1 Financial Management
“Financial Management is the application of the
FINANCIAL MANAGEMENT
Unit 1. Introduction.
A business is an activity which is carried on
with the intention of earning profits. If the operations of
a typical manufacturing organization are considered, it
involves the purchasing of raw material, processing the
same with the help of various factors of production like
labour and machinery, manufacturing the final product
and marketing and selling the finished product in the
market to earn the profits.
Thus production, marketing and business
financing are the key operational areas in case of any
business organization, out of which finance is the most
crucial one. This is so as the functions of production and
marketing are related with the function of finance. If the
decisions relating to money and funds fail, it may result
into the failure of the business organization as a whole.
Hence, it is utmost important to take the proper financial
decisions and that too at a proper point of time.
Finance is the life-blood of modern business
economy. We cannot imagine a business without finance
in the modern world. It is the basis of all economic
activities, no matter; the business is big or small. The
problem of finance and that of financial management is
to be dealt within every organisation. The problem of
finance is equally important to government, semi-
governments and private bodies, and to profit and non-
profit organisations.
Definition.
Financial management is that managerial
activity which is concerned with planning and
controlling of firms financial resources.
According to Paul. G. Hasings, 'Finance' is the
management of the monetary affairs of a company. It
includes determining what has to be paid for raising the
money on the best terms available and devoting the
available resources to best uses."
Kenneth Midgley and Ronald Burns state. "Financing
is the process of organizing the flow of funds so that a
business can carry out its objectives in the most efficient
manner and meet its obligations as they fall due."
“Financial Management is an area of financial decision
making harmonizing individual motives and enterprise
goals.”-Weston and Brigam.
planning and control functions to the finance function.”-
Howard and Upton.
“Financial Management is the operational activity of a
business that is responsible for obtaining and effectively,
utilizing the funds necessary for efficient operations.”-
Joseph and Massie.
From the above definitions of the term finance
given above, it can be concluded that the term business
finance mainly involves rising of funds and their
effective utilization keeping in view the over all
objectives of the firm. The management makes use of
the various financial techniques, devices etc for
administering the financial affairs of the firm in the most
effective and efficient way.
FINANCE AND RELATED DISCIPLINES.
Financial management -an integral part of over
all management is not a totally independent area. It
draws heavily on related disciplines and fields of study,
such as Economics, Accounting, Marketing, Production,
and Quantitative Methods.
FINANCIAL MANAGEMENT AND ECONOMICS.
The relevance of economics to Financial
Management can be described in the lights of the two
broad areas of economics, -macro economics, and micro
economics. Macro economics is concerned with the over
all institutional environment in which the Company
operates. It looks at the Economy as a whole. It is
concerned with the institutional structure of the banking
system, money and capital markets, financial
intermediaries, monetary credit, and fiscal policies.
Since the business operates in the macro economic
environment, it is important for financial managers to
understand the broad economic environment.
Micro economics deals with the economic
decisions of individuals and organizations. It concerns
itself with the determination of optimal operating
strategies. A financial manger uses these to run the firm
efficiently and effectively.
FINANCIAL MANAGEMENT AND ACCOUNTING.
Accounting function is a necessary input in to
the finance function. ie. accounting is a sub function of
finance. Accounting generates information about a firm.
The end products of accounting constitute financial
statements such as Balance Sheet, P&L Account and the
statement of changes in financial position. The
information contained in this reports and statements
assist financial managers in assessing the past
performance and taking future decisions of the firm and
in meeting the legal obligations such as payment of
NSS College. Rajakumari.
2 Financial Management
Taxes and so on. Thus accounting and finance are
functionally closely related.
FINANCE AND OTHER RELATED DISCIPLINES.
Apart from economics and accounting, finance
also draws considerably for its key day today decisions-
on supportive disciplines such as Marketing, Production,
and Quantitative methods. For instance financial
managers should consider the impact of new product
development and promotion plans made in the
marketing area since their plans will require Capital or
Fund out flows and have an impact on the projected cash
flows. Similarly changes in the production process may
necessitate capital expenditure which the financial
managers must evaluate and finance. And finally the
tools of analysis developed in the quantitative
techniques are helpful in analyzing complex financial
management problems.
Thus the marketing, production and quantitative
techniques are only indirectly related to day to day
decision making by financial managers and are
supportive in nature , while Economics and Accounting
are primary disciplines on which the financial managers
draws substantially.
SCOPE OF FINANCIAL MANAGEMENT.
The approach to the scope and functions of
financial management is divided in to two broad
categories. Traditional Approach and Modem Approach.
TRADITIONAL APPROACH.
The traditional approach to the scope of
financial management refers to the subject matter, in
academic literature in the initial stages of its
development, as a separate branch of academic study.
The term 'Corporation Finance' was used to describe
what is known as Financial management. As the name
suggests, the concern of 'Corporation Finance' was with
the financing of Corporate enterprises. In other words
the scope of finance function was treated by the
traditional approach in the narrow sense of procurement
of fund by corporate enterprises to meet their financing
needs. So the field of study included,
1. Institutional arrangements in the form of financial
institutions which comprise the organization of
Capital Market.
2. Financial instruments through which Funds are raised
from the capital market. &
3. The Legal and Accounting relationship between a
firm and its sources of funds.
The traditional approach was criticized in the following
grounds.
1. The approach equated finance function with raising
and administering of funds only. The limitation was that
internal decision-making was completely ignored.
2. The focus was on financing problems of Corporate
enterprises (i.e. Companies). Non corporate
organizations lay outside its scope.
3. The approach laid over emphasis on the problems of
long term financing. Hence day to day financial
problems and working capital management of a business
did not receive any attention.
MODERN APPROACH.
The modern approach views the term 'Financial
management' in a broad sense and provides a conceptual
and analytical frame work for financial decision making.
According to it Finance function covers both
acquisitions of funds as well as their allocations. Thus
the Financial Management, in the modern sense of the
term, can be broken down in to 3 major decisions as
functions of Finance.
1. The investment Decision
2. The Financing Decision
3. The Dividend Policy Decision.
FINANCE FUNCTIONS.
1. INVESTMENT DECISION.
The investment decision relates to the selection
of Assets in which funds will be invested by a firm. The
Assets which can be acquired fall in to two broad
categories.
A. Long Term or Fixed Assets, which yield
a return over a period of time in future.
B. Short term or Current Assets which in
the normal course of business are convertible in
to cash usually within a year.
The aspects of financial decision making with
reference to long term assets is popularly known as
Capital Budgeting and financial decision making with
reference to current assets is popularly termed as
Working Capital Management.
CAPITAL BUDGETING.
Capital Budgeting is probably the most crucial
financial decisions for a firm. It relates to the selection
of an asset or investment proposal or course of action
whose benefits are likely to be available in future over
the life time of the project.
The first aspect of capital budgeting decision
relates to the choice of the new asset out of the
alternatives available or the reallocation of capital, when
an existing asset fails to justify the funds committed.
Whether an asset will be accepted or rejected will
depend upon the relative benefits and returns associated
NSS College. Rajakumari.
3 Financial Management
with it. The measurement of worth of the investment
proposal is, there for, a major element in Capital
budgeting decisions.
The second element of Capital Budgeting
decision is the analysis of risk and uncertainty. Since the
benefits from the investment proposals extend in to the
future, there accrual is uncertain. They have to be
estimated under various assumptions of the physical
volume of sales and the level of prices. An element of
risk in the sense of 'uncertainty of future benefits' is thus
involved in the capital budgeting. The returns from
capital budgeting decisions should, there fore, be
evaluated in relation to the risk associated with it.
WORKING CAPITAL MANAGEMENT.
Working capital management is concerned with
the management of current asset. One aspect of working
capital management is the trade off between profitability
and risk. There is a conflict between profitability and
liquidity. If a firm does not have adequate working
capital, it may become illiquid and consequently may
not have the ability to meet its current obligations. If
current assets are too large, profitability is adversely
affected. The key strategies and considerations in
ensuring a trade oil' between profitability and liquidity is
one of the major dimensions of working capital
management. In addition, the individual current asset
should be efficiently managed so that neither in
adequate nor unnecessary funds are locked up.
2. FINANCING DECISIONS.
The second major decision involved in financial
management is the financing decision. The concern of
the financing decision is with the Financing Mix or
Capital Structure or Leverage. The term capital structure
refers to the proportion of debt (i.e., fixed interest source
of financing) and equity capital (or variable dividend
security). The financing decision of a firm relates to the
choice of the proportion of these sources to finance the
investment requirements. A capital structure with a
reasonable proportion of debt and equity capital is called
optimum capital structure.
3. DIVIDEND POLICY DECISION.
The third major decision of financial
management is the decision relating to dividend policy.
Two alternatives’ are available in dealing with the
profits of the firm. They can be distributed to the share
holders in the form of dividends or they can be retained
in the business itself. The final decision will depend
upon the preference of the share holders and the
investment opportunities available within the firm. The
optimum dividend policy is one which maximizes the
market value of the Co's shares. Most profitable Co's
pay cash dividend regularly. Periodically additional
shares, called Bonus shares, are also issued to the
existing share holders in addition to the cash dividend.
OBJECTIVES OF FINANCIAL MANAGEMENT.
Financial management is concerned with the
efficient use of capital funds. It evaluates how funds are
procured and used. Financial management covers
decision making in three inter related areas namely
Investment, Financing and Dividend policy. The
financial manager has to take these decisions with
reference to the objectives of the firm. The objectives
provide a frame work for optimal financial decision
making. There are two widely discussed approaches in
this regard.
1. Profit Maximization Approach
2. Wealth Maximization Approach.
PROFIT MAXIMISATION APPROACH.
According to this approach, actions that increase
profits should be undertaken and that decrease profits
should be avoided. Profits maximization approach
implies that the functions of financial management/
Decisions taken by financial mangers (i.e. the
investment, financing, and dividend policy decisions)
should be oriented towards maximization of profits or
Rupee income of the firm. Or the Company should
select those assets, projects, and decisions which are
profitable and reject those which are not.
In the Economic theory, the behaviour of a
Company is analyzed in terms of profit maximization.
While maximizing profits, a firm either produces
maximum output for a minimum input, or uses
minimum input for a given out put. So the underlying
logic of profit maximization is efficiency. Profit is a test
of economic efficiency and it provides a yard stick by
which economic performance can be judged.
The profit maximization criterion has however
been criticized on several grounds. The main technical
flaws are ambiguity, timing of benefits and quality of
benefits.
1. AMBIGUITY.
One practical difficulty with profit
maximization criterion for financial decision making is
that, the term profit is a vague and ambiguous concept.
It is amenable to different interpretations by different
people. It is not clear in what sense the term profit has
been used. It may be total profit before tax or after tax or
profitability rate. Rate of profitability may again be in
relation to Share capital; owner's funds, total capital
employed or sales. Furthermore, the word profit does
NSS College. Rajakumari.
4 Financial Management
not speak anything about the short-term and long-term
profits. Profits in the short-run may not be the same as
those in the long run. A firm can maximise its short-
term profit by avoiding current expenditures on
maintenance of a machine. But owing to this neglect, the
machine being put to use may no longer be capable of
operation after sometime with the result that the firm
will have to make huge investment outlay to replace the
machine. Thus, profit maximisation suffers in the long
run for the sake of maximizing short-term profit.
Obviously a loose expression like profit can't form the
basis of operational criterion for financial management.
2. TIMING OF BENEFIT
A more important technical objection to profit
maximization is that it ignores the differences in the
time pattern of the benefits received. The profit
maximization criterion does not consider the distinction
between returns received in different time periods and
treats all benefits irrespective of the timings, as equally
valuable. This is not true in actual practice as benefits in
early years should be valued more highly than
equivalent benefits in later years. The assumption of
equal value is in consistent with the real world situation.
mutually exclusive projects, the one with the highest
NPV should be adopted.
The objective of wealth maximisation takes care
of the questions of the timing and risk of expected
benefits. These problems are handled by selecting an
appropriate rate for discounting the expected flow of
future benefits. It should be remembered that the
benefits are measured in terms of cash flows. In
investment and financing decisions it is flow of cash
which is important, not the accounting profits. The
Wealth created by a Company through its actions is
reflected in the market value of companies' shares. The
value of the companies share is represented by the
market price, which in turn, is a reflection of the firm's
financial decisions. The market price of the share serves
as the performance indicator.

3. QUALITY OF BENEFITS.

Profit maximization ignores the quality aspect

of benefits associated with a financial course of action.
The term quality refers to the degree of certainty with
which benefits can be expected. As a rule, the more
certain the expected return, the higher is the quality of
the benefits. An uncertain and fluctuating return implies
risk to the investors.

To conclude the profit maximization criterion is

unsuitable and in appropriate as an operational objective
of investment, financing and dividend decision of a firm.
It is not only vague and ambiguous, but it also ignores
risk and time value of money.

WEALTH MAXIMIZATION APPROACH.

This is also known as value maximization or

Net Present Worth maximization. It removes the
technical limitations of profit maximization criterion.
(i.e. ambiguity, timing of benefit and quality of benefit.)

Wealth maximization means maximizing the

Net Present Value (or wealth) of a course of action. The
Net present value of a course of action is the difference
between the present value of its benefits and the present
value of its costs. A financial action which has a positive
Net Present Value creates wealth and there fore it is
desirable. A financial action resulting in negative NPV
should be rejected. Between a number of desirable

NSS College. Rajakumari.

5 Financial Management
UNIT 2.
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
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.
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.
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.
NSS College. Rajakumari.
6 Financial Management
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
NSS College. Rajakumari.
7 Financial Management
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 on
the 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
NSS College. Rajakumari.
8 Financial Management
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:
NSS College. Rajakumari.
9 Financial Management
(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.
Merits
The 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
NSS College. Rajakumari.
10 Financial Management
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 credit
2. Bank credit
– Loans and advances
– Cash credit
– Overdraft
– Discounting of bills
3. Customers’ advances
4.. 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) Loans
When 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 Credit
It 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
NSS College. Rajakumari.
11 Financial Management
amount of limit. Banks ask for collateral security for of these banks are largely comparable to the functions of
the grant of cash credit. In this arrangement, the commercial banks.
borrower can draw, repay and again draw the amount
within the sanctioned limit. Interest is charged only on 5. Indigenous Bankers.
the amount actually withdrawn and not on the amount of
entire limit. They are private individuals engaged in the
business of financing small and local business units.
(iii) Overdraft They provide short term and medium term loans.
However they charge very high rates of interest and are,
When a bank allows its depositors or account therefore, considered only as a last resort of finance.
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

NSS College. Rajakumari.

12 Financial Management
Unit 3.
WORKING CAPITAL MANAGEMENT
Introduction
Capital required for a business can be classified
under two main heads:
i. Fixed Capital
ii. Working Capital
Fixed 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.
TYPES OF WORKING CAPITAL
.
Sometimes, working capital is divided into two varieties
as:
i) Permanent working capital
ii) Variable working capital
Permanent Working Capital: (Fixed working
capital):- Though working capital has a limited life and
usually not exceeding a year, in actual practice some
part of the investment in that is always permanent. Since
firms have relatively longer life and production does not
stop at the end of a particular accounting period some
investment is always locked up in the form of raw
materials, work-in-progress, finished stocks, book debts
and cash. The investment in these components of
working capital is simply carried forward to the next
year. This minimum level of investment in current assets
that is required to continue the business without
interruption is referred to as permanent working capital.
Fluctuating (Variable Working Capital): This is also
known as the circulating or transitory working capital.
This is the amount of investment required to take care of
the fluctuations in the business activity. While
permanent working capital is meant to take care of the
minimum investment in various current assets, variable
working capital is expected to care for the peaks in the
business activity.
NEED FOR WORKING CAPITAL - OPERATING
CYCLE.
The basic aim of Financial management is to
maximize the wealth of the share holders and in order to
achieve this; it is necessary to generate sufficient sales
and profit. However sales do not convert in to cash
instantly. The time between purchase of inventory items
NSS College. Rajakumari.
13 Financial Management
(raw material or merchandise) for the production and
their conversion into cash is known as operating cycle
or working capital cycle..
A study of the operating cycle would reveal that
the funds invested in operations are re-cycled back into
If it were possible to complete the sequence
instantly, there would be no need for current
assets( working capital). But since it is not possible, the
firm is forced to have current assets. Since cash inflows
and outflows do not match, the firm has to keep cash for
meeting short term obligations.
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
cash. The cycle, of course, takes some time to complete.
The longer the period of this conversion the longer is the
operating cycle. A standard operating cycle may be for
any time period but does not generally exceed a
financial year.
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
NSS College. Rajakumari.
14 Financial Management
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.
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.
NSS College. Rajakumari.
15 Financial Management
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.
OBJECTIVES OF CASH MANAGEMENT.
The basic objectives of cash management are
two fold. Meeting payment schedule and minimising
funds locked up as cash balance.
A. Meeting Payment Schedule.
In the normal course of business, (inns
have to make payment of cash on a regular and
continuous basis to suppliers of goods, employees, and
so on. At the same time there is a constant inflow of
cash through collections from debtors. A basic objective
of cash management is to meet the payment schedule,
that is to have sufficient cash to meet the cash
disbursement needs of a firm It prevents insolvency or
bankruptcy arising out of the in ability of a firm to meet
its obligations. It also helps in keeping good relation
with banks and creditors. Cash discount can be availed
of, if the payment is made within the due date.
B. Minimising Funds Locked up as Cash
Balance.
In minimising the cash balance, two conflicting
aspects have to be reconciled. A higher cash balance
ensures proper payment with all its advantages. But
this will result in a large balance of cash remaining
idle. Low level of cash balance may result in failure of
the firm to meet the payment schedule. The finance
manager should, there fore, try to have an optimum
amount of cash balance, keeping in view the above factors.
CASH MANAGEMENT TECHNIQUES / PROCESS.
The strategic aspect of an efficient cash management are: -
1. Preparation of cash budget
2. Efficient Inventory Management
3. Speedy Cash collection
4. Delaying Payments.
SPEEDY CASH COLLECTION.
In managing cash efficiently, the cash inflow
process can be accelerated through systematic planning and
refined techniques. There are two broad approaches to do
this. In the first place the customers should be encouraged
to pay as quickly as possible. Secondly the payment from
the customers should be converted in to cash with out any
delay.
A. Prompt payment by customers.
One way to ensure prompt payment by customers is
prompt billing. What the customer has to pay and the dale
and period of payment should be notified accurately and in
advance. The use of mechanical devises for billing along
with a self addressed return envelope will speed up the
payment.
Another technique is offering cash discount.
The availability of discount implies savings to customers.
To avail these facility, customers would be eager to make
payment early.
B. Early conversion of payment in to cash.
NSS College. Rajakumari.
16 Financial Management
A firm can conserve cash and reduce its
requirements for cash balance, if it can speed up its cash
collections. Cash collection can be accelerated by
reducing the time gap between the time the customer
pays the bill and the time the cheque is collected and funds
become available for the firms use.
Three steps are involved in this time interval.
1 Transit or Mailing time :- This is the lime taken by
the post office too transfer the cheque from the
customers to the firm. This delay is referred to as Postal
Float.
2. Time taken in processing the cheque within the firm
before they are deposited in the Bank.
3. Collection time within the bank called Bank Float.
The early conversion of payment in to cash, as a
technique to speed up collection , is done to reduce the
time lag between depositing of the cheque by the customer
and the realisation of money by the firm. The collection of
account receivable can be accelerated, by reducing
transit, processing and collection time. An important cash
management technique adopted for this is Decentralised
Collection. The principal methods of establishing a
decentralised collection network are;
A. Concentration Banking .
This is a system of operating through a number of
collection centres, instead of a single collection centre at
the head office. Under this arrangement, the customers are
required to send their payments (cheques) to the collection
centres covering their region. It reduces the mailing time, &
time involved in sending the bill to the customers.
B. Lock Box System.
Under this system, a firm arranges a Post office Lock Box
at important collection centres. The customers are required
to remit payments to the Post office lock box. The firms
local bank is given the authority to pick up the remittances
directly from the Box. The bank pick ups the mail several
times a day and deposits the cheques in the firms A/C.
after crediting the A/C, the bank sends a deposit slip along
with the list of payments and other enclosures if any.
Although the use of concentration banking and
lock box system accelerates the collection of cash, they
involve a cost, (cost in terms of maintenance of collection
centres, compensation to the bank for services etc.). If the
income exceeds the cost, the system is profitable.
DELAYING PAYMENTS.
Apart from speedy collection of cash , the
operating cash requirements can be reduced by slow
disbursement of A/C Payable. Slow disbursement
represent a source of fund requiring no interest
payment. There are several techniques to delay payment
of A/C payable, namely
1. Avoidance of early payment
2. Centralised disbursement
3. Floats
4. Accruals
1.Avoidance of early payments.
One way to delay payments is to avoid early
payments. According to the terms of credit, a firm is
required to make payment within a stipulated period. If
the firm pays it accounts payable before the due date, it
has no special advantage. Thus a firm would be well
advised not to make payments early, i.e. not before the
due date.
2.Centralised Disbursements.
All the payments should be made by the head
office from a centralised disbursement account. Such an
arrangement would delay payments, because it involves
increase in the transit time. The remittance from the
head office to the customers in distant places would
involve more mailing time.
3. Floats
It refers to the amount of money tied up in cheques
that have been written, but not yet en cashed It is due to
transit and payment delays. There is a time lag between the
issue of a cheque and its presentation. So although the
cheque has been issued, cash would be required later,
when the cheque is presented for encashment. There fore a
firm can send remittance, although it does not have cash in
its Bank A/C at the time of issue of cheque. There are two
ways of doing it.
1. Paying from a distant Bank: The firm may issue a
cheque on banks away from the creditor's bank. This
would involve relatively longer transit time for the
creditor's bank to gel payment and thus enable the firm
to use its funds longer.
2. Cheque Encashment Analysis : Another way is to
analyse on the basis of past experience, the time lag in
the issue of cheques and their encashment. For E.g.:
Cheques issued to pay wages and salary may not be
cashed immediately, it may be spread over a few days,
say 25% on first day, 50% on the second day and
balance 3r day. It would mean that the firm should keep
in the bank, not the entire amount of a pay roll, but only
a fraction represented by actual withdrawal each day.
This would enable to save operating cash.
3. Accruals: - These are liabilities, that represent a
service/goods received by a firm, but not yet paid for. For
e.g.: Salary to employees who render service in advance
and receive payment later. They extend a credit to the
firm for a period at the end of which they are paid (a
week or a month). The longer the period, the greater is
the amount of free financing and the smaller is the
amount of cash balance required.
NSS College. Rajakumari.
17 Financial Management
MANAGEMENT OF RECEIVABLES.
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.
Objectives of credit sales.
The major objectives of credit sales are,
1. Achieving growth in sales:
If a firm sells goods on credit, it will generally be in a
position to sell more goods than if it insisted on immediate
cash payment. This is because many customers are either
not prepared or not in a position to pay cash when they
purchase goods . the firm can sell goods to such customers ,
in case it gives credit.
2. Increasing Profits.
Increase in sales results in higher profits for the firm, not
only because of increase in the volume of sales but also
because of the firm charging a higher margin of profit on
credit sales as compared to cash sales.
3. Meeting Competition.
A firm may have give credit facilities to its customers
because of similar facilities being granted by the
competing firms to avoid the loss of sales from customers
who would buy else where if they did not receive the
expected credit.
The over all objective of committing funds to A/C
receivable is to generate a large flow of operating
revenue and hence profit than what would be achieved
in the absence of no such commitment.
Cost of maintaining receivables.
The costs with respect to maintenance of receivables can be
identified as follows.
1. Capital Costs
Maintenance of A/C receivables results in blocking
of the firms financial resources in them. This is because
there is a time lag between the sale of goods to
customers and the payments by them. The firm has,
there fore, to arrange for additional funds to meet its
own obligations, such as payment to employees,
suppliers of raw materials, etc while awaiting for
payments from its customers. Additional funds may
either be raised from outside or out of profits retained in
the business. In both cases the firm incurs a cost. In the
former case, the firm has to pay the interest to the
outsider, while in the second case there is an opportunity
cost to the firm. - i.e. the money the firm could have
earned otherwise by investing the funds else where.
2 Administrative Cost.
The firm has to incur additional administrative cost for
maintaining Account Receivables in the form of salaries
to the staff kept for maintaining accounting records
relating to customers, cost of conducting investigation
regarding customers credit worthiness etc.
3. Collecting Cost.
The firm has to incur costs for collecting payments
from its credit customers. Some times additional steps
may have to be taken to recover money from defaulting
customers.
4. Defaulting Cost.
NSS College. Rajakumari.
18 Financial Management
Some times after making all serious efforts to
collect money from defaulting customers, the firm may
not be able to recover the over dues because of the in
ability of the customers. Such debts are treated as bad
debts and have to be written off since they cant be
realised.
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.
SYSTEM OF CONTROL OF RECEIVABLES.
It is in the interest of the enterprise to keep the
investment in receivables in a controllable limit. The
financial management should consider the following four
factors which control the receivables management cost at a
minimum point.
1. Deciding acceptable level of Risk.
The first consideration in this regard is to decide
to whom goods are to be sold bearing in mind the risk
involved. Because every credit transaction involves risk
element, the financial management should consider the
credit capacity of every customer before allowing any credit
to him. Capacity of a customer can be judged by
understanding his Character, Capacity^ Capital, Collateral
Security offered and Conditions of sales.
2. Terms of Credit Sales.
The next thing the company has to decide is the Credit
Terms and the Level of Discount. The extension of credit
represents an investment having some cost of capital. It will
increase the sale of the organisation resulting in larger
profits. In deciding upon the credit terms the firm should
think over certain basic issues involved in it - such as cost
of capital, cash discount, volume of sales, period of credit
sales, and so on. By considering all these factors, — i.e.
the Cost and the Benefits— the financial manager should
fix the most desirable credit terms.
3. Credit Collection Policy.
After granting the credit sale, the Co. should try to get
the amount collected from its customers as early as
possible. It needs a sound and strict collection policy to
keep bad debts and losses at the minimum. The must also
provide a certain amount as reserve for bad debt. The
company should follow a collection procedure in a clear
cut sequence. — i.e. polite letter, strong worded reminders,
personal visits and then legal action.
4. Analysing the Investments in Receivables.
The last step is to analyse the amount of receivables
from time to time with the help of certain ratios such as
calculation of average collection period, debtors turn over
ratio, ratio of receivables to current assets etc. A proper
analysis of receivables will help the management in keeping
the amount of receivables within reasonable limits.
NSS College. Rajakumari.
19 Financial Management
Unit 4
FINANCIAL STATEMENT ANALYSIS.
The financial statements are prepared for the
purpose of presenting a periodical review or report of
the progress made by the concern. It shows the 'status of
the investment' in the business, and 'results achieved'
during the accounting period.
Financial statements refer to at least two
statements which are prepared at the end of a given
period. These statements are Income Statement (P'&L
Account ) and Position Statement, (i.e. Balance Sheet).
The purpose of' Income statement' is to ascertain the net
result of trading activities. Position statement is prepared
to find out the financial position of the business as on a
particular date.
According to John. N .Myer, " the financial
statements provide a summary of the accounts of a
business enterprise, the balance sheet reflecting the
assets and liabilities and the income statement showing
the results of operations during a certain period.
In addition to P&L A/C and Balance sheet,
Statement of Retained Earnings, Fund Flow Statement
and cash flow Statements are also considered as
important financial statements.
The financial statements are of much interest to
a number of groups of persons. These groups are very
much interested in the analysis of financial statements.
The process of critical evaluation of the financial
information contained in the financial statements in
order to understand and make decisions regarding the
operations of the firm is called ‘Financial Statement
Analysis’. It is basically a study of relationship among
various financial facts and figures as given in a set of
financial statements, and the interpretation thereof to
gain an insight into the profitability and operational
efficiency of the firm to assess its financial health and
future prospects.
Analysis means to put the meaning of a
statement in to simple terms for the benefit of a person.
Analysis comprises resolving the statements by breaking
them in to simpler statements by a process of re
arranging, regrouping, and collection of information
Broadly the term is applied to almost any kind of
detailed enquiry in to financial data. A financial
manager has to evaluate the past performance, present
financial position, liquidity situation, enquire in to
profitability of the firm and to plan for future operations.
For all this, they have to study the relationship among
various financial variables in a business as disclosed in
various financial statements.
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. INVESTORS
An 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 LENDERS
Bankers 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
NSS College. Rajakumari.
20 Financial Management
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. EMPLOYEES
Employees interested in better emoluments,
bonus and continuance of the business, would like to
know its financial performance and profitability.
6. GOVERNMENT
Government 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.
TYPES OF FINANCIAL ANALYSIS
Following are the various types of financial
analysis.
A. On the basis of material used.
1 External analysis
Analysis of financial statements may be carried
out on the basis of published information. i.e
information made available in the Annual Report of the
enterprise. Such analysis are usually carried out by those
who do not have access to the detailed accounting
records of the Co. ie Banks, Creditors etc.
2 Internal Analysis.
Analysis may also be based on detailed
information available within the Co, which is not
available to the outsiders. Such analysis is called
internal analysis. This type of analysis is of a detailed
one and is carried out on behalf of the management for
the purpose of providing necessary information for
decision-making. Such analysis emphasizes on the
performance appraisal and assessing the profitability of
different activities.
B. According to objectives of analysis.
1. Short Term Analysis
Short term analysis is mainly concerned with the
working capital analysis. In the short run, a Co must
have ample funds readily available to meet its current
needs and sufficient borrowing capacity to meet the
contingencies. In short term analysis the current assets
and current liabilities are analyzed and liquidity is
determined.
2. Long Term Analysis.
In the long term a Co: must earn a minimum
amount sufficient to maintain a reasonable rate of return
on the investment to provide for the necessary growth
and development of the Co; and to meet the cost of
capital. Financial planning is also desirable for the
continued success of a Co. Thus in the long term
analysis the stability and the earning potentiality of the
Co is analyzed, i.e fixed assets, long term debt structure
and the ownership interest is analyzed.
C. According to the Modus Operandi of analysis.
1. Horizontal Analysis.
Analysis of financial statements involves
making comparisons and establishing relationships
among related items. Such comparison or establishing of
relationship may be based on financial statements of a
Co for a number of years and the financial statements of
different Co's for the same year. Such analysis is called
Horizontal Analysis. It may take the following two
forms.
A. Comparative Financial Statement Analysis
B. Trend Analysis.
2. Vertical Analysis.
Analysis of financial data based on relationship
among items in a single period of financial statement is
NSS College. Rajakumari.
21 Financial Management
called vertical analysis. From a single Balance Sheet be of two types. Comparative Balance Sheet and
or P&L A/C, relationships of various items may be Comparative P&L A/C.
established. E.g., various assets can be expressed as
percentage of total assets. Statements containing such
analysis are also called as common size statements. The
common size P&L A/C is more useful in analyzing the
operating results and costs during the year. It shows
each element of cost as a percentage of sales. Similarly
common size Balance Sheet shows fixed assets as a
percentage to total assets.

TOOLS OF FINANCIAL ANALYSIS

(METHODS).
The analysis of financial statements consist of a
study of relationship and trends to determine whether or
not the financial position of the concern and its
operating efficiency have been satisfactory. In the
process of this analysis various tools or methods are
used by financial analyst. These tools are,
1. Comparative statements
2. Common size statements
3. Trend Analysis
4. Average Analysis
5. Statement of changes in working capital
6. Fund Flow Analysis
7 Cash Flow analysis &
8. Ratio Analysis.
COMPARATIVE FINANCIAL STATEMENTS.
The preparation of comparative financial
statement is an important device of horizontal analysis.
Financial data becomes more meaningful when
compared with similar data for a previous period or a
number of periods. Statements prepared in a form that
reflect financial data for two or more periods are known
as comparative statements. Annual data can be
compared with similar data for prior years. Such
statements are very helpful in measuring the effects of
the conduct of a business during the period under
consideration.
The following steps may be followed to prepare the
comparative statements:
Step 1 : List out absolute figures in rupees relating to
two points of time (as shown in columns 2 and 3)
Step 2 : Find out change in absolute figures by
subtracting the first year (Col.2)from the second year
(Col.3) and indicate the change as increase (+) or
decrease (–) and put it in column 4.
Step 3 : Preferably, also calculate the percentage
change as follows and put it in Column 5.
Change in absolute figure x 100
First year figure
Advantages
1. These statements indicate trends in sales, cost of
production, profits, etc., helping the analyst to evaluate
the performance, efficiency and financial condition of
the undertaking. For example, if the sales are increasing
coupled with the same or better profit margins, it
indicates healthy growth.
2. Comparative statements can also be used to compare
the position of the firm with the average performance of
the industry or with other firms. Such a comparison
facilitates the identification or weaknesses and
remedying the situation.

Financial statements of two or more firms may

also be compared for drawing inferences. This is known
as inter-firm comparison. Comparative statements can

NSS College. Rajakumari.

22 Financial Management

Illustration 1.
Convert the following Income Statement into a comparative income statement of BCR Co. Ltd and interpret
the changes in 2005 in the light of the conditions in 2004.

Interpretation.

NSS College. Rajakumari.

23 Financial Management
1. The Company has
made efforts to
reduce the cost
which is evident
from the fact that
the cost of goods
sold has not
increased in the
same ratio as the
amount sales.

2. The gross profit has

increased in 2005
as compared to
2004 considerably,
33.64% with an
increase 20% in
sales.

3. The company has

also concentrated
on reducing the
operating cost;
hence the
percentage of
operating profit has also considerably increased, i.e 106.07%.

Thus the overall performance of the Co has immensely improved in the year 2005.

Illustration 2.

From the following income statement of Madhu Co Ltd, prepare comparative income statement for the year
ended 31st march, 2005 and 2006 and interpret the same.

Particulars 2005 2006

Sales 4 00 000 6 50 000
Purchases 2 00 000 2 50 000
Opening stock 20 600 32 675
Closing stock 32 675 20 000
Salaries 16 18 000
Rent 010 6 000
Postage and stationary 5 4 100
Advertising 100 4 600
Commission on sales 3 200 3 500
Depreciation 2 600 500
Loss on sale of plant 3 160 2 000
Profit on sale of investments 200 4 500
4 000
3 000

NSS College. Rajakumari.

24 Financial Management

Interpretation.
1. The comparative balance sheet of the company reveals that there has been an
increase in sales by Rs 2 500 000, ie 62.5% where as cost of goods sold has increased
only by Rs 74 750. Ie 39.78%. This reveals that the company has made efforts to
reduce the cost of goods sold thereby the gross profit of the company has increased by
Rs 1 75 250. Ie 82.64%.

2. The expenses of the Co have increased by R s 6430 ie 21.24% only, and the operating
profit has increased by Rs 1 68 820, ie 92.86%.

3. The net profit of the Co has increased by 95.31%

NSS College. Rajakumari.

25 Financial Management
4. The overall performance of the Co is good.

NSS College. Rajakumari.

26 Financial Management

Interpretation.

1. The comparative balance sheet of the company reveals that during the year 2006, there has been an increase in
fixed assets by Rs.1,10,000, i.e. 13.5% while long-term liabilities have relatively increased by Rs.1,50,000 and equity
share capital has increased by Rs.2 lakhs. This fact depicts that the policy of the company is to purchase fixed assets
from long-term source of finance, thereby not affecting the working capital.

2. The current assets have increased by Rs.1,52,000, i.e. 24.52%. The current liabilities have increased only by
Rs.20,000, i.e. 12.9%. This shows an improvement in the liquid position of the Company.

3. Shareholder’s funds (share capital plus reserves) have shown an increase of Rs. 92,000.
4. The overall financial position of the company is satisfactory.

Illustration 4

From the following information, prepare a comparative Balance Sheet of Deepti Ltd. :

Particulars 31.3.2003 31,3.2002

(Rs.) (Ks.)

Equity share capital 50,00,000 50,00,000

Fixed assets 72,00,000 60,00,000

Reserves and surplus 1 2,00,000 1 0,00,000

Investments 1 0,00,000 10,00.000

Long-term loans 30,00,000 30,00,000

Current assets 21,00,000 30,00,000

Current liabilities 11 ,00,000 10,00,000

NSS College. Rajakumari.

27 Financial Management

Solution :
Comparative Balance Sheet
as on 31.3.2002 and 31.3.2003
2002 Rs. 2003 Rs. Absolute Change Percentage
Rs. Change (%)

Assets
Fixed assets 60,00,000 72,00,000 12.00,000 20
Investments 10,00,000 10,00,000 - —
Current assets 30,00,000 21,00,000 (9,00,000) - 30

Total assets 1,00,00,000 1.03,00,000 3,00,000 3

Liabilities and Capital 50,00,000 50,00,000 - -

Equity share capital 10,00,000 12.00,000 2,00,000 20
Reserves and surplus Long-term loans 30,00,000 30,00,000 - -
Current liabilities 10,00,000 1 1 ,00,000 1,00,000 10

1 ,00,00,000 1,03,00,000 3,00,000 1

NSS College. Rajakumari.

28 Financial Management

Debentures 2,00,000 3,00,000 + 1,00.000 +50

Long-term loans on Mortgage 1 .50,000 2.00,000 +50.000 +33

6,75,000 + 1.70.000 +33.66

Total Liabilities 5,05000

Equity Share Capital 6,00,000 8.00,000 +2.00.000 +33

Reserve & Surpluses 3,30.000 2.22.000 - 1 08,000 -32.73

Total 14.35,000 1 6,97.000 +2.62.000 + 1K.26

Interpretation
(1) The comparative balance sheet of" the company reveals that during 2002 there has been an increase in fixed assets of 1,10,000
i.e 13.49% while long-term liabilities to outsiders have relatively increased by Rs. 1,50,000 and equity share capital has increased
by Rs. 2 lakhs. This fact depicts that the policy of the company is to purchase fixed assets from the long-term sources of finance
thereby not affecting the working capital.
(2) The current assets have increased by Rs. 1,52,000 i.e.24.52% and cash has increased by Rs.60.000. On the other hand, there
has been an increase in inventories amounting to Rs, 1 lakh. The current liabilities have increased only by Rs.20,000.
i.e. 12.9%. This further confirms that the company has raised long-term finances even for the current assets resulting into an
improvement in the liquidity position of the company.
(3) Reserves and surpluses have decreased from Rs.3,30,000 to Rs.2,22,000 i.e.,32 73% which shows that the company has
utilised reserves and surpluses for the payment of dividends to shareholders either in cash or by the issue of bonus shares.
(4) The overall financial position of the company is satisfactory.

Illustration 6.
The income statements of a concern are given for the year ending on 31st Dec., 200 8and 2007.
NSS College. Rajakumari.
29 Financial Management
Re-arrange the figures in a comparative form and study the profitability position of the concern.

200 7 2008
Rs.(OOO) Rs.(OOO)

Net sales 785 900

Cost of goods sold 450 500

Operating Expenses:

General and administrative expenses 70 72

Selling expenses 80 90

Non-operating Expenses :

Interest paid 25 30

Income -tax 70 80

Solution :
Comparative Income Statement
for the year ended 3 1st Dec. 2007 and 2008

31 December Increase(+) Increase(+)

Decrease (-) Decrease (-)
2007 2008 Rs. ('000) (Percentages)
Rs. ('000) (Rs. ('000)

785 900 + 115 + 14.65

Net Sales +50 + 11.0
Less : Cost of goods sold 450 500

335 400 +65 + 19.40

Gross Profit

Operating Expenses:
General & Administrative Expenses 70 72 +2 +2.8
Selling Expenses 80 90 + 10 + 12.5

Total Operating Expenses 150 162 + 12 +8.0

Operating Profit 185 238 +53 +28.65

Less : Other deductions Interest paid 25 30 +5 +20

Net profit before tax 160 208 +48 +30.0

Less : Income tax 70 80 + 10 + 14.3

90 128 +38 +42.22

Net Profit after tax

Interpretation
NSS College. Rajakumari.
30 Financial Management
The comparative income statement given above reveals that there has been an increase in net sales of 14.65%
while the cost of goods sold has increased nearly by 11 % thereby resulting in an increase in the gross profit of 19.4%.
Although the operating expenses have increased by 8% the increase in gross profit is sufficient to compensate for the
increase in operating expenses and hence there has been an overall increase in operational profits amounting to Rs.53,000
i.e. 28.65% in spite of an increase in financial expenses of Rs.5,000 for interest and Rs. 10,000 for income -tax. There in an
increase in net profits after tax amounting to Rs.38,000 i.e. 42.22%. It may be concluded that there is sufficient progress in
the company and the overall profitability of the company is good.
…………………………………………………………………………………………………………………………………
…….
Balance sheet. This statement establishes relation
between each asset and total value of asset and each
liability against total liabilities.
COMMON SIZE STATEMENTS. Common Size Income Statement. A Common Size
Income statement is a statement in which each item of
Comparative statements that give only the expense is shown as a percentage of net sale. A
vertical percentage ratio for financial data with out significant relationship can be established between
giving Rupee values are known as common size items of income statement and volume of sales.
statements For example, if the Balance sheet items
are expressed as the ratio of each asset to total assets The following procedure may be adopted for preparing
and the ratio of each liability to total liabilities, it will be the common size statements.
called a common size balance sheet. Thus a common
size statement shows the relation of each component 1. List out absolute figures in rupees at two points of
to the whole. It is useful in vertical financial analysis time, say year 1, and year 2 (Column 2 & 4 of Exhibit
and comparison of two business enterprises at a 2)
certain date.Common size statements include :
Common size Balance Sheet and Common size 2. Choose a common base (as 100). For example,
Income Statement. Sales revenue total may be taken as base (100) in
case of income statement, and total assets or total
Common size Balance Sheet - A statement in which liabilities (100) in case of balance sheet.
Balance Sheet items are expressed as percentage of 3. For all items of Col. 2 and 4 work out the
each asset to total asset and percentage of each percentage of that total. Column 3 and 5 show these
liability to total liabilities is called Common Size percentages.

Illustration 1.

NSS College. Rajakumari.

31 Financial Management

Interpretation :

1. In 2005, both current assets and current liabilities decreased as compared to 2004, but the decrease in current
assets is more than the decrease in the current liabilities. As a result, the firm may face liquidity problem.
2. In 2005 both fixed assets and the long-term liabilities increased, but the increase in the fixed assets is more than
the increase in long-term liabilities. The firm sold some investments to acquire fixed assets and used short-term funds
to purchase fixed assets.
3. The firm has undertaken expansion programme reflected in addition to land and buildings.
The overall financial position of the firm is satisfactory. It should improve its liquidity.

Illustration 2.

From the following financial statements, prepare Common Size Statements for the year ended March 31, 2004 and
2005.

NSS College. Rajakumari.

32 Financial Management

NSS College. Rajakumari.

33 Financial Management

Interpretation :

1. On comparison of the percentage of the cost of goods sold, it is observed that the company has tried to reduce its cost to
improve its profit margin.

2. The profitability of the company has improved as compared to the previous year as the profit after tax percentage has gone up
by 13.28%.

3. The company has issued share capital in order to finance the purchase of fixed assets like furniture and land and buildings.

4. The company has improved its liquidity position as reflected in the increase of its current assets.

Thus, there is an improvement in the working of the company.

Illustration 3.

NSS College. Rajakumari.

34 Financial Management
Prepare Common Size Statement from the following income statement of Karan Ltd. for the year ended March 31,
2006.

Illustration 4.
From the profit and loss accounts of Dharmasa Ltd for the years ended on 31st December, 2006, 2007, and 20089
prepare common size statement and interpret.

NSS College. Rajakumari.

35 Financial Management
DHARMASA LTD
PROFIT AND LOSS ACCOUNTS. For the years ended December31.

Interpretation. The absolute figures in rupees show that sales, cost of goods sold and gross profit all have
continuously increased since 2007. But common-size statement reveals that cost of goods sold in relation to sales
decreased in 2008 and again increased in 2009. Consequently rate of gross profit in 2008 over 2007 increased but in
2009 over 2008 decreased. Similarly, net profit after tax, in absolute figures, shows an increasing trend since 2007 but
the rate of net profit on sales in 2009 is 4.4 in contrast to 6.2 in 2008 and 5.4 in 2007.

FUND FLOW ANALYSIS static summary of assets and liabilities on a particular

The technique of fund flow has been
developed to account for changes in assets and
liabilities that take place in the course of the
accounting year. Financial accounting has a very
limited role to perform in this regard. Financial
accounting provides essential basic accounting
information. But its utility is very much limited for
analysis and interpretation. The balance sheet is a
date. It doesn’t highlight the factors that were
responsible for changes in balance sheet figures
relating to two periods. Certain important transactions
which might take place during the accounting year
may not find any place in the balance sheet. To
highlight changes in assets and liabilities, a statement
is prepared which is called a fund flow statement.
NSS College. Rajakumari.
36 Financial Management
Fund flow analysis is the second tool of
analysis of financial statement. (Ratio analysis
occupies the first position.). If we look at the balance
sheets of a Company on two different days, we notice
differences in the figures of assets and liabilities. A
fund flow statement attempts to account for this
difference. In fact Fund Flow analysis measures the
changes in the assets and liabilities of a Company.
The changes in Current Assets and Current
Liabilities are shown in the Schedule of changes in the
Working Capital and the changes in non current assets
and non current liabilities are shown in Fund Flow
Statement.
Fund Flow statement is also known as statement of
sources and applications of funds.
MEANING OF FUND FLOW.
The term “Fund” has been used to convey a
variety of meanings. To many writers the term fund
means cash. To others the term fund means working
capital. These are the two extreme opinions. There are
also two concepts of working capital- Gross Concept
and Net Concept.
Gross working capital refers to firms
investments in total current assets. Net working
capital refers to the excess of current assets over
current liabilities. The most widely acceptable view of
fund is the Net Working capital, which is the excess of
Current Assets over Current Liabilities. Thus the term
fund means Net Working Capital.
The term Flow means movement or change.
There fore, fund flow means change in funds. In other
words, fund flow means flaw of funds in and out of the
area of net working capital. Thus fund flow statement
broadly measures the flow of fund in and out of the
area of net working capital.
There are many transactions which result in
the flow of fund, while there are transactions which do
not result in the flow of fund. Any external transaction
which increases net working capital would be taken as
a source of fund and any such transaction which
decreases net working capital will be considered as
application of fund.
1. Schedule of Changes in Working Capital.
Many expert have opined that only the net
change in working capital should be shown in the fund
flow statement in place of individual changes in all
current assets and current liabilities. For this purpose, a
separate statement or schedule of working capital is
being prepared in which net change in the working
capital is ascertained. The increase in working capital
is treated as application of fund and decrease in
working capital is termed as source of fund.
This statement or schedule is prepared in such
a way as to indicate the amount of working capital at
the end of two years as well as increase or decrease in
the individual items of current assets and current
liabilities. The difference in the amount of working
capital at the end of two years will depict either
increase or decrease in net working capital.
While ascertaining the increase or decrease in
individual items of current assets and current liabilities
and its impact on working capital, the following rules
should be taken in to account.
Increase in the items of current asset will increase the
working capital
2. Decrease in the items of current asset will
decrease the working capital.
3. Increase in items of current liabilities will
decrease working capital.
4. Decrease in items of current liabilities will
increase working capital.
The following points should be taken in to
consideration, while preparing a fund flow statement.
1. All changes in Current Assets and Current
Liabilities are shown in the Schedule.
2. The schedule should be prepared exclusively
from the items given in the Balance Sheet.
The items given in the adjustments do not
affect the preparation of this schedule.
3. Current Assets or Current Liabilities, once
taken in the schedule, will not require any
further treatment else where.
Treatment of Provision for Bad debt.
Some times it is shown as reserve for bad debt.
This item should be shown along with current
liabilities, in the schedule of changes in working
capital.
Provision for Tax.
1. If the problem itself classifies the provision for
tax under current liabilities, then treat it as a
current liability. Once it is taken in the
schedule, it will not find any place in the fund
flow statement.
2. If this item is not specifically classified as a
current liability, but is merely shown as one of
the items on the liability side, then this item
may be taken as a non current liability. Thus it
goes to the fund flow statement.
Proposed dividend.
NSS College. Rajakumari.
37 Financial Management
The same procedure is followed in respect of
proposed dividend as has been given for provision for Application (Uses) of fund.
tax. 1. Redemption of Preference shares.
2. Redemption of debentures
3. Repayment of Loan
4. Purchase of Fixed Assets
5. Dividend Paid
6. Income Tax paid etc
2. Fund Flow statement
3. Calculation of FUND FROM OPERATION.
This is second, but most important part of fund
flow analysis. It is prepared on the basis of changes in P&L A/C closing balance xxx
fixed assets, long term liabilities and share capital on Less: P&L A/C opening balance xxx
the basis of values of these items shown in the balance ---------
sheet. Of course additional information must also be Current year profit. xxx
considered.
Add:
Increase in fixed assets is application of fund Depreciation xx
and decrease in fixed asset on account of sale is a Provision for tax xx
source of fund. Increase in long term liabilities is Proposed Dividend xx
source of fund and decrease in long term liabilities is Interim dividend paid xx
application. Thus the preparation of fund flow Loss on sale of asset xx
statement involves the ascertainment of increase or Amortisation of goodwill xx
decrease in the various items of fixed assets, long term Preliminary expenses-
liabilities, and share capital, in the light of additional written off xx
information given. Transfer to reserve xx
---------------
Sources of Fund. xxxx
1. Issue of shares Less:
2. issue of debentures Dividend received xx
3. Raising of new loans Profit on sale of asset xx
4. Sale of fixed assets -----------------
5. Fund from operation Fund from Operation. xxxx
6. Non trading income like dividend received, -----------------
interest on deposit etc.

CASH FLOW ANALYSIS

Cash flow analysis is another important technique of financial analysis. It involves preparation of cash flow
statement for identifying sources and application of cash. The term cash here stands for cash and bank balance. A
cash flow statement is a statement depicting changes in cash position from one period to another. It explains the
reasons for such inflows or out flows of cash .
A cash flow statement can be prepared on the same pattern on which a fund flow statement is prepared. The
changes in cash position from one period to another is computed by taking in to account ‘Sources and Applications’ of
cash.

Format of cash flow statement.

Source Rs Application Rs
Opening balance: Decrease in liabilities XXX
Cash XXX Increase in asset XXX
Bank XXX Redemption of preference XXX
NSS College. Rajakumari.
38 Financial Management
shares XXX
Sources of cash. Repayment of loan XXX
Purchase of fixed asset XXX
Increase in liabilities XXX Tax paid XXX
Decrease in current assets XXX Dividend paid
Issue of shares XXX
Raising of long term loans XXX
Sale of fixed assets XXX
Short term borrowings. XXX
Closing balance XXX
Cash from operations. XXX Cash XXX
Bank
XXXX XXXX
Calculation of cash from operation

(Refer calculation of fund from operation.)

RATIO ANALYSIS. Ratios can be grouped into various classes

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.
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 Asset
Current 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.

NSS College. Rajakumari.

39 Financial Management
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 securities
Cash 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 sold
Inventory 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 sales
Debtors 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 months
Or 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 purchase
CTR = -------------------------------------------
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
NSS College. Rajakumari.
40 Financial Management
Net credit purchases.
Creditors + B/P
= --------------------------------- x 12
Net credit purchases
12 months
Or 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 profit
Or 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 expense
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.
NSS College. Rajakumari.
41 Financial Management
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 100
Average 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 shareholders
EPS =
------------------------------------------------------------
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 shareholders
DPR =---------------------------------------------- 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.
NSS College. Rajakumari.
42 Financial Management
Market price of share
P 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
a firm.
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 Turnover
This reflects the turnover of the firm’s net working
capital in the course of the year.

Net sales
Debt Outsiders fund Working capital turnover Ratio =
Debt Equity Ratio = --------- or ------------------- ---------------------------
Equity. Share holders fund. Net working capital.
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 Operating Ratio.
refers to networth or shareholders fund. It shows the proportion that the cost of sales
bears to sales. Cost of sales includes direct cost of
Proprietary ratio. goods sold as well as other operating expenses. It is
calculated by dividing the total operating cost by net
This ratio shows the long term solvency of the sales. Total operating expenses include all costs like
business. It is calculated by dividing shareholders administration, selling and distribution expenses etc,
funds by total assets. but do not include financing cost and income tax.
Lower the ratio, the more profitable are the operations
Share holders fund indicating an efficient control over costs and
Proprietary ratio = ------------------------------- appropriate selling price.
Total assets.
Operating Ratio =
Capital gearing ratio.
(Cost of goods sold + Operating expense)
This is also known as Leverage ratio. This is --------------------------------------------------x
mainly used to analyse the capital structure of a 100
company. The term capital gearing normally refers to Net sales

Illustration : 1
From the following compute current ratio:
Rs. Rs.
Stock 36,500 Prepaid expenses 1,000
Sundry Debtors 63,500 Bank overdraft 20,000
Cash in hand & bank 10,000 Sundry creditors 25,000
Bills receivable 9,000 Bills payable 16,000
Short term investments 30,000 Outstanding expenses 14,000

Solution:
Current Assets
Current Ratio = ————————
Current Liabilities
Current Assets = Stock + Sundry debtors + Cash in hand and bank + Bills receivable + Short term
investments + Prepaid expenses
= 36,500 + 63,500 + 10,000 + 9,000 + 30,000 + 1,000

NSS College. Rajakumari.

43 Financial Management
= Rs. 1,50,000
Current Liabilities = Bank overdraft + Sundry creditors + Bills payable + Outstanding expenses
= 20,000 + 25,000 + 16,000 + 14,000 = Rs. 75,000.
1,50,000
Current Ratio = —————
75,000
=2:1

Illustration :2
Calculate Debt Equity Ratio from the following information.
Rs.
Debentures 2,00,000
Loan from Banks 1,00,000
Equity share capital 1,25,000
Reserves 25,000

Solution:
Total Long Term Debt
Debt - Equity Ratio = ———————————
Shareholders funds
Total long term debt = Debentures + Loans from Bank
= 2,00,000 + 1,00,000 = Rs. 3,00,000
Shareholders funds = Equity Share Capital + Reserves.

= 1,25,000 + 25,000 = Rs. 1,50,000

3,00,000
Debt-Equity Ratio = ————— = 2:1
1,50,000

From the following particulars ascertain gross profit ratio

Rs. Rs.
Cash sales 40,000 Sales return 5,000
Credit sales 65,000 Gross profit 40,000

Solution:
Gross Profit
Gross Profit Ratio = —————— x 100
Sales
Sales = Total Sales –– Sales Returns
= 40,000 + 65,000 –– 5,000 = Rs. 1,00,000
40,000
= ————— x 100 = 40%
1,00,000

Problem 3

The following is the Balance sheet of ABC ltd as on 31st December 2005.
Balance Sheet
NSS College. Rajakumari.
44 Financial Management
Liabilities Rs Assets Rs
Share capital 2 00 Fixed assets 1 60 000
Reserves and surplus 000 Stock 50 000
Creditors 30 000 Debtors 20 000
Bills payable 20 000 Bills receivable 15 000
Bank overdraft 5 000 Prepaid expense 5 000
Outstanding expense 17 000 Cash at bank 30 000
Provision for tax 8 000 Cash in hand 20 000
20 000 3 00 000
3 00
000

Calculate 1) Current ratio, 2) Quick ratio, 3) Absolute liquid ratio.

Answer.

Current asset 1 40 000

Current ratio = -------------------------- = -------------------= 2:1
Current Liability 70 000

Quick asset 85 000

Quick ratio = -------------------- = ----------------- = 1.21 :1
Current Liability 70 000

cash and bank balance 50 000

Absolute liquid asset. = --------------------------------------- = --------------------- = 0.71 :1
Current liabilities 70 000

NSS College. Rajakumari.

45 Financial Management

NSS College. Rajakumari.

46 Financial Management

Calculate profitability ratios.

Solution:
Gross Profit
1. Gross Profit Ratio = —————— x 100
Sales
1,80,000
= —————— x 100
4,00,000
= 45%

Net Profit
2. Net Profit Ratio = —————— x 100
Sales
1,55,000
= —————— x 100
4,00,000
= 38.75%

Operating Profit
3. Operating Profit Ratio = —————— x 100
Sales
Operating Profit = Net Profit + Non-operating expenses – Non-operating income
= Net Profit + Interest + Loss on sale of machinery – Dividend
= 1,55,000 + 2,000 + 5,000 – 2,000 = Rs. 1,60,000

1,60,000
Operating Profit Ratio = -------------------- x 100
4,00,000

Cost of goods + Operating Expenses

4. Operating Ratio = ————————
Sales
Cost of goods sold = Sales – Gross Profit = 4,00,000 – 1,80,000 = Rs. 2,20,000

NSS College. Rajakumari.

47 Financial Management
Operating Expenses = Administration + Selling Expenses
= 10,000 + 10,000 = Rs. 20,000
2,20,000 + 20,000
Operating Ratio = ———————— x 100 = 60%*
4,00,000

* Note : Operating ratio = 100% –– Operating profit ratio = 100% –– 40% = 60%

Illustration 5

Calculate the current ratio from the following information :

Working capital Rs. 9,60,000; Total debts Rs.20,80,000; Long-term Liabilities Rs.16,00,000; Stock
Rs. 4,00,000; prepaid expenses Rs. 80,000.

Solution
Current Liabilities = Total debt- Long term debt
= 20,80,000 – 16,00,000
= 4,80,000

Working capital = Current Assets – Current liability

9,60,000 = Current Assets – 4,80,000
Current Assets = 14,40,000

Quick Assets = Current Assets – (stock + prepaid expenses)

= 14,40,000 – (4,00,000 + 80,000)
= 9,60,000

Current ratio = Current Assets / Current liabilities

= 14,40,000/4,80,000
= 3:1
Quick ratio = Quick Assets / Current liabilities
= 9,60,000/4,80,000
= 2:1
Illustration 6

From the following information, calculate Debt Equity Ratio, Debt Ratio,Proprietary Ratio and Ratio of
Total Assets to Debt.

Balance Sheet as on December 31, 2006

Equity share Capital 3,00,000 Fixed Assets 4,50,000

Preference Share Capital 1,00,000 Current Assets 3,50,000
Reserves 50,000 Preliminary Expenses 15,000
Profit & loss A/C 65,000
11 % Mortgage Loan 1,80,000
Current liabilities 1,20,000
8,15,000 8,15,000

Solution

Shareholders Funds = Equity Shares capital + Preference Shares capital +

Reserves + profit % loss A/C - Preliminary Expenses

= Rs. 3,00,000 + Rs. 1,00,000 + Rs.50,000 + Rs. 65,000- Rs. 15,000

= Rs. 5,00,000

Debt Equity Ratio = Debt / Equity

NSS College. Rajakumari.
48 Financial Management
= Rs. 1,80,000/Rs. 5,00,000 = 0.36: 1

Proprietary Ratio = Proprietary funds / Total Assets

= Rs. 5,00,000/Rs. 8,00,000
= 0.625:1

Total Assets to Debt Ratio = Total Assets / Debt

= Rs. 8,00,000/Rs. 1,80,000
= 4.44:1

Illustration 7
Calculate the Gross profit Ratio, Net Profit Ratio and Operating Ratio from the given the following
information:

Sales Rs. 4,00,000

Cost of Goods Sold Rs. 2,20,000
Selling expenses Rs. 20,000
Administrative Expenses Rs. 60,000

Solution

Gross Profit = Sales – Cost of goods sold

= Rs. 4,00,000 – Rs. 2,20,000
= Rs. 1,80,000

Gross Profit Ratio = Gross s Profit X 100

Sales
= Rs. 1 ,80,000 X 100
Rs 4 ,00,000
= 45 %

Net Profit = Gross Profit – Indirect expenses

= Rs. 1,80,000 – (Rs. 20,000 + Rs. 60,000)
= Rs. 1,00,000

Net Profit Ratio = Net profit / Sales × 100

= Rs.(1,00,000/ 4,00,000) X 100
= 25 %

Operating Expenses = Selling Expenses + Administrative Expenses

= Rs. 20,000 + 60,000
= Rs. 80,000

Operating Ratio = Cost of goods + Operating Expenses X 100

Net Sa les
= Rs. 2 ,20,000 + Rs. 80,000 X 100
Rs4, 00,000
= 75 %

Illustration 8

NSS College. Rajakumari.

49 Financial Management

NSS College. Rajakumari.

50 Financial Management

Problem

NSS College. Rajakumari.

51 Financial Management

Problem 2.

The following is the Balance sheet of XYZ ltd, as on 31st March 2005.

Liabilities Rs Assets Rs

Equity share capital 2 00 Land and buildings 1 50 000

Preference share 000 Plant and machine 2 50 000
capital 2 00 Furniture 50 000
General reserve 000 Stock 1 50 000
Profit and loss account 80 000 Debtors 70 000
12 % debentures 40 000 Bills receivable 80 000
Creditors 2 20 Cash at bank 1 00 000
Bills payable 000 Cash in hand 40 000
1 00 8 90 000
000
50 000

8 90
000

Calculate 1). Current Ratio. 2) Quick ratio, 3) debt Equity ratio, 4) Proprietary ratio, 5)Fixed asset to net worth, 6)
Capital gearing ratio.

Answer.
Current assets 4 40 000
Current ratio = ------------------------ = ---------------------- = 2.93 :1
Current liabilities 1 50 000

NSS College. Rajakumari.

52 Financial Management
Quick assets 2 90 000
Quick ratio = -------------------------- = ----------------- = 1.93 : 1
Current liabilities 1 50 000

Debt
Debt equity ratio = ------------------
Equity
(Debt = debenture + creditors + bills payable
Equity = Equity share capital + Pref share + General reserve + P& L account )

Shareholders fund 5 20 000

Proprietary ratio = ---------------------------------- = ---------------------- = 0.58 : 1
Total assets. 8 90 000

(Where, share holders fund = 2 00 000+ 2 00 000+ 80 000+ 40 000 = 5 20 000).

Fixed asset 4 50 000

Fixed asset to net worth ratio = -------------------- = -------------------- = .86 :1.
Net worth.(share holders fund) 5 20 000

Preference share capital + debentures

Capital gearing ratio = Equity share capital + Reserves and surplus.

= 2 00 000 + 2 20 000 = 1.31:1

2 00 000 + 80 000+ 40 000

Problem 3

From the following, work out 1) Gross profit ratio, 2)Net profit ratio, 3)Operating profit ratio, and 4)Operating ratio.

Trading and P&L Account.

particulars Rs Particulars Rs
To Opening stock 40 000 By Sales 5 00 000
Purchases 4 00 Closing stock 1 00 000
Direct expenses 000
Gross profit c/d 60 000
1 00 6 00 000
000
To operating expense 6 00 By gross profit b/d 1 00 000
Administration 000
exp
Selling expense
Finance expense 20 000
Income tax 10 000
Net profit 20 000 1 00 000
10 000
40 000
1 00
000
Gross profit ratio = gross profit x 100 = 1 00 000 x 100
Sales 5 00 000

Net profit ratio = Net profit after interest and tax x 100 = 40 000 x 100 = 8 %.
Net sales 5 00 000

NSS College. Rajakumari.

53 Financial Management
Operating ratio = cost of goods sold + operating expense x 100
Net sales

Cost of goods sold = sales – gross profit

( ie opening stock + purchases + direct expense ) – Closing stock
ie 5 00 000 – 1 00 000 = 4 00 000.

Operating ratio = 4 00 000 + 30 000 x 100 = 86 %.

5 00 000

Operating profit ratio = 100 – Operating ratio.

= 100 – 86 = 14 %.

Illustration : 5
From the following calculate Proprietory Ratio
Rs. Rs.
Equity share capital 1,00,000 Furniture 10,000
Preference share capital 75,000 Bank 20,000
Reserves & surplus 25,000 Cash 25,000
Machinery 30,000 Stock 15,000
Goodwill 5,000

Solution :
Shareholders funds
Proprietory Ratio = —————————
Total tangible assets.

Shareholders fund = Equity capital + Preference Share Capital + Reserve & Surplus
= 1,00,000 + 75,000 + 25,000 = Rs. 2,00,000
Total tangible assets= Machinery + Furniture + Bank + Cash + Stock
= 30,000 + 10,000 + 20,000 + 25,000 + 15,000 = Rs. 1,00,000
2,00,000
= ————— = 2:1
1,00,000

NSS College. Rajakumari.

54 Financial Management

NSS College. Rajakumari.

55 Financial Management

NSS College. Rajakumari.

56 Financial Management

NSS College. Rajakumari.

57 Financial Management

From thew following, Calculate Stock Turnover.

NSS College. Rajakumari.
58 Financial Management

NSS College. Rajakumari.

59 Financial Management

NSS College. Rajakumari.

60 Financial Management

NSS College. Rajakumari.

61 Financial Management

NSS College. Rajakumari.

62 Financial Management

NSS College. Rajakumari.

63 Financial Management
Problem

NSS College. Rajakumari.

64 Financial Management

NSS College. Rajakumari.

65 Financial Management

NSS College. Rajakumari.

66 Financial Management

NSS College. Rajakumari.

67 Financial Management

Problem. 4

The following are the final accounts of Tata consultancy limited for the years ended 31st March
2005 and 2006.
BALANCE SHEET
LIABILITIES 2004 2005 ASSSETS 2004 2005

NSS College. Rajakumari.

68 Financial Management
Share capital Property, plant and
Equity shares of 10 each 2 39 150 2 32 570 equipment 6 08 060 3 67 730
14% Preference shares 32 650 0 Less depreciation 2 00 830 1 02 810
4 07 230 2 64 920
P&L Account 82 050 62 280
General Reserve 2 13 430 1 61 560 Patent etc 0 2 490
Other fixed assets 4 290 800
12 % debentures of Current assets
Rs100 3 20 000 92 500 Stock 2 32 820 68 690
Book debts 2 90 530 1 92 500
Sundry creditors 1 03 680 53 370 Prepaid expense 6 640 4 150
Outstanding expense 13 090 6960 Bank 1 18 430 1 04 360
Other current liabilities 55 890 28 670
10 59 940 6 37 910 10 59 940 6 37 910

REVENUE STATEMENT
2005 2004 2005 2004
Cost of sales 12 84 340 6 07 760 Sales 19 32 130 9 19 540
Gross profit 6 47 790 3 11 780
19 32 130 9 19 540 19 32 130 9 19 540

Administration and 2 63 690 1 38 440 Gross profit . 6 47 790 3 11 780

selling expense .
Bonus paid 98 310 41 670 Other income 9 560 2 730
Interest paid 38 400 11 100
Provision for taxation 1 47 120 69 340
Transfer to reserve 37 200 36 300
Net income 72 630 17 660
6 57 350 3 14 510 6 57 350 3 14 510

From the above,

1) Work out various ratios for the management.

2) With the help of ratios, give a clear account of the profitability and financial condition of the Co in 2004 – 05 , on
a comparative scale.

Solution:

Ratios 2005 2004

Profitability Ratios.

Return on capital employed based on 2 85 790 1 31 670

operating profit, before interest and tax. --------------x 100 = 32.21 % ------------ x 100 = 23.99%
8 87 280 5 48 910

Net profit Ratio 2 85 790 1 31 670

------------ x 100 = 14.79 % ------------ x 100 = 14.32 %
19 32 130 9 19 540

Gross profit ratio 6 47 790 3 11 780

-------------- x 100 = 33. 53 % --------------- x 100 = 33.91%
19 32 130 9 19 540

12 84 340 6 07 760
Cost of sales ratio(cost of sales / sales) -------------- x 100 = 66. 47 % -------------- x 100 = 66.09%
NSS College. Rajakumari.
69 Financial Management
19 32 130 9 19 540

Operating Ratio. 16 46 340 7 87 870

(cost of sales + operating exp) --------------- x 100 = 85. ---------------- x 100 = 85.68%
------------------------------------ x 100 21% 9 19 540
Sales 19 32 130

Turnover Ratios.
9 19 540
General turn over ratio 19 32 130 ---------------- =1. 68
(sales / capital employed) -------------- = 2.18 5 48 910
8 87 280
9 19 540
Turn over of fixed capital 19 32 130 ---------------- = 3.44
--------------- = 4. 74 2 67 410
4 07 230
9 19 540
Turnover of net working capital 19 32 130 ------------------ = 3. 28
-------------- = 4. 06 2 80 700
4 75 760
Stock turnover ratio 6 07 760
(cost of sales/ closing stock.) 12 84 340 ----------------- = 8.85
-------------- = 5.52 68 690
2 32 820
1 92 500
Average debt collection period 2 90 530 ------------x 12 = 2.51months
------------ x 12 = 1.8 months 9 19 540
19 32 130
Financial Position Ratios.
3 69 700
Current ratio 6 48 420 ------------- = 4.15 : 1
--------------- = 3.76 : 1 89 000
1 72 660
2 96 860
Liquidity ratio 4 08 960 ---------------- = 3.3.4 :1
-------------- = 2.37 : 1 89 000
1 72 660
92 500
Debt equity ratio 3 20 000 --------------- = 0.17
-------------- = 0.36 5 48 910
8 87 280
2 67 410
Fixed asset ratio 4 07 230 --------------= 0.55 :1
---------------- = 0.51 :1 4 86 630
8 05 230
53 960
EPS 1 09 830 --------------- = Rs 2.32
-------------- = Rs 4. 59 23 257
23 915

ASSESSMENT.

The activity of the company (derived from sales figures) during 2005 as compared to 2004 has more than
doubled. Correspondingly, the gross profit has also more than doubled.
He overall profitability ( return on capital employed) has shown a rise. It means in the year 2005 the profit has
increased not only in volume corresponding to the increase in sales, but more than proportionate to the increase in
sales.
Though the net profit and gross profit ratio were almost maintained, still the return on capital employed has
increased. This is mainly due to the increase in turnover of the capital employed. On the whole the performance is
satisfactory.
NSS College. Rajakumari.
70 Financial Management
On the financial side there have been some setbacks. The liquidity position has worsened and so has debt
equity ratio. Though the situation is not serious yet a close watch should be kept.
Ther have been very heavy long term borrowings. During the year money has been raised from preference
shares and debentures from long term assets. This has pushed the debt equity ratio to a level beyond which probably it
cannot go. It may be better for the company to broaden the equity base by reducing outstanding debentures and raising
additional funds from equity shares.

Problem 5
The ratios relating to Cosmos Limited are given below as follows.
Gross profit ratio : 15 %
Stock velocity : 6 months
Debtors velocity : 3 months
Creditors velocity : 3 months
Gross profit for the year ending 31 st December amounts to Rs 6 00 000. Closing stock is equal to opening stock.

Find out 1) sales, 2) Closing stock, 3 ) Sundry debtors, 4 ) Sundry creditors.

Solution.

Gross profit ratio = Gross profit x 100

Sales

15% = Rs 6 00 000
Sales
Sales = 6 00 000 x 100 = 4 00 000.
15

Closing Stock.

Stock velocity = Cost of goods sold

Average stock

Cost of goods sold = Sales – Gross profit = 4 00 000 – 60 000 = 3 40 000.

12 = 3 40 000 x 6 = Rs 1 70 000.
6 12
Since opening and closing stock are the same ; closing stock is Rs 1 70 000.
Sundry Debtors
Debtors velocity = Total debtors x No of months
Sales

3= Total debtors x 12
4 00 000
Total debtors = 4 00 000 x 3 = 1 00 000.
12

Sundry Creditors
For calculating sundry creditors, the figure for credit purchases will be required.
Cost of goods sold = Opening stock + Purchases – Closing stock
Rs 3 400 000 = Rs 1 70 000 + Purchases – Rs 1 70 000

Purchases = Rs 3 40 000.

Creditors velocity = Total creditors x No of months

Purchases
3= Total creditors x 12
3 40 000

Total creditors = 3 40 000 x 3 = Rs 85 000.

12
NSS College. Rajakumari.
71 Financial Management
Problem 6

Prepare a Balance sheet in the given format, with the help of the following ratios.
Total assets / Net worth : 3.5
Sales / Fixed assets :6
Sales / current assets :8
Sales / Inventory : 15
Sales / debtors :18
Current ratio : 2.5
Annual sales : Rs 25 00 000.

Balance sheet
Liabilities Rs Assets Rs
Net worth ------ Fixed assets -----
Long term debt ----- Inventory -----
Current ----- Debtors -----
liabilities Liquid -----
------ assets -------
-

Solution.

1. Sales / Fixed assets = 6 :1

Sales = Rs 25 00 000 ( ie 6)
Fixed assets = 25 00 000 x 1 = Rs 4 16 667.
6

2. Sales / Current assets = 8 :1

Sales = Rs 25 00 000 ( ie 8)
Current assets = 25 00 000 x 1 = Rs 3 12 500.
8

3. Sales / Inventory = 15 times.

Inventory = 25 00 000 x 1 = Rs 1 66 667.
15

4. Sales / Debtors = 18 times.

Debtors = 25 00 000 x 1 = Rs 1 38 889.
18

5. Current assets = Inventory + Debtors+ Liquid assets

There fore, liquid assets = current assets – (inventory + debtors)

Liquid assets = 3 12 500 – (1 66 667 + 1 38 889)

Liquid assets = Rs 6 944.

6. Current Ratio = Current assets = 2.5

Current liabilities
Current assets = 3 12 500 (ie 2.5)

Current liabilities = 3 12 500 x 1 = Rs 1 25 000.

2.5

7. Total assets / Networth = Total assets = 3.5 :1

Networth
NSS College. Rajakumari.
72 Financial Management
Where total assets = Fixed assets +Inventory +Debtors +Liquid assets.
Total assets = 4 16 667 + 1 66 667 + 1 38 889 + 6 944 = Rs 7 29 167.

Networth = 7 29 167 x 1 = Rs 2 08 333.

3.5

8. Long term debt = Total liabilities – (current liabilities + net worth)

Long tem debt = 7 29 167 - ( 1 25 000 + 2 08 333) = Rs 3 95 834.

Balance sheet
Liabilities Rs Assets Rs
Net worth 2 08 Fixed assets 4 16 667
Long term debt 333 Inventory 1 66 667
Current 3 95 Debtors 1 38 889
liabilities 834 Liquid 6 944
1 25 assets
000 7 29 167

7 29
167

Problem 7

You are given the following figures.

Current ratio -2.5
Stock turnover - 6 times
Average debt collection period
- 2 months.
Gross profit ratio 20 %
Liquidity ratio- 1.5 Net working capital-Rs 300 000
Gross profit ratio 20 % Fixed asset turnover ratio
Fixed asset / shareholders net (on cost of asset)- 2 times
worth 0.08 Reserves and surplus to capital
0.50

Draw up the Balance Sheet of the company.

Solution.

Working capital:-
If current liabilities are 1, current assets are 2.5.
It means the difference or working capital 1.5.
Working capital Rs 3 00 000.

There for current assets = 3 00 000 X 2.5 = 5 00 000.

1. 5

Current liabilities = 3 00 000 X 1 = 2 00 000.

1.5

As liquidity ratio = 1.5 and current liabilities 2 00 000,

Liquid assets are = 2 00 000 x 1.5 = 3 00 000.
Stock ( 5 00 000 – 3 00 000, ie current assets – liquid assets ) Rs 2 00 000.
Cost of sales ( as stock turnover ratio is 6) = 12 00 000.
Sales ( as gross profit ratio is 20 % 12 00 000 + 20 x 12 00 000 = 15 00 000.
80
NSS College. Rajakumari.
73 Financial Management
Fixed assets are ( since fixed assets turnover ratio is 2 ) Rs 12 00 000 = 6 00 000.
2
Debtors are ( since debt collection period is 2 months )15 00 000 = 2 50 000.
6
Shareholders Net worth 6 00 000 = 7 50 000
0.80
Out of shareholders net worth reserves and surplus = 2 50 000
There fore share capital = 5 00 000.

Liabilities Rs Assets . Rs
Share capital 5 00 000 Fixed assets 6 00 000
Reserves and surplus 2 50 000 Stock 2 00 000
Long term 1 50 000 Debtors 2 50 000
borrowings 2 00 000 bank 50 000
( balancing figure )
Current liabilities 11 00 11 00 000
000
Income Statement – Model form.

Rs Rs

Sales X XXX
Less sales returns XX

Net sales. X XXX

Less. Cost of goods sold

Opening stock of material XXX

Add: Purchases of material XXX
Add: Direct expense XXX
Manufacturing expense XXX
X XXX
Less: Closing stock of material XXX

Cost of production X XXX

Add: Opening stock of finished product XXX
XXX X
XXX
Less :Closing stock of finished product

(Cost of goods sold) XXXX

Gross profit XXX

Less. Operating expense

Administration exp Xxx
Selling and distribution exp Xxx

Operating exp Xxx

Xxxx
Add: Non trading income Xxx
Xxxx
Less: Non trading expense Xxx

NSS College. Rajakumari.

74 Financial Management
EBIT ( Earning before Interest and Tax) XXXX

Less. Interest on debenture Xxx

Xxxx
Net income
Xxx
Less. Tax

Net profit after tax. / EAIT. XXX

(Earning After Interest and Tax)

Problem 8

Following is the P&L Account and Balance Sheet of Jai hind Ltd. Re draft them for the purpose of analysis
and calculate the following ratio.
1) Gross Profit Ratio 2) Overall profitability Ratio 3) Current Ratio 4) Debt Equity Ratio 5) Stock
Turnover Ratio 6) Liquidity Ratio.

P&L Account
Particulars Rs Particulars Rs
Opening stock of finished 1 00 000 Sales 10 00 000
goods 50 000 Closing stock of materials 1 50 000
Opening stock of materials 3 00 000 Closing stock of finished 1 00 000
Purchases of materials 2 00 000 goods 50 000
Direct wages 1 00 000 Profit on sale of shares
Manufacturing expense 50 000
Administration expense 50 000
Selling and distribution expense 55 000
Loss on sale of plant 10 000
Interest on debentures
3 85 000
Net profit 13 00 13 00 000
000

Balance sheet
Liabilities Rs Assets Rs
Equity share capital 1 00 Fixed assets 2 50 000
Preference share 000 Stock of raw 1 50 000
capital . 1 00 materials . 1 00 000
Reserves 000 Stock of finished stock 1 00 000
Debentures 1 00 Sundry debtors 50 000
Sundry debtors 000 Bank balance
Bills payable 2 00
000 6 50 000
1 00
000
50 000

6 50
000

Solution

NSS College. Rajakumari.

75 Financial Management
Income Statement
Sales 10 00 000
Less: Cost of sales:
Raw material consumed
(Opening stock + Purchases – closing 2 00
stock) . 000
Direct wages 2 00
Manufacturing expense 000
Cost of production 1 00
Add : Opening stock of finished goods 000
5 00
Less : Closing stock of finished goods 000
1 00 5 00 000
Cost of goods sold. 000
6 00 5 00 000
Gross Profit. 000
1 00
Less : Operating expense: 1 00 000
000
Administration expense
4 00 000
Selling and distribution expense
Net operating profit
Add : Non trading income: 50 000
Profit on sale of shares 4 50 000

Less : Non trading expense or loss. 50 000 55 000

Loss on sale of plant 50 000 3 95 000
Income before interest and tax 10 000
Less : Interest on debentures
3 85 000
Net profit before tax.
Solution

1) Gross profit Ratio = Gross profit x 100 = 5 00 000 x 100 = 50 %

Sales 10 00 000

2) Overall profitability Ratio = Operating profit x 100 = 4 00 000 x 100 = 80 %

Capital employed 5 00 000

3) Current Ratio = Current assets x 100 = 4 00 000 = 2 .67

Current liabilities 1 50 000

4) Debt equity Ratio = External equities x 100 = 3 50 000 = 1.17

Internal equities 3 00 000
Or

Total long term debt = 2 00 000 = 0.67

Share holders fund 3 00 000

5) Stock turnover ratio = Cost of goods sold = 5 00 000 = 2.5

Average Inventory 2 00 000

6) Liquid Ratio = Liquid Assets = 1 50 000 =1

Current Liabilities 1 50 000

COST OF CAPITAL

NSS College. Rajakumari.

76 Financial Management
The cost of capital of a firm is the minimum rate of return expected by its investors. It is the weighted
average cost of various sources of finance used by a firm. The capital used by a firm may be in the form of debt,
preference capital, retained earnings and equity shares. The concept of cost of capital is very important in the financial
management. A decision to invest in a particular project depends upon the cost of capital of the firm or the cut off rate
which is the minimum rate of return expected by the investors. In case a firm is not able to achieve even the cut off
rate, the market value of its shares will fall. In fact, cost of capital is the minimum rate of return expected by its
investors which will maintain the market value of shares at its present level. Hence, to achieve the objective of wealth
maximisation, a firm must earn a rate of return more than its cost of capital.

Further, optimal capital structure maximises the value of a firm and hence the wealth of its owners and
minimises the firm's cost of capital. The cost of capital of a firm or the minimum rate of return expected by its
investors has a direct relation with the risk involved in the firm. Generally, higher the risk involved in a firm, higher is
the cost of capital.
Cost of capital for a firm may be defined as the cost of obtaining funds, i.e., the average rate of return that the
investors in a firm would expect for supplying funds to the firm.
In the words of Hunt, William and Donaldson, "Cost of capital may be defined as the rate that must be earned
on the net proceeds lo provide the cost elements of the burden at the time they are due".
James C. Van Home defines cost of capital as, "a cut-off rate for the allocation of capital to investments of
projects. It is the rate of return on a project that will leave unchanged the market price of the stock."
Hampton, John J. defines cost of capital as, "the rate of return the firm requires from its investments, in order
to increase the value of the firm in the market place".
Thus, we can say that cost of capital is that minimum rate of return which a firm, must and, is expected to earn
on its investments so as to maintain the market value of its shares.

SIGNIFICANCE OF THE COST OF CAPITAL

The concept of cost of capital is very important in the financial management. It plays a crucial role in both
capital budgeting as well as decisions relating to planning of capital structure. Cost of capital concept can also be used
as a basis for evaluating the performance of a firm and it further helps management in taking so many other financial
decisions.

1. As an Acceptance Criterion in Capital budgeting. In the words of James T.S. Posterfield 'the concept of cost of
capital has assumed growing importance largely because of the need to devise a rational mechanism for making the
investment decisions of the firm'. Capital budgeting decisions can be made by considering the cost of capital.
According to the present value method of capital budgeting, if the present value of expected returns from investment
is greater than or equal to the cost of investment, the project may be accepted; otherwise; the project may be rejected.
The present value of expected returns is calculated by discounting the expected cash inflows at cut-off rate (which is
the cost of capital). Hence, the concept of cost of capital is very useful in capital budgeting decision.

2. As a Determinant of Capital Mix in Capital Structure Decisions. Financing the firm's assets is a very crucial
problem in every business and as a general rule there should be a proper mix of debt and equity capital in financing a
firm's assets. While designing an optimal capital structure, the management has to keep in mind the objective of
maximising the value of the firm and minimising the cost of capital. Measurement of cost of capital from various
sources is very essential in planning the capital structure of any firm.

3. As a Basis for Evaluating the Financial Performance. In the words of S .K. Bhattachary the concept of cost of
capital can be used to 'evaluate the financial performance of top management'. The actual profitability of the project is
compared to the projected overall cost of capital; and the actual cost of capital of funds raised to finance the project. If
the actual profitability of the project is more than the projected and the actual cost of capital, the performance may be
said to be satisfactory.

4. As a Basis for taking other Financial Decisions. The cost of capital is also used in making other financial
decisions such as dividend policy, capitalisation of profits, making the rights issue and working capital.

Computation of cost of capital

Computation of cost of capital involves (1) Computation of cost of each specific source of finance and (2)
Computation of composite cost termed as weighted average cost.

NSS College. Rajakumari.

77 Financial Management
1. Cost of Debt / Debenture.

Debt may be issued at par, at premium or at discount.

Debt issued at par.

Cost of debt = Kd = (1 – T) R
Where; Kd = Cost of debt
T = Tax Rate
R = Debenture interest rate.
For example if a company has issued 9 % Debentures and the tax rate is 50 %, the cost will be
Kd = (1-T) R
= (1 - .5) 9 = 4.5 %.

Debt issued at premium or discount.

In case the debentures are issued at premium or discount, the cost of debt should be calculated on the basis of
net proceeds realized on account of issue of such debentures or bonds.

Kd = I . (1 –T)
NP
Where; Kd = Cost of debt after tax
I = Annual interest payable
NP = Net proceeds of loans or debentures
T = Tax rate.

2. Cost of Redeemable Debt.

If debentures are redeemable after a fixed period,

( P- NP)
I+ ----------------
n
Kd ( before tax) = ------------------------------------------- x 100
( P + NP )
----------------
2
Where, I = Annual interest payable
P = Par value of debentures.
NP = Net proceeds of debentures
.n = number of years to maturity.

Kd ( after tax) = Kd (before tax) x ( 1 – T)

3. Cost of Preference Capital.

DP
KP = ---------- x 100.
NP
Where Kp = Cost of preference capital.
DP = Preference dividend.
NP = Net proceeds.

4. Cost of Redeemable Preference shares.

( P- NP)
NSS College. Rajakumari.
78 Financial Management
D+ ----------------
n
KP ( before tax) = ------------------------------------------- x 100
( P + NP )
----------------
2
Where, D = Dividend
P = Par value of debentures.
NP = Net proceeds of debentures
.n = number of years to maturity.

5. Cost of Equity Share Capital.

A. Dividend Price Method. ( DP Approach).

New Equity Share Capital.

D
Ke = --------- x 100
NP

Where, D = Dividend
NP = Net proceeds.

Existing shares.

D
Ke = -------- x 100.
MP
Where, MP = Market Price.

B. Earning Price Method.

E
Ke = ------------- x 100
NP

Or
E
Ke = ---------------------x 100
MP
Where, E = Earning per share
NP = Net proceeds
MP = Market price.

6. Weighted Average Cost of Capital.

After calculating the cost of each component of capital, the average cost of capital is generally calculated on the basis
of weighted average method. This may also be termed as overall cost of capital. Weighted average cost of capital is the
average cost of the costs of various sources of financing. Weighted average cost of capital is also known as composite cost
of capital, overall cost of capital or average cost of capital. Once the specific cost of individual sources of finance is
determined, we can compute the weighted average cost of capital by putting weights to the specific costs of capital in
proportion of the various sources of funds to the total.

The computation of the weighted average cost of capital involves the following steps.

1. Calculation of the cost of each specific source of funds.

This involves the determination of the cost of debt, equity capital, preference capital etc. This can be done
either on before tax basis or after tax basis.
NSS College. Rajakumari.
79 Financial Management
2. Assigning weights to specific costs.
This involves determination of the proportion of each source of funds in the total capital structure of the
company. This may be done according to marginal weight method, or Historical weights method.

3. Adding of the weighted cost of all sources of funds to get an over all weighted average cost of capital.

CAPITAL SRTUCTURE.

In order to run and manage a company, funds are needed. Right from the promotional stage up to end,
finances play an important role in a company's life. If funds are inadequate, or not properly managed, the entire
organisation suffers. It is, therefore, necessary that correct estimate of the current and future need of capital be made to
have an optimum capital structure which shall help the organisation to run its work smoothly and without any stress.

Capital structure of a company refers to the make up of its capitalisation. A company procures funds by
issuing various types of securities i.e. ordinary shares, preference shares, bonds and debentures. According to
Gerestenbeg, "Capital structure of a company refers to the composition or make-up of its capitalisation and it includes
all long-term capital resources viz : loans, reserves, shares and bonds." The capital structure is made up of debt and
equity securities and refers to permanent financing of a firm. It is composed of long-term debt, preference share
capital and shareholder's funds.For example, a company has equity shares of Rs. 1,00,000, debentures Rs. 1,00,000,
preference shares of Rs. 1,00,000 and retained earnings of Rs. 50,000. The term capitalisation is used for total long-
term funds. In this case it is of Rs. 3,50,000. The term capital structure is used for the mix of capitalisation. In this
case it will be said that the capital structure of the company consists of Rs. 1,00,000 in equity shares, Rs. 1,00,000 in
preference shares, Rs. 1,00,000 in debentures and Rs. 50,000 in retained earnings

Before issuing any of these securities, a company should decide about the kinds of securities to be issued. In
what proportion will the various kinds of securities be issued, should also be considered.

CAPITALISATION, CAPITAL STRUCTURE AND FINANCIAL STRUCTURE.

The terms, capitalisation, capital structure and financial structure, do not mean the same. Capitalisation refers
to the total amount of securities issued by a company while capital structure refers to the kinds of securities and the
proportionate amounts that make up capitalisation. For raising long-term finances, a company can issue three types of
securities viz. Equity shares, Preference Shares and Debentures. A decision about the proportion among these types of
securities refers to the capital structure of an enterprise.

Some authors on financial management define capital structure in a broad sense so as to include even the proportion of
short-term debt. In fact, they refer to capital structure as financial structure. Financial structure means the entire
liabilities side of the balance sheet.

OPTIMUM CAPITAL STRUCTURE; and FACTORS DETERMINING CAPITAL STRUCTURE

The optimum or balanced capital structure means an ideal combination of borrowed and owned capital that
may attain the marginal goal, ie maximizing of market value per share or minimization of cost of capital. The market
value will be maximised or the cost of capital will be minimised when the real cost of each source of fund is the same.

The capital structure of a company is to be determined initially at the time the company is floated. Great
caution is required at this stage, since the initial capital structure will have long-term implications. Of course, it is not
possible to have an ideal capital structure but the management should set a target capital structure and the initial
capital structure should be framed and subsequent changes in the capital structure should be done keeping in view the
target capital structure. Thus, the capital structure decision is a continuous one and has to be taken whenever a firm
needs additional finances.

Following are the factors which should be kept in view while determining the capital structure of a company:
(1) Trading on Equity.

NSS College. Rajakumari.

80 Financial Management
A company may raise funds either by issue of shares or by debentures. Debentures carry a fixed rate of interest and
this interest has to be paid irrespective of profits. Of course, preference shares are also entitled to a fixed rate of
dividend but payment of dividend depends upon the profitability of the company. In case the rate of return (ROI) on
the total capital employed (shareholders' funds plus long-term borrowed funds) is more than the rate of interest on
debentures or rate of dividend on preference shares, it is said that the company is trading on equity. For example, the
total capital employed in a company is a sum of Rs. 2 lakhs. The capital employed consists of equity shares of Rs. 10
each. The company makes a profit of Rs. 30,000 every year. In such a case the company cannot pay a dividend of
more than 15% on the equity share capital. However, if the funds are raised in the following manner, and other things
remain the same, the company may be in a position to pay a higher rate of return on equity shareholders' funds:

(2) Retaining Control.

The capital structure of a company is also affected by the extent to which the promoter/existing management of
the company desire to maintain control over the affairs of the company. The preference shareholders and
debentureholders have not much say in the management of the company. It is the equity shareholders who
select the team of managerial personnel. It is necessary, therefore, for the promoters to own majority of the equity
share capital in order to exercise effective control over the affairs of the company. The promoters or the
existing management are not interested in losing their grip over the affairs of the company and at the same time,
they need extra funds. They will, therefore, prefer preference shares or debentures over equity shares so long they
help them in retaining control over the company.
(3) Nature of Enterprise
The nature of enterprise also to a great extent affects the capital structure of the company. Business enterprises which
have stability in their earnings or which enjoy monopoly regarding their products may go for debentures or preference
shares since they will have adequate profits to meet the recurring cost of interest/fixed dividend. This is true in case of
public utility concemes. On the other hand, companies which do not have this advantage should rely on equity share
capital to a greater extent for raising their funds. This is, particularly, true in case of manufacturing enterprises.
(4) Legal Requirements
The promoters of the company have also to keep in view the legal requirements while deciding about the capital
structure of the company. This is particularly true in case of banking companies which are not allowed to issue any
other type of security for raising funds except equity share capital on account of the Banking Regulation Act.
(5) Purpose of Financing
The purpose of financing also to some extent affects the capital structure of the company. In case funds are required
for some directly productive purposes, for example, purchase of new machinery, the company can afford to raise 4he
funds by issue of debentures. This is because the company will have the capacity to pay interest on debentures
out of the profits so earned. On the other hand, if the funds are required for non-productive purposes, providing
more welfare facilities to the employees such as construction of school or hospital building for company's employees,
the company should raise the funds by issue of equity shares.
(6) Period of Finance
The period for which finance is required also affects the determination of capital structure of companies. In case,
funds are required, say for 3 to 10 years, it will be appropriate to raise them by issue of debentures rather than by issue
of shares. This is because in case the funds are raised by issue of shares, their repayment after 8 to 10 years (when
they are not required) will be subject to legal complications. Even if such funds are raised by issue of redeemable
preference shares, their redemption is also subject to certain legal restrictions. However, if the funds are required more
or less permanently, it will be appropriate to raise them by issue of equity shares.
(7) Market Sentiments
The market sentiments also decide the capital structure of the company. There are periods when people want to have
absolute safety. In such cases, it will be appropriate to raise funds by issue of debentures. At other periods, people may
be interested in earning high speculative incomes; at such times, it will be appropriate to raise funds, by issue of equity
shares. Thus, if a company wants to raise sufficient funds, it must take into account market sentiments; otherwise its
issue may not be successful.
(8) Requirement of Investors
Different types of securities are to be issued for different classes of investors. Equity shares are best suited for bold or
venturesome investors. Debentures are suited for investors who are very cautious while preference shares are suitable
for investors who are not very cautious. In order to collect funds from different categories of investors, it will be
appropriate for the companies to issue different categories of securities. This is particularly true when a company
needs heavy funds.
(9) Size of the Company
Companies which are of small size have to rely considerably upon the owners' funds for financing. Such companies
find it difficult to obtain long-term debt. Large companies are generally considered to be less risky by the investors

NSS College. Rajakumari.

81 Financial Management
and, therefore, they can issue different types of securities and collect their funds from different sources. They are in
a better bargaining position and can get funds form the sources of their choice.
(10) Government Policy
Government policy is also an important factor in planning the company's capital structure. For example, a change in
the lending policy of financial institutions may mean a complete change in the financial pattern. Similarly, by virtue of
the Securities & Exchange Board of India Act, 1992 and the Rules made there under, the Securities & Exchange
Board of India can also considerably affect the capital issue policies of various companies. Besides this, the monetary
and fiscal policies of the Government also affect the capital structure decision.
(11) Provision for the Future
While planning capital structure the provision for future should, also be kept in view. It will always be safe to keep the
best security to be issued in the last instead of issuing all types of securities in one installment. In the words of
Gerestenberg, "Manager of corporate financing operations must always think of rainy days or the emergencies. The
general rule is to keep your best security or some of your best securities till the last".

DU-PONT CONTROL CHART.

A system of management control designed by an American company named Du-Pont paint Company is popularly
called Du-Pont Control Chart., This system uses the ratio inter-relationship to provide charts for managerial attention. The
standard ratios of the company are compared to present ratios and changes in performance are judged.
The chart is based on two elements i.e., Net profit and capital employed. Net profit is related to operating expenses.
If the expenses are under control then profit margin will increase. The earnings as a percentage of sales or earnings divided
by sales give us percentage of profitability. Earnings can be calculated by deducting cost of sales from sales. Cost of sales
includes cost of goods sold plus office and administrative expenses and selling and distributive expenses. Capital employed,
on the other hand, consists of current assets and net fixed assets. Current assets include debtors, stock, bills receivables,
cash, etc. Fixed assets are taken after deducting depreciation. So profit margin is divided by capital employed and is
multiplied by 100.

So ratio will be Profit margin x 100

capital employed .

DU PONT CHART

Net profit ratio Investment Turnover

Sales / Investments
Operating profit / Sales

Investments
Sales Operating Expense Fixed assets + Working capital

Cost of goods sold + Selling

administrative and others.

The efficiency of a concern depends upon the working operations of the concern. The return on investment
becomes a yardstick to measure efficiency because return influences various operations. The profit margin will show the
efficiency with which assets of the business have been used. The efficiency can be improved either by a better relationship
between sales and costs or through more effective use of available capital. The profitability can be increased by controlling
costs and/or increasing sales. The investments turnover can be raised by having a control over investments in fixed assets
and working capital without adversely affecting sales. The sales may also be increased with the use of same Capital. The
management is able to pinpoint weak spots and take corrective measures. The performance can be better judged by having
NSS College. Rajakumari.
82 Financial Management
inter-firm comparison. The ratios of return on investment, assets turnover and profit margins of comparable companies
can be calculated and these can be used as standards of performance.

NSS College. Rajakumari.