividend policymay be dictated by the income-tax status of its shareholders. If the dividend income ofshareholders is heavily taxed being in high income bracket, the shareholders may foregocash dividend and prefer bonus shares and capital gains.9. Inflation: Inflation acts as a constraint in the payment of dividends. when prices .rise,funds generated by depreciation would not be adequate to replace fixed assets, and henceto maintain the same assets and capital intact, substantial part of the current earningswould be retained. Otherwise, imaginary and inflated book profits in the days of risingprices would amount to payment of dividends much more than warranted by the realprofits, out of the equity capital resulting in erosion of capital.10. Control Objectives: As in case of a high dividend pay-out ratio, the retained earnings areinsignificant and the company will have to issue new shares to raise funds to finance itsfuture requirements. The control of the existing shareholders will be diluted if theycannot buy the additional shares issued by the company.11. Requirements of Institutional Investors: Dividend policy of a company can be affectedby the requirements of institutional investors such as financial institutions, banksinsurance corporations, etc. These investors usually favor a policy of regular payment ofcash dividends and stipulate their own terms with regard to payment of dividend onequity shares.