SESSION 1 AND 2

FINANCIAL PLANNING AND FORECASTING

Financial Planning is a process by which funds required for each course of action is decided. A
financial plan has to consider capital structure, capital expenditure and cash flow. Financial
planning generates financial plan which indicates:
 The quantum of funds required to execute business plans
 Composition of debt and equity
 Formulation of polices for giving effect to the financial plans under consideration Process
of financial planning
 Projection of financial statements
 Determination of funds needed
 Forecast the availability of funds
 Establish and maintain systems of controls
 Develop procedures
 Establish performance-based compensation system

Benefits of financial planning:

 Effective utilisation of funds
 Flexibility in capital structure is given adequate consideration
 Formulation of policies and instituting procedures for elimination of all types of wastages
in the process of execution of strategic plans.
 Maintaining the operating capability of the firm through the evolution of scientific
replacement schemes for plant and machinery and other fixed assets.
Factors affecting financial plan:
1. Nature of the industry
2. Size of the company
3. Status of the company in the industry
4. Sources of finance available
5. The capital structure of a company
6. Matching the sources with utilisation
7. Flexibility
 8. Government policy
Three key aspects to the financial planning process are:
1. Cash Planning, forecasting the need for cash.
2. Forecasting future profitability.
3. Forecasting the need for financing
Planning can be Long Term or Short Term.
Long-term financial plans are the planned financial actions and the anticipated financial
impact of those actions over periods ranging from 2 to 10 years. Such planning projections
may be carried out as a regular function of the firm’s operations, or in conjunction with
corporate strategic planning efforts.
Short-term financial plans are those planned financial actions and the anticipated impact of
those actions over periods ranging from one to two years. Because of their relevance to
immediate operations, such plans form a regular and needed function to the firm.

Components of a Financial Plan

1. Economic Assumptions
2. Sales Forecast
3. Proforma Statements
4. Asset Requirements
5. Financing Plan
6. Cash Budget
Sales Forecast: The sales forecast is typically the starting point of the
financial forecasting exercise. Sales forecasting techniques fall into three broad categories:
1. Qualitative techniques - Expert opinion and Delphi Method
2. Time series projection methods - Regression
3. Causal models
Pro Forma Statements: Pro Forma statements are important for management to evaluate the
future expected financial position, and Investors and Creditors to evaluate the firm’s ability to
provide a return on funds invested
Three key outputs of forecasting:
 Pro forma income statement,
 Pro forma balance sheet, and
 Statement of external financing requirements
Requirements for Preparing Pro Forma statements
 Financial statements from the previous year,
 Sales forecast for the forecast year, and
 Forecasts for all other financial statement accounts.

Pro Forma Income Statements are based on the sales forecast.

The approaches of forecasting expenses are:
1. Percentage of sales method
2. Budgeted expense method
3. Combination Method

Percentage of sales method

The cost items are calculator as a proportion of sales. This uses unitary method and is an easy
way of extrapolating cost figures depending on sales forecast. Percentage of sales is determined
on past data. However there are weaknesses of the percent-of-sales approach:
 It is unrealistic to assume all expenses will remain exactly the same percentage from year to
year.
 It essentially locks in a fixed profit margin.
 It assumes all costs are variable.
 Basing forecasts solely on past data tends to understate profits when sales increase, and
overstate profits when sales decline
The Judgmental Approach
It is a method for developing the Pro Forma Balance Sheet where values of certain balance sheet
accounts are estimated, and others are calculated, based on a ratio analysis. Projected changes in
assets from the latest fiscal year to the forecast year determines the Total Financing Required
(TFR). Increases in accounts payable and accruals generate the internal “spontaneous sources of
financing. When internal financing is less than the Total Financing Required, the Pro Forma
Balance Sheet will determine the External Financing Required (EFR).Both financial managers
and lenders can analyze the firm’s expected financial performance. After analyzing pro forma
statements, managers can take steps to adjust planned operations to better achieve short-term
financial goals.
The assumption of constant ratios and identical growth rates may be appropriate sometimes, but
not always. In particular its applicability is suspect in the following situations:
1. Economies of scale
2. Lumpy assets
3. Forecasting errors and excess assets

Calculation of EFR:

EFR = A/S (△S) – L/S (△S) – mS1 (1 – d)

EFR = external funds requirement
A/S = current assets and fixed assets as a proportion of sales
△S = expected increase in sales
L/S = current liabilities and provisions (spontaneous liabilities) as a
proportion of sales
m = net profit margin
S1 = projected sales for next year
d = dividend payout ratio

Internal Growth Rate

The internal growth rate is the maximum growth rate that can be achieved with no external
financing whatsoever. It is the growth rate that can be sustained with retained earnings,
which represents internal financing.

Internal = Return on assets x Ploughback ratio

growth rate 1 – Return on assets x Ploughback ratio

Sustainable Growth Rate

The sustainable growth rate is the maximum growth rate that a firm can achieve without
resorting to external equity finance.

Sustainable = Return on equity x Ploughback ratio

growth rate 1 – Return on equity x Ploughback ratio

 SESSIONS 3 AND 4

LEVERAGE

The term leverage refers to a relationship between two interrelated variables. In a business

firm, these variables may be costs, output, sales, revenue, EBIT, Earning per share etc. Thus,

leverage reflects the responsiveness or influence of one variable over some other financial

variables. In leverage analysis, the emphasis is on the measurement of the relationship of two

variables rather than on measuring these variables. It is important to remember that leverage

arises from the existence of fixed costs in a company.

In simple terms, leverage may be defined as the % change in one variable divided by the %

change in some other variable. Here, the numerator is the dependent variable (X) and the (Y)

is the independent variable.

Algebraically, Leverage =% Change in the dependent variable / % Change in Independent

variable.

Leverage may be classified into two broad categories:

1. Operating Leverage

2. Financial Leverage

Operating Leverage:

The relationship between Sales revenue and EBIT is defined as operating leverage.A business

with high fixed costs is said to have high operating leverage. Operating leverage is measured

by the sensitivity of profit before interest and taxes to change in sales. It is calculated as

percentage change in earningsbefore interest and tax for each 1% change in sales. Degree of

operating leverage (DOL) is

DOL=% Change in PBIT/ % change in Sales Revenue

Question 1: ABC ltd. Sells 1000 units @ Rs. 10 per unit. The cost of production is Rs. 6 per

unit and is of variable nature. Theoperating profit (EBIT)of the firm is 1000 x (Rs 10 – 6) =
4000. Suppose the firm is able to increase the sales level by 50% resulting in total sales of

1500 units. The operating profit of the firm would now be 1500 x (Rs10 – Rs6) = Rs 6000.

The operating leverage of the firmis

Operating Leverage = % Change in EBIT % Change in Sales Revenue

= Increase in EBIT / EBIT
----------------------------------
Increase in Sales / Sales

= Rs.2000 / Rs 4000
----------------------------
Rs. 5000 / Rs.10,000
=1

The operating leverage of 1 denotes that the EBIT level increase or decreases in direct

proportion to the increase or decrease in sales level. This is due tothe fact that there is not any

fixed cost and total cost is variable in nature.However,this is generally not the

case.Companieshave fixed costs in their cost structure.So let us consider the example of the

same firm with same data.

Let us assume that the firm has fixed costs of Rs 1,000.

Question2: ABC ltd. Sells 1000 units @ Rs. 10 per unit. The cost of production is Rs. 6 per

unit and is of variable nature. The firm has a fixed cost of Rs. 2000 in addition to the variable

costs of Rs 6 per unit. Suppose the firm is able to increase the sales level by 50% resulting in

total sales of 1500 units. The operating leverage of the firm is

Particulars Present Expected Increase

Sales @10 pu 10,000 15,000 5,000

Less: Variable Cost@ 6 pu 6,000 9,000

Contribution 4,000 6,000 2,000

Less:Fixed Cost 1,500 1,500

Earnings before interest and tax 2,500 4,500 2,000

Operating Leverage = % Change in EBIT % Change in Sales Revenue

= Increase in EBIT / EBIT

Increase in Sales / Sales

= Rs.2000 / Rs 2500

Rs. 5000 / Rs.10,000

= 1.6

The Operating Leverage of 1.5 means that the % increase in the level of EBIT is 1.6 times

that of % increase in sales level.That is, for every increase of 1% in sales level, the %

increase in EBIT would be 1.6%. In the case of ABC Ltd, the % increase in EBIT is 80% and

% increase in sales is 50%. It means that. This relationship between % change in EBIT and %

change in sales is known as Degree of Operating leverage.

Degree of operating leverage = Contribution/ EBIT

Below is a table showing estimated operating leverage of large US companies by Industry

Industry High Operating Leverage Industry Low Operating Leverage

Steel 2.2 Food .79

Railroads 1.99 Clothing .88

Automobile 1.57

Significance of Operating Leverage:

A firm having higher DOL (Degree of operating Leverage) can experience a magnified effect

on EBIT for a small change in sales revenue. Higher DOL can lead to an immense increase in

operating profits for a very small percentage increase in sales.This helps a company in the

growth phase where operating profits increase in greater proportion to sales. But if there is

decline in sales level, EBIT. may be reduce equally drastically or even be negated, i.e., a loss

may be incurred. This means that in a down phase a firm may reach the breakeven point very

quickly. That is the operating profit may become zero for a very small or marginal drop in
sales. If the fixed costs are higher, the firm’s operating leverage and its operating risks are

higher. If operating leverage is high, it means that the break-even point would also be reached

for a very marginal drop in sales.

Financial Leverage

Financial leverage is a measure of the relationship between the EBIT and the EPS. TheDFL

(Degree of Financial Leverage) reflects the effect of change in EBIT on the level of EPS. It is

defined as % change in EPS divided by the % change in EBIT.

Degree of Financial leverage = % Change in EPS % /Change in EBIT (OR)

Degree of Financial leverage = EBIT /EBT

EBT = (EBIT – I)

EBT=Earnings before tax

I=Interest

Question 3:A Ltd. has the following capital structure:

Equity share capital (of Rs. 10 each) 1,00,000

12% Preference share capital (of Rs. 10 each) 2,00,000

10% debentures (of Rs. 100 each) 2,00,000

If EBIT is (a) Rs. 1,00,000 (ii) Rs. 80,000 and (iii) Rs. 1,20,000, Calculate financial leverage

under three situations. Assume 50% tax rate.

Particulars (i) (ii) (iii)

EBIT 1,00,000 80,000 1,20,000

Less: Interest on 20,000 20,000 20,000

debentures@10%

EBT 80,000 60,000 1,00,000

Tax @50% 40,000 30,000 50,000

EAT 40,000 30,000 50,000

Less:Pref Dividend 24,000 24,000 24,000

@12%

Earnings available to 16,000 6,000 26,000

equity shareholders

No of equity shares 10,000 10,000 10,000

EPS 1.6 0.6 2.6

DFL 1.25 1.33 1.2

Significance of Financial Leverage:

A firm can finance its investments through debt and equity.In addition, companies may also

use preference capital. The rate of interest on debt is fixed.Similarly the rate of dividend on

preference shares is fixed, though preference dividend is paid from profit after tax. The rate

of equity dividend,however,depends on the dividend policy of the company.The use of fixed

charge source of funds such as debt and preference capital along with owners’ equity in the

capital structure is called financial leverage or gearing or trading on equity.

Financial leverage plays a major role in deciding the optimum capital structure. The capital

structure is concerned with the raising of long-term funds both from the shareholders and

through debt. A financial manager has to decide about the ratio between fixed cost funds and

equity share capital. The effects of debt (fixed cost funds)on cost of capital and financial risk

have to be considered before selecting a final capital structure. The EPS of a company is

strongly affected by the degree of financial leverage. If the company is in a growth phase,

then a high financial leverage will help the company use its fixed cost funds to increase

profits for equity shareholders.However,in a down phase,a high financial leverage may wipe
out the company’s profit before tax or even lead to losses before tax.Thus financial leverage

is also very significant for profit planning.

Additional measures of financial leverage:

There are some other measures of financial leverage.

1. Debt Ratio =D/(D+E)

2. Debt Equity Ratio =D/E

3. Interest Coverage Ratio = EBIT/Interest

Where

D=Debt ;E=Equity

The first two measures are also called measures of capital gearing.However,they suffer from

certain limitations when it comes to measuring financial leverage.Since they are static

measures that reflect the borrowing position at one point in time,they fail to reflect the level

of financial risk of the company’s ability to repay interest and debt in relation to its earnings.

CombinedLeverage:

Both the financial and operating leverage magnify the revenue of the firm. While operating

leverage has an effect on the firm EBIT,financial leverage affects the firm’s profit after tax or

earnings per share.Combinedor Composite leverage is a combination of operating and

financial leverage. It focuseson the percentage change in EPS for a given change in sales. If a

company has a high operating and financial leverage,even a small change in sales will have a

magnified effect on the EPS.The degree of combined leverage(DCL) is given by:

% Change in EBIT % Change in EPS

The degree of combined leverage =----------------------- -----------------------------

% Change in sales % Change in EBIT

% Change in EPS
 = ------------------------- (OR)

% Change in sales

The degree of combined leverage = Operating leverage x Financial leverage.

Question 4:A company has sales of Rs. 8,00,000, Variable cost of Rs. 5,00,000, fixed cost of

Rs. 1,00,000 and long-term loans of Rs. 8,00,000 at 10% rate of interest. Calculate combined

leverage.

Solution:

Particulars

Sales 800,000

Less: Variable Cost@ 6 pu 500,000

Contribution 300,000

Less: Fixed Cost 100,000

Earnings before interest and tax 200,000

Less: Interest@10% 80,000

EBT 120,000

Operating leverage = Contribution/ EBIT

= Rs 3,00,000/ Rs 200,000 = 1.5

Financial leverage = EBIT/ EBT

= 2 00,000/ 120,000 = 1.67

Combined leverage = Operating leverage x financial leverage = 1.5 x 1.67 =2.5

Question 5:

Two firms A and B have the following information.

All the data is given in Rs in Lakhs

 Sales Variable costs Fixed costs Debentures

Firm A 1,800 450 900 2000

Firm B 1.500 750 375 3000

Rate of interest is 10%

1. Find the leverage ratios of both the firms. Which firm is riskier?

2. Calculate the leverage ratios of both the firms if they experience a decreaseof

20% in sales. How have the leverage ratios changed?

Solution 5a:

Particulars Firm A Firm B

Sales 1,800 1,500

LESS: Variable Costs 450 750

Contribution 1,350 750

Less:Fixed Costs 900 375

EBIT 450 375

DOL

Firm A = Contribution/EBIT =1350/450 = 3

Firm B = Contribution/EBIT =750/375 =2

Firm A has a higher operating leverage. SoFirm A is riskier. Under favourable conditions

Firm A’s operating profit margin will increase at a faster rate than Firm B.However,in

unfavourable conditions Firm B would do better since its profits will fall at a lesser rate.As a

result, Firm B will have a lower break-even point than FirmA.This makes Firm A more prone

to losses in an unfavourable phase.

Solution 5b:

If sales drop by 20%

Particulars Firm A Decrease by Firm B Decrease by

20% 20%

Sales 1,800 1,440 1,500 1,200

less: Variable Costs 450 360 750 600

Contribution 1,350 1,080 750 600

less: Fixed Costs 900 900 375 375

EBIT 450 180 375 225

DOL 3 6 2 2.67

The DOL of Firm has increased to 6 after a 20% drop in sales whereas the DOL of firm B has

increased to 2.67. After the 20% drop Firm A has a higher operating leverage.This is because

the fixed cost of firm A is 2.4 times that of Firm B. This makes Firm A very vulnerable in a

downphase.The EBIT of Firm A has fallen by 60% for a 20% drop in sales .The EBIT of firm

B has fallen by 40% for the same 20% drop in sales

Question 6:

XYZ Company has currently and equity share capital of Rs 40 lakhs consisting of 40,000

equity shares of Rs. 100 each. The management is planning to raise another Rs. 30 lakhs to

finance a major programme of expansion through one of the four possible financing plans.

The options are:

1. Entirely through equity shares

2. Rs. 15 lakhs in equity shares of Rs. 100 each and the balance in 8% debentures.

3. Rs. 10 lakhs in equity shares of Rs. 100 each and the balance through long-term

borrowings at 9% interest p.a.

 4. Rs. 15 lakhs in equity shares of Rs. 100 each and the balance through preference

shares with 12% dividend.

The company’s EBIT will be Rs. 15 lakhs. Assuming corporate tax of 50%. Determine the

EPS and financial leverage. Which plan has the highest risk?

Solution 6:

Plan 1 Plan 2 Plan 3 Plan 4

EBIT 15,00,000 15,00,000 15,00,000 15,00,000

Less: Interest on debentures 1,20,000

(15,00,000X8%)

Less: Interest on Long Term 1,80,000

Borrowings(20,00,000X9%)

EBT 15,00,000 13,80,000 13,20,000 15,00,000

Less:Tax @50% 7,50,000 6,90,000 6,60,000 7,50,000

EAT 7,50,000 6,90,000 6,60,000 7,50,000

Veszprem 1,80,000

dividend(15,00,000X12%)

Earnings available to equity 7,50,000 6,90,000 6,60,000 5,70,000

shareholders

No of equity shares 70,000 55,000 50,000 55,000

EPS 10.71 12.54 13.2 10.36

DFL(EBIT/(EBIT-I) 1 1.08 1.136 1

Plan 3 (1.136)has the financial leverage and highest risk. This plan will lead to the maximum

drop in EPS for percentage drop in EBIT. Plan 1 and Plan 4 have thelowest financial leverage

and minimum risk(1)

Question 7:

Consider the following information for Kalinga enterprises:

Particulars Rs in Lakh

EBIT 1,120

EBT 320

Fixed Cost 700

Calculate the percentage change in EPS if sales increase by 5%.

Solution 7:

(Contribution = EBIT+Fixed Cost = 1,120+700=1,820)

DOL = Contribution/EBIT =1820/1,120=1.625

DFL =EBIT/EBT =1,120/320 =3.5

DCL=DOLXDFL

=1.625X3.5

=5.6875

If sales change by 5%,percentage change in EPS =

DCL = % change in EPS/% change in sales

5.6875 = % change in EPS/5

% change in EPS

=5X5.6875 =28.4375%
Capital Structure and its Theories
Capital Structure means a combination of all long-term sources of finance. It includes
Equity Share Capital, Reserves and Surplus, Preference Share capital, Loan,
Debentures and other such long-term sources of finance. A company has to decide
the proportion in which it should have its own finance and outsider’s finance
particularly debt finance. Based on the proportion of finance, WACC and Value of a
firm are affected. There are four capital structure theories for this, viz. net income,
net operating income, traditional and M&M approach.
CAPITAL STRUCTURE
Capital structure is the proportion of all types of capital viz. equity, debt, preference
etc. It is synonymously used as financial leverage or financing mix. Capital structure
is also referred to as the degree of debts in the financing or capital of a business
firm.
Financial leverage is the extent to which a business firm employs borrowed money
or debts. In financial management, it is a significant term and it is a very important
decision in business. In the capital structure of a company, broadly, there are mainly
two types of capital i.e. Equity and Debt. Out of the two, debt is a cheaper source of
finance because the rate of interest will be less than the cost of equity and the
interest payments are a tax-deductible expense.
Capital structure or financial leverage deals with a very important financial
management question. The question is – ‘what should be the ratio of debt and
equity?’ Before scratching our minds to find the answer to this question, we should
know the objective of doing all this. In the financial management context, the
objective of any financial decision is to maximize the shareholder’s wealth or
increase the value of the firm. The other question which hits the mind in the first
place is whether a change in the financing mix would have any impact on the value
of the firm or not. The question is a valid question as there are some theories which
believe that financial mix has an impact on the value and others believe it has no
connection.
HOW CAN FINANCIAL LEVERAGE AFFECT THE VALUE?
One thing is sure that wherever and whatever way one sources the finance from, it
cannot change the operating income levels. Financial leverage can, at the max, have
an impact on the net income or the EPS (Earning per Share). Changing the financing
mix means changing the level of debts. This change in levels of debt can impact the
interest payable by that firm. The decrease in interest would increase the net income
and thereby the EPS and it is a general belief that the increase in EPS leads to an
increase in the value of the firm.
Apparently, under this view, financial leverage is a useful tool to increase value but,
at the same time, nothing comes without a cost. Financial leverage increases the risk
of bankruptcy. It is because higher the level of debt, higher would be the fixed
obligation to honour the interest payments to the debt providers.
Discussion of financial leverage has an obvious objective of finding an optimum
capital structure leading to maximization of the value of the firm.
Important theories or approaches to financial leverage or capital structure or
financing mix are as follows:
 NET INCOME APPROACH
This approach was suggested by Durand and he was in favour of financial leverage
decision. According to him, a change in financial leverage would lead to a change in
the cost of capital. In short, if the ratio of debt in the capital structure increases, the
weighted average cost of capital decreases and hence the value of the firm
increases.
Weighted Average Cost of Capital (WACC) is the weighted average costs of equity
and debts where the weights are the amount of capital raised from each source.
According to Net Income Approach, change in the financial leverage of a firm will
lead to a corresponding change in the Weighted Average Cost of Capital (WACC)
and also the value of the company. The Net Income Approach suggests that with the
increase in leverage (proportion of debt), the WACC decreases and the value of firm
increases. On the other hand, if there is a decrease in the leverage, the WACC
increases and thereby the value of the firm decreases.
For example, vis-à-vis equity-debt mix of 50:50, if the equity-debt mix changes to 20:
80, it would have a positive impact on the value of the business and thereby increase
the value per share.

ASSUMPTIONS OF NET INCOME APPROACH

Net Income Approach makes certain assumptions which are as follows.
 The increase in debt will not affect the confidence levels of the investors.
 There are only two sources of finance; debt and equity. There are no sources
of finance like Preference Share Capital and Retained Earning.
 All companies have uniform dividend pay-out ratio; it is 1.
 There is no flotation cost, no transaction cost and corporate dividend tax.
 Capital market is perfect, it means information about all companies are
available to all investors and there are no chances of over pricing or under-
pricing of security. Further it means that all investors are rational. So, all
investors want to maximize their return with minimization of risk.
 All sources of finance are for infinity. There are no redeemable sources of
finance.
In case of Net Income Approach, with increase in debt proportion, the total market
value of the company increases and cost of capital decreases. Reason for this
conclusion is that assumption of NI approach that irrespective of debt financing in
capital structure, cost of equity will remain same. Further, cost of debt is always
lower than cost of equity, so with increase in debt finance WACC reduces and value
of firm increase.
For Diagrammatic representation and Examples, please refer to the book.
 NET OPERATING INCOME APPROACH
This approach is also provided by Durand. It is opposite of the Net Income Approach
if there are no taxes. This approach says that the weighted average cost of capital
remains constant. It believes in the fact that the market analyses a firm as a whole
and discounts at a particular rate which has no relation to debt-equity ratio. If tax
information is given, it recommends that with an increase in debt financing WACC
reduces and value of the firm will start increasing.
As per this approach, the market value is dependent on the operating income and
the associated business risk of the firm. Both these factors cannot be impacted by
the financial leverage. Financial leverage can only impact the share of income
earned by debt holders and equity holders but cannot impact the operating incomes
of the firm. Therefore, change in debt to equity ratio cannot make any change in the
value of the firm.

It further says that with the increase in the debt component of a company, the
company is faced with higher risk. To compensate that, the equity shareholders
 expect more returns. Thus, with an increase in financial leverage, the cost of equity
increases.
ASSUMPTIONS / FEATURES OF NET OPERATING INCOME APPROACH:
1. The overall capitalization rate remains constant irrespective of the degree of
leverage. At a given level of EBIT, the value of the firm would be
“EBIT/Overall capitalization rate”
2. Value of equity is the difference between total firm value less value of debt i.e.
Value of Equity = Total Value of the Firm – Value of Debt
3. WACC (Weightage Average Cost of Capital) remains constant; and with the
increase in debt, the cost of equity increases. An increase in debt in the
capital structure results in increased risk for shareholders. As a compensation
of investing in the highly leveraged company, the shareholders expect higher
return resulting in higher cost of equity capital.
In the case of Net Operating Income approach, with the increase in debt proportion,
the total market value of the company remains unchanged, but the cost of equity
increases.
For Diagrammatic representation and Examples, please refer to the book.
 TRADITIONAL APPROACH
This approach does not define hard and fast facts. It says that the cost of capital is a
function of the capital structure. The special thing about this approach is that it
believes an optimal capital structure. Optimal capital structure implies that at a
particular ratio of debt and equity, the cost of capital is minimum and value of the firm
is maximum.
As per this approach, debt should exist in the capital structure only up to a specific
point, beyond which, any increase in leverage would result in the reduction in value
of the firm.
It means that there exists an optimum value of debt to equity ratio at which the
WACC is the lowest and the market value of the firm is the highest. Once the firm
crosses that optimum value of debt to equity ratio, the cost of equity rises to give a
detrimental effect to the WACC. Above the threshold, the WACC increases and
market value of the firm starts a downward movement.
ASSUMPTIONS UNDER TRADITIONAL APPROACH: 
 The rate of interest on debt remains constant for a certain period and
thereafter with an increase in leverage, it increases.
 The expected rate by equity shareholders remains constant or increases
gradually. After that, the equity shareholders start perceiving a financial risk
and then from the optimal point and the expected rate increases speedily.
 As a result of the activity of rate of interest and expected rate of return, the
WACC first decreases and then increases. The lowest point on the curve is
optimal capital structure.
For Diagrammatic representation and Examples, please refer to the book.
 MODIGLIANI AND MILLER APPROACH (MM APPROACH)
The Modigliani and Miller approach to capital theory, devised in the 1950s, advocates
the capital structure irrelevancy theory. This suggests that the valuation of a firm is
irrelevant to the capital structure of a company. Whether a firm is highly leveraged or
has a lower debt component has no bearing on its market value. Rather, the market
value of a firm is solely dependent on the operating profits of the company.

The fundamentals of the Modigliani and Miller Approach resemble that of the Net
Operating Income Approach.
 Proposition I: It says that the capital structure is irrelevant to the value of a
firm. The value of two identical firms would remain the same and value would not
affect by the choice of finance adopted to finance the assets. The value of a firm is
dependent on the expected future earnings. It is when there are no taxes.

ASSUMPTIONS OF MODIGLIANI AND MILLER APPROACH

1. There are no taxes.
2. Transaction cost for buying and selling securities, as well as the bankruptcy
cost, is nil.
3. There is a symmetry of information. This means that an investor will have
access to the same information that a corporation would and investors will thus
behave rationally.
4. The cost of borrowing is the same for investors and companies.
5. There is no floatation cost, such as an underwriting commission, payment to
merchant bankers, advertisement expenses, etc.
6. There is no corporate dividend tax.
The Modigliani and Miller Approach indicates that the value of a leveraged firm (a firm
that has a mix of debt and equity) is the same as the value of an unleveraged firm (a
firm that is wholly financed by equity) if the operating profits and future prospects are
same. That is, if an investor purchases shares of a leveraged firm, it would cost him the
same as buying the shares of an unleveraged firm.

Formula
The Modigliani-Miller theory believes that valuation of a firm is irrelevant to its capital
structure. The equation describing this relationship is as follows:

VU = V L

where VU is the market value of an unlevered firm (capital is represented by equity

only), and VL is the market value of a levered firm (capital is represented by a mix of
debt and equity).

Thus, the market value of a firm depends on the operating income and business risk
rather than its capital structure. Therefore, the market value of an unlevered firm can be
calculated using the following formula:

VU = V L = EBIT
--------
ke0
where EBIT is earnings before interest and taxes, and ke 0 is the required rate of return
on equity of an unlevered firm.

The Modigliani-Miller theory of capital structure also believes that the weighted average
cost of capital (WACC) is fixed at any level of financial leverage and equals the
required rate of return on equity of an unlevered firm (ke 0).

WACC = ke0
Another proof of the Modigliani-Miller theory of capital structure is arbitrage, i.e.,
simultaneous buying and selling of shares with the same business risk but with different
prices. In this case, investors will sell overvalued stock and buy undervalued stock;
therefore, the price of overvalued stock will decline, and the price of undervalued stock
will increase until they are equal, i.e., until the moment when market equilibrium will
occur. When the market reaches equilibrium, arbitrage becomes impossible. Therefore,
the market value of firms within the same class of business risk will be the same
regardless of their capital structure.

 Proposition II: It says that the financial leverage boosts the value of a firm
and reduces WACC. It is when tax information is available.

It says that financial leverage is in direct proportion to the cost of equity. With an
increase in the debt component, the equity shareholders perceive a higher risk to the
company. Hence, in return, the shareholders expect a higher return, thereby increasing
the cost of equity. A key distinction here is that Proposition 2 assumes that debt
shareholders have the upper hand as far as the claim on earnings is concerned. Thus,
the cost of debt reduces.
This theory recognizes the tax benefits accrued by interest payments. The interest paid
on borrowed funds is tax deductible. However, the same is not the case with dividends
paid on equity. In other words, the actual cost of debt is less than the nominal cost of
debt due to tax benefits. The trade-off theory advocates that a company can capitalize
its requirements with debts as long as the cost of distress, i.e., the cost of bankruptcy,
exceeds the value of the tax benefits. Thus, the increased debts, until a given threshold
value, will add value to a company.

This approach with corporate taxes does acknowledge tax savings and thus infers that
a change in the debt-equity ratio has an effect on the WACC (Weighted Average Cost
of Capital). This means that the higher the debt, the lower the WACC. The Modigliani
and Miller approach is one of the modern approaches of Capital Structure Theory.
Please refer to the book for Examples and detailed diagrams.
Criticism of MM Approach
The Modigliani-Miller theory of capital structure was criticized because the assumption
that capital markets are perfect is completely unrealistic. The arbitrage, as proof of the
Modigliani-Miller theory, was also strongly criticized. If there are no perfect capital
markets, the arbitrage will be useless because a levered and an unlevered firm within
the same class of business risk will have different market values.
The reasons why arbitrage does not allow market equilibrium in real life are as follows:
 Transaction costs. If there are transactions costs, buying stock will require bigger
initial investments, but the return remains the same. Therefore, the market value
of a levered firm will be higher than an unlevered one, assuming that both of
them are within the same class of business risk.
 The cost of borrowing is not the same for individuals and firms. The cost of
borrowing depends on the individual credit rating of the borrower.
 Institutional constraints. Institutional investors slow down arbitrage because they
limit the use of financial leverage by their clients.
 Bankruptcy cost. The higher the financial leverage, the higher is the probability
of bankruptcy. Therefore, bankruptcy costs have a strong influence on firms.
Many critics of the Modigliani-Miller theory of capital structure believe that assumptions
are unrealistic and that the market value of a firm as well as WACC depends on
financial leverage.

THE TRADE-OFF THEORY OF CAPITAL STRUCTURE

The trade-off theory states that the optimal capital structure is a trade-off between
interest tax shields and cost of financial distress.

Value of firm = Value if all-equity financed + PV(tax shield) - PV(cost of financial

distress)
Note that PV(tax shield) initially increases as the firm borrows more, until additional
borrowing increases the probability of financial distress rapidly. In addition, the firm
cannot be sure to benefit from the full tax shield if it borrows excessively as it takes
positive earnings to save corporate taxes. Cost of financial distress is assumed to increase
with the debt level.
Firms with safe, tangible assets and plenty of taxable income to shield should have high
target debt ratios. The theory is capable of explaining why capital structures differ
between industries, whereas it cannot explain why profitable companies within the
industry, like HUL and Colgate Palmolive, have lower debt ratios (trade-off theory
predicts the opposite as profitable firms have a larger scope for tax shields and therefore
subsequently should have higher debt levels).

SIGNALLING THEORY / PECKING ORDER

The pecking order theory has emerged as alternative theory to the trade-off theory.
Rather than introducing corporate taxes and financial distress into the MM framework,
the key assumption of the pecking order theory is asymmetric information. Asymmetric
information captures that managers know more than investors and their actions
therefore provides a signal to investors about the prospects of the firm.
Asymmetric information is an unequal distribution of information. The managers
generally have more information about company’s performance, prospects and risks
than outside creditors or investors. Some companies have a high level of asymmetric
information like companies with a complex or technical product, companies with less
accounting transparency etc. Higher the asymmetry of information, higher the risk in the
company.
Also, it is not possible for the investors to know everything about a company. So, there
will always be some amount of information asymmetry in every company. If a creditor
or an investor has less information about the company, he/she will demand higher
returns against the risk taken. Along with providing higher returns, the company will
have to incur costs to issue the debt and equity. It will also have to incur some agency
cost like paying the board of directors’ fees to ensure shareholders’ interests are
maximized. All these reasons make retained earnings a cheaper and convenient
source of finance than external sources.
If a company does not have sufficient retained earnings, then it will have to raise money
through external sources. Managers would prefer debt over equity because the cost of
debt is lower compared to the cost of equity. The company issuing new debt will
increase the proportion of debt in the capital structure and it will provide a tax shield.
Hence, this will reduce the weighted average cost of capital (WACC).
After a certain point, increasing the leverage in capital structure will be very risky for the
company. In such scenarios, the company will have to issue new equity shares as a
last resort.
SIGNALS FROM THE CHOICE OF FINANCE
Company’s choice of finance sends some signals in the market. If a company is able to
finance itself internally, it is considered to be a strong signal. It shows that company has
enough reserves to take care of funding needs. If a company issues a debt, it shows
that management is confident to meet the fixed payments. If a company finances itself
with new stock, it’s a negative signal. The company, generally, issues new stock when
it perceives the stock to be overvalued.

All the above-mentioned logics are applied to develop the hierarchy of pecking order
theory. This hierarchy should be followed while taking decisions related to capital
structure.
Capital Structure Policy
Capital Structure Decision: Whether to use debt or equity for capital budgeting activities, or what
proportion to be maintained in capital structure??
Trading on Equity: means use of debt i.e. financial leverage in capital structure would enhance
the earning of shareholders i.e. EPS (earning per share).
Practical Considerations in Determining Capital Structure:
1. Assets
2. Growth Opportunities
3. Debt and Non-debt Tax Shields
4. Financial Flexibility and Operating Strategy
5. Loan Covenants
6. Financial Slack
7. Control
8. Marketability and Timing
9. Issue Costs
10. Capacity of Raising Funds
EPS under Alternative Finance Plans

EBIT – EPS ANALYSIS

EBIT‐EPS analysis is a powerful analytical tool that helps evaluation of different financing
patterns to establish a target capital structure.
The EBIT indifference point between two alternative financing plans can be obtained by solving
the following equation for EBIT*
(EBIT* - Int1)(1 – T) = (EBIT* - Int2)
N1 N2
In above data shown, EBIT indifference point is Rs. 28,00,000.
1. EPS under capital structure Equity Financing is higher than the EPS
under capital structure Debt Financing when EBIT is less than EBIT*
(Indifference Point).
2. EPS under capital structure Debt Financing is higher than the EPS under capital structure
Equity Financing when EBIT is more than EBIT* (Indifference Point).
 3. EPS under two capital structures is same at EBIT* (Indifference Point).
Effect of Leverage on EPS & ROE
Favourable if ROI > Cost of Debt (Kd)
UnFavourable if ROI < Cost of Debt (Kd)
Neutral if ROI = Cost of Debt (Kd)
ROI-ROE Analysis:
 ROE under capital structure Equity Financing is higher than the ROE under capital
structure Debt Financing when ROI is less than cost of debt.
 ROE under capital structure Debt Financing is higher than the ROE under capital
structure Equity Financing when ROI is more than cost of debt.
 ROE under two capital structures is same when ROI is equal to cost of debt
 ROE = [ROI + (ROI – Kd) x (D/E)](1-T)

Example:
A company’s present capital structure contains 4,000,000 equity shares and 100,000 preference
shares. The firm’s current PBIT is Rs.25 million. Preference shares carry a dividend of Rs.3 per
share. The earnings per share is Rs.4. The firm is planning to raise Rs.40 million of external
financing. Two financing alternatives are being considered: (i) issuing 4,000,000 equity shares
for Rs.10 each, (ii) issuing debentures for Rs.40 million carrying 12 percent interest.
Required (a) Compute the EPS-PBIT indifference point.

Solution:
Teaching Notes for Dividend Policy

a. Dividend Policy
b. The dividend policy of a firm determines what proportion of earnings is paid to
shareholders by way of dividends and what proportion is ploughed back in the firm for
reinvestment purposes
c. Since the principal objective of corporate financial management is to maximize the
market value of equity shares, the key question of interest to us is: What is the
relationship between dividend policy and market price of equity shares?
d. Traditional Position
e. According to the Traditional Position expounded eloquently by Benjamin Graham and
David Dodd, the stock market places considerably more weight on dividends than on
retained earnings
f. Their view is expressed as follows:

g.
h. P: market price per share; D: dividend per share, E: Earnings per share; m: multiplier
i. Traditional Position
j. According to them:
k. “… the considered and continuous verdict of the stock market is overwhelmingly in
favour of liberal dividends as against niggardly one.”
l. Advocates of the traditional position cite the results of cross-section regression analysis
like the following:
m. Price = a + b Dividends + c Retained Earnings
n. Traditional Position
o. Empirically, the omission of risk imparts an upward bias to ‘b’, the coefficient of
dividend, and the measurement error characterizing retained earnings imparts a
downward bias to ‘c’, the coefficient of retained earnings.
p. Hence the claim of traditionalists that b > c implies that a higher dividend payout ratio
increases stock value cannot be vindicated.
q. Walter Model
r. Assumptions:
 The firm is an all-equity financed entity. Will rely on retained earnings to finance its
future investments
 The rate of return on investment is constant
 The firm has an infinite life
1. Walter Model – Valuation Formula

2.
3. P: price per equity share,
4. D: dividend per share
5. E: earnings per share
6. (E-D): retained earnings per share
7. r : rate of return on investments
8. k : cost of equity
9. Walter Model - Implications
1) The optimal payout ratio for a growth firm ( r > k) is nil
2) The optimal payout ratio for a normal firm ( r = k) is irrelevant
3) The optimal payout ratio for a declining firm ( r < k) is 100 percent
1. Gordon Model - Assumptions
a) Retained earnings represent the only source of financing for the firm
b) The rate of return on the firm’s investment is constant
c) The growth rate of the firm is the product of its retention ratio and its rate of return
d) This assumption follows the first two assumptions
e) The cost of capital remains constant and its greater than growth rate
f) The firm has a perpetual life
g) Tax does not exist
 Gordon Model - Formula


 P0: price per share at the end of year 0,
 E1: earnings per share at the end of year 1,
 (1-b): fraction of firm’s earnings distributed as dividend
 b: fraction of firm’s earnings retained
 k: shareholders’ required rate of return
 r: rate of return on firm’s investments
 br: growth rate of earnings and dividends
 Gordon Model - Implications
1. The optimal payout ratio for a growth firm ( r > k) is nil
2. The optimal payout ratio for a normal firm ( r = k) is irrelevant
3. The optimal payout ratio for a declining firm ( r < k) is 100 percent
a. Miller and Modigliani Position
b. Assumptions:
1. Information is freely available to everyone equally
2. There are no taxes
3. Floatation and transaction costs do not exist
4. There are no contracting or agency costs
5. No one exerts enough power in the market to influence the price of a security. Price
Takers
6. Investment and financing decision are independent
- Miller and Modigliani Position
(a) If a company retains earnings instead of giving it out as dividends, the shareholders enjoy
capital appreciation equal to the amount of earnings retained.
(b) If it distributes earnings by way of dividends instead of retaining it, the shareholders
enjoy dividends equal in value to the amount by which his capital would have appreciated
had the company chosen to retain its earnings.
(c) Hence, the division of earnings between dividends and retained earnings is irrelevant
from the point of view of the shareholders
(1) Criticisms of MM Position
(i) Information about Prospects: In a world of uncertainty the dividends paid by the
company, based as they are on the judgment of the management about future, convey
information about the prospects of the company
(ii) Uncertainty and Fluctuations: Due to uncertainty, share prices tend to fluctuate,
sometimes rather wildly. Investors who prefer a higher current income may prefer a
higher payout ratio, while those who may prefer a lower current income may prefer a
lower payout ratio
1. Criticisms of MM Position
I. Offering of Additional Equity at Lower Prices: In practice, firms guided by merchant
bankers, offer additional equity at a price lower than the current market price. This
practice of ‘underpricing’ mostly due to market compulsions, ceteris paribus, makes a
rupee of retained earnings more valuable than a rupee of dividends.
II. Issue Cost: In the real world where issue cost is incurred, the amount of external
financing has to be greater than the amount of dividend paid. Retained earnings are
preferred
(a) Criticisms of MM Position
V. Transaction Costs
VI. Differential Rate of Taxes
VII. Rationing: Self-imposed or Market-imposed
VIII. Unwise Investments
 Rational Expectations Hypothesis
 What matters in economics is not what actually happens but the difference between what
actually happens and what was supposed or expected to happen
 Hence only the surprises in policy would have the kind of effects the policy maker is
striving to achieve
 Rational Expectations Hypothesis
 If the dividend is announced equal to what the market had expected, there would be no
change in the market price of the share, even if the dividend were higher (or for that
matter lower) than the previous dividend.
 The higher expectation was reflected in the market price already
 Rational Expectations Hypothesis
 In a world of rational expectations, unexpected dividend announcements would transmit
messages about changes in earnings potential which were not incorporated in the market
price earlier
 The reappraisal that occurs as a result of these signals leads to price movements which
look like responses to the dividends themselves, though they are actually caused by an
underlying revision of the estimate of earnings potential
 Radical Position
 Directly or indirectly dividends are generally taxed more heavily than capital gains.
 So, radicalists argue that firms should pay as little dividend as they can get away with so
that investors earn more by way of capital gains and less by way of dividends

Advance Financial Management Notes

Sessions 11 to 20
 Topics: Basics of capital expenditure decision/The nature of investments of capital
expenditure decisions
(i)Identification of potential investment opportunity 
To identify the potential investment opportunities, the promoter has to scan the environment that
throws the promising opportunities in investment and understand what are the existing
governmental regulatory framework which helps of facilitating this investment.

One should look at the market characteristics of different industry

  identify some emerging trends in technology,
  import and exports government on promoting export-oriented Industries,
  the social-economic trends, 
 the consumption pattern of foreign countries and how we can cater to the sector,
 that the revival of sick units by investing in them and investing in that backward and
forward integration of Units 
(ii)Preliminary screening of it are the capability with the promoter has to be looked at and then
screen the idea compatibility with government priorities the availability of raw materials and
utilities size of the potential market, the Inherent risk of the project and the cost associated with
associated with

(iii) Feasibility study: After the preliminary screening, a detail feasibility study is conducted. In
this, a detailed project report is prepared which consists of
 the cost of the project,
 means of Financing 
 the schedule of implementation of the project 
 estimation of profitability based on projected sales
 and social profitability is looked at. 
The ultimate decision whether to go for this project or not done here. 
 
(iv) Implementation of a project

 Preparation of the blueprints and the design of the project and planned engineering selection of
Missionaries and equipment negotiations for the project for the actual construction of the
building, training the employees and commission to the plant to run commercial production.
 (V)Performance review: In the performance, the review takes a realistic view of the assumptions
undertaken by the project. It is a valuable tool for decision making in future. It looks at whether
the trial runs are successful actual performance with the performance of the project in the
feasibility study.

Aspects of project appraisal

9. Market appraisal
10. Technical appraisal 
11. Financial appraisal 
12. Economical appraisal 
 Market appraisal attempts to look at, what is the size of the market for which the products or
services have been offered.
Technical analysis looks at the availability of technical quality, the number of raw materials and
other inputs, the availability of utility like power and water, the proposed technology concerning
the alternative state-of-the-art technology available, technical specification of the plant
Missionary concerning propose. 
The financial appraisal looks at the risk & returns characteristic of the project. It examines
whether the risk-adjusted return exceeds the cost of financing the project.
Economic appraisal
This evaluation criteria on that economic appraisal is in addition to financial appraisal most the
project sponsored by government authorities are subjected to social cost-benefit analysis
otherwise known as Economic appraisal looks at impact to the project on distribution of income
in the society and looks at the level of saving and investment that it brings out to society by the
introduction of this project contribution of the project to the social decidable object is like self-
sufficiency employment extra for successful implementation project each step of the capital
budgeting process is equally important.

Basic principles of estimating cost and benefits of investment

Appraisal criteria discounted and non-discounted method
Non-discounted methods
7. Payback period 
8. The average rate of return (ARR)
Discounted methods
2. Net present value (NPV)
3. Benefit-cost ratio (BCR)
4. Internal rate of return (IRR)
5. Annual capital charge
 
Payback period measures the length of time required to recover the initial outlay in the project.
 The project with a payback period less than or equal to the cut-off period will be accepted. If the
payback period for investment appraisal criteria for the following reason.
· It is simple in concept and application
· it helps in weeding out risky projects by favoring only those projects which generate substantial
inflow in the early years
 The payback period criteria suffer from following serious our shortcomings 
· Its non-discounted method so does not use the time value of money concept 
· The cut off period is chosen arbitrarily and applied uniformly for valuing projects regardless of
the life of regardless of their lifespan

Accounting rate of return(ARR) = Average profit of a tax divided by the average book value of
the investment.
 ARR appraise criteria for projects using the accounting profits, like payback criterion
accounting rate of return is simple in both concept and application and does not consider the time
value of money concept. It considers return over the entire life of the project and therefore serves
better as a measure of profitability. 

Net present value (NPV)

 The net present value is equal to the net the present value of future cash flows and Less
immediate cash outflow or the investment.
NPV is a conceptually sound criterion for investment appraisal because it takes into account the
time value of money and considers the cash flow streams in its entirety. Since the net present
value represents the contribution of the wealth of the shareholders maximizing NPV is
concurrent with the objective of investment decision, maximizes of shareholder’s wealth. The
only problem with NPV criteria is, it is difficult to comprehend for a non-finance executive or a
business, it takes some time to internalize this concept.

Benefit-cost ratio (BCR) or Profitability Index 

The benefit-cost ratio is given by the present value of future cash flow divided by the initial
investment 
a variation of the benefit-cost ratio is the net with benefit-cost ratio (NBCR) are which is defined
as the net present value of cash flow divided by the initial investment the benefit-cost ratio and
the net benefit-cost ratio the project can be looked at like this 
BCR is greater than 1 accept the project
BCR less than 1 reject the project 
Net benefit-cost ratio (NBCR)greater than zero accept the project 
A net benefit-cost ratio of less than zero reject the project 
The benefit-cost ratio measures the present value for a rupee of the total outlay it is considered to
be useful criteria for ranking a set of projects in an order of decreasing It is an efficient use of
capital but there are some limitations in this criteria 
 first, it provides no means of aggregating several small projects into a package that can be
compared with the large project 
 second, when the investment outlay is spread over more than one period these criteria
cannot be used.
The Internal Rate of Return (IRR) is that rate of return which equates the present value of cash
flow to the present value of cash outflow.
 The internal rate of return can be also represented or interpreted as that rate at which the
net present value of the project is equal to zero. For IRR we have to compute the NPV of
the project for different rates of interest until we find that rate at which the NPV of the
project is equal to zero or sufficiently close to zero. 
 IRR is a very popular method of investment appraisal and has several merits it takes into
consideration the concept of the time value of money.
 It considered as cash flow stream over the entire investment period like an IRR takes it
makes sense to the Businessman who prefers to think in terms of rate of return on capital
employed.
 The selection criteria will be that if IRR is greater than the cost of capital you accept the
project otherwise reject the project. If the IRR cash flow stream has one or more cash
outflows in, then multiple problems of multiple IRR.
 IRR criterion can be misleading when the decision-maker had to choose between
mutually exclusive projects that the first think significantly in terms of investment outlay 

Annual capital charge this kind of Appraisal criteria is used in evaluating mutually exclusive
projects,cash flow estimation by evaluating projects with unequal life.
 Steps involved in computing the annual capital charge or as follows·        
Step One determine the present value of the initial investment and
operating costs using the cost of capital as the discounting rate. 

Step Two define the present value of an annuity of the number of

years of the life and the project. Annual capital charge of a project is
chosen from various alternatives the minimum annual capital charges selected
because you're looking at the cost of the investment of the project rather than
the cash inflow.

Topic: Analysis of project cash flow

 Sub Topics Cash flow estimation: At this stage, we need to define the stream of cash flow (both
inflows and outflows associated with the project).
 The appraisal of the cash flow stream is determined whether the project financially viable
or not.
 The principles underlying the measurement of the cash flow occurs only once a year
  The risk characteristics of the project are similar to the risk complexion of the ongoing
projects of the form of the firm 
 The cost and benefits of all costs must be measured in terms of cash flow basis. This
implies that all the non-cash charges for expenses like depreciation which are considered
for purpose of determining the profit after tax must be added back to arrive at the net cash
flow for a purpose.
  Consider only relevant cash flow of the firm. 
 Interest on long term loan must be included for determining the net cash flow. The net
cash flows are defined from the point of view of suppliers of long term funds.
  the cash flow must be measured in incremental terms
  sunk costs must be ignored
  opportunity cost associated with the project must be considered
Topic Estimation of Working Capital needs:
How to determine the required for working capital? Working capital is the difference between
current assets and current liabilities. The basic objective of working capital is to provide
adequate support for the smooth functioning of the normal business operations of a company.
The static view of working capital means, your working capital requirement as on a particular
date (as on the balance sheet date) which means that you know prepare balance sheet to identify
current assets and current liabilities that is appearing in the book, subtract current assets from
current liabilities and determine the working capital requirement. This is called static because it
only gives you from a point of view of a date. But in real business, we need a dynamic view of
working capital.

Dynamic view of working capital 

Working capital can be viewed as an amount of capital required for the smooth and
uninterrupted functioning of the normal business operation of a company. In Dynamic approach
one needs to forecast and find out the quantum of raw materials inventory to be maintained by a
company.
The availability of it depends upon various criteria as of factors like availability of raw materials
in domestic market. The need for importing it extra. The quantity of finished goods Inventory of
a company is basically determined by the degree of accuracy in forecasting sales, on the ability
to meet certain and unforeseen spurt in the demand for finished goods.

Factors affecting the composition of working capital 

4. nature of business 
5. nature of raw materials used 
6. process technology used 
7. nature of finished goods 
8. degree of competition in the market 
9. paying habit of the customer 
10. the degree of synchronization between the cash flows inflows and outflows

Operating cycle approach to Working Capital Management

 3. Raw material storage period
4.  finished goods storage period
5.  average collection period
6.  average payment period
Operating cycle approach floors were quite useful as a technique for exercising control over
working capital.

Criteria for evaluating Working Capital Management

4. Liquidity
5. availability of cash
6.  inventory turnover
7.  credit extended to customers
8.  credit obtained from supplier
9.  under trading and over trading 
Ratio analysis of working capital
3. Current ratio
4.  quick ratio
5.  cash to current asset ratio
6.  sales to cash ratio
7.  average collection period
8.  inventory turnover ratio 

Topic Inventory Management

-Nature of inventory and its role in the working capital 
-purpose of inventory 
-types and cost of inventory management techniques
- pricing of investments 
-inventory planning and control
Inventory management involves the control of assets being produced for sale.
In a normal course of
the company's operations inventory includes 
(i)Raw material inventory:
basic materials that has not yet been committed to production in manufacturing firm.
 Stores and space this category include those products which are
accessories to the main product produced for sale example bolts,
nuts, clamp, screws etc.
 
(ii)work-in-progress inventory: This category includes those materials that have been committed
to the production process but have not been completed
 
(iii) finished goods inventory:
these are completed products awaiting sales the purpose of finished goods
inventory 
 
the core of an effective
in inventory management is to minimize the total cost that are associated with
holding inventory. 

The purpose of inventory includes:

5. avoid loss sales 
6. gaining quantity discount 
7. reducing ordering cost 
8. achieving efficient production 
9. reducing risk of production shortage
 Costs associated with inventory 
· material cost: These are the cost of purchasing the goods including transportation and holding
cost
· ordering cost: any manufacturing Organisation has to purchase material, the ordering cost refers
to the costs associated with preparation of purchase requisition by the department, preparation of
purchase order and follow up measures taken by the purchase department, transportation of
materials, audit for inspection and handling at the warehouse, all these are considered for
ordering cost.
· Carrying cost: Includes the expense of storing goods, carrying costs are considered to be almost
25 % of the value of the inventory held in storage
 Cost of funds tied up with inventory: Whenever a firm committed its resources to
inventory, this fund otherwise might be available for other purposes.
 Cost of running out of goods: these are cost associated with the in availability to produce
due to lack of inventory. When marketing proportional are unable to honour their
commitment to the customers in making finished goods available for sale. There must be
loss, this kind of lost sales have a cost attached to it, this is called as the cost of lost sale.
Inventory management techniques
 Economic order quantity: the economic order quantity(EOQ) refers to the optimal order
size that will result in the lowest total of order and carrying cost for an item of inventory.
EOQ assumptions
4. Constant uniform demand
5.  constant unit price
6.  constant carrying cost
7.  constant ordering cost
8.  instantaneous delivery
9.  independent auditor's
We have inflation and economic order quantity assumptions very.
 Determinants of optimal production quantity.
 Reorder point system and safety stock
 Other inventory management techniques include
 ABC system
this is system the general procedure for categorizing of items into A, B and C
groups, all the items of inventory are to be ranked in the descending order of their
annual use each value.
 Advanced Financial Management
Topics
7. Estimation of Working Capital Needs
8. Inventory Management
9. Receivables Management
10. Financing Current Assets
11. Treasury Management and Control

Estimation of Working Capital

Working Capital and Working Capital Management:

That portion of company’s capital, invested in short term or current assets

to carry on its day to day operations smoothly, is called the ‘Working
Capital’.

Working Capital refers to a firm’s investment in short term assets viz. cash,
short term securities, accounts receivable and inventories.

The management of working capital is no less important than the

management of long-term financial investment. Sufficient liquidity is
necessary and must be achieved and maintained to provide firm’s pay-off
obligation as they arise or mature. The efficient working capital management
is necessary to maintain a balance of liquidity and profitability.

Components of Working Capital:

 Current Assets
o Cash and Bank Balances
o Temporary Investments
o Short term Advances
o Prepaid Expenses
o Receivables
o Inventory of Raw Material, Stores and Spares
o Inventory of work-in-progress
o Inventory of Finished Goods
 Current Liabilities
o Creditors for Goods purchased
o Outstanding Expenses
o Short term Borrowings
o Advances received against Sales
o Taxes and Dividends payable
o Other Liabilities maturing within a year

IBS: Mumbai Page 1

Gross and Net Working Capital:

Gross Working Capital refers to a firm’s investment in current assets. Since

profits are earned by the firm by making investment in both fixed and
current assets, an aggregate of current assets should be taken to mean the
working capital. Total current assets also represent the total funds available
for operating purpose and an increase in overall investment in the firm
brings an increase in working capital.

Net working capital refers to the excess of current assets over current
liabilities and it is difference between current assets and current liabilities.
It is an indicator of the liquidity position of a firm and the extent to which
the working capital may need to be financed by permanent sources of funds.

The gross and net working capital are ascertained as below:

Current Assets:
Raw material Stock xxx
Work-in-process stock xxx
Finished goods stock xxx
Sundry Debtors xxx
Bills Receivable xxx
Short term investments xxx
Cash and bank balances xxx
Gross Working Capital xxx

Less Current Liabilities:

Creditors for materials xxx
Creditors for expenses xxx
Bills payable xxx
Tax liability xxx
Short term loans xxx
Net Working Capital xxx.

Permanent and Temporary Working Capital

Permanent Working Capital is the minimum level working capital required to

carry on the business irrespective of change in level of sales or production. It
also referred to as ‘regular working capital’. These are generally financed
through long term debt and equity.

Temporary Working Capital also referred to as ‘fluctuating working capital’,

depends on changes in sales and production, over and above permanent
working capital. It represents additional assets required for the operations of
the year. This excess requirement of working capital is financed from short-
term financing sources.

IBS: Mumbai Page 2

Source: Financial Management, Ravi Kishore, 7th Edition

Objectives of Working Capital Management:

 By optimizing the investment in current assets and by reducing the

level of current liabilities, the company can reduce the locking-up of
funds in working capital thereby; it can improve the return on capital
employed in the business.
 Company should always be in a position to meet its current
obligations which should properly be supported by the current assets
available with the company. But maintaining excess funds in working
capital means locking of funds without return.
 The company should manage its current assets in such a way that the
marginal returns on investment in these assets is not less than the
cost of capital employed to finance current assets.
 The company should maintain proper balance between current assets
and current liabilities to enable the firm to meet its day to day
financial obligations.

IBS: Mumbai Page 3

Operating Cycle:

The Operating Cycle is the length of time between the company’s outlay on raw
materials, wages and other expenses and inflow of cash from sale of goods. Quicker the
operating cycle less amount of investment in working capital is needed and it improves the
profitability. The duration of operating cycle depends on nature of industry and efficiency in
working capital management.

Cash

Materials,
Receivables Labour
Expenses

Sales
WIP

Finished
Goods

The operating cycle is ascertained as follow:

11. Raw Material Holding Period: Average Raw Material Stock/
Average consumption of Raw Material/365

12. Work-In-Process Period: Average Work-In-Process / Average cost

of goods/365

13. Finished Goods Holding Period: Average Finished Goods stock/

Average cost of goods sold/365

14. Receivables Collection Period: Average Receivables/ Average Sales/365

15. Creditors Payment Period: Average Creditors/ Average Purchase of

Raw Materials/365

When depreciation is excluded from expenses in the operating cycle, the net
operating cycle represents the ‘cash conversion cycle’.

IBS: Mumbai Page 4

The period of the Operating Cycle can be ascertained as follows:

Days
Raw Material Holding Period xx
Work-In-Process Period xx
Finished Goods Holding Period xx
Receivables Collection Period xx
Gross Operating Cycle xx
Less: Creditors Payment Period xx
Net Operating Cycle xx

Illustration on Operating Cycle

The following information is available for Swagat Ltd. (Rs. Million)

Average stock of raw materials and stores 200
Average work-in-process inventory 300
Average finished goods inventory 180
Average accounts receivable 300
Average accounts payable 180
Average stock of raw materials and stores purchased on credit and
consumed per day 10
Average work-in-process value of raw material committed per day 12.5
Average cost of goods sold per day 18
Average sales per day 20

The operating cycle is ascertained as follow:

4. Raw Material Holding Period: Average Raw Material Stock/ Average
consumption of Raw Material per day 200/10 = 20 days

5. Work-In-Process Period: Average Work-In-Process / Average WIP value

of raw material committed per day 300/12.5 = 24 days

6. Finished Goods Holding Period: Average Finished Goods stock/ Average

cost of goods sold per day 180/18 = 10 days

7. Receivables Collection Period: Average Receivables/ Average Sales

per day 300/20 = 15 days

8. Creditors Payment Period: Average Creditors/ Average Purchase of

Raw Materials per day 180/10 = 18 days

Duration of Operating Cycle = (20+24+10+15) – 18 = 51 days

IBS: Mumbai Page 5

Positive and Negative Working Capital:

The Net Working Capital of a firm may be positive or negative.

a. The ‘Positive Net Working Capital’ represents the excess of current

assets over current liabilities.
b. Sometimes the Net Working Capital turns to be negative when
current liabilities are exceeding the current assets. The Negative
Working Capital situation will lead to closure of business and the
enterprise is said to be technically insolvent.

Factors Determining Working Capital Requirement:

 Nature of Business
 Manufacturing Cycle
 Production Process
 Business Cycle
 Seasonal Variations
 Scale of Operations
 Inventory Policy
 Credit Policy
 Accessibility to Credit
 Business Standing
 Growth of Business
 Market Conditions
 Supply situation
 Environment Factors

Working Capital Management Strategies:

Conservative Approach: It suggests not taking any risk in working capital

management and carrying high levels of current assets in relation to sales. It
requires maintaining a higher level of working capital and it should be
financed by long-term funds like share capital or long-term debt. Sufficient
stocks of finished goods are maintained to meet the market fluctuations.
Large investment in current assets leads to higher interest and carrying cost
and encouragement for inefficiency.

Aggressive Approach: Under this approach current assets are maintained

just to meet the current liabilities without keeping any cushion for the
variations in working capital needs. The core working capital is financed by
long-term sources of capital, and seasonal variations are met through short-
term borrowings. Adoption of this strategy will minimize the investment in
net working capital and ultimately it lowers the cost of financing working
capital. The main drawbacks of this strategy are that it necessitates frequent
financing and also increases risk as the firm is vulnerable to sudden shocks.

IBS: Mumbai Page 6

 Matching Approach: Under this approach, financing working capital
requirements of a firm, each asset in the balance sheet side would be offset
with a financing instrument of the same approximate maturity. The basic
objective of this method of financing is that the permanent component of
current assets, and fixed assets would be met with long-term funds and
short- term or seasonal variations in current asset would be financed with
short- term debt.

Financing Strategy:
Long-term funds = Fixed Assets + Total Permanent Current Assets
Short-term funds = Total Temporary current assets

Zero Working Capital Approach: This is one of the latest trends in working
capital management. The idea is to have zero working capital i.e., at all
times the current assets shall equal the current liabilities. Excess
investment in current assets is avoided and firm meets its current liabilities
out of the matching current assets.
Total Current Assets = Total Current Liabilities
Or
Total Current Assets – Total Current Liabilities = Zero

Estimation of Working Capital

Working Capital Leverage: It reflects the sensitivity of the return on capital
employed to the changes in level of current assets. It measures the
responsiveness of Return on Capital Employed (ROCE) for changes in
current assets.

IBS: Mumbai Page 7

ROCE/ROI = EBIT % Change in ROCE
Working Capital Leverage =
Total % in Current Assets
Assets

C.A.
Working Capital Leverage =
T.A.−⌂ C.A.

Where: C.A = Current Assets, T.A. = Total Assets (i.e. Net Fixed Assets+
Current Assets) ⌂ C.A. = Change in Current Assets

Illustration-01:

From the following information calculate the responsiveness of ROCE for

changes in current assets if there is decline in current assets by 20%:

[Rs. In Lakhs]

Particulars Company X Company Y

Fixed Assets 300 200
Current Assets 200 300
Total Assets 500 500
EBT 90 90
ROCE 18% 18%

IBS: Mumbai Page 8

Solution:
 C.A.
Working Capital Leverage =
200 T.A.−⌂ C.A.
Company X =
500 −40
= 0.435
300
Company Y =
500 −60
= 0.682
Analysis: From the above analysis it is observed that, Working Capital
Leverage is higher for Company Y and therefore, it is more responsive as
compared to Company X.

Illustration-02:

Following information is given of Mars Ltd.: [Rs. In Lakhs]

Fixed Assets 300

Current Assets 200
Total Assets 500

The entire current assets are being financed by the bank finance @16% p.a.
The EBT is Rs.100 Lakhs. The Company is planning to reduce its level of
investments in current assets by Rs.100 Lakhs with an efficient working
capital management. Show the impact of change in working capital on the
Company’s return on investment (ROI).

Solution:

Calculation of ROI prior to Reduction in Current Assets

EBT 100
ROI = X 100 ROI = X 100 = 20%
Total 500
Assets

Calculation of ROI prior to Reduction in Current Assets to Rs.100 Lakhs

EBT 100
Add: Savings in interest due to reduction in investment in 16
current assets
Total EBT 116
Revised ROI = 116
X 100 = 29%
400

Analysis: With the efficient management of working capital, by reducing the

level of investments in current assets, the company can improve its ROI
from 20% to 29%.
Methods of Working Capital Estimation:

Operating Cycle Method- It can be used in estimation of working capital.

The longer the length of operating cycle, the higher the requirement for
working capital and vice versa. For estimation of working capital, the
following formula can be used:
 Operating Cycle
[Estimated COGS X ] + Desired Cash Balance
365 Days

Illustration-03:

XYZ Ltd. expects its COGS for 2018-19 to be Rs. 136 Crores. The operating
cycle for the planned year is expected to be 54 Days. The company wants to
maintain a desired cash balance of Rs. 1.5 Crores to meet the contingencies.
What is the expected working capital requirement for the year 2018-19.
(Assume 360 Days in a year).

Solution: Estimation of Working Capital for the year 2018-19 based on

operating cycle=

54 Days
[Rs. 136 Crores X ] + Rs. 1.5 Crores = Rs. 21.90 Crores
360 Days

Operating Cycle Method:

Under this method, each individual item of current assets and current
liabilities are estimated as follows:

Raw Material Stock:

Budgeted Production p.a. (units) X Material Cost per unit X Raw Material
Holding Period / 365 days or 52 weeks or 12 months

Work-In-Progress Stock:

Budgeted Production p.a. (units) X Per Unit cost of (Material 100%+Labour

50%+Overheads 50%) X Work-In-Progress Holding Period / 365 days or 52
weeks or 12 months

Finished Goods Stock:

Budgeted Production p.a. (units) X Cost of Goods produced per unit X

Finished Goods Holding Period / 365 days or 52 weeks or 12 months

Investment in Debtors:

Budgeted Credit Sales p.a. (units) X Raw Material Cost per unit X Creditors
Payment Period / 365 days or 52 weeks or 12 months
Cash Balances:

The required Cash Balance can be estimated using Cash Budget

Prepaid Expenses:

Expenses paid in advance require investment in terms of working capital

Sundry Creditors:

Budgeted Production p.a. (units) X Selling Price per unit X Debtors Collection
Period / 365 days or 52 weeks or 12 months

Creditors for Wages and Expenses:

Budgeted Production p.a. (units) X Wages or Overheads per unit X Lag-in

Payment / 365 days or 52 weeks or 12 months

Advances:

Any advances received, along with orders, reduce the amount of required
working capital.

Illustration on Working Capital estimation:

Prepare an estimate of net working capital requirement for WCM Ltd. adding
10 percent for contingencies from the information given below:

Estimated per unit cost of production of Rs 170 includes raw materials

Rs.80, direct labour Rs.30 and overheads Rs. 60.
Selling Price Rs.200 per unit.
Level of activity per annum 1,04,000 units.
Raw material in stock: 4 weeks
Work-in-progress (assume 50% completion) 2 weeks
Finished goods in stock 4 weeks
Credit allowed by suppliers 4 weeks
Credit allowed to debtors 8 weeks
Lag in payment of wages 1.5 weeks
Cash at bank is expected to be Rs.25000.
You may assume that production is carried evenly throughout the year ( 52
weeks) and wages and overheads accrue similarly. All sales are on credit
basis only.

Estimation of Net Working Capital requirement

Current Assets:
Raw material stock: (104000 units X Rs. 80 X 4/52) 6,40,000
Work-in-progress:
Raw Material (104000 units X Rs. 80 X 2/52) 3,20,000
Labour (104000 units X Rs. 15 X 2/52) 60,000
Overheads (104000 units X Rs. 30 X 2/52) 1,20,000 5,00,000
Finished goods stock: (104000 units X Rs. 170 X 4/52) 13,60,000
Sundry Debtors: (104000 units X Rs. 170 X 8/52) 27,20,000
Cash at Bank: 25,000
52,45,000

Current Liabilities:
Creditors for raw materials: (104000 units X Rs. 80 X 4/52) 6,40,000
Creditors for wages: (104000 units X Rs. 30 X 1.5/52) 90,000
7,30,000
Net Working Capital 45,15,000
Add: 10% for contingencies 4,51,500
Total Working Capital 49,66,500

Debtors calculated at cost of goods sold

Practice Questions

Problem-01

Calculate operating cycle of a company which gives the following details

related to its operations:

Rs.
Raw materials consumption per annum 842000
Annual cost of production 1425000
Annual cost of sales 1530000
Annual sales 1950000
Average value of current assets held:
Raw materials 124000
Work in progress 72000
Finished Goods 122000
Debtors 260000
The company gets 30 days credit from its suppliers. All sales are made on
credit only. A year is considered to have 365 days.

Problem-02

The Board of Directors of Ruby Ltd. requests you to prepare a statement

showing the working capital requirements forecast for a level of activity of
156000 units of production. The following information is available for your
calculation: [Rs. Per unit]

Raw Material 90
Direct Labour 40
Overheads 75
205
Profit 60
Selling Price Per Unit 265
s. Raw Materials are in stock on average one month.
t. Materials are in process, on average 2 weeks.
u. Finished goods are in stock, on average one month.
v. Credit allowed by suppliers- one month.
 w. Time lag in payment from debtors- 2 months
x. Lag in payment of wages- 1½ weeks.
y. Lag in payment of overheads- one month

20% of the output is sold against cash. Cash in hand and at bank is
expected to be Rs.60000. it is to be assumed that production is carried on
evenly throughout the year. Wages and Overheads accrue similarly and a
time period of 4 weeks is equivalent to a month.

Problem-03

Estalla Garment Ltd is a famous manufacturer and exporter of garments.

The finance manager of the company is preparing its working capital
forecast for the next year.

Production during the previous year was was 15,00,000 units. The same
level of activity is intended to be maintained during the current year. The
expected ratios of cost to selling price are:

Raw materials 40%

Direct wages 20%
Overheads 20%

The raw materials ordinarily remain in stores for 3 months before

production. Every unit of production remains in the process for 2 months
and is assumed to be consisting of 100% raw material, wages and
overheads. Finished goods remain in warehouse for 3 months. Credit
allowed by the creditors is 4 months from the date of the delivery of raw
material and credit given to debtors is 3 months from the date of dispatch.

Estimated balance of cash to be held Rs 2,00,000

Lag in payment of wages ½ month

Lag in payment of expenses ½ month

Selling price is Rs 10 per unit. You are required to make a provision of 10%
for contingency (except cash). Prepare the working capital forecast
statement.

References:
'Financial Management - Comprehensive text with case studies’- Ravi Kishore
Edition 7.
 Inventory Management

Background:

“Inventory” represent second largest category of `Asset’ after `Fixed Assets’ for
a manufacturing company.

The proportion of `Inventory to Total Asset’ generally varies from 15% to 30%
in a manufacturing concern.

Hence, there is a need for effective and efficient management of inventory in

an organisation.

Nature of Inventories:

Normally, `Inventories’ consist of:

 Raw Materials : These are materials and components that are

required as inputs in making of the final
product.
 Work-in-progress : It refers to the goods which are in the
intermediate stages of production.
 Finished Goods : It consists of final `Finished Products’ that are
ready for sale.

Types of Inventory:

The `Accounting Standard – 2’ [AS-2] of “The Institute of Chartered

Accountants of India”, has classified “Inventory” into:

10. Raw Materials - consisting of “Raw Material and Component”

11. Stores and Spares - consisting of “Fuel and Spare Parts”
12. Work-In-Progress - representing “Partly Finished Goods”
13. Finished Goods - referring to “Completely Finished Goods”
ready for sale.
Cost of Inventory:

The `Inventory Cost’ may be categorised as:

4) Material Cost:

It refers to the “Total Cost of Material Purchased” or “Landed Cost of

Material Procured” (which is Material Cost PLUS incidental expenses.)

5) Ordering Cost:

It is the `Cost of Placing an Order and Receiving’ the Material.

`Cost of Placing an Order’ refers to the expense involved in complying

with the `Purchase Procedure’ within the organisation.

`Cost of Receiving’ the Material represents the expenses incurred for

receipt of material, testing & inspection and storing of materials.

6) Carrying Cost:

It consists of the Storage Cost, Material Maintenance Cost, Insurance

Cost, Interest element of Funds parked in Inventories, etc.

7) Shortage Cost:

It refers to the situation where the quantity of material in hand is less

than the quantity actually required. Hence, there is a `Shortage of
Material’.

This can have repercussion on:

 Upsetting the Production Schedules;
 Non-compliance of Customer’s Orders in time;
 Purchase of costlier substitutes;
 Deterioration of Company’s Goodwill in the Market. Etc.

Purpose / Objective of Inventory:

The main purpose or objectives of `Inventory Management’ is to:

2. Prevent `under-stocking’ or `over-stocking’ of materials;

3. Ensure timely procurement of inventories;
4. Minimise `Total Inventory Cost’;
5. Prevent `Manipulations of Records’;
6. Avoid `Frauds’ with respect to items of inventories;
7. Provide correct & ready information (with respect to items of `Inventories’):
 To Management for Decision Making;
 For Periodic Stock-taking;
 For timely reporting of `Inventory Value’ in Financial Statements.

Role of Inventory in Working Capital:

The `Working Capital `Operating Cycle’ of a Manufacturing Concern

represents:

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The above `Operating Cycle’ indicates that major portion is represented by

inventories in different formats like: Raw Material, Work-In-Progress, and
Finished Goods.

As a result there is a considerable amount of funds being blocked at each

stage. This in turn, will lead to increase in the requirement of Working
Capital in an organisation.
Inventory Management Techniques

ABC Analysis- ABC analysis stands for Always Better Control Analysis. It is
an inventory management technique where inventory items are classified
into three categories namely: A, B, and C. The items in A category of
inventory are closely controlled as it consists of high-priced inventory which
may be less in number but are very expensive. The items in B category are
relatively lesser expensive inventory as compared to A category and the
number of items in B category is moderate so control level is also moderate.
The C category consists of a high number of inventory items which require
lesser investments so the control level is minimum.

JUST IN TIME (JIT) Method- In Just in Time method of inventory control,

the company keeps only as much inventory as it needs during the
production process. With no excess inventory in hand, the company saves
the cost of storage and insurance. The company orders further inventory
when the old stock of inventory is close to replenishment. This is a little
risky method of inventory management because a little delay in ordering
new inventory can lead to stock out situation. Thus this method requires
proper planning so that new orders can be timely placed.

VED Analysis- VED stands for Vital Essential and Desirable. Organizations
mainly use this technique for controlling spare parts of inventory. Like, a
higher level of inventory is required for vital parts that are very costly and
essential for production. Others are essential spare parts, whose absence
may slow down the production process, hence it is necessary to maintain
such inventory. Similarly, an organization can maintain a low level of
inventory for desirable parts, which are not often required for production.

FAST, SLOW & NON-MOVING (FSN) METHOD- This method of inventory

control is very useful for controlling obsolescence. All the items of inventory
are not used in the same order; some are required frequently, while some
are not required at all. So this method classifies inventory into three
categories, fast-moving inventory, slow-moving inventory, and non-moving
inventory. The order for new inventory is placed based on the utilization of
inventory.

Economic Order Quantity (EOQ) Model

Economic Order Quantity technique focuses on taking a decision regarding

how much quantity of inventory should the company order at any point of
time and when should they place the order. In this model, the store manager
will reorder the inventory when it reaches the minimum level. EOQ model
helps to save the ordering cost and carrying costs incurred while placing the
order. With the EOQ model, the organization is able to place the right
quantity of inventory.
EOQ is also referred to as the optimum lot size.

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Example of EOQ

P Ltd is a company manufacturing water purifiers The annual demand for

the product in the India market is 250000 units. The cost of holding per
unit of water purifier is Rs100. Also the ordering cost per order is Rs 500.
Calculate
:

h) EOQ
i) Total Ordering Cost p.a

Solution:

a) EOQ = √2*250000*500/100
= 1581 units

b) Total Ordering Cost p.a

Total orders per year =250000/1581=158 (app)

Therefore , total ordering cost =158*500= Rs 79000

www.eFinanceManegement.com

Fixation of Inventory Levels

Having too much or too little inventory is unfavourable for any busi- ness. If
the inventory is too little, the organisation would face regular stock-outs,
which would in turn involve high ordering costs. On the other hand, a large
investment in inventory can also be disadvantageous. Therefore, an
organisation should ideally keep an optimum level of inventory where the
inventory cost is the lowest. The various stock levels maintained by an
organisation can be discussed as follows:

 Minimum Stock Level: Represents the rate of inventory that must be

maintained at all the times. If the inventory is less than the min- imum
level, the production of goods may hamper due to shortage of materials.
The formula to calculate the minimum stock level is as follows:
Minimum Stock Level = Reorder level – (Normal Usage*Average Lead Time)

 Reorder Level: Refers to the level of inventory at which an organisation

reorders raw material. In other words, when the amount of raw material
reaches a certain level, a new order for the same is forwarded. The order
is
 forwarded before the amount of raw material depletes to a minimum
stock level. The reordering level is fixed somewhere between the
minimum level and maximum level of inventory. The formula to calculate
reordering level is as follows:
Reorder Level = Maximum Usage*Maximum Lead Time

 Maximum Stock Level: Refers to the maximum amount of inventory

that an organisation should keep with itself. The organisation should not
go beyond the maximum stock level because it would unnecessarily
increase the cost of holding the inventory. In addition, over-stocking
would block working capital, which would in turn result in wastage of
material. The formula to calculate the maximum stock level is as follows:
Maximum Stock Level = (Reordering level + Economic Order Quantity) –
(Minimum Usage × Minimum Lead Time)

 Danger Level: Refers to the level beyond which the inventory should not
fall in any case. If the danger level is reached, immediate steps should be
taken to replenish the stocks, even if it means incurring additional costs
in arranging the materials. The danger level is determined by the
following formula:
Danger Level = Average consumption × Lead Time for emergency purchases

 Average Stock Level: It is the average of minimum and maximum stock

levels.
Or
Average Stock Level = Minimum Level + Reorder Quantity/2

Example

Compute re-order level, minimum level, maximum level and average

stock level for component A and B of company XYZ Ltd.
Normal usage- 90 units per week
Minimum usage- 50 units per week
Maximum usage- 140 per week
Re-order period- Component A:2 to 6 weeks; Component B: 4 to 8
weeks
Economic Order quantity- Component A: 600 units; Component B:
800 units
Re-order level = Maximum Usage *Maximum Lead time
A = 140*6 = 840units
B = 140*8 = 1120units
Minimum Level = Reorder level -(Normal Usage)*Average Lead Time
A = 840-(90*4)
= 480 units
B = 1120-(90*6)
= 580 units
Maximum Level =Reorder level+ Economic order quantity-(Minimum usage
* Minimum Delivery time)
A= 840+600-(50*2) =1340units
B= 1120+800-(50*4) =1720units

Conclusion
Inventory management is an essential part of every business. With an
effective inventory management system in place, the business can
significantly reduce its various costs like warehousing cost, inventory
carrying cost, ordering cost, cost of obsolescence, etc. It improves the supply
chain of the business. Managers are able to forecast the level of production at
which they need to place new orders for inventory. Hence, organizations
should take all the necessary steps to maintain an effective inventory
management and control system.

References:
4. Text Book on `Financial Management – Theory and Practice’ by Prasanna
Chandra (9th Edition).
5. Text Book on `Financial Management – Principles and Practice’ by G.
Sudarsana Reddy.
6. Text Book on `Cost Accounting – Principles and Practice’ by Manash Dutta.
7. Text Book on `Introduction to Cost Accounting’ by Dr. P. C. Tulsian.
8. https://www.accountingcoach.com/blog/what -is-eoq
9. https://efinancemanagement.com/costing-terms/inventory-management-
techniques
Receivables Management

Meaning and Objective

The word receivable stands for the amount of payment not received. This
means the company has extended credit facility to its customers. The sale of
goods on credit is an essential part of the modern competitive economic
systems. When firms extend trade credit, that is, invest in receivables, they
intend to increase the sales to existing customers or attract new customers.
This motive for investment in receivables is growth-oriented. Secondly, the
firm may extend credit to protect its current sales against emerging
competition. Here, the motive is sales-retention. As a result of increased
sales, the profits of the firm will increase.

Accounts receivable appear in the assets side of the Balance Sheet.

Accounts receivables form a major part of the organization’s asset and it
leads to the generation of cash in-flow in the books of the organization.

The extension of credit involves risk and cost. Management of receivables

refers to planning and controlling of debt owed to the firm from customer on
account of credit sales. It is also known as trade credit management. A good
receivable management contributes to the profitability by reducing the risk
of any bad debts. Management is not only about reminding the customers
and collecting the money on time. It also involves identifying the reasons for
such delays and finding a solution to those issues. Management should
weigh the benefits as well as cost to determine the goal of receivables
management. The objective of receivables management is ‘to promote sales
and profits until that point is reached where the return on investment in
further funding receivables is less than the cost of funds raised to finance
that additional credit (i.e. cost of capital).

The major categories of costs associated with the extension of credit and
accounts receivable are:

(i) Collection cost: Collection cost is the administrative cost incurred

in collecting receivables
 (ii) Capital cost: Collection cost is the administrative cost incurred in
collecting receivables
(iii) Delinquency cost: is cost arising out of failure of customers to
pay on due date.
(iv) Default cost: are the over dues (bad debts) that cannot be
recovered and are written off in the books of accounts.

Process involved in the Accounts receivable management:

c. Credit rating i.e the paying ability of the customers shall be reviewed
before agreeing to any terms and conditions.

d. Continuously monitoring any risk of non-payment or delay in receiving

the payments.

e. Customer relations should be maintained and thus to reduce the bad debts.

f. Addressing the complaints of the customers.

g. After receiving the payments, the balances in the particular account

receivable should be reduced.

h. Preventing any bad debts of the receivables outstanding during a

particular period.

ILLUSTRATIONS

7. H Ltd has at present annual sales level of Rs 10,000 units at Rs 300 per
unit. The variable cost is Rs 200 per unit and fixed cost amount to Rs
3,00,000 per annum. The present credit period allowed by the company is 1
month. The company is considering a proposal to increase the credit period
to 2 months and 3 months and has made the following estimates:

Existing Proposed

Credit period (month) 1 2 3

Increase in sales (per cent) — 15 30

Bad debts (per cent) 1 3 5

 There will be increase in fixed cost by Rs 50,000 on account of increase in
sales beyond 25 per cent of present level. The company plans a pre-tax
return of 20 per cent on investment in receivables. You are required to
calculate the most paying credit policy for the company.

Solution

Decision-making (liberalisation of credit period to 2 months or 3 months)

Particulars 1 month 2 Months 3 months
Sales (units) 10000 11500 13000
Rs Rs Rs

Sale revenue 30,00,000 34,50,000 39,00,000

Less: Variable costs 20,00,000 23,00,000 26,00,000

Total contribution 10,00,000 11,50,000 13,00,000

Less: Other costs:

Fixed costs 3,00,000 3,00,000 3,50,000

Bad debts 30,000 1,03,500 1,95,000

Investment cost (see working
notes) 38,000 86,667 1,47,500

Profi t 6,32,000 6,59,833 6,07,500

working note existing 2 months 3 months

Investment in debtors (VC +
FC)/Debtors turnover 23,00,000 26,00,000 29,50,000

12 6 4

1,91,666.67 433333.3333 737500

Cost of investment (Investment in

debtors 0.20) 38,333.33 86,666.67 1,47,500.00
8. A Firm is contemplating to have stricter collection policy. At present the
firm is selling 36000 units @ Rs 32 each. The variable cost is Rs 25/unit
while the average cost is Rs 29/unit.

Average collection period is 58 days which can go down to 40 days if new

policy is followed. Currently the collection expenses are Rs 10000 which
may go up by Rs 20000. Bad debts which are now at 3% will go down to 1%,
however the sales volume is likely to decline by 500 units should the new
policy be followed. If the ROI of the company is 20%, should the company
implement the new policy?

Solution:
Current Proposed
Sales 36000 35500
Revenue@32/unit 1152000 1136000
VC@25/unit 900000 887500
FC 144000 144000
Collection exp 10000 30000
BD (% of revenue) 34560 11360
Profit from sales (A) 63440 63140
Investment in 1044000*58/360 1031500*40/360=114611
debtors = 168200
Opp cost on 33640 22922
investment in
debtors @ 20% (B)
Net Profit (A-B) 29800 40218
Net gain from 10418
implementing new
policy

Hence accept the new policy.

 9. Aseema Ltd is in the business of wholesale plastic containers. It
currently extends credit to all its dealers. The firm is contemplating
offering a 2% cash discount scheme for payment within 10 days, to
speed up the collections from its dealers. At present the company has
annual sales of 200000 units at the rate of Rs 30. Variable cost is
Rs20 and average cost is Rs 25 at the current sales volume. The ACP
is 60 days.
With the introduction of cash discount, sales may touch 225000 units
and the ACP may fall to 45 days. However due to increased sales, an
additional Rs 100000 will be required as working capital (excluding
increase in debtors). Assuming that 50% of the total sales will be on
cash discount , should the firm offer cash discount if its ROI is 20%?
Solution:

Current Proposed
Sales-units 200000 225000
Revenue 6000000 6750000
VC 4000000 4500000
FC 1000000 1000000
ACP 60 45
Avg Investment in
debtors 833333.333 687500
Opp cost on investment
in debtors 166666.667 137500
Opp cost on Working
capital @20% - 20000
Cash discount (WN) - 67500
Net profit 833333.333 1025000
Additional benefit due to
CD 191666.6667

WN : Cash discount = 6750000*0.5*0.02 = 67500

Since the proposed policy yields an additional profit of Rs 1,91,667, firm is

advised to implement the same.
Ageing Schedule
The Ageing schedule (AS) classifies outstanding accounts receivables
at a given period of time into different age brackets.

Age Group (in days) Percent of Receivables

0 - 30 35
31 - 60 40
61 - 90 20
> 90 5

The actual AS of the firm is compared with some standard AS to

determine whether accounts receivable are in control. A problem is
indicated if the actual AS shows greater proportion of receivables,
compared with the standard AS, in the higher age groups.

Factoring
The modern factoring involves a continuing arrangement under which
a financing institution assumes the credit control/protection and
collection functions for its client, purchases his receivables as they
arise (with or without recourse to him for credit losses, i.e., customer’s
financial inability to pay), maintains the sales ledger, attends to other
book-keeping duties relates to such accounts receivables and
performs other auxiliary functions.
Factoring is an asset based method of financing as well as specialized
service being the purchase of book debts of a company by the factor,
thus realizing the capital tied up in accounts receivables and
providing financial accommodation to the company.

The book debts are assigned to the factor who collects them when due
for which he charges an amount as discount or rebate deducted from
the bills. Thus, the factor is an intermediary between the supplier and
customers who performs financing and debt collection services.
Factoring Process

The following steps are involved in the process of factoring:

 The seller sells the goods to the buyer and raises the invoice on
customer.
 The seller then submits the invoice to the factor for funding. The
factor verifies the invoice.
 After verification, the factor pays 75 to 80 percent to the
client/seller.
 The factor then waits for the customer to make the payment to
him.
 On receiving the payment from the customer, the factor pays
the remaining amount to the client.
 Fees charged by factor or interest charged by factor may be
upfront i.e. in advance or it may be in arrears. It depends upon
the type of factoring agreement.
 In case of non – recourse factoring services factor bears the risk
of bad debt so in that case factoring commission rate would be
comparatively higher.
 The rate of factoring commission, factor reserve, the rate of
interest, all of them are negotiable. These are decided depending
upon the financial situation of the client.

Advantages Of Factoring

The following are the advantages:

 It reduces the credit risk of the seller.

 The working capital cycle runs smoothly as the factor
immediately provides funds on the invoice.
 Sales ledger maintenance by the factor leads to a reduction of
cost.
  Improves liquidity and cash flow in the organization.
 It leads to improvement of cash in hand. This helps the
business to pay its creditors in a timely manner which helps in
negotiating better discount terms.
 It reduces the need for the introduction of new capital in the
business.
 There is a saving of administration or collection cost.

Disadvantages Of Factoring
The following are the disadvantages:
 Factor collecting the money on behalf of the company can lead
to stress in the company and the client relationships.
 The cost of factoring is very high.
 Bad behavior of factor with the debtors can hamper
the goodwill of the company.
 Factors often avoid taking responsibility for risky debtors. So
the burden of managing such debtor is always in the company.
 The company needs to show all details about company
customers and sales to factor.

References:
Financial Management – Khan & Jain – 6th edition
Financing Current Assets

Sources of Current Asset Financing

Cash credit and overdraft

Cash credit and overdraft are two types of short-term financing that
financial institutions provide to their customers. Both are used to prevent
checks from bouncing or debit cards from being declined when there are
insufficient funds in checking accounts. The primary difference between
these forms of borrowing is how they are secured.

Business accounts are more likely to receive cash credit, and it typically
requires collateral in some form. Overdrafts, on the other hand, allow
account holders to have a negative balance without incurring a large
overdraft fee.

Acceptance of a Bill of Exchange

A bill of exchange is a written document that serves as an order or a

promissory note obliging a buyer (known in this process as the drawee) to
make a specified payment to the payee. The acceptance of a Bill of
Exchange is a procedure that involves the acceptance of a seller’s bill of
exchange by the drawee. The drawee often finalizes his acceptance by
signing under the words ‘accepted’ on the face of the bill, which essentially
turns him into an acceptor. Post acceptance, the bill of exchange is
converted into a post-dated check that places an unconditional obligation on
the part of the acceptor to make the payment on or before its maturity date.

Commercial paper

Commercial paper is a commonly used type of unsecured, short-term debt

instrument issued by corporations, typically used for the financing of
payroll, accounts payable and inventories, and meeting other short-term
liabilities. Maturities on commercial paper typically last several days, and
rarely range longer than 270 days.1 Commercial paper is usually issued at a
discount from face value and reflects prevailing market interest rates.

A major benefit of commercial paper is that it does not need to be registered

with the Securities and Exchange Commission (SEC) as long as it matures
before nine months, or 270 days, making it a very cost-effective means of
financing. Although maturities can go as long as 270 days before coming
under the purview of the SEC, maturities for commercial paper average
about 30 days, rarely reaching that threshold. 1
The proceeds from this type of financing can only be used on current
assets, or inventories, and are not allowed to be used on fixed assets, such
as a new plant, without SEC involvement.

Trade credit

A trade credit is a business-to-business (B2B) agreement in which a

customer can purchase goods on account without paying cash up front,
paying the supplier at a later scheduled date. Usually businesses that
operate with trade credits will give buyers 30, 60, or 90 days to pay, with the
transaction recorded through an invoice. Trade credit can be thought of as a
type of 0% financing, increasing a company’s assets while deferring payment
for a specified value of goods or services to some time in the future and
requiring no interest to be paid in relation to the repayment period.

Factoring Services

Introduction
Debtor’s Management has been one of the major aspects of working capital
management besides cash and inventory management. As the accounts
receivable amount to the blocking of the firm‘s funds, the need for an outlet
to impart these liquidity is obvious. Other than the lag between the date of
sale and the date of receipt of dues, collection of receivables involves a cost
of inconvenience associated with tapping every individual debtor. Thus, if
the firm could contract out the collection of accounts receivable it would be
saved from many things such as administration of sales ledger, collection of
debt and the management of associated risk of bad-debts etc.

Factoring is a type of financial service which involves an outright sale of the

receivables of a firm to a financial institution called the factor which
specialises in the management of trade credit. Under a typical factoring
arrangement, a factor collects the accounts on the due dates, effects
payments to the firm on these dates (irrespective of whether the customers
have paid or not) and also assumes the credit risks associated with the
collection of the accounts. As such factoring is nothing but a substitute for
in-house management of receivables. A factor not only enables a firm to get
rid of the work involved in handling the credit and collection of receivables,
but also in placing its sales in effect on cash basis.

Origin
Factoring has a long and fascinating history and the word factor has its
etymological origin in the Latin word ―Facere which means to make or do,
i.e. to get things done. During 15th and 16th centuries, factors were
appointed
by manufacturers in England, France and Spain in order to arrange for
sales and distribution of then goods in the colonies in the New World. The
first credit factors in modern times were textile agents in the eighteenth
century. Thus, the earlier factors used to provide services under marketing,
distribution, administration and finance. From 1920s however the factors
began to specialise in performing the credit and collection function for their
clients.

Definition and functions

Factoring may be defined as a relationship between the financial institution
or banker (factor) and a business concern (the supplier) selling goods or
providing
services to trade customers (the customer) whereby the factor purchases
book debts with or without recourse (with a recourse‘ means that in the
event of bad debts factor can approach the supplier‘) to the supplier and in
relationship thereto controls the credit extended to the customers and
administers the sales ledger of the supplier.‖
Though the purchase of book debts is fundamental to the functioning of
factoring, there are a number of functions associated with this unique
financial service. A proper appreciation of these functions would enable one
to distinguish it from the other sources of finance against receivables. They
are:
- assumption of credit and collection function;
- credit protection;
- encashing of receivables;
- collateral functions such as:
(d) loans on inventory,
(e) loans on fixed assets, other security and on open credit,
(f) advisory services to clients.

Factoring vs. Accounts Receivable Loans

Accounts receivable loan is simply a loan secured by a firm‘s accounts
receivable by way of hypothecation or assignment of such receivables with
the power to collect the debts under a power of attorney. In case of factoring
however, there is an outright sale of receivables. Thus in case of the former,
the bank may debit client‘s account for ‗handling charges‘ if the debt turns
out to be bad as against non-recourse factoring.

Factoring vs. Bill Discounting

Under a bill discounting arrangement, the drawer undertakes the
responsibility of collecting the bills and remitting the proceeds to the
financing agency, whereas under factoring agreement, the factor collects
client‘s bills. Moreover, bill discounting is always with recourse whereas
factoring can be either with recourse or without recourse. The finance house
discounting bills does not offer any non-financial services unlike a factor
which finances and manages the receivables of a client.

Mechanics of factoring
Factoring offers a very flexible mode of cash generation against receivables.
Once a line of credit is established, availability of cash is directly geared to
sales so that as sales increase so does the availability of finance. The
dynamics of factoring comprises of the sequence of events outlined in figure.
(2) Seller (client) negotiates with the factor for establishing factoring
relationship.
(3) Seller requests credit check on buyer (client).
(4) Factor checks credit credentials and approves buyer. For each approved
buyer a credit limit and period of credit are fixed.
(5) Seller sells goods to buyer.
(6) Seller sends invoice to factor. The invoice is accounted in the buyers
account in the factor‘s sales ledger.
(7) Factor sends copy of the invoice to buyer.
(8) Factor advices the amount to which seller is entitled after retaining a
margin, say 20%, the residual amount paid later.
(9) On expiry of the agreed credit period, buyer makes payment of invoice
to the factor.
(10)Factor pays the residual amount to seller.

Types of factoring
Type of Avail- Protection* Credit Sales Collection Disclosure
Factoring ability against bad Advice Ledger Customers
of debts Adminis-
Finance tration
Full Yes Yes Yes Yes Yes Yes
Source
(Non-
Recourse)
Recourse Yes - Yes Yes Yes Yes
Factoring

Agency Yes Possible - No No Yes

Factoring

Bulk Yes Possible - No No Yes

Factoring
Banking Norms and Macro Aspect of Working Capital Management

Commercial banks grant working capital advances by way of cash credit

limits and are the major suppliers of working capital to trade and industry.
In the past, the practices in commercial banks as revealed by the findings of
different Study Groups appointed by RBI were as follows:
The current limit was related to the security offered by the clients of banks
without assessing financial position of the borrower through cash flow
analysis. Short-term advances were not utilised for short-term purposes and
defeated their self liquidating objective. In large number of accounts, no
credit balance existed nor was the debit balance fully wiped out over a
period of years because withdrawals were more than deposits.

To control the tendency of over-financing and the diversion of the banks

funds, Daheja Study Group (National Credit Council constituted in 1968
under the Chairmanship of V.T. Daheja) made recommendations for the
banking system to finance industry on the basis of a total study of the
borrower‘s operations rather than on security considerations. Further,
present as well as future cash credit accounts should be distinguished as
between the hard core and the short-term components. The hard core
should represent the minimum level of raw materials, finished goods and
stores which the industry required to hold in order to maintain a given level
of production, and the bank finance should be provided on strong financial
basis as term loan and be subjected to regular repayment schedule whereas
short- term component of the account would represent the requirement of
funds for temporary purposes i.e. a short term increase in inventories, tax,
dividends and bonus payments, etc. the borrowing being adjsuted in a short
period out of sales.

Although the above recommendations were implemented but no

improvement was noticed in money drain to strong industrial groups by
banks and RBI appointed another study group under the chairmanship of
Shri P.L. Tandon in August 1975. Tandon committee made certain
recommendations inter alia comprising of recommendations on norms for
inventory and receivables for 15 major industries, new approach to bank
lending, style of lending credit, information system and follow up,
supervision and control and norms of capital structure. A brief appraisal of
the Tandon committee recommendations would prove more enlightening as
given below:

(iii) Norms for inventory and receivables recommended by Tandon

Committee for 15 major industries, cover about 50 per cent of industrial
advances of banks. These norms were arrived at after examining the trends
reflected in the company finance studies conducted by the Reserve Bank of
India and detailed discussion with representatives and experts of the
industries concerned.
(iv) Bank lending: The Committee introduced the concept of working capital
gap. This gap arised due to the non-coverage of the current assets by the
current liabilities other than bank borrowings. A certain portion of this gap
will be filled up by the borrower‘s own funds and long-term borrowings. The
Committee developed three alternatives for working out the maximum
permissible level of bank borrowings:

2. 75% of the working capital gap will be financed by the bank i.e.

Total Current assets

Less: Current Liabilities other than Bank Borrowings

= Working Capital Gap.

Less: 25% of Working Capital gap from long-term sources.

3. Alternatively, the borrower has to provide for a minimum of 25% of the

total current assets out of long-term funds and the bank will provide the
balance. The total current liabilities inclusive of bank borrowings will not
exceed 75% of the current assets:

Total Current Assets

Less: 25% of current assets from long-term sources.

Less: Current liabilities other than Bank borrowings

= Maximum Bank Borrowing permissible.

4. The third alternative is also the same as the second one noted above
except that it excludes the permanent portion of current assets from the
total current assets to be financed out of the long-term funds, viz.

Total Current assets

Less: Permanent portion of current assets

Real Current Assets

Less: 25% of Real Current Assets

Less: Current liabilities other than Bank Borrowings

Maximum Bank Borrowing permissible.

Thus, by following the above measures, the excessive borrowings from

banks will be gradually eliminated and the funds could be put to more
productive purposes.

The above methods may be reduced to equation as under:

1st Method : PBC = 0.75 (CA – CL)

2nd Method : PBC = 0.75 CA – (CL)

3rd Method : PBC = 0.75 (CA – CCA) – (CL)

Where,

PBC stands for Permissible Bank Credit

CA stands for Total Current Assets

CL stands for Other Current Liabilities (i.e. Current Liabilities other than
Bank Borrowings)

CCA stands for Amount required to finance Core Current Assets.

The three alternative methods mentioned above may be illustrated by taking

the following figures of a borrower‘s financial position, projected at the end
of next year.

Q. From the following information, calculate maximum permissible bank

finance under the three methods of permissible bank finance;

Liabilities;

Creditors – 1,20,000, Other Current Liabilities – 40,000, Bank Borrowing –

2,50,000

Assets:

Raw Material – 1,80,000, WIP – 60,000, Finished Goods – 1,00,000, Debtors

– 1,50,000

Other Current Assets – 20,000

Core Current assets – 2,00,000

Ans: Maximum Bank Borrowing permissible by alternate methods of Bank

Finance.

1st Method :

Current Liabilities = Creditors + Other Current Liabilities

= 1,20,000 + 40,000 = 1,60,000

Current Assets = RM + WIP + FG + Debtors + Other CA

= 1,80,000+60,000+1,00,000+1,50,000+20,000 = 5,10,000

PBC = 0.75 (CA – CL) = 0.75* (5,10,000 – 1,60,000) = 2,62,500

2nd Method :

PBC = 0.75 CA – (CL)

PBC = 0.75 * (5,10,000) – 1,60,000 = 2,22,500

3rd Method :

PBC = 0.75 (CA – CCA) – (CL)

PBC = 0.75 (5,10,000 – 2,00,000) – (1,60,000) = 72,500

Source: Institute of Company Secretaries Financial Management Module

References:
Institute of Company Secretaries Financial Management Module

https://www.investopedia.com/
 Treasury Management And Control

Cash management is one of the key areas of working capital management.

Apart from the fact that it is the most liquid current asset, cash is the
common denominator to which all current assets can be reduced because
the other major liquid assets, that is, receivables and inventory get
eventually converted into cash. Cash is the ready currency to which all
liquid assets can be reduced. Cash management, also known as treasury
management, is the process that involves collecting and managing cash
flows from the operating, investing, and financing activities of a company. In
business, it is a key aspect of an organization’s financial stability.

III. Why is Cash important?

Cash is the primary asset individuals and companies use regularly to settle
their debt obligations and operating expenses, e.g., taxes, employee salaries,
inventory purchases, advertising costs, and rents, etc. Cash is used as
investment capital to be allocated to long-term assets, such as property,
plant and equipment and other non-current assets. Excess cash after
accounting for all expenses often goes towards dividend distributions.
Companies have a multitude of cash inflows and outflows that must be
prudently managed in order to meet payment obligations, plan for future
payments and maintain adequate business stability. The efficient
management of cash is crucial to the solvency of the firm and cash is
generally referred to as the “life blood of a business enterprise.

IV. Nature of Cash

The term ‘cash’ with reference to cash management is used in two senses. In
a narrow sense, it is used broadly to cover currency and generally accepted
equivalents of cash, such as cheques, drafts and demand deposits in banks.
Cash is the ready currency to which all liquid assets can be reduced . The
broad view of cash also includes near-cash assets, such as marketable
securities and time deposits in banks. Near cash implies marketable
securities viewed the same way as cash because of their high liquidity.
Marketable securities are short-term interest earning money market
instruments used by firms to obtain a return on temporarily idle funds. The
main characteristics of these is that they can be readily sold and converted
into cash. They serve as a reserve pool of liquidity that provides cash quickly
when needed. They also provide a short-term investment outlet for excess
cash and are also useful for meeting planned outflow of funds.

V. Motives for Holding Cash

Cash itself does not produce goods or services. It is used as a medium to
acquire other assets. It is the other assets which are used in manufacturing
goods or providing services. Irrespective of the form in which it is held, a
distinguishing feature of cash, as an asset, is that it has no earning power.
Despite cash not generating any return per se, businesses need to hold
cash. There are four primary motives for maintaining cash balances:
(i) Transaction motive
(ii) Precautionary motive
(iii) Speculative motive
(iv) Compensating motive

Transaction motive
This refers to the holding of cash to meet routine cash requirements to
finance the transactions which a firm carries on in the ordinary course of
business. A firm needs cash for making transactions in the day to day
operations. Cash is needed to make purchases, pay expenses, taxes,
interest, dividend, etc. Similarly, there is a regular inflow of cash to the firm
from sales operations, returns on outside investments, and so on. These
receipts and payments constitute a continuous two-way flow of cash. The
need for cash as a buffer arises due to the fact that there is no complete
synchronization between cash receipts and payments. Sometimes cash
receipts exceed cash payments or vice-versa. Thus, to ensure that the firm
can meet its obligations in a situation in which disbursements are in excess
of the current receipts, it must have an adequate cash balance.

Precautionary Motive
A firm is required to keep cash for meeting various contingencies. Firms
hold cash to meet uncertainties, emergencies, running out of cash and
fluctuations in cash balances. The future cash flows and the ability to
borrow additional funds at short notice are often uncertain. Sometimes,
uncertainty can result in prolongation or disruption of operating cycle. The
cash balances held in reserve for such random and unforeseen fluctuations
in cash flows i.e. to meet unexpected contingencies are called as
precautionary balances. The more unpredictable are the cash flows, the
larger is the need for such balances.

Speculative Motive
It refers to the desire of a firm to take advantage of opportunities which
present themselves at unexpected moments and which are typically outside
the normal course of business. While the precautionary motive is defensive
in nature, the speculative motive represents a positive and aggressive
approach. The speculative motive helps to take advantage of an opportunity
to purchase raw materials at a reduced price on payment of immediate cash;
a chance to speculate on interest rate movements by buying securities when
interest rates are expected to decline; delay purchases of raw materials on
the anticipation of decline in prices; and make purchase at favourable
prices.
 Compensating Motive
This is a motive for holding cash/ near-cash to compensate banks for
providing certain services or loans. Usually clients are required to maintain
a minimum balance of cash at the bank. Since this balance cannot be
utilised by the firms for transaction purposes, the banks themselves can use
the amount to earn a return. Such balances are compensating balances.
These are also required by some loan agreements between a bank and its
customers.

VI. Cost Benefit analysis of Cash Management

Cash is a non-earning asset, therefore the Finance Manager should take
care to minimise the assets in the form of cash. Surplus balance of cash can
be suitably invested in liquid, short-term and long-term investments as per
the policy of the company. The cost of holding cash is the loss of interest
that would be earned if the cash is invested profitably elsewhere. The cost of
surplus cash is the cost of interest/ opportunities foregone. The cost of
shortage of cash is measured as the cost of raising finance or ultimately as
the cost of bankruptcy or restructuring. Cash shortages can result in
suboptimal investment decisions and suboptimal financing decisions.

VII.Objectives of Cash Management

The basic objectives of cash management are two-fold:
(b) to meet the cash disbursement needs (payment schedule) - i.e. to have
sufficient cash to fulfill working capital requirement, capital expenditure,
handle unforeseen contingencies, in general to avoid insolvency
(c) to minimise funds committed to cash balances
In minimising the cash balances, two conflicting aspects have to be
reconciled. A high level of cash balances will ensure prompt payment
together with all the advantages. But it also implies that large funds will
remain idle, as cash is a non-earning asset and the firm will have to
forego profits. A low level of cash balances, on the other hand, may mean
failure to meet the payment schedule. The aim of cash management,
therefore, should be to have an optimal amount of cash balances.

IX. Cash Management Strategies

Broad cash management strategies are essentially related to the cash
turnover process, that is, the cash cycle together with the cash turnover.
The cash cycle refers to the process by which cash is used to purchase
materials from which are produced goods, which are then sold to
customers, who later pay the bills. The firm receives cash from customers
and the cycle repeats itself. The cash turnover means the number of
times cash is used during each year. Cash management strategies are
intended to minimise the operating cash balance requirement. The basic
strategies that can be employed to do the needful are as follows:
(a) Stretching Accounts Payable
(b) Efficient Inventory-Production Management
(c) Speeding collection of Accounts Receivable

Stretching Accounts Payable

One basic strategy of efficient cash management is to stretch the
accounts payable. In other words, a firm should pay its accounts payable
as late as possible without damaging its credit standing. It should,
however, take advantage of the cash discount available on prompt
payment.

Efficient Inventory-Production Management

Another strategy is to increase the inventory turnover, avoiding stock-
outs, that is, shortage of stock. This can be done in the following ways:
 Increasing the raw materials turnover by using more efficient
inventory control techniques
 Decreasing the production cycle through better production planning,
scheduling and control
 techniques; it will lead to an increase in the work-in-progress
inventory turnover
 Increasing the finished goods turnover through better forecasting of
demand and a better planning of production.

Speeding Collection of Accounts Receivable

Yet another strategy for efficient cash management is to collect accounts
receivable as quickly as possible without losing future sales because of
high-pressure collection techniques. The average collection period of
receivables can be reduced by changes in (i) credit terms, (ii) credit
standards and (iii) collection policies.

Combined Cash Management Strategies

An effective combination of the above-mentioned strategies will optimize
the cash balance.

The three basic strategies of cash management, related to accounts

payable, inventory, and accounts receivable, lead to a reduction in the
cash balance. But, they imply certain problems for the management.
First, if the accounts payable are postponed too long, the credit standing
of the firm may be adversely affected. Secondly, a low level of inventory
may lead to a stoppage of production as sufficient raw materials may not
be available for uninterrupted production, or the firm may be short of
enough stock to meet the demand for its product, that is, ‘stock-out’.
Finally, restrictive credit standards, credit terms and collection policies
may jeopardize sales. These implications should be constantly kept in
view while working out cash management strategies.
X. Causes of Problems with Cash Management

Unfortunately, many businesses engage in poor cash management, and

there are several reasons for the problem. Some of them are as follows:
1. Poor understanding of the cash flow cycle
Business management should clearly understand the timing of cash
inflows and outflows from the entity, such as when to pay for accounts
payable and purchase inventory. During rapid growth, a company can
end up running out of money because of over-purchasing inventory, yet
not receiving payment for it from their debtors.
2. Lack of understanding of profit versus cash
A company can generate profits on its income statement and be burning
cash on the cash flow statement. When a company generates revenue, it
does not necessarily mean it already received cash payment for that
revenue. So, a very fast-growing business that requires a lot of inventory
may be generating lots of revenue but not receiving positive cash flows on
it.
3. Lack of cash management skills
It is crucial for managers to acquire the necessary skills despite the
understanding of the above-mentioned issues. The skills involve the
ability to optimize and manage the working capital. It can include
discipline and putting the proper frameworks in place to ensure the
receivables are collected on time and that payables are not paid more
quickly than is needed.
4. Bad capital investments
A company may allocate capital to projects that ultimately do not
generate sufficient return on investment or sufficient cash flows to justify
the investments. If such is the case, the investments will be a net drain
on the cash flow statement, and eventually, on the company’s cash
balance.

Determining Optimum Cash Balance:

 Optimum Cash Balance under Certainty: Baumol’s Model
 Optimum Cash Balance under Uncertainty: The Miller–Orr Model

Baumol’s Model

Assumptions
 The firm is able to forecast its cash needs with certainty.
 The firm’s cash payments occur uniformly over a period of time.
 The opportunity cost of holding cash is known and it does not change
over time.
 The firm will incur the same transaction cost whenever it converts
securities to cash.
The Model
The firm incurs a holding cost for keeping the cash balance. It is an
opportunity cost; that is, the return foregone on the marketable
securities. If the opportunity cost is k, then the firm’s holding cost for
maintaining an average cash balance is as follows:
Holding Cost=k(C/2)
The firm incurs a transaction cost whenever it converts its marketable
securities to cash. Total number of transactions during the year will be
total funds requirement, T, divided by the cash balance, C, i.e., T/C. The
per transaction cost is assumed to be constant. If per transaction cost is
c, then the total transaction cost will be:
Transaction cost=c(T/C)
The total annual cost of the demand for cash will be:
Total Cost=k(C/2) +c(T/C)
The optimum cash balance, C*, is obtained when the total cost is
minimum. The formula for the optimum cash balance is as follows:

2cT
C*
k

Baumol's model for cash balance

Cost trade-off: Baumol's model

For Example, the outgoings of Gemini Ltd. are estimated to be Rs. 5,00,000
per annum, spread evenly throughout the year. The money on deposit earns
12% p.a. more than money in a current account. The switching costs per
transaction is Rs. 150. Calculate the optimum amount to be transferred.
Solution:
According to Baumol, the optimum amount to be transferred each time
is ascertained as follows:
Where,
C = Optimum transaction size
A = Estimate cash outgoings per annum Le. Rs. 5,00,000
T = Cost per transaction Le. Rs. 150
I = Interest rate on fixed deposit Le. 12% p.a.

Number of transactions p.a. = Rs. 5,00,000/Rs. 35,000 = 14 transactions

Miller-Orr Model:
The MO model provides for two control limits–the upper control limit and the
lower control limit as well as a return point.
If the firm’s cash flows fluctuate randomly and hit the upper limit, then it
buys sufficient marketable securities to come back to a normal level of cash
balance (the return point).
Similarly, when the firm’s cash flows wander and hit the lower limit, it sells
sufficient marketable securities to bring the cash balance back to the
normal level (the return point).

The difference between the upper limit and the lower limit depends on the
following factors:
 the transaction cost (c)
 the interest rate, (i)
 the standard deviation (s) of net cash flows.
The formula for determining the distance between upper and lower control
limits (called Z) is as follows:
1/ 3
(Upper Limit – Lower Limit) = (3/ 4 × Transaction Cost × Cash Flow Variance/ Interest Rate)

Upper Limit= Lower Limit+3Z

Return Point= Lower Limit+Z

The net effect is:

Average Cash Balance= Lower Limit+4/3Z

For Example: Interest rate per day/annum = 0.3%/10.95%

Transaction cost per sale = Rs.20
Variance of cash flows per day/annum = Rs. 3,000/Rs. 90,00,000
Cash balance lower limit = Rs. 20,000
Therefore, the upper limit is equal to the lower limit of Rs. 20,000 plus the
spread of a Rs. 23,000 i.e., Rs. 43,000.
The return point is equal to the lower limit of Rs. 20,000 plus the spread of
Rs. 23,000/3 i.e., Rs. 20,000 + Rs. 23,000/3 = Rs. 27,667.
Therefore, the firm’s cash management policy should be based on lower and
upper control limits of Rs. 20,000 and Rs. 43,000 respectively and the need
to initiate action to keep will arise if it moves outside this band.

References:
https://corporatefinanceinstitute.com/resources/knowledge/finance/cash-
management/
https://www.investopedia.com/terms/c/cash-management.asp
https://www.accountingnotes.net/firm/motives-for-holding-cash-balances-
in-a-firm-5-motives/11106
https://www.yourarticlelibrary.com/accounting/working-capital-
management/cash-nature-and-motives-for-holding-it-working-
capital/68146
Financial Management – Ravi M Kishore – 7th edition
Financial Management – Khan & Jain – 6th edition
Financial Management- I. M Pandey: 11th Edition