Financial Management

FINANCIAL MANAGEMENT
(FOR PRIVATE CIRCULATION ONLY)

2018
PROGRAMME COORDINATOR
Dr. Padmpriya Irabatti
COURSE DESIGN AND REVIEW COMMITTEE

Dr. Shirish Limaye Dr. N.M. Vechlekar
Dr. Bhama Venketraman Prof. Abhinav D. Jog
Prof. Sudhir Gijre Prof. Arun Vartak
Dr. Ravi Chitnis Prof. Prashant Ubarhande
COURSE WRITER
Dr. Satish Inamdar
EDITOR
Ms. Neha Mule
Published by Symbiosis Centre for Distance Learning (SCDL), Pune

July, 2011 (Revision 03, 2018)
Copyright © 2018 Symbiosis Open Education Society

All rights reserved. No part of this book may be reproduced, transmitted or utilised in any form or by any
means, electronic or mechanical, including photocopying, recording or by any information storage or retrieval
system without written permission from the publisher.
Acknowledgement
Every attempt has been made to trace the copyright holders of materials reproduced in this book. Should any
infringement have occurred, SCDL apologises for the same and will be pleased to make necessary corrections
in future editions of this book.
PREFACE
Finance is the most basic and the most significant function in virtually every business activity. The
success of business activity depends upon the success of its finance function. From academic point of
view, finance is the subject, which is considered to be one of the most technical ones, having a very
wide scope and having constantly changing rules and regulations. This is the reason a normal student
attempts to keep himself away from the subject of finance. This aggravates the problems for the
students. One cannot afford to ignore the function of finance. The ultimate evaluation of any business
activity is profit-based evaluation and the term profit itself is a financial phenomenon. As such, one
needs to be acquainted with the basics of finance, despite the hardships involved in the process.
My objective of writing this book is to introduce the basic principles of finance to a non-technical
student in the simplest possible language. As such, I have deliberately avoided too much of quantitative
or mathematical elaboration or explanation to any of the basic concepts or principles. I have attempted
to explain the basic concepts with the help of examples and illustrations. Good numbers of problems
have been incorporated for self study.
I am thankful to Symbiosis Centre for Distance Learning for providing me this opportunity to reach
out to a very wide spectrum of readership. Maximum efforts have been made to incorporate the latest
status of the subject and to make the text free of errors. Still, if any omissions are pointed out and
intimated, necessary modifications can be made in the subsequent editions.
Dr. Satish Inamdar
iii
ABOUT THE AUTHOR
Dr. Satish Inamdar holds a Master’s Degree in Commerce and Bachelor’s Degree in Law. He has
completed his Ph.D. in Management. He has done his research in the subject of Urban Co-operative
Banks. He is Fellow Member of the Institute of Chartered Accountants of India, Associate Member
of The Institute of Cost and Works Accountants of India and Associate Member of The Institute of
Company Secretaries of India. He is associated with the industry for almost three decades in various
senior capacities.
He has been working as the Director at Balaji Institute of international Business since 2007. Before that,
he was associated with Symbiosis Institute of Business Management as a Faculty of Finance for close
to two decades. He has conducted Management Development Programmes and Executive Development
Programmes for various private sector and public sector organisations. He has authored six books on
the subjects like Cost and Management Accounting, Financial Management and Management Control
Systems. He is the Charter Member of Rotary Club of Pune, Kothrud.
iv
CONTENTS
Unit No. TITLE Page No.

1 Finance Function 1 - 18
1.1 Introduction
1.2 Approaches to the Term Finance
1.3 Scope of Finance Function
1.4 Goals/Objectives of Finance Function
1.5 Organisation of Finance Function
1.6 Duties and Responsibilities of Finance Executive
1.7 The Fields of Finance
1.8 Finance Function in Relation with Other Functions
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
2 Forms of Business Organisation 19 - 30
2.1 Introduction
2.2 Proprietary Firms
2.3 Partnership Firms
2.4 Joint Stock Companies
Summary
Key Words
Suggested Reading
3 Financial Statements 31 - 54
3.1 Introduction
3.2 Nature of Financial Statements
3.3 Basic Concepts in Accounting
3.4 Structure of Financial Statements
3.5 Role Played by Financial Statements
3.6 Limitations of Financial Statements
3.7 Analysis and Interpretation of Financial Statements
Summary
Key Words
Suggested Reading
v
4 Interpretation of Financial Statements (Ratio Analysis) 55 - 88
4.1 Introduction
4.2 Interpretation of Ratios
4.3 Role of Ratio Analysis
4.4 Classifications of Ratios
4.5 Limitations of Ratio Analysis
4.6 Illustrative Problems
Summary
Key Words
Suggested Reading
5 Interpretation of Financial Statements (Funds Flow/Cash Flow 89 - 106
Statements)
5.1 Introduction
5.2 Concept of Funds
5.3 Construction of Funds Flow Statement
5.4 Cash Flow Statement
5.4.1 Key Difference between Funds Flow and Cash Flow Statements
5.6 Interpretation of Funds Flow Statement
Summary
Key Words
Suggested Reading
6 Capitalisation 107 - 120
6.1 Introduction
6.2 Theories of Capitalisation
6.3 Overcapitalisation
6.4 Undercapitalisation
6.5 Overcapitalisation vs. Undercapitalisation
6.6 Watered Stock/Watered Capital
6.7 Watered Capital vs. Overcapitalisation
Summary
Key Words
Suggested Reading
vi
7 Sources of Long-Term and Medium Term Finance 121 – 148
7.1 Introduction
7.2 Shares
7.3 Debentures
7.4 Term Loans
7.5 Public Deposits
7.6 Lease Financing
7.7 Hire Purchasing
7.8 Retained Earnings
Summary
Key Words
Suggested Reading
8 Capital Structure 149 – 170
8.1 Introduction
8.2 Goals/Principles of Capital Structure Management
8.3 Factors affecting Capital Structure
8.4 Cost of Capital
8.5 Importance and Measurement of Cost of Capital
8.6 Composite Cost of Capital
Summary
Key Words
Suggested Reading
9 Leverages and Theories of Capital Structure 171 – 190
9.1 Introduction
9.2 Concept of Leverages
9.3 Leverages
9.4 Theories of Capital Structure
Summary
Key Words
Suggested Reading
vii
10 Capital Market 191 – 214
10.1 Introduction
10.2 SEBI Guidelines for Public Issue and Rights Issue
10.3 SEBI Guidelines for the Issue of Debt Instruments
10.4 Intermediaries in Capital Market
10.5 Recent Trends in Capital Market
10.6 Credit Rating
10.7 Buyback of Shares
10.8 Venture Capital
Summary
Key Words
Suggested Reading
11 Capital Budgeting 215 – 246
11.1 Introduction
11.2 The Process of Capital Budgeting
11.3 How to Compute Cash Flows
11.4 Time Value of Money
11.5 Techniques for Evaluation of Capital Expenditure Proposals
11.6 Limitations of Capital Budgeting
11.7 Evaluation Criteria in Certain Typical Situations
11.8 Planning, Organisation and Control of Capital Expenditure
11.9 Capital Rationing
11.10 Capital Budgeting and Risk
Summary
Key Words
Problems
Suggested Reading
viii
12 Working Capital Management 247 – 274
12.1 Introduction
12.2 Working Capital – The Term
12.3 Principles of Working Capital Management
12.4 Factors affecting Working Capital Requirement
12.5 Financing of Working Capital Requirement
12.6 Control over Working Capital
Summary
Key Words
Suggested Reading
13 Management of Cash 275 – 288
13.1 Introduction
13.2 Motives of Holding Cash
13.3 Estimating the Cash Requirements
13.4 Principles of Cash Management
13.5 Concept of Float
Summary
Key Words
Suggested Reading
14 Management of Receivables 289 – 306
14.1 Introduction
14.2 Objectives of Management of Receivables
14.3 Float in Receivables Management
14.4 Areas Covered by Receivables Management
14.5 Factoring
Summary
Key Words
Suggested Reading
ix
15 Management of Inventory 307 – 328
15.1 Introduction
15.2 Motives of Holding Inventory
15.3 Objectives of Inventory Management
15.4 Techniques of Inventory Management
15.5 Calculation of Various Levels
Summary
Key Words
Suggested Reading
16 Dividend Policy 329 – 344
16.1 Introduction
16.2 Importance of Dividend Policy
16.3 Approaches to Dividend Policy
16.4 Factors Determining Dividend Policy
16.5 Choosing the Dividend Policy
16.6 Forms of Dividend Payment
Summary
Key Words
Suggested Reading
x
Finance Function
UNIT
1
Structure:
1.1 Introduction
1.2 Approaches to the Term Finance
1.3 Scope of Finance Function
1.4 Goals/Obectives of Finance Function
1.5 Organisation of Finance Function
1.6 Duties and Responsibilities of Finance Executive
1.7 The Fields of Finance
1.8 Finance Function in Relation with Other Functions
Summary
Key Words
Suggested Reading
Finance Function 1
Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Define the concept and purpose of financial management
----------------------
• Explain scope and role of finance function in a business organisation
---------------------- • Underline various activities that come under the ambit of finance
function
----------------------
• Identify the goals of financial management
----------------------
---------------------- 1.1 INTRODUCTION

---------------------- A business is an activity, which is carried on with the intention of earning
profits. If the operations of a typical manufacturing organisation are considered,
---------------------- it involves the purchasing of raw material, processing the same with the help
---------------------- of various factors of production like labour and machinery, manufacturing the
final product and selling the finished product in the market to earn the profits.
---------------------- Thus, production, marketing and finance are the key operational areas in case of
a manufacturing organisation, out of which finance, is the most crucial one. This
---------------------- is so, as the functions of production and marketing are related with the function
---------------------- of finance. If the decisions relating to money or funds fail, it may result into the
failure of the business organisation as a whole. Hence, it is utmost important
---------------------- to take the proper financial decisions and that too at a proper point of time.
In practical situations, in order to overcome temporary financial problems, the
---------------------- organisations tend to take hasty decisions, which may prove to be fatal over a
---------------------- longer span of time.
---------------------- 1.2 APPROACHES TO THE TERM FINANCE

---------------------- The concept of finance has changed markedly with the change in times and
---------------------- circumstances. The various approaches on finance can be categorised as stated
below.
---------------------- 1. According to the first approach, the term finance was interpreted to mean
---------------------- the procurement of funds by corporate enterprises to meet their financing
needs. The term ‘procurement’ was used in a broad sense to include the
---------------------- whole gamut of raising the funds externally.
---------------------- This approach towards finance was criticised on various grounds.
a. It is too narrow and restrictive in nature. Procurement of the funds is
----------------------
only one of the functions of finance and other functions are ignored by
---------------------- this approach.
----------------------
----------------------
2 Financial Management
b. It considers the financial problems only of corporate enterprises. In Notes
that sense, it ignores the financial problems of non-corporate entities
like proprietary concerns, partnership firms etc. ----------------------
c. It considers only the basic and non-recurring problems relating to the ----------------------
business. Day-to-day financial problems of a normal company do not
receive any attention. ----------------------
d. It concentrates only on long-term financing. It means that the working ----------------------
capital management is out of the purview of finance function.
----------------------
2. The second approach holds that finance is concerned with cash. As all the
transactions are ultimately expressed in terms of cash, the term finance will ----------------------
be concerned with every activity of the enterprise. Thus, according to this
approach, the finance function is concerned with all the functional areas of ----------------------
the business for example, Production, Marketing, Purchasing, Personnel
----------------------
Administration, Research and Development and so on. Obviously, this
approach is too broad to be meaningful. ----------------------
3. The third approach, which is a more balanced one and hence the acceptable ----------------------
one to the modern scholars, interprets the term finance as being concerned
with procurement of funds and wise application of funds. This approach is ----------------------
supposed to be more acceptable as it gives equal weightage to procurement
of funds as well as utilisation of the funds. This approach is called the ----------------------
managerial approach to the term finance. ----------------------
In the light of the above discussions, it will be worthwhile to note some of the
definitions of the finance function given by some modern scholars. ----------------------
R.C. Osborn: The finance function is the process of acquiring and utilising ----------------------
funds of a business.
----------------------
Bonneville and Dewey: Financing consists of the raising, providing, managing
of all the money, capital or funds of any kind to be used in connection with the ----------------------
business.
----------------------
Prather and Wert: Business finance deals primarily with raising, administering
and disbursing funds by privately owned business units operating in non- ----------------------
financial fields of industry.
----------------------
Check your Progress 1 ----------------------
----------------------
Multiple Choice Single Response.
----------------------
1. Wrong decisions relating to finance adversely affect
i. Finance department ----------------------
ii. Marketing department ----------------------
iii. Production department ----------------------
iv. All the above departments
----------------------
Finance Function 3
Notes
2. According to the first approach to finance, which includes procurement
---------------------- of funds for
i. Corporate entities
----------------------
ii. Partnership firms
----------------------
iii. Sole trading organisations
---------------------- iv. None of the above
---------------------- v. i to iii above.
---------------------- 3. The first approach to finance concentrates on
i. Non-recurring problems
----------------------
ii. Day to day problems
----------------------
iii. Long-term problems
----------------------
iv. Short-term problems
---------------------- v. Working capital problems
---------------------- 4. The second approach to finance is concerned with cash. This approach is:
---------------------- i. Narrow
ii. Moderate
----------------------
iii. Broad
----------------------
iv. Too broad to be meaningful
---------------------- 5. The third approach to finance includes procurement and application of
funds. This approach is:
----------------------
i. Narrow
----------------------
ii. Moderate
---------------------- iii. Broad
---------------------- iv. Too broad to be meaningful
---------------------- v. Acceptable to the modern scholars
----------------------
Activity 1
----------------------
---------------------- Prepare a flow chart showing widening scope of finance function.
----------------------
----------------------
----------------------
----------------------
1.3 SCOPE OF FINANCE FUNCTION Notes
According to the modern approach, the function of finance is concerned with ----------------------
the following three types of decisions:
----------------------
Financing Decisions
Financing decisions are the decisions regarding the process of raising the ----------------------
funds. This function of finance is concerned with providing the answers to the ----------------------
various questions like:
----------------------
a. What should be the amount of funds to be raised? In simple words, the
amount of funds to be raised by the organisation should not be more or less ----------------------
than what is required as both the situations involve adverse consequences.
----------------------
b. What are the various sources available to the organisation for raising the
required amount of funds? For raising the funds, the organisation can go ----------------------
for internal sources as well as external sources.
----------------------
c. What should be the proportion in which the internal and external sources
should be used by the organisation? ----------------------
Investment Decisions ----------------------
Investment Decisions are the decisions regarding the application of funds
raised by the organisation. The investment decisions relate to the selection of ----------------------
the assets in which the funds should be invested. ----------------------
The assets in which the funds can be invested are basically of two types:
----------------------
a. Fixed Assets – Fixed Assets indicate the infrastructural facilities and
properties required by the organisation. Fixed Assets are the assets, which ----------------------
bring the returns to the organisation over a longer span of time. The
----------------------
investment decisions in these types of assets are technically referred to as
‘Capital Budgeting Decisions.’ ----------------------
b. Current Assets – Current Assets are the assets, which are generated
----------------------
during the course of operations and are capable of being converted in the
form of cash or being utilised within a short span of time of one year. ----------------------
Current Assets keep on changing the form and shape very frequently. The
investment decisions in these types of assets are technically referred to as ----------------------
‘Working Capital Management.’.
----------------------
Dividend Policy Decisions
----------------------
Profits earned by the organisation belong to the owners of the organisation.
In case of the corporate form of organisation, shareholders are the owners and ----------------------
they are entitled to receive the profits in the form of dividend. However, there
is no specific law or statute, which specifies as to how much amount of profits ----------------------
should be distributed by way of dividend and how much amount of profits should ----------------------
be retained in the business. The alternatives available to the organisation to
distribute the profits in the form of dividend on one hand and retention of profits ----------------------
in the business have reciprocal relationship with each other. If the dividends
paid are higher, retained profits are less and vice versa. If the organisation ----------------------
Finance Function 5
Notes pays higher dividends, shareholders are very happy as they get more recurring
income and the company may be able to gain the confidence of the shareholders.
---------------------- However, the organisation can be in financial problems as payment of dividend
results into the withdrawal of profits from the business. On the other hand, if
---------------------- the organisation pays less dividend, the organisation may be in a favourable
---------------------- situation. However, the shareholders are likely to be offended. As such, the
organisation is required to take the decisions regarding the payment of dividend
---------------------- in such a way that neither the shareholders are offended nor the organisation
is in financial problems. As such, dividend policy decisions are the strategic
---------------------- financial decisions and are concerned with the answers to the questions like:
---------------------- 1 What are the forms in which the dividends can be paid to the shareholders?
---------------------- 2 What are the legal and procedural formalities to be completed while paying
the dividend in different forms?
----------------------
---------------------- 1.4 GOALS/OBJECTIVES OF FINANCE FUNCTION
---------------------- Profit Maximisation:

As a basic principle, any business activity aims at earning profits. According
----------------------
to this principle, all the functions of the business will have the profit as the
---------------------- main objective. Similarly, the finance function will also have the profits as the
main objective. But this was only a traditional belief. Now, profit cannot be the
---------------------- sole and only goal or objective of the finance function, due to the following
problems connected with this objective.
----------------------
1. The term profit is an ambiguous concept, which is not having precise
---------------------- connotation. For example, Profits can be long-term or short-term. Profits
can be before tax or after tax and so on. If profit maximisation is accepted
----------------------
as the goal of finance function, the next question that arises is “Which
---------------------- types of profits should be maximised?”
---------------------- 2. The profits always go hand in hand with risks. The more profitable ventures
necessarily involve more amount of risk. The owners of the business will
---------------------- not like to earn more and more profits by accepting more risk. If profit
maximisation is accepted as the goal of finance function, it totally ignores
---------------------- the risk factor.
---------------------- 3. Profit maximisation as the objective does not take into consideration the
social considerations as well as the obligations to various interests of workers,
---------------------- consumers, society etc. and the ethical trade practices. If these factors are
---------------------- ignored, the organisation cannot survive for long. Profit maximisation at the
cost of social and moral obligations is a shortsighted policy.
---------------------- As such, profit maximisation cannot be a prime objective of the finance
---------------------- function. The objective has to be one having more broad a base, which is more
precise, which considers risk factor and time value of money and which gives
---------------------- consideration to social and ethical elements also. The alternative is in the form
of wealth maximisation as the objective of the finance function.
----------------------
Wealth Maximisation: Notes
Due to the limitations attached with profit maximisation as an objective of
----------------------
the finance function, it is no more accepted as the basic objective. As against it,
it is now accepted that the objective of the business should be to maximise its ----------------------
wealth and value of the shares of the company. This object can also be stated as
maximisation of value. ----------------------
The value of an asset is judged not in terms of its cost but in terms of the ----------------------
benefit it produces. Similarly, the value of a course of action is judged in terms
of the benefits it produces less the cost of undertaking it. The benefits can be ----------------------
measured in terms of stream of future expected cash flows, but they must take
----------------------
into consideration not only their magnitude but also the extent of uncertainty.
Thus, wealth maximisation goal as a decision criteria suggests that, any ----------------------
financial action which creates wealth or which has discounted stream of future
----------------------
benefits exceeding its cost, is desirable and should be accepted and that which
does not satisfy this test should be rejected. ----------------------
The goal of wealth maximisation is supposed to be superior to the goal of ----------------------
profit maximisation due to following reasons:
1. It uses the concept of future expected cash flows rather than the ambiguous ----------------------
term of profits. As such, measurement of benefits in terms of cash flows ----------------------
avoids ambiguity.
2. It considers time value of money. It recognises that the cash flows generated ----------------------
earlier are more valuable than those generated later. That is why while ----------------------
computing value of total benefits, the cash flows are discounted at a certain
discounting rate. At the same time, it recognises the concept of risk also, by ----------------------
making necessary adjustments in discounting rate. As such, cash flows of
a project involving higher risk are discounted at a higher discounting rate ----------------------
and vice versa. ----------------------
Thus, the discounting rate used to discount future cash flows reflects the
----------------------
concepts of both time and risk.
Due to the above reasons, the wealth maximisation is considered superior ----------------------
to profit maximisation as an objective or goal of finance function. However, it
----------------------
should be noted that wealth maximization goal is only an extension of profit
maximization goal. If the time is too short and risk element is minimum, both ----------------------
wealth maximisation and profit maximisation will mean the same thing.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Finance Function 7
Notes
Check your Progress 2
----------------------
---------------------- Multiple Choice Single Response.

1. Investment decisions are decisions relating to the
----------------------
i. Procurement of funds
----------------------
ii. Application of funds
---------------------- 2. Investment decisions are technically referred to as
---------------------- i. Working capital management decisions
---------------------- ii. Current assets management decisions
iii. Capital budgeting decisions
----------------------
iv. None of the above
----------------------
3. Profits of the company belong to the
---------------------- i. Company
---------------------- ii. Employees
---------------------- iii. Directors
iv. Shareholders
----------------------
4. The rate of profit to be distributed as dividend is declared by
----------------------
i. Legal provisions in Companies Act, 1956
---------------------- ii. A director
---------------------- iii. Board of Directors
---------------------- iv. Shareholders in the general meeting
5. Objective of business should be
----------------------
i. Profit maximisation
----------------------
ii. Wealth maximisation
---------------------- iii. Goodwill maximisation
---------------------- 6. Wealth maximisation and profit maximisation would mean same thing
---------------------- i. If the time period is too short and the risk is minimum
ii. If the time period is too long and the risk is maximum
----------------------
iii. If the time period is moderate and the risk is also moderate
----------------------
iv. All the above
----------------------
----------------------
Notes
Activity 2
----------------------
Meet any businessman and discuss with him the factors he considers ----------------------
challenges that he encountered while procuring and investing funds.
----------------------
1.5 ORGANISATION OF FINANCE FUNCTION ----------------------
At the outset, it must be cleared that there is no standard pattern for the ----------------------
organisation of finance function. It varies from enterprise to enterprise and its ----------------------
characteristics vary in terms of nature, size, convention etc. In smaller concerns,
where the operations are relatively less complicated and simple, there may not ----------------------
be a separate executive to look after the finance function. In fact, the proprietor
or partners only will be looking after all the functional areas like production, ----------------------
marketing, finance etc. ----------------------
In bigger concerns, the execution of finance function becomes a specialised
----------------------
task and may be handled by an executive who may be the Treasurer, Finance
Controller, Finance Manager, Vice-President (Finance) and so on. He is ----------------------
generally given the charge of credit and collection accounting, investment and
audit departments. He is responsible for preparing annual financial reports. He ----------------------
reports directly to the President and Board of Directors.
----------------------
Secondly, it should be noted that generally the organisation of finance
function is centralised one, unlike other business functions. Board of Directors ----------------------
takes the main financial decisions. Board of Directors may delegate the powers
----------------------
to the executive committee, comprising of managing director, other one or
two directors and finance officer of the company. This executive committee ----------------------
takes all the financial decisions. Routine financial matters may be delegated to
lower level officers. The reasons for finance function being a highly centralised ----------------------
function are obvious.
----------------------
1. Financial decisions are the most crucial ones on which survival or failure
of the organisation depends. ----------------------
2. Financial decisions affect the solvency position of the organisation and a ----------------------
wrong decision in this area may land the organisation into crisis.
----------------------
3. The organisation may gain economies of centralisation in the form of
reduced cost of raising the funds, acquisition of fixed assets at competitive ----------------------
prices etc.
----------------------
Though there is no standard pattern for organisation of the finance function, in
general terms, the organisation of finance function takes the following form. ----------------------
----------------------
----------------------
----------------------
Finance Function 9
Notes Board of Directors
----------------------
Executive Committee
----------------------
---------------------- Vice President Vice President Vice President

(Production) (Finance) (Marketing)
----------------------
Finance Controller Treasurer
----------------------
---------------------- (1) Accounting and Costing (1) Receivables Management

(2) Annual Reporting (2) Taxes and Insurance
----------------------
(3) Internal Auditing (3) Cost Management
----------------------
(4) Budgeting (4) Securities
---------------------- (5) Statistics and Finance (5) Banking Relations
---------------------- (6) Record Keeping (6) Real Estates
---------------------- (7) Dividend Distribution
----------------------
1.6 DUTIES AND RESPONSIBILITIES OF FINANCE
---------------------- EXECUTIVE
---------------------- Based on the scope of the finance function, which has already been discussed,
the various duties and responsibilities that a finance executive has to fulfill can
----------------------
be classified as below:
---------------------- Recurring Duties
---------------------- a. Deciding the Financial Needs: In case of a newly started or growing
concern, the basic duty of the finance executive is to prepare the financial
---------------------- plan for the company. Financial plan decides in advance the quantum
of funds required, their duration, etc. The funds may be needed by the
----------------------
company for initial promotional expenditure, fixed capital, working capital
---------------------- or for dividend distribution. The finance executive should assess this need
of funds properly.
----------------------
b. Raising the Funds Required: The finance executive has to choose the
---------------------- sources of funds to fulfill financial needs. The sources may be in the form
of issue of shares, debentures, borrowing from financial institutions or
---------------------- general public, lease financing etc. The finance executive has also to decide
the proportion in which the various sources should be raised. For this, he
---------------------- may have to keep in mind basic three principles of cost, risk and control.
---------------------- If the company decides to go in for issue of securities say in the form of
shares or debentures, he has to arrange for the underwriting or listing of
---------------------- the same. If the company decides to go in for borrowed capital, he has to
negotiate with the lenders of the funds.
----------------------
c. Allocation of Funds: The financial executive has to ensure proper allocation Notes
of funds. He can allocate the funds basically for two purposes.
----------------------
i. Fixed Assets Management: He has to decide in which fixed assets
the company should invest the funds. He has to ensure that the fixed ----------------------
assets acquired or to be acquired satisfy the present as well as future
needs of the company. He has to ensure that the funds invested in ----------------------
the fixed assets justify the investments in terms of the expected cash
----------------------
flows generated by them in future. If there are more than one proposal
for making the investments in fixed assets, the finance executive has ----------------------
to decide in which proposal the company should invest the funds.
For this purpose, he may be required to take the help of various ----------------------
techniques of capital budgeting to evaluate the various proposals, For
----------------------
example, Pay Back Period, Net Present Value, Internal Rate of Return,
Profitability Index etc. If the outright purchases of fixed assets are not ----------------------
useful, the finance executive has to ensure that in order to facilitate
the replacement of fixed assets after their economic life is over, proper ----------------------
depreciation policies are formulated. The wrong policies in the area
----------------------
of providing for the depreciation may result into over-capitalisation or
under¬capitalisation. ----------------------
ii. Working Capital Management: The finance executive has to ensure
----------------------
that sufficient funds are made available for investing in current assets,
as it is the life¬blood of the business activity. Non-availability of ----------------------
funds to invest in current assets in the form of say cash, receivable,
inventory etc. may halt the business operations. At the same time, he ----------------------
has to ensure that there is no blocking of funds in the current assets, as
----------------------
it may prove to be costly in terms of cost of these funds and in terms of
opportunity cost of their use. Thus, the finance manager has to ensure ----------------------
that investments in the current assets are minimum without affecting
the operations of the company. ----------------------
d. Allocation of Income: Allocation of the income of the company is the ----------------------
exclusive responsibility of the finance executive. For this purpose, basically
the income may be distributed among the shareholders by way of dividend ----------------------
or it may be retained in the business for future purpose like expansion.
----------------------
Decision in this regard may be taken in the light of financial position,
present and future cash requirements, preferences of the shareholders etc. ----------------------
e. Control of Funds: The finance executive is responsible to control the use ----------------------
of funds committed in the business so as to ensure that cash is flowing
as per the plan and if there is any deviation between estimates and plans, ----------------------
proper corrective action may be taken in the light of financial position of
the company. For this purpose, he may be required to supervise the cash ----------------------
receipts and disbursements, ensure the safety of cash balances, expedite ----------------------
receipts and delay the payments wherever possible etc.
----------------------
----------------------
Finance Function 11
Notes f. Evaluation of Performance: The financial executive may be required to
evaluate and interpret the financial statements, financial position and
---------------------- operations of the company. For this purpose, he may be required to
ensure that proper books and records are maintained in a proper way so
---------------------- that whatever data is required of this purpose is available in time. For the
---------------------- evaluation and interpretation of the financial statements, financial executive
may use the techniques like ratio analysis, funds flow statement etc.
----------------------
g. Corporate Taxation: As the company is a separate legal entity, it is subjected
---------------------- to the various direct and indirect taxes like income tax, wealth tax, excise
and customs duty, sales tax etc. The finance executive may be expected
---------------------- to deal with the various tax planning and tax saving devices in order to
minimise the tax liability.
----------------------
h. Other Duties: In addition to all the above duties the financial executive
---------------------- may be required to prepare annual accounts, prepare and present financial
reports to top management, carrying out internal audit, get done statutory
----------------------
and tax audit, safeguarding securities and assets of company by properly
---------------------- insuring them etc.
Non-recurring Duties:
----------------------
The non-recurring duties of the finance executive may involve preparation of
---------------------- financial plan at the time of company promotion, financial readjustments in
---------------------- times of liquidity crisis, valuation of the enterprise at the time of acquisition
and merger thereof etc.
----------------------
----------------------

---------------------- 1. In the organisational hierarchy of finance function, finance controller
and treasure assist
----------------------
1. Board of Directors
---------------------- 2. Executive Committee
---------------------- 3. Vice President Finance
---------------------- 4. Vice President Production
5. Vice President Marketing
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Notes
Activity 3
----------------------
1. Classify the following duties of finance executive into recurring or ----------------------
non-recurring duties.
----------------------
Recurring /
Duty Non-recurring ----------------------
classification
Allocation of income received from different sources ----------------------
Financial plan at the time of company promotion
----------------------
Financial readjustment at the time of financial crises
Corporate taxation ----------------------
Evaluation of performance
Valuation of enterprise at the time of acquisition and ----------------------
mergers
----------------------
1.7 THE FIELDS OF FINANCE ----------------------
The finance function may operate in various fields. In each field, finance ----------------------
executives deal with the management of money and claims against money. The ----------------------
distinctions arise due to variety of problems and variety of objects. The various
fields of finance can be stated as below: ----------------------
1. Business Finance: The term business and hence business finance is a ----------------------
very broad term. It covers all the activities carried on with the intention of
earning profits. Thus, business finance covers the study of finance function ----------------------
in the area of business, which includes both trade as well as industry.
----------------------
2. Corporation Finance: Corporation finance is a part of business finance
and deals with the financial practices, policies and problems of corporate ----------------------
enterprises or companies to describe in simple words. The corporation
finance studies the financial operations carried on by a corporate enterprise ----------------------
from the stage of its inception to the stage of its growth and expansion. ----------------------
3. International Finance: International finance is the study of flow of funds
between individuals and organisations beyond national boundaries and ----------------------
developing the methods to handle these funds more effectively. This study
----------------------
may become crucial, as it involves exchange of currencies and also as the
governments of either of the nations may have close watch and control on ----------------------
these transactions involving foreign currencies.
4. Public Finance: It deals with the financial matters of the Governments. ----------------------
It becomes crucial as the Governments deal with huge sums of money, ----------------------
which can be raised through the sources like taxes or other methods and are
required to be utilised within the statutory and other limitations. Further, the ----------------------
Government does not operate with objectives similar to that of the private
organisations i.e. earning the profits is not the intention with which the ----------------------
Governments operate, but they operate with the intention of accomplishing ----------------------
social or economic objectives.
Finance Function 13
Notes 5. Private Finance: It deals with the financial matters of non-government
organisations.
----------------------
----------------------
1.8 FINANCE FUNCTION IN RELATION WITH OTHER
FUNCTIONS
----------------------
Other than finance, every business generally operates in three main
---------------------- functional areas viz. Production, Marketing and Personnel. All these functions
are closely related to finance function due to the simplest reason that for
----------------------
executing these functions, funds are required which is the area covered by
---------------------- finance function.
For example, to produce good quality of finished goods, the business needs
----------------------
good infrastructural facilities like building, machineries etc., a regular flow of
---------------------- production facilities like quality, raw material, work in progress, consumable
stores, quality control equipments, good maintenance facilities etc. All these
---------------------- activities need the investment to be made in terms of either fixed capital and/or
working capital, which is the area of finance function. To market the finished
----------------------
goods properly in the market, the business has to have a proper investment in
---------------------- the finished goods to guarantee regular flow of goods in the market. It may be
required to have good distribution systems, which may call for investment in
---------------------- terms of fixed assets or labour force. All these activities need the investments
to be made in terms of either fixed capital and/or working capital, which is
----------------------
the area of finance function. The personnel function deals with the availability
---------------------- of proper kinds of labourers at proper time, training them properly and fixing
their job responsibilities. All these activities need funds. For example, to pay
---------------------- salaries, wages and other facilities to workers, funds are needed, to provide
training facilities to workers, it may be necessary to invest in some fixed assets
----------------------
like building or equipments etc.
---------------------- To conclude, it may be stated that all the functions or activities of the
---------------------- business are ultimately related to finance. The success of the business depends
on how best all these functions can be coordinated.
----------------------
----------------------
---------------------- Match the following.

---------------------- i. Business finance a. Two nations, two currencies, two
governments
---------------------- ii. Corporation finance b. Financial matters of non-governmental
organisations
----------------------
iii. International finance c. Financing of trade and financing of
---------------------- industry
iv. Public finance d. Financing from inception to growth and
---------------------- development
v. Private finance e. Collection of taxes and it’s utilisation
----------------------
Notes
Activity 4
----------------------
Read job advertisements in newspapers and keep a record of the qualities ----------------------
and qualifications required for a Finance Manager.
----------------------
Summary ----------------------
l A
ny business activity is carried out with the intention of earning profit. ----------------------
Finance function deals with the activities related to procurement of funds
----------------------
and deployment of funds in business.
l S
cope of finance function includes financing decisions, investment ----------------------
decisions and dividend policy decisions.
----------------------
l T
he main object of finance function is the wealth maximisation of the
shareholders of the company. ----------------------
l S
ome of the duties of finance executive consist of assessing the funds ----------------------
requirement for the business activity, procurement of funds, allocation of
funds, allocation of income and control of funds. ----------------------
l F
inance function is closely related to all main activities of the business ----------------------
such as Production, Marketing and Personnel since funds are required to
carry out all these activities smoothly. A proper co-ordination between ----------------------
finance function and all other business activities is a prerequisite to ensure ----------------------
the success of business.
----------------------
Keywords ----------------------
• Current Assets: Current Assets are the assets, which are generated during ----------------------
the course of operations and are capable of being converted in the form of
cash or being utilised within a short span of time of one year. ----------------------
• Fixed Assets: Fixed Assets indicate the infrastructural facilities and ----------------------
properties required by the organisation. Fixed Assets are the assets, which
bring the returns to the organisation over a longer span of time. ----------------------
• Allocation of Income: Allocation of the income of the company is the ----------------------
exclusive responsibility of the finance executive.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Finance Function 15
Notes
----------------------
1. Describe the scope and importance of the finance function in the
---------------------- management of a corporation.
2. Explain the meaning, nature and scope of Business Finance.
----------------------
3. Explain the organisational framework of finance function. State the relation
---------------------- of finance function to other functions of a business enterprise.
---------------------- 4. What are the duties discharged by the financial executives in a large
business organisation?
----------------------
5. Explain the traditional and modern concept of finance function.
----------------------
6. State the relation of finance function to other functions of a business
---------------------- enterprise.
7. Describe the organisational structure of finance department of a large
----------------------
business concern.
---------------------- 8. How is finance function organised in business firms?
---------------------- 9. Explain the internal structure of the finance department in medium and
large business enterprises with a suitable chart.
----------------------
---------------------- Answers to Check your Progress

---------------------- Check your Progress 1

1. Wrong decisions relating to finance adversely affect
----------------------
iv. All the above departments
----------------------
2. According to the first approach to finance, which includes procurement of
---------------------- funds for
i. Corporate entities
----------------------
3. The first approach to finance concentrates on
----------------------
iii. Long-term problems
---------------------- 4. The second approach to finance is concerned with cash. This approach is:
---------------------- iv. Too broad to be meaningful
---------------------- 5. The third approach to finance includes procurement and application of
funds. This approach is:
----------------------
v. Acceptable to the modern scholars
----------------------
----------------------
----------------------
Check your Progress 2 Notes
----------------------
1. Investment decisions are decisions relating to the
----------------------
ii. Application of funds
2. Investment decisions are technically referred to as ----------------------
iii. Capital budgeting decisions ----------------------

3. Profits of the company belong to the ----------------------
iv. Shareholders
----------------------
4. The rate of profit to be distributed as dividend is declared by
----------------------
iv. Shareholders in the general meeting
5. Objective of business should be ----------------------
ii. Wealth maximisation ----------------------

6. Wealth maximisation and profit maximisation would mean same thing ----------------------
i. If the time period is too short and the risk is minimum
----------------------
----------------------
1. In the organisational hierarchy of finance function, finance controller and ----------------------
treasure assist ----------------------
iii. Vice president finance
----------------------
----------------------
Match the following.
i. c ----------------------
ii. d ----------------------
iii. a ----------------------
iv. e
----------------------
v. b
----------------------
Suggested Reading ----------------------
1. Ainapure & Ainapure. Auditing and Assurance. ----------------------

2. Kaplan & Atkinson. Advanced Management Accounting Book. ----------------------
----------------------
----------------------
----------------------
Finance Function 17
Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Forms of Business Organisation
UNIT
2
Structure:
2.1 Introduction
2.2 Proprietary Firms
2.3 Partnership Firms
2.4 Joint Stock Companies
Summary
Key Words
Suggested Reading
Forms of Business Organisation 19

Notes
Objectives
----------------------
----------------------
• Define various forms of business organisations
----------------------
• Differentiate between various forms of business organisations
---------------------- • Evaluate the advantages and disadvantages of each type of business
organisation
----------------------
• Distinguish between private and public limited company
----------------------
• Generalise the mode of operations of each type of business
---------------------- organisation
----------------------
2.1 INTRODUCTION
----------------------
The finance function of the organisation is greatly affected by the forms of
---------------------- organisation. The form of business organisation means the basic constitution of
the organisation in which it is set. It is generally defined by its ownership. The
---------------------- owners are persons who own the business organisation and they are a major
source of finance for the organisation. The various laws applicable to business
----------------------
entities as well as the mode of conducting business depend upon the form of
---------------------- business organisation. In practical circumstances, we come across basically
three forms of business organisations viz. Proprietary Firms, Partnership Firms
---------------------- and Joint Stock Companies.
----------------------
2.2 PROPRIETARY FIRMS
----------------------
In this case, only one person is the owner of the business who is called as the
---------------------- ‘Proprietor’ and the same person is the manager. All the profits earned by the
business belong to the proprietor and he is liable for the losses and liabilities of
----------------------
the business.
---------------------- Advantages:
---------------------- a. Proprietary Firm is the easiest and most economical form of business
organisation to form and operate. Not many of the government regulations
---------------------- are applicable to the Proprietary Firms.
---------------------- b. This form of organisation is very suitable where the size of the business
is small and the complexities involved in the business are comparatively
---------------------- less. However, if the size of the business increases or the complexities in
---------------------- the business operations grow, this form may prove to be insufficient.
Disadvantages:
----------------------
a. This form of organisation does not have any legal status. The proprietary
---------------------- firms exist due to the existence of the proprietor. If the proprietor ceases to
be in existence, the firm ceases to be in existence.
----------------------
b. As only one person is the owner and the manager, the capacity of the Notes
business to raise funds and to cope up with complex business operations is
comparatively limited. ----------------------
----------------------
----------------------
State True or False.
----------------------
1. The forms of business organisation means the basic constitution of the
organisation in which it is set. ----------------------
2. Proprietary is a difficult and expensive form of business organisation. ----------------------

3. Sole trading form of business organisation has no separate legal status. ----------------------
4. When scale of operation increases, sole trading form of business
----------------------
organisation is not suitable.
5. Proprietor’s liability is always limited to his capital investments. ----------------------
6. Income of the proprietary firm and the proprietor is combined. ----------------------
7. Liabilities of the proprietary firm cannot be paid by the proprietor out ----------------------
of his personal assets.
8. When the proprietor transfers his business to another person, the basic ----------------------
constitution of business is affected. ----------------------
----------------------
Activity 1
----------------------
Read financial statements of any two sole proprietors and compare their ----------------------
a. The sources of finance
----------------------
b. The application of finance
----------------------
c. Amount of profit earned
d. Amount of profits ploughed back ----------------------
----------------------
2.3 PARTNERSHIP FIRMS ----------------------
In this case, more than two persons but less than twenty persons come ----------------------
together and form a partnership firm. Each of these partners is the owner of the
business in the proportion decided among themselves. Partnership is a contract ----------------------
among the partners and the relationship among the partners is governed on the ----------------------
basis of terms and conditions laid down in an official and written document
called as ‘partnership deed’ or ‘partnership agreement’. ----------------------
----------------------
----------------------

Notes Advantages:
a. This form of organisation is also reasonably easy and economical to
----------------------
form and operate.
---------------------- b. As resources of more than one person are pooled together, capacity
---------------------- of the business to handle more complex business operations or
operations requiring more amounts of funds is better as compared to
---------------------- the proprietary firms.
---------------------- c. The tax structure applicable to the partnership firms is reasonable.
---------------------- d. Not many of the government regulations are applicable to the partnership
firms.
----------------------
Disadvantages:
---------------------- a. This form of organisation also does not have any legal status. The
---------------------- partnership firms exist due to the existence of the partners. If the
partners cease to be in existence, the firm ceases to be in existence.
---------------------- The retirement or death of a partner leads to the dissolution of the
partnership firm.
----------------------
b. The capacity of the business to raise the funds and to cope up with
---------------------- the complex business operations is comparatively limited though it is
more than that of the proprietary firms.
----------------------
c. Partnership firm is also an unlimited liability organisation. In the
---------------------- sense, if the assets of the firm are insufficient to meet its liabilities,
personal property of the partners is always at stake.
----------------------
d. It is not possible to transfer the ownership of the business to somebody
---------------------- else without affecting the basic constitution of the business.
----------------------
2.4 JOINT STOCK COMPANIES
----------------------
Joint stock companies have become a major form of organisation in the
---------------------- recent past. This form of organisation can raise large amount of funds as the
resources of larger number of people can be pooled together. In this case, the
----------------------
total requirement of funds of the organisation is split into smaller units, each
---------------------- of such units being called as a ‘share’. Each such share carries a denomination
value, which is called as ‘face value’ or ‘nominal value’. An individual can
---------------------- participate in the capital requirement of an organisation by purchasing the
shares of the company and he becomes the part owner of the company to the
----------------------
extent of his shareholding in the overall amount of capital of the company. Such
---------------------- shareholder can exercise his ownership rights through the voting rights offered
to him.
----------------------
The joint stock companies have the following characteristic features:
---------------------- a. All the joint stock companies have a legal entity separate from their owner
viz. shareholders. They gain the legal status by being registered under
----------------------
Companies Act, 2013, which governs and regulates the operations of all
joint stock companies in India. As legal entities, the joint stock companies Notes
can own assets, incur liabilities, enter into contracts, sue and be sued. The
shareholders of the company cannot be held liable for the actions of the ----------------------
company.
----------------------
b. Generally, all joint stock companies are limited liability organisations and
the liability of the shareholders is limited to the extent of amount of shares ----------------------
they undertake to purchase. For example, if Mr. A undertakes to purchase
----------------------
100 shares of a company of Rs. 100 each, his liability ceases once he pays
Rs. 10,000 to the company. His personal property is never in danger despite ----------------------
the losses and liabilities incurred by the company.
----------------------
c. Segregation of ownership and management is a typical feature of joint
stock companies. In case of the companies, shareholders are the owners. ----------------------
However, due to large number of shareholders and their wide geographical
spread, it may not be possible for the shareholders to exercise their ----------------------
ownership rights by participating in the day-to-day affairs of the company.
----------------------
As such, the shareholders appoint their representatives (viz. directors)
to manage the day-to-day affairs of the company. In case of joint stock ----------------------
companies, shareholders are the owners while directors/board of directors
are the managers. ----------------------
d. Transferability of shares is a feature of a joint stock company. A shareholder ----------------------
can transfer his ownership rights in the company by transferring his shares
to some other person. In case of public limited companies, shares are freely ----------------------
transferable and such transfer can be greatly facilitated if the shares are
----------------------
listed on the stock exchange. In case of private limited companies, there
may be some restrictions on the transfer of shares. ----------------------
e. Being an artificial legal person, the company enjoys a perpetual existence. ----------------------
The company can die only a legal death, after complying with the prescribed
legal formalities. There is a very famous case under the Companies Act, ----------------------
where during the war, all the members of a private company, while in
meeting, were killed by a bomb, but the company survived. ----------------------
f. A company is an artificial legal person that does not have a body like a ----------------------
natural person and hence it cannot sign any documents. However, being
a legal personality, it is bound only by those documents, which bear its ----------------------
signature. Hence, as a substitute to the signature, the law provides for the ----------------------
use of common seal. Any document having the common seal and witnessed
by at least two directors is binding on the company legally. ----------------------
Advantages: ----------------------
a. The capacity of the corporate organisations to raise the funds is comparatively
----------------------
high. As the number of persons contributing to the requirement of funds is
large, it is possible to raise large amount of funds. ----------------------
b. As the company has a separate legal entity, apart from its owners, viz.
----------------------
shareholders, the personal property of the shareholders is generally not in
danger. ----------------------

Notes c. Transferability of shares is a facility available to the shareholders. If the
shareholders want to release their investment in shares, they can transfer
---------------------- their shares to any other person. However, it should be remembered that in
case of private limited companies, the shares are not freely transferable.
----------------------
Disadvantages:
----------------------
The company form of organisation is subjected to elaborate legal and procedural
---------------------- formalities to be complied with, not only for the purpose of formation but also
for the regular operation. The basic applicable law in this connection is in the
---------------------- form of Companies Act, 2013. However, it should be noted that in case of
private limited companies, these formalities are less rigorous in nature.
----------------------
As the company form of organisation is the most frequently found form of
---------------------- organisation, for the future discussion in the following units, we will refer the
business organisation to be a ‘company’.
----------------------
In practical situations, we come across two types of limited liability companies:
----------------------
a. Private Limited Company
---------------------- In non-technical language, operations of a private limited company affect
---------------------- the fate of a smaller number of people. As such, Companies Act, 2013 is very
liberal towards the private limited companies. Private Limited Company is
---------------------- entitled to many privileges/ exemptions from the various provisions of the
Companies Act, 2013. A private limited company is characterised by the
---------------------- following features:
---------------------- a. Minimum number of members is 2 and the maximum number is 200.
---------------------- b. A private limited company cannot approach public in general for
subscribing to the shares/debentures of the company. Similarly, a
---------------------- private limited company cannot invite or accept deposits from public
in general other than its shareholders, directors or their relatives. The
----------------------
funds required by the company are required to be collected through
---------------------- the private circulation only.
---------------------- c. In case of a private limited company, right of the shareholders to

transfer the shares is restricted. These restrictions are usually in two
---------------------- forms:
---------------------- i. That the shares to be transferred should be offered to the existing

members on priority basis and if the existing members do not
---------------------- want to take up those share, they can be transferred to anybody
else.
----------------------
ii. That the directors will have the power to refuse to register the
---------------------- transfer of shares provided that such power should be exercised
by the directors in good faith and in the interest of the company.
----------------------
d. A private limited company needs to have a minimum paid-up share
---------------------- capital of Rs. 1 Lakh or any higher amount as may be prescribed.
----------------------
b. Public Limited Company Notes
In non-technical language, a public limited company affects the fate of a
----------------------
larger number of people. As such, operations of public limited companies
are subjected to a close control in the form of compliance to the various ----------------------
provisions of Companies Act, 2013.
----------------------
A public limited company is characterised by the following features:
a. Minimum number of shareholders is 7 and there is no restriction on the ----------------------
maximum number of shareholders.
----------------------
b.
Public limited company can freely approach public in general for
subscribing to the shares and/or debentures of the company. ----------------------
c. The shareholders of a public limited company can freely transfer their ----------------------
shares to any other person. As such, shares of only a public limited company
can be listed on the stock exchange. ----------------------
d. A public limited company needs to have a minimum paid-up share capital ----------------------
of Rs. 5 Lakh or any higher amount as may be prescribed.
----------------------
----------------------
Multiple Choice Multiple Response.
1. Minimum and maximum number of partners is __________. ----------------------
i. Minimum two and maximum 10 in case of banking ----------------------

ii. Minimum 10 and maximum 20 in case of banking and 10 in case ----------------------
of other businesses
----------------------
iii. Minimum 3 and maximum 10 in case of banking and 20 in case of
other businesses ----------------------
iv. Minimum two and maximum 20 in case of other businesses
----------------------
2. Formation and operation of partnership is:
----------------------
i. Difficult
ii. Easy ----------------------
iii. Expensive ----------------------

iv. Economic ----------------------
3. The liability of partners is
----------------------
i. Limited
ii. Unlimited ----------------------
iii. Joint and several ----------------------
iv. Unique
----------------------
----------------------

Notes
4. Partnership firm as such has
---------------------- i. Legal status
ii. No legal status
----------------------
iii. No perpetual succession
---------------------- iv. Perpetual succession
1. Shareholders of a Joint Stock Company are its
---------------------- i. Creditors
---------------------- ii. Debtors
iii. Suppliers
----------------------
iv. Owners
---------------------- 2. If the face value of a share is Rs.100 and the shareholder has already
paid Rs.75, then the liability of the shareholder is restricted to
---------------------- i. Rs.100
---------------------- ii. Rs.75
iii. Rs.25
----------------------
---------------------- 3. Shareholders are
i. Shareholders but not the members
----------------------
ii. Managers but not the owners
---------------------- iii. Owners but not managers
---------------------- iv. Members but not the shareholders
4. A Joint Stock Company comes into existence when it is
---------------------- i. Promoted
---------------------- ii. Incorporated
iii. Functioning
----------------------
---------------------- 5. Public companies are
i. Government companies
----------------------
ii. Non-government companies
---------------------- iii. Having minimum 7 members
----------------------
----------------------
1. Company is an artificial person and therefore it cannot sign.
---------------------- 2. Company can die a natural death.
---------------------- 3. Common seal is a signature of the company.
---------------------- 4. Company can sue but cannot be sued.

5. A shareholder may me a member but a member may not be a shareholder.
----------------------
Notes
6. If the liabilities of a Joint Stock Company are unpaid, the creditor can
sue the members. ----------------------
7. During war period, even a bomb cannot kill a company.
----------------------
8. Shares of all Joint Stock Companies are freely transferable.
----------------------
9. Shares are transferable but the right to transfer shares is restricted.
10. In a Joint Stock Company, owners and managers and managers are ----------------------
owners. ----------------------
11. A private company can collect capital by issuing shares to the public at
large. ----------------------
12. Private company’s shares are listed in stock exchange. ----------------------
----------------------
Activity 2 ----------------------
----------------------
1. Meet the accountants officer in a partnership firm and collect the
following information: ----------------------
a. Read the partnership deed of the firm and find out the profit sharing ----------------------
ratio among the various partners and the capital contributed by
each partner. ----------------------
b. Find out the method followed for computation of salary and ----------------------
interest on capital of the various partners.
----------------------
2. Study the Memorandum and Articles of Association of the company
and note down the main objects of the company. State the Authorised ----------------------
Capital of the company.
----------------------
3. Prepare a list of provisions of Companies Act, which are not applicable
to a Private Limited Company. ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes Summary
---------------------- • This unit specifies the various types of constitutions under which any
business activity can be conducted.
----------------------
• A business can be carried out as a proprietary concern or as a partnership
---------------------- firm or as a corporate entity.
---------------------- • A proprietary concern is easy to operate; however, it does not have a legal
status. One of the major disadvantages of a proprietary concern is the
---------------------- unlimited liability of proprietor.
---------------------- • A partnership firm is an entity when two or persons come together to run a
business activity. A major advantage of partnership firm is the pooling of
---------------------- resources and skill sets of various partners. However, a partnership firm
---------------------- also is an unlimited liability organisation.
---------------------- Keywords
----------------------
• Joint stock companies: This form of organisation can raise large amount
---------------------- of funds as the resources of larger number of people can be pooled together.
• Artificial legal person: The company enjoys a perpetual existence.
----------------------
---------------------- Self-Assessment Questions

----------------------
1. Critically evaluate the following forms of business organisations:
---------------------- (a) Proprietary Firms
---------------------- (b) Partnership Firms
---------------------- (c) Joint Stock Companies

2. Make a list of the advantage of Partnership Firms.
----------------------
3. Define the features of Joint Stock Companies with its advantages.
----------------------
4. Differentiate between the following:
---------------------- a. Proprietary Firms and Partnership Firms
---------------------- b. Joint Stock Companies and Partnership Firms
---------------------- 5. Write short notes on the following:

a. Taxation of Partnership Firms
----------------------
b. Types of Companies
----------------------
----------------------
----------------------
----------------------
Answers to Check your Progress Notes
State True or False. ----------------------
1. True
----------------------
2. False
----------------------
3. True
4. True ----------------------
5. False ----------------------
6. True ----------------------
7. False
----------------------
8. True
----------------------
Multiple Choice Multiple Response. ----------------------
1. Minimum and maximum number of partners is __________. ----------------------
i. Minimum two and maximum 10 in case of banking ----------------------
iv. Minimum two and maximum 20 in case of other businesses
----------------------
2. Formation and operation of partnership is:
----------------------
ii. Easy
iv. Economic ----------------------
3. The liability of partners is ----------------------
ii. Unlimited ----------------------
iii. Joint and several
----------------------
4. Partnership firm as such has
----------------------
ii. No legal status
iii. No perpetual succession ----------------------
Multiple Choice Single Response ----------------------

1. Shareholders of a Joint Stock Company are its ----------------------
iv. Owners
----------------------
2. If the face value of a share is Rs.100 and the shareholder has already paid
Rs.75, then the liability of the shareholder is restricted to ----------------------
iii. Rs.25 ----------------------
3. Shareholders are ----------------------
iii. Owners but not managers
----------------------

Notes 4. A Joint Stock Company comes into existence when it is
ii. Incorporated
----------------------
5. Public companies are
----------------------
iii. Having minimum 7 members
---------------------- State True or False.
---------------------- 1. False
---------------------- 2. False
---------------------- 3. False
---------------------- 4. False
---------------------- 5. True
6. False
----------------------
7. True
----------------------
8. True
---------------------- 9. True
---------------------- 10. False
---------------------- 11. False
12. False
----------------------
---------------------- Suggested Reading

---------------------- 1. Krishnamurti & Viswanath. Advanced Corporate Finance.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Financial Statements
UNIT
3
Structure:
3.1 Introduction
3.2 Nature of Financial Statements
3.3 Basic Concepts in Accounting
3.4 Structure of Financial Statements
3.5 Role Played by Financial Statements
3.6 Limitations of Financial Statements
3.7 Analysis and Interpretation of Financial Statements
Summary
Key Words
Suggested Reading
Financial Statements 31
Notes
Objectives
----------------------
----------------------
• State the meaning of financial statements
----------------------
• List the basic principles followed in preparation of accounts
---------------------- • Summarise the structure of financial statements of a company as
required by the Companies Act
----------------------
• Specify the role of financial statements in business environment
----------------------
• Support the limitations of financial statements
----------------------
---------------------- 3.1 INTRODUCTION
---------------------- Financial statements of an organisation are the basis of data required for
financial decision-making. The financial statements and their accompanying
---------------------- notes explain a company’s financial performance and recent financial history.
Financial analysts use these statements in several ways such as to evaluate a
----------------------
company’s overall performance, identify strengths and weaknesses, anticipate
---------------------- future successes or problems, and ultimately help them decide if the company
is a good investment opportunity.
----------------------
As such, correct understanding of the structure of financial statements and also
---------------------- of the tools available for the interpretation of financial statements is a must
before one talks of any of the further discussions on financial management.
----------------------
---------------------- 3.2 NATURE OF FINANCIAL STATEMENTS
---------------------- Any organisation doing the business, whether it is a manufacturing

activity or trading activity or service activity, is interested in knowing
---------------------- two facts about the business.
---------------------- a. Where the business stands at any given point of time in financial
----------------------
terms?
b. What is the result of operations carried out by the business organisation
----------------------
during specific period?
---------------------- In order to answer these two questions, the organisation carries out the
process of recording various transactions in a defined set of records, technically
----------------------
referred to as ‘accounting’, which effectively result into the preparation of what
---------------------- are called as financial statements. These financial statements are in two forms.
a. First financial statement is Balance Sheet. This is the answer to the first
----------------------
question viz. Where the business stands in financial terms? Balance Sheet
---------------------- informs about the various sources used by the organisation to raise the
funds which technically result into what are referred to as ‘liabilities’ and
---------------------- the way these sources are used which technically result into the creation
of ‘assets’. Sometimes, Balance Sheet is also referred to as “Statement of Notes
Sources and Application of Funds”. Effectively, Balance Sheet is a listing
of various assets and liabilities of the organisation at any given point of ----------------------
time. Technically, Balance Sheet is a position statement in the sense it
refers to a particular date. As such, Balance Sheet is referred to as “Balance ----------------------
Sheet as on ———” or “Balance Sheet as at ———”. ----------------------
b. Second financial statement is Profitability Statement. In technical language,
----------------------
it is referred to as ‘Profit and Loss Account’. This is the answer to the
second question viz. What is the result of the operations of the business ----------------------
during the specific period i.e. whether the operations have resulted into a
profit or loss and by what amount? Technically, Profitability Statement is ----------------------
a period statement in the sense it refers to a particular period. This may be
----------------------
a month, a quarter, a half year or a year depending upon the organisation
and the purpose for which it is prepared. As such, Profitability Statement is ----------------------
referred to as “Profit and Loss Account for the year ending on ———”.
----------------------
1. ‘Balance sheet’ is an account showing assets and liabilities. ----------------------

2. When the credit side of Profit and Loss Account is more than the debit ----------------------
side, there is a “profit”.
----------------------
3. When the debit side of Profit and Loss Account is more than the credit
side, there is a “loss”. ----------------------
4. Balance sheet is an account showing assets and liabilities of the firm.
----------------------
5. Entries in Profit and Loss Account are posted during the year and the
net profit is calculated at the end of the year. ----------------------
----------------------
Activity 1 ----------------------
----------------------
Procure an annual report of any limited company and go though the Balance
Sheet and Profitability Statements given there in. ----------------------
----------------------
3.3 BASIC CONCEPTS IN ACCOUNTING
----------------------
The theory and practice of accounting is based upon certain basic assumptions,
which are referred to variously as concepts, principles, conventions and rules. ----------------------
For the convenience purpose, we will term them as ‘concepts’. Various concepts ----------------------
that form the basis of theory and practice of accounting can be discussed as
below: ----------------------
----------------------
Notes 1. Business Entity Concept:
According to this concept, the business is assumed to be a distinct entity
---------------------- from the persons who own the business e.g. if there is a partnership
---------------------- concern carrying the name of M/s. X, where Mr. A and Mr. B are partners,
from accounting point of view, M/s. X is supposed to be a separate entity
---------------------- from Mr. A or Mr. B. The financial statements prepared on the basis of
accounting records relate to the business i.e. M/s. X and not to Mr. A or Mr.
---------------------- B individually. It should be noted in this connection that the business entity
---------------------- concept has nothing to do with the legal entity of the business. It applies to
both corporate organisation (which by itself is a legal entity separate from
---------------------- the owners) as well as non-corporate organisation (which is not a legal
entity separate from the owners.)
----------------------
2. Money Measurement Concept:
---------------------- According to this concept, only those transactions and facts find the place
---------------------- in the process of accounting and hence on financial statements which can
be expressed in terms of money. As such, all those transactions and facts
---------------------- which cannot be expressed in terms of money (e.g. morale and motivation
of the workers, goodwill of the organisation in the market etc.) are not
---------------------- within the purview of accounting though they may be having direct or
---------------------- indirect bearing on the business. This principle imposes severe restrictions
on the kind of information available from the financial statements. In fact,
---------------------- it is one of the major drawbacks of financial statements.
3. Cost Concept:
----------------------
According to this concept, the assets acquired by a business are recorded
---------------------- at their cost of acquisition and this cost is considered for all the subsequent
accounting purposes say charging of depreciation. This concept does not
----------------------
take into consideration the current market prices of the various assets.
---------------------- 4. Going Concern Concept:
---------------------- According to this concept, it is assumed that the business entity is going
to be in business for an indefinitely long period and is not likely to close
---------------------- down its business in a shorter period. This concept affects the valuation of
assets and liabilities. As such, the assets are shown on the Balance Sheet
----------------------
at cost less depreciation and not at the current market price or realisable
---------------------- value. If the assets are to be disclosed at the correct value in the Balance
Sheet, the current market price will be most suitable. However, as the
---------------------- business is likely to be a going concern in future and as the assets are not
likely to be sold in the market in the near future, they are disclosed at cost
----------------------
less depreciation.
---------------------- 5. Conservatism Concept:
---------------------- This concept is usually expressed as, “Anticipate all the future losses and
expenses, however do not anticipate the future incomes and profits”. This
---------------------- principle is applicable to current assets generally and hence the current
assets are valued at cost or market price whichever is lower. The valuation
---------------------- of non-current assets is made at cost (as per the cost concept).
6. Dual Aspect Concept: Notes
According to this concept, every business transaction has two aspects,
----------------------
however the basic relationship between assets and liabilities i.e. assets are
equal to liabilities, remains the same e.g. if Mr. A starts the business by ----------------------
introducing the capital of Rs. 50,000 the assets and liabilities structure will
be as below: ----------------------
Liabilities Rs. Assets Rs. ----------------------
Capital 50,000 Cash 50,000
----------------------
Now, if Mr. A uses the cash to purchase the material worth Rs. 40,000; the
assets and liabilities structure will change as below : ----------------------
Capital 50,000 Stock in trade 40,000
Cash 10,000 ----------------------
50,000 50,000
----------------------
If Mr. A sells the above material worth Rs. 40,000 for Rs. 45,000, on credit
basis, the assets and liabilities structure will change as below : ----------------------

Capital 55,000 Receivables 45,000
Cash 10,000 ----------------------
55,000 55,000 ----------------------
7. Accounting Period Concept:
----------------------
According to this concept, even though a business is likely to be a going
concern over a longer period, in order to facilitate the preparation of ----------------------
financial statements periodically, the future time is divided into shorter
----------------------
segment, each one of them being in the form of Accounting Period. Income
is computed according to this accounting period (by preparing profitability ----------------------
statement) and financial position is assessed at the end of such accounting
period (by preparing a Balance Sheet). It may be noted that the length of ----------------------
the accounting period may depend upon various factors like characteristics
----------------------
of the business, tax considerations, statutory requirements and so on.
8. Matching Concept: ----------------------
According to this concept, in order to calculate the profit for the accounting ----------------------
period in a correct manner, the expenses and costs incurred during that
period, whether paid or otherwise, should be matched with the revenues ----------------------
generated during that period. ----------------------
9. Materiality Concept:
----------------------
According to this concept, while accounting for the various transactions,
only those that are having material impact on profitability or financial ----------------------
position of the organisation will be considered, ignoring the insignificant
----------------------
ones. E.g. if an organisation purchases some postage stamps some of
which remain non-used at the end of the accounting period, according to ----------------------
Notes matching concept, the cost of such non-used stamps should not be treated
as an item of expenditure. However, as its impact on profitability is likely
---------------------- to be negligible, the cost of non-used stamps may be ignored, treating the
cost of purchase of stamps as expenditure. Now which transactions should
---------------------- be treated as material ones is a subjective concept and depends upon the
---------------------- judgment and knowledge of the accountant.
10. Consistency Concept:
----------------------
According to this concept, whatever accounting policies and procedures are
---------------------- adopted, they should be adopted consistently from one period to another to
enable the comparison between two different sets of financial statements.
----------------------
If there is any change in the accounting policies and procedures, this fact
---------------------- coupled with its effect on profitability should be disclosed specifically.
---------------------- 3.4 STRUCTURE OF FINANCIAL STATEMENTS

----------------------
As there is no specific law applicable to the preparation of financial
---------------------- statements of non-corporate organisations like proprietary firms or partnership
firms, these organisations can prepare their financial statements in whatever
---------------------- structure they want. However, in case of a corporate organisation, in simple
language, a company form of organisation, there is a uniform law applicable
----------------------
to these types of organisations viz. Companies Act, 2013. As such, a company
---------------------- form of organisation is required to prepare and present its financial statements in
accordance with the provisions of Companies Act, 2013, to be more specific as
---------------------- per the provisions of Schedule VI of the Companies Act, 2013. The underlying
presumption of the Schedule VI provisions is that it is through the financial
----------------------
statements that the companies communicate with the various outsiders. As
---------------------- such, it is required that the financial statements should be as transparent and
as informative as possible. Hence, Schedule VI lays down various disclosure
---------------------- requirements, which the companies are required to follow while preparing their
financial statements.
----------------------
Schedule VI of the Companies Act, 2013 is subdivided into four parts: Part
---------------------- I deals with the format of the Balance Sheet. Part II deals with the Profit and
Loss Account. Part III deals with Consolidated Financial Statements.
----------------------
---------------------- Part I: Structure of Balance Sheet:

As stated above, Part I of Schedule VI deals with Balance Sheet. It lays down
----------------------
both the vertical as well as horizontal form of preparing the Balance Sheet,
---------------------- though in normal circumstances we come across vertical form of Balance Sheet.
---------------------- Following items appear in the Balance Sheet.

In addition to the above items of assets and liabilities, the various contingent
---------------------- liabilities are required to be disclosed by way of a footnote.
----------------------
----------------------
Liabilities side Notes
A. Share Capital:
----------------------
The share capital is required to be disclosed under the following headings:
----------------------
a. Authorised: _____ shares of Rs. _____ each
b. Issued: _____ shares of Rs. _____ each ----------------------
c. Subscribed: _____ shares of Rs. _____ each ----------------------
d. Called up: _____ shares of Rs. _____ each ----------------------
e. Less: Calls Unpaid
----------------------
f. Add: Forfeited Shares (Amount originally paid up)
----------------------
Notes:
a. The details of issued and subscribed capital should be given after ----------------------
distinguishing between the different classes of shares. It should be ----------------------
noted that in the Indian circumstances, the company can issue only
two types of shares i.e. Equity Shares and Preference Shares. In case ----------------------
of preference shares, details of different classes of preference shares
should be given. Similarly, in case of redeemable or convertible ----------------------
preference shares, the terms of redemption on conversion should be ----------------------
given.
b. If the shares are allotted as fully paid shares pursuant to a contract ----------------------
without payments being received in cash, the details of the same ----------------------
should be given.
----------------------
c. If the shares are allotted as fully paid bonus shares, details of the same
should be given along with the sources from which the bonus shares ----------------------
are issued i.e. capitalisation of profits or reserves, share premium etc.
Similarly, the details of bonus shares held by i) directors and ii) others ----------------------
should be given.
----------------------
d. It is provided that any profit on the reissue of forfeited shares should
be transferred to capital reserve. ----------------------
B. Reserves and Surplus: ----------------------
Reserves indicate that portion of the earnings, receipt or other surplus of ----------------------
the company (whether capital or revenue) appropriated by the management
for a general or specific purpose other than provisions for depreciation or ----------------------
for a known liability. The reserves can be primarily of two types: i) Capital
Reserve and ii) Revenue Reserve. Capital Reserve is that reserve which ----------------------
cannot be distributed by way of dividend. Revenue Reserve is any other ----------------------
reserve than the capital reserve.
The reserves are required to be classified as below: ----------------------
a. Capital Reserve. ----------------------

b. Capital Redemption Reserve (As per the provisions of Section 80 of ----------------------
Notes the Companies Act, 1956, this reserve is created for the redemption of
redeemable preference shares).
----------------------
c. Share Premium Account.
---------------------- d. Other reserves specifying the nature of each reserve and the amount in
respect thereof.
----------------------
Less: Debit balance in Profit and Loss Account, if any.
----------------------
e. Surplus i.e. balance in Profit and Loss Account after providing for
---------------------- proposed allocations viz. dividend, bonus shares or reserves.
---------------------- f. Proposed additions to reserves.

g. Sinking fund.
----------------------
Notes:
----------------------
a. Additions and deductions since the last balance sheet are required to
---------------------- be given under each head of reserves and surplus.
---------------------- b. In case of the share premium account, the details of the utilisation of
the balance in share premium account should be given. It should be
---------------------- noted that as per the provisions of Section 78 of the Companies Act,
1956, the amount lying to the credit of share premium account can be
---------------------- used for:
---------------------- i. For issuing fully paid bonus shares.
---------------------- ii. To write off preliminary expenses.

iii. To write off the balance of commission/discount allowed/paid
----------------------
while issuing shares / debentures.
---------------------- iv. To provide for premium payable on the redemption of preference
shares.
----------------------
c. The word ‘fund’ is generally used interchangeably with the word
---------------------- ‘reserve fund’. The word fund indicates that there is a specific
investment against such reserves.
----------------------
d. Debit balance in Profit and Loss Account should be deducted from the
---------------------- unspecified reserves. If there are no unspecified reserves, such debit
---------------------- balance should be shown on assets side.
C. Secured Loans:
----------------------
Loans borrowed by the company, secured wholly or partly, against the
---------------------- assets of the company are stated as secured loans.
---------------------- Secured Loans are classified as below:
a. Debentures
----------------------
b. Loans and Advances from Banks
----------------------
c. Loans and Advances from Subsidiaries
---------------------- d. Other Loans and Advances
Notes: Notes
a. In case of debentures, the terms of redemption or conversion, if any, should
----------------------
be specified together with the earliest date of redemption or conversion.
b. Nature of security should be specified. ----------------------
c. Interest accrued and due on secured loans should be included under the ----------------------
appropriate sub-head under secured loans.
----------------------
d. Loans taken from directors and managers should be shown separately.
e. If the loans are guaranteed by director or manager, it is required to mention ----------------------
the guarantee and the amount of loan under each head. ----------------------
D. Unsecured Loans:
----------------------
Unsecured Loans are those loans, which are not secured against the security
of any of the assets of the company. Unsecured portion of the partly secured ----------------------
loans should be shown under unsecured loans.
----------------------
Unsecured Loans are classified as below:
----------------------
a. Fixed Deposits
b. Loans and Advances from Subsidiaries ----------------------
c. Short-term Loans and Advances ----------------------

i) from Subsidiaries ----------------------
ii) from others
----------------------
d. Other Loans and Advances
----------------------
i) from subsidiaries
ii) from others ----------------------
Notes: ----------------------
a. Interest accrued and due on secured loans should be included under ----------------------
the appropriate sub-head under unsecured loans.
----------------------
b. Loans taken from directors and managers should be shown separately.
c. If the loans are guaranteed by the director or manager, it is required to ----------------------
mention the guarantee and the amount of loan under each head. ----------------------
d. Short-term loans and advances are those, which are due for repayment
within one year from the date of the balance sheet. ----------------------
e. Inter-corporate unsecured deposits and Commercial Papers fall under ----------------------

this head.
----------------------
E. Current Liabilities and Provisions:
----------------------
The Guidance Note issued by The Institute of Chartered Accountants of
India on Terms used in Financial Statements defines ‘Current Liability’ as ----------------------
liability including loans, deposits and bank overdraft which falls due for
payment in a relatively short time, normally not more than 12 months. ----------------------
Notes Current Liabilities and Provisions are classified as below:
1. Current Liabilities:
----------------------
a. Acceptance: This includes the bills payable including the promissory
---------------------- notes issued by the Company.
---------------------- b. Sundry Creditors for goods purchased or services received
---------------------- c. Subsidiary Companies

d. Advance received and unexpired discount
----------------------
e. Unclaimed dividend
----------------------
f. Other liabilities, if any
---------------------- g. Interest accrued but not due on loans
---------------------- 2. Provisions:
---------------------- a. Provision for Taxation

b. Proposed Dividend
----------------------
c. Provision for Contingencies
----------------------
d. Provision for Provident Fund Scheme
---------------------- e. Provision for insurance, pension and other similar staff benefit
schemes
----------------------
f. Other provisions
----------------------
Assets Side
---------------------- A. Fixed Assets: Schedule VI requires the company to classify the fixed assets
---------------------- as far as possible under the following heads:
a. Goodwill
----------------------
b. Land
----------------------
c. Buildings
---------------------- d. Leaseholds
---------------------- e. Railway Sidings
---------------------- f. Plant and Machinery
g. Furniture and Fittings
----------------------
h. Development of Property
----------------------
i. Patents, Trade Marks and Designs
---------------------- j. Livestock
---------------------- k. Vehicles etc
---------------------- Under each of the above heads, original cost and the additions thereto or the
deductions therefrom during the year and the total depreciation written off or
---------------------- provided up to the end of the year should be stated.
In the practical circumstances, in the vertical form of balance sheet, the fixed Notes
assets are presented as below:
----------------------
a. Gross Block (which indicates accumulated original cost)
b. Less: Depreciation (which indicates accumulated depreciation) ----------------------
c. Net Block (which indicates Gross Block less Depreciation) ----------------------
d. Capital Work-in-Progress
----------------------
Note: Capital work-in-progress indicates the fixed assets under construction or
under installation. After the construction of fixed assets is complete or the fixed ----------------------
assets are installed, they are capitalised under the suitable head. No depreciation
will be provided by the company on capital work-in-progress. ----------------------
Usually details of original cost, additions, deductions, depreciation etc. are ----------------------
shown in a separate schedule.
----------------------
B. Investments:
Investments indicate the assets held by a company for earning income ----------------------
by way of dividend, interest etc. or for capital appreciation or for other ----------------------
benefits to the investing company.
Investments are required to be distinguished as below: ----------------------
a. Investments in Government or Trust securities. ----------------------
b. Investments in shares, debentures or bonds showing separately, shares
----------------------
fully paid up and partly paid up and also distinguishing the different
classes of shares. Similar details should be given in case of investment ----------------------
in subsidiary companies.
----------------------
c. Immovable Properties
d. Investment in capital of Partnership Firm. ----------------------
e. Balance of unutilised monies raised by issue. ----------------------
Notes:
----------------------
a. It is necessary to indicate the nature of investment and mode of
valuation, for example cost or market value. ----------------------
b. It is required to disclose –
----------------------
i) Aggregate amount of company’s quoted investments and the
market value thereof. ----------------------
ii) Aggregate amount of company’s unquoted investments. Quoted ----------------------
investment means an investment that is traded on a recognised
stock exchange and unquoted investment means otherwise. ----------------------
C. Current Assets, Loans and Advances: ----------------------
1. Current Assets ----------------------
Cash and other assets, which are expected to be converted into cash or
----------------------
consumed in the production of goods or rendering the services in the
normal course of business, are defined as current assets. ----------------------
Notes Current Assets are required to be classified as:
a. Interest accrued on investments
----------------------
b. Stores and spare parts
----------------------
c. Loose tools
---------------------- d. Stock-in-Trade (This in turn may consist of stock of raw materials and
---------------------- stock of finished goods)
e. Work-in-Progress
----------------------
f. Sundry Debtors, viz. i) Debts outstanding for a period exceeding six
---------------------- months ii) Other Debts
---------------------- Less: Provision
g. Cash balance on hand
----------------------
h. Bank Balances
----------------------
i) With Scheduled Bank
---------------------- ii) With others
---------------------- Notes:
---------------------- a. Mode of valuation of stock-in-trade and work-in-progress should be
specified.
----------------------
b. Sundry debtors are required to be disclosed based on security in the
---------------------- following manner.
---------------------- i) Debts considered good and in respect of which the company is fully
secured.
---------------------- ii) Debts considered good for which the company holds no security other
---------------------- than the debtor’s personal security.
iii) Debts considered bad or doubtful.
----------------------
Further, following details are also required to be disclosed in case of
---------------------- debtors:
---------------------- i) Debts due by directors or other officers of the company or any of them
either jointly or severally with any other person.
----------------------
ii) Debts due by firms in which any director is a partner or debts due by
---------------------- a private company in which a director is a director or member.
---------------------- iii) Maximum amount due by directors or other officers of the company at
any time during the year is required to be shown by way of a note.
---------------------- iv) Debts due from the companies under the same management as defined
---------------------- in Section 370(1B) of the Companies Act, 1956 are required to be
shown separately along with the names of these companies.
----------------------
----------------------
c. In case of bank balances, following details are required to be given: Notes
i) Balance lying with Scheduled Bank in current account, call account
----------------------
or deposit account. It should be noted here that a Scheduled Bank is
defined in Section 2(e) of the Reserve Bank Act, 1934. ----------------------
ii) Balances lying with banks other than Scheduled Banks in current
----------------------
account, call account or deposit account. It is further required to state
the names of all such banks and the maximum amount outstanding at ----------------------
any time during the year from each such bank.
----------------------
iii) Nature of interest of the directors or the relatives of the directors in the
non-scheduled bank is also required to be stated. ----------------------
2. Loans and Advances: ----------------------
The Loans and Advances may not always be in the form of current assets.
However, for the purpose of Schedule VI they are clubbed with current ----------------------
assets. ----------------------
The Loans and Advances are classified as:
----------------------
a. Advances and loans to subsidiaries.
----------------------
b. Advances and loans to partnership firms in which the company or any
of its subsidiaries is a partner. ----------------------
c. Bills of exchange. ----------------------
d. Advances recoverable in cash or in kind or for value to be received
e.g. Rates, Taxes, Insurance etc. ----------------------
e. Balances with customs, port trust etc. (where payable on demand) ----------------------
Disclosure requirements applicable to sundry debtors equally apply to ----------------------
Loans and Advances.
----------------------
a. Loans and advances are required to be classified as i) Outstanding for
a period exceeding six months ii) Other Loans and Advances ----------------------
b. Provision for bad and doubtful advances is required to be reduced
----------------------
from the balance of loans and advances.
c. Advances due by directors or other officers of the company or any of ----------------------
them either jointly or severally with any other person are required to ----------------------
be disclosed separately.
d. Advances due by firms in which any director is a partner or debts due ----------------------
by a private company in which a director is a director or member is ----------------------
required to be disclosed separately.
e. Maximum amount due by directors or other officers of the company at ----------------------
any time during the year is required to be shown by way of a note. ----------------------
f. Advances due from the companies under the same management as
----------------------
defined in Section 370(1B) of the Companies Act, 1956 are required
to be shown separately along with the names of these companies. ----------------------
Notes Notes : -
1. Miscellaneous Expenditure: (to the extent not written off or adjusted)
----------------------
In accounting language, this amount arises due to the deferred revenue
---------------------- expenditure incurred by the company. Deferred revenue expenditure is that
expenditure, which is neither capital expenditure nor revenue expenditure. It is
----------------------
not a capital expenditure as no fixed asset is created due to this expenditure. It
---------------------- is not even revenue expenditure, as the benefits received from such expenditure
are staggered benefits. Such expenditure should not be transferred to Profit and
---------------------- Loss Account in the year of incurrence. In practical circumstances, following
expenditure may appear under this head.
----------------------
a. Expenditure incurred in connection with drafting and printing of
---------------------- Memorandum of Association and Articles of Association of the Company,
legal charges, stamp duty and filing fees paid for getting the company
----------------------
registered as per the provisions of Companies Act, 1956 etc.
---------------------- b. Expenditure incurred in connection with the preparation of feasibility
---------------------- report, conducting the market survey etc.
c. Expenditure incurred in connection with the public issue of shares and
---------------------- debentures like underwriting commission, brokerage, drafting and printing
---------------------- of prospectus, advertisement and legal charges etc.
As per the provisions of Section 35D of the Income Tax Act, 1961, such
---------------------- expenditure can be written off to Profit and Loss Account over the period of
---------------------- five years.
2. Contingent Liabilities:
----------------------
Contingent liabilities may be defined as the liabilities the crystallisation of which
---------------------- depends upon the happening or non-happening of certain events. Contingent
Liabilities are never a part of main Balance Sheet. They are to be disclosed
----------------------
below the Balance Sheet by way of ‘Foot Note.’ In practical circumstances,
---------------------- contingent liabilities are disclosed in the Annexure to the Balance Sheet in the
form of ‘Notes on Accounts.’
----------------------
The contingent liabilities referred to in Schedule VI are as below:
---------------------- a. Claims against the company not acknowledged as debts. (In simple
---------------------- language, they are the disputed claims. They are likely to become final
liability only if the company loses the suit.)
---------------------- b. Uncalled liability on shares partly paid. (This liability may arise if the
---------------------- company has invested some amount in the shares of another company the
entire amount of which is not called.)
----------------------
c. Arrears of dividend on cumulative preference shares.
---------------------- d. Estimated amount of contracts remaining to be executed on capital accounts
and not provided for.
----------------------
e. Other money for which the company is contingently liable. (In practical
---------------------- circumstances, it may include the amounts like bills discounted by the
company with banks, the amount of guarantees given by the company on Notes
behalf of directors or other officers of the company etc.)
----------------------
Part II: Structure of Profitability Statement:
The profitability statement of a company may be split into the following ----------------------
components.
----------------------
a. First component discloses profits earned by the company after the
manufacturing function is over. This profit is technically referred to as ----------------------
‘Gross Profit’ and is calculated as Sales less Cost of Goods Manufactured
----------------------
(also called as Factory Cost).
b. Second component discloses profits earned by the company after all ----------------------
the operating activities are over. This profit is technically referred to as ----------------------
‘Operating Profit’ and is calculated as Sales less Operating Cost.
c. Third component discloses final profit earned by the Company after all the ----------------------
activities are over. This profit is technically referred to as ‘Profit After Tax’ ----------------------
and is calculated as:
Operating Profit ----------------------
Add: Non-operating incomes ----------------------

Less: Non-operating expenses ----------------------
Less: Taxation ----------------------
d. Fourth component indicates the profits retained in the business after the
Profit After ----------------------
Tax is distributed among the owners by way of dividend. Based upon the ----------------------
above discussion, the structure of the profitability statement can be drafted
as below: ----------------------
Sales Less: Factory Cost ----------------------

Gross Profit Less: Administrative and Selling Overheads Operating Profits ----------------------
Less: Non-Operating Expenses Add: Non-Operating Incomes
----------------------
Profit Before Tax Less: Taxes
Profit After Tax Less: Dividend Paid ----------------------
Retained Profit ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Notes
----------------------
---------------------- Match the following.

i. Business entity concept a. Anticipate all losses and not gains
----------------------
ii. Money measurement concept b. Expenses and costs must match
---------------------- iii. Cost concept c. Include material, exclude
immaterial transactions
---------------------- iv. Going concern concept d. You are your business are two
entities
---------------------- v. Conservatism concept e. Select one principal and follow it
---------------------- for long time
vi. Dual aspect concept f. Include monetary transactions
---------------------- only
vii. Accounting period concept g. Acquisition cost is important,
---------------------- market price is not
---------------------- viii. Matching concept h. Future time is divided in shorter
segmentations
---------------------- ix. Materiality concept i. Opening and closing balance
x. Consistency concept j. Every debit has a corresponding
---------------------- credit
---------------------- 1. The accounts that have debit balances are shown on the liability side of
balance sheet.
---------------------- 2. The accounts that have debit balances are shown on asset side of
---------------------- balance sheet.
3. Profit and Loss Account Debit Balance is shown on the asset side of
----------------------
balance sheet.
---------------------- 4. Profits set aside from business are called reserves.
---------------------- 5. Issued capital is that part of authorised capital, which is issued to the
public.
----------------------
6. Authorised capital is the capital mentioned in the memorandum of
---------------------- association.
---------------------- 7. Subscribed and called up capital are synonyms.

8. Forfeited shares means shares, which are surrendered by shareholders
---------------------- to the company.
---------------------- 9. Bonus shares are issued when profits are capitalised.
---------------------- 10. Contingent liabilities are included in total of liabilities.
----------------------
----------------------
Notes
Activity 2
----------------------
1. Study the revised structure of Schedule VI of Companies Act, 1956. ----------------------
2. Study the accounts of a business organisation and note how the above-
----------------------
mentioned accounting concepts have been followed in preparation of
accounts. If you find any deviation from any of the basic concepts, ----------------------
make a note of the same. Talk to a Chartered Accountant and get your
doubts clarified. ----------------------
----------------------
3.5 ROLE PLAYED BY FINANCIAL STATEMENTS
----------------------
In the present circumstances, the process of financial accounting and
----------------------
hence the preparation of financial statements has been made a mandatory
legal requirement, either directly or at least indirectly. As such, the preparation ----------------------
of financial statements indicates the compliance with the various legal
requirements. Moreover, it is through the financial statements that a host of ----------------------
persons dealing with an organisation get the information to enable them to take
----------------------
proper decisions e.g. on the basis of financial statements, the shareholders may
decide whether to retain the investment in the company or not or the prospective ----------------------
shareholders may decide whether to invest in the shares of the company or not.
On basis of financial statements, the creditors of an organisation may decide ----------------------
whether to continue extending the credit or not, and if yes to what extent. On
----------------------
the basis of financial statements, the employees may base their demands for
additional wages or various benefits i.e. the employees’ demands will definitely ----------------------
carry weight if the organisation is having good profitability. It is on the basis
of financial statements that the banks and/or financial institutions appraise ----------------------
the applications made by the organisations for the grant of or renewal of or
----------------------
continuance of credit facilities, as the financial statements give a good indication
about the performance and financial condition of an organisation. The financial ----------------------
statements may be used by the various agencies like Government or Reserve
Bank of India, to formulate certain policy decisions. The financial statements ----------------------
may be used by the various tax authorities to ascertain the tax liability of the
----------------------
organisation in various areas like Income Tax, Sales Tax etc. Last but not the
least, on the basis of financial statements the management may review the ----------------------
progress of the organisation and decide about the course of action to be taken
in future. However, it may be stated that the financial statements may not be ----------------------
available to the management as a tool for decision-making due to the various
----------------------
limitations attached to the same. Nevertheless, their basic role in the decision-
making process is undeniable. Thus, it is by way of the financial statements ----------------------
that an organisation speaks to the various persons dealing with it and gives the
report to them about the performance and financial position of itself. It may not ----------------------
be out of place to mention here that if the accounts are required to be audited as
----------------------
per any of the statutory requirements (like provisions of Companies Act, 2013
or Income Tax Act, 1961. the financial statements prepared therefrom may be ----------------------
treated as more credible by the readers.
Notes 3.6 LIMITATIONS OF FINANCIAL STATEMENTS
---------------------- 1. Financial statements are available only after the specific period of time
is over e.g. the Balance Sheet as on 31st March, 2019 is available only
---------------------- after 31st March, 2019 is over. The various legal provisions also provide
for sufficient time lag for the preparation of financial statements. Thus,
----------------------
the financial statements give the information about the historic facts,
---------------------- which may not be sufficient from decision-making point of view for the
management.
----------------------
2. Financial statements are necessarily interim reports and cannot be final
---------------------- ones. E.g. to understand the correct profitability and to understand the
correct position of various assets and liabilities, it will be necessary to stop
---------------------- the business operations and dispose of all the assets and liquidate all the
---------------------- liabilities which may not be practicable and feasible. In order to prepare
the financial statements for a specific period, it may be necessary to cut off
---------------------- various transactions involving costs and incomes at the date of closing the
accounts that may involve the personal judgments. Various policies and
---------------------- principles are required to be formulated and followed consistently for such
---------------------- cutting off of incomes and costs.
3. As ‘going concern principle’ is followed while preparing the Balance Sheet,
---------------------- the various assets and liabilities are shown at historical prices and do not
---------------------- necessarily represent the current market prices or the liquidation prices.
This may affect the profitability statement as well in the form of incorrect
---------------------- provision for depreciation. This problem maybe more critical during the
periods of extreme inflation or depression. As such, any conclusions drawn
---------------------- on the basis of such financial statements may be misleading ones.
---------------------- 4. Financial statements consider only those transactions, which can be
expressed in monetary terms. All other transactions or factors, which
----------------------
cannot be expressed in terms of money, are ignored by the financial
---------------------- statements. E.g. assume that the business of a company is such that it is
likely to be injurious to the health of local community. As such, there is a
---------------------- strong opposition from the local community for the company’s carrying
on of business at that location. This opposition is something, which cannot
----------------------
be expressed in terms of money and hence finds no place in the financial
---------------------- statements, though it is affecting the business operations of the company to
a very great extent.
----------------------
5. The financial statements prepared may be useful for the use of normal users
---------------------- under normal circumstances. If a user wants to use the financial statements
for some special purposes, the necessary information or details may not
---------------------- be available from the financial statements. E.g. if an user, on the basis
of financial statements available wants to value the equity shares of the
----------------------
company with the methods considering earnings capacity of the company,
---------------------- the required details may not be available from the financial statements.
Similarly, the financial statements may not give correct indications about
---------------------- the profitability or the financial conditions of the business under abnormal
circumstances. E.g. suppose that the production and sales of a company in Notes
a particular year are abnormally high due to the prolonged strike in one of
the major competitor companies, and hence profits in that particular year ----------------------
are abnormally high. Now when both the sales and profits are at normal
level, the performance of that year may be treated as bad as compared to ----------------------
an abnormal year. ----------------------
6. Financial statements, howsoever carefully and correctly prepared, do not
----------------------
mean anything all by themselves unless the information stated therein is
properly studied, analysed and interpreted. As such, merely the preparation ----------------------
of financial statements is not sufficient; equally important is the task of
their analysis and interpretation. ----------------------
----------------------
----------------------
1. Financial Statements are outward looking statements.
----------------------
2. Financial statements are interim reports and not final reports.
----------------------
3. Financial statements represent historical prices and not current market
prices. ----------------------
4. Financial statements include the transactions that can be expressed in
----------------------
terms of money.
5. Financial statements can give correct indicators under abnormal ----------------------
circumstances.
----------------------
6. Without analysis and interpretation, financial statements are inadequate.
----------------------
----------------------
Activity 3
----------------------
1. Obtain a copy of the Annual Report of any company listed on stock
----------------------
exchange and find out the following:
a. Authorised, issued, subscribed, called up, paid up capital ----------------------
b. Face value of the company’s shares ----------------------
c. Write the details of various amounts written under ----------------------
i. Reserves and Surplus
----------------------
ii. Investments
----------------------
iii. Secured and unsecured loans
iv. Profit before tax and profit after tax ----------------------
2. Write down the significant accounting policies followed by the company. ----------------------
----------------------
Notes 3.7 ANALYSIS AND INTERPRETATION OF FINANCIAL
STATEMENTS
----------------------
As stated earlier, the financial statements are not useful unless they are
---------------------- properly analysed and interpreted. The process of analysis of financial statements
---------------------- involves the arrangement and rearrangement, grouping and regrouping of
the financial and operational data appearing on the financial statements, and
---------------------- the calculations of ratios and trends therefrom. The process of interpretation
follows that of analysis and involves the attempts to arrive at logical conclusions
---------------------- regarding the performance and financial position of the business organisation.
---------------------- Types of Analysis:
---------------------- There can be basically two ways in which the analysis of financial statements
can be carried out.
----------------------
1. Internal Analysis:
---------------------- This indicates the analysis carried out by those parties who have the access
---------------------- to the books and records of the company. Naturally, it indicates basically
the analysis carried out by the management of the company to enable the
---------------------- decision-making process. This may also indicate the analysis carried out
in the legal or statutory matters where the parties who are not a part of the
---------------------- management of the company may have the access to the books and records
---------------------- of the company.
2. External Analysis:
----------------------
This indicates the analysis carried out by those parties who do not have
---------------------- the access to the books and records of the company. This may involve
the analysis carried out by creditors, prospective investors and other
----------------------
outsiders. Naturally, those outsiders are required to depend upon the
---------------------- published financial statements. As such, the depth and correctness of the
external analysis is restricted, though some of the recent amendments to
---------------------- the statutes like Companies Act, 2013 have made it mandatory for the
companies to reveal maximum information relating to the operations and
----------------------
financial position, in order to facilitate the correct and proper analysis and
---------------------- interpretation of the financial statements by the readers.
Techniques of Analysis and Interpretation:
----------------------
Though there may be numerous techniques available for the analysis and
---------------------- interpretation of financial statements, we will consider the following two
techniques in details.
----------------------
(a) Ratio Analysis
----------------------
(b) Funds Flow/Cash Flow Analysis
----------------------
----------------------
----------------------
Notes
----------------------
Fill in the blanks by stating whether the analysis of financial statements ----------------------
carried out by these is internal analysis or external analysis.
----------------------
1. Income tax office: ____________
2. Company management: ____________ ----------------------
3. Department of corporate affairs: ____________ ----------------------
4. Shareholders: ____________ ----------------------
5. Creditors and bankers: ____________
----------------------
----------------------
Activity 4
----------------------
Contact a share broker and discuss with him about the manner in which he
carries out the analysis of financial statements. ----------------------
----------------------
Summary ----------------------
• Financial statements of an organisation give the details of financial ----------------------
performance of the organisation as well as the financial standing of the
organisation. ----------------------
• The organisation carries out the process of accounting, which effectively ----------------------
results into the preparation the financial statements. These financial
statements are basically in two forms namely the Balance Sheet and the ----------------------
Profit and Loss Account.
----------------------
• Balance Sheet gives details of the various sources used by the organisation
to raise the funds and the various assets in which these funds are deployed. ----------------------
The result of operations of the business during the specific period, i.e. ----------------------
whether the operations have resulted into a profit or loss and by what
amount is given by the Profit and Loss Account. ----------------------
• A company is required to prepare and present its financial statements in ----------------------
accordance with the provisions of Schedule VI of the Companies Act,
2013. Schedule VI lays down various disclosure requirements, which the ----------------------
companies are required to follow while preparing their financial statements.
----------------------
• The financial statements of a company are used by the shareholders,
creditors, banks, financial institutions, employees, government agencies for ----------------------
decision-making in dealing with the company. It is by way of the financial
statements that an organisation gives the report about the performance and ----------------------
financial position of itself. ----------------------
----------------------
Notes • Financial Statements are further analysed and interpreted to arrive at
logical conclusions regarding the performance and financial position of
---------------------- the company.
----------------------
Keywords
----------------------
• Contingent Liabilities: Contingent liabilities may be defined as the
---------------------- liabilities the crystallisation of which depends upon the happening or non-
happening of certain events.
----------------------
• Internal Analysis: This indicates the analysis carried out by those parties
---------------------- who have the access to the books and records of the company.
---------------------- • External Analysis: This indicates the analysis carried out by those parties
who do not have the access to the books and records of the company.
----------------------

---------------------- 1. Explain the meaning of the term Financial Statements. What information is
conveyed by the Financial Statements?
----------------------
2. Enumerate the basic concepts followed in accounting. Explain the meaning
---------------------- of each concept in brief.
---------------------- 3. Write a note on the requirements of Schedule VI of the Companies Act
with regards to the structure of Financial Statements of a Company.
----------------------
4. Who are the users of Financial Statements? What is the utility of Financial
---------------------- Statements to these users?
---------------------- 5. What are the limitations of Financial Statements?
6. Write a note on analysis and interpretation of Financial Statements.
----------------------

1. False
----------------------
2. True
----------------------
3. True
---------------------- 4. False
---------------------- 5. False
----------------------
----------------------
----------------------
----------------------
i. d
----------------------
ii. f
iii. g ----------------------
iv. i ----------------------
v. a ----------------------
vi. j
----------------------
vii. h
----------------------
viii. b
ix. c ----------------------
x. e ----------------------
1. False
----------------------
2. True
----------------------
3. True
4. True ----------------------
5. True ----------------------
6. True ----------------------
7. False
----------------------
8. False
9. True ----------------------
10. False ----------------------

----------------------
1. True
----------------------
2. True
3. True ----------------------
4. True ----------------------
5. False ----------------------
6. True
----------------------
----------------------
----------------------
Notes Check your Progress 4
Fill in the blanks by stating whether the analysis of financial statements
----------------------
carried out by these is internal analysis or external analysis.
---------------------- 1. Income tax office: External analysis
---------------------- 2. Company management: Internal analysis
3. Department of corporate affairs: External analysis
----------------------
4. Shareholders: External analysis
----------------------
5. Creditors and bankers: External analysis
----------------------
---------------------- 1. Miranda & Fackler. Applied Computational Economics and Finance

2. Sofat & Hiro. Basic Accounting Book.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Interpretation of Financial Statements (Ratio Analysis)
UNIT
4
Structure:
4.1 Introduction
4.2 Interpretation of Ratios
4.3 Role of Ratio Analysis
4.4 Classifications of Ratios
4.5 Limitations of Ratio Analysis
Summary
Key Words
Suggested Reading
Interpretation of Financial Statements (Ratio Analysis) 55

Notes
Objectives
----------------------
----------------------
• Define the meaning of ratio analysis
---------------------- • Discuss the role played by ratio analysis in the interpretation of
---------------------- financial statements
• xplain the technique of financial analysis by computation of
E
---------------------- various ratios
---------------------- • Construct the meaning of various ratios
---------------------- • nalyse the limitations of various ratios and accordingly apply

A
precautions while drawing conclusions from ratio analysis of a
---------------------- business entity
---------------------- 4.1 INTRODUCTION

---------------------- Generally, an absolute figure conveys no meaning. A figure may become
meaningful if it is compared with some other information. Similarly, the
----------------------
absolute figures appearing on the financial statements, either the profitability
---------------------- statement or the balance sheet, may not give the qualitative indication regarding
the financial position or performance of an organisation, which may be
---------------------- available, if the accounting figures appearing in the financial statements can be
compared with each other. For example, if the profitability statement discloses
----------------------
the amount of Rs. 1 Lakh as the net profit, it appears to be a good performance.
---------------------- But if this information is supported by the fact that the sales turnover during the
corresponding period was Rs. 10 crore, it can be immediately concluded that
---------------------- the performance of the organisation is not all that fabulous, as the net profit as
a percentage of sales turnover is only 0.1%. The comparison of profit on one
----------------------
hand and sales turnover on the other hand, gives a qualitative indication about
---------------------- the performance of the organisation. Here comes into the picture the technique
of ‘Ratio Analysis’.
----------------------
The term ‘ratio’ implies arithmetical relationship between two related
---------------------- figures. The technique of ‘Ratio Analysis’ as technique for interpretation of
financial statements deals with computation of various ratios, by grouping or
---------------------- regrouping the various figures and/or information appearing on the financial
---------------------- statements (either profitability statement or Balance sheet or both) with the
intention to draw the fruitful conclusions therefrom.
---------------------- It should be remembered that ratios, depending on the nature of ratio, may
---------------------- be expressed in either of the following ways:
1. Fractions (e.g. 2/3)
---------------------- 2. Decimals (e.g. 2.5)
---------------------- 3. Percentage of other financial figure (e.g. 20% of sales)
4. Colon (:) between numbers (e.g. 2:3)
----------------------
5. Number of times of certain financial figure (e.g. 2 times of sales etc.)
4.2 INTERPRETATION OF RATIOS Notes
The ratios calculated on the basis of grouping and regrouping of the figures ----------------------
appearing on either profitability statement or Balance Sheet or both, may not
all by themselves mean anything, unless they can be compared with some ----------------------
yardstick. The yardstick with which the ratios can be compared maybe in the
following three forms: ----------------------
1) The ratios of one organisation may be compared with the ratios of the same ----------------------
organisation for the various years, either the previous years or the future
years. This may be in the form of ‘intra-firm comparison.’ ----------------------
2) The ratios of one organisation may be compared with the ratios of ----------------------
other organisations in the same industry and such comparison will be
meaningful as the various organisations in the same industry may be ----------------------
facing similar kinds of financial problems. This may be in the form
of ‘inter-firm comparison.’ ----------------------
3) The ratios of an organisation maybe compared with some standards which ----------------------
maybe supposed to be the thumb rule for the evaluation of the performance
For example, If the comparison of current assets and current liabilities ----------------------
of an organisation is to be made, the result of 2: 1, i.e. two rupees of
current assets for one rupee of current liabilities is supposed to be ideal. ----------------------
The position as reflected by the actual current assets and actual current
----------------------
liabilities maybe compared with this standard to evaluate the performance
of the organisation. ----------------------
----------------------
1. Absolute figures convey no meaning. ----------------------
2. Figures do not become meaningful if they are compared with some
----------------------
other information.
3. Ratios can be expressed either as a percentage or as fractions or as ----------------------
comparison.
4. The ratios of the organisation may be compared with some standards, ----------------------
which are supposed to be thumb rules.
----------------------
1. Ratio implies ----------------------
i. Statistical relationship between two related figures
----------------------
ii. Technical relationship between two related figures
iii. Mathematical relationship between two related figures ----------------------
2. When ratios of an organisation are compared with the same organisation, ----------------------
it is called ----------------------
i. Inter firm comparison
ii. Intra firm comparison ----------------------
iii. Both the above
----------------------

Notes
Activity 1
----------------------
---------------------- Get a copy of an annual report of any company and identify the areas where
ratio analysis has been used for financial interpretation. Select any five
---------------------- ratios and find out whether they were expressed as a percentage or as a
fraction or as a comparison.
----------------------
----------------------
4.3 ROLE OF RATIO ANALYSIS
----------------------
It is true that the technique of Ratio Analysis is not a creative technique
---------------------- in the sense that it uses the same figures and information, which is already
appearing in the financial statements. At the same time, it is also true that what
---------------------- can be achieved by the technique of Ratio Analysis cannot be achieved by the
---------------------- mere preparation of financial statements.
Ratio Analysis helps to appraise the firms in term of their profitability and
---------------------- efficiency of performance, either individually or in relation to those of other
---------------------- firms in the same industry. The process of this appraisal is not complete until
the ratios so computed can be compared with something, as the ratios all by
---------------------- themselves do not mean anything. This comparison may be the intra-firm
comparison, inter-firm comparison or comparison with standard ratios. Thus,
---------------------- proper comparison of ratios may reveal where a firm is placed as compared with
---------------------- earlier periods or in comparison with other firms in the same industry.
Ratio Analysis is one of the best possible techniques available to the
----------------------
management to impart the basic functions like planning and control. As the
---------------------- future is closely related to the immediate past, ratios calculated based on
historical financial statements maybe of good assistance to predict the future.
---------------------- For example, on the basis of inventory turnover ratio or debtor’s turnover ratio
in the past, the level of inventory and debtors can easily be ascertained for
----------------------
any given amount of sales. Similarly, ratio analysis may be able to locate and
---------------------- point out the various areas, which need the management’s attention in order
to improve the situation. For example, Current Ratio, which shows a constant
---------------------- declining trend, may indicate the need for the further introduction of long-term
finance in order to improve the liquidity position. It should be remembered that
----------------------
a few specific ratios indicate certain specific aspects of the conduct of business.
---------------------- As such, the importance of various ratios may vary for different category of
persons as well. For example, the commercial bankers, trade creditors and
---------------------- lenders of short-term credit are interested in the liquidity position of the
organisation and as such, the ratios like current ratio, acid test ratio, inventory
----------------------
turnover ratio and average collection period are more important. On the other
---------------------- hands, the financial institutions and lenders of long-term finance are interested
in the solvency and profitability position of the organisation and as such, the
---------------------- ratios like debt equity ratio, debt service coverage ratio, interest coverage ratio
and return on investment are more important.
----------------------
As the ratio analysis is concerned with all the aspects of a firm’s financial Notes
analysis, i.e., liquidity, solvency, activity, profitability and overall performance,
it enables the interested persons to know the financial and operational ----------------------
characteristics of an organisation and take the suitable decisions.
----------------------
4.4 CLASSIFICATIONS OF RATIOS ----------------------
The ratios may be classified under various ways, which may use various criteria ----------------------
to do the same. However, for convenience purposes, we will classify the ratios
under the following: ----------------------
(a) Liquidity Group (d) Profitability Group ----------------------

(b) Turnover Group (e) Overall Profitability Group ----------------------
(c) Solvency Group (f) Miscellaneous Group
----------------------
(a) Liquidity Group
----------------------
The ratios computed under this group indicate the short-term position of
the organisation and also indicate the efficiency with which the working ----------------------
capital is being used. Commercial banks and short-term creditors may be
basically interested in the ratios under this group. Two most important ----------------------
ratios may be calculated under this group. ----------------------
1. Current Ratio:
----------------------
It is calculated as:
Current Assets ----------------------
Current Liabilities ----------------------
Components: ----------------------
Current Assets include cash in hand or at bank, marketable securities, sundry ----------------------
debtors, bills receivables, inventories, prepaid expenses and short-term loans
and advances. ----------------------
Current liabilities include sundry creditors, bills payable, outstanding expenses ----------------------
and bank overdraft or cash credit.
----------------------
Following propositions should be considered:
----------------------
i. Disagreement may be there for inclusion of bank overdraft or cash credit
in current liabilities. Strictly speaking, in legal terminology, cash credit ----------------------
or overdraft facilities are the demand facilities i.e., Banks can ask for
repayment at any time. However, in practice, these facilities are usually ----------------------
permanent facilities. Hence, it may be argued that they should be considered
----------------------
as noncurrent liabilities. However, considering the legal implications of
the same, it is better to treat them as current liabilities. ----------------------
ii. If bills receivables raised by the organisation are discounted with the Bank,
----------------------
they cease to appear as the receivables in the Balance Sheet except by way
of the note to the same. At the same time, they indicate the working capital ----------------------

Notes facility granted by the Bank to that extent. For the purpose of correct
computation of current ratio, the amount of bills discounted with Banks
---------------------- should be added to both current assets as well as current liabilities.
---------------------- Indication / Precautions:
Current ratio indicates the backing available to current liabilities in the form
----------------------
of current assets. In other words, a higher current ratio indicates that there are
---------------------- sufficient assets available with the organisation which can be converted in the
form of cash, without any reduction in value, in a short span of time i.e., current
---------------------- assets, to pay off the liabilities which are to be paid off in the short span of
time, i.e. current liabilities. As such, higher the current ratio better will be the
----------------------
situation. A current ratio of 2:1 is supposed to be standard and ideal. However,
---------------------- a blind comparison of actual current ratio with the standard current ratio, may
lead to unrealistic conclusions. As such, before drawing the conclusion that
---------------------- higher current ratio indicates safe situation, following propositions should be
kept in mind:
----------------------
1. It should be ensured that the valuation of current assets and current
---------------------- liabilities is made on a consistent basis and as per the accepted accounting
principles.
----------------------
2. It should be ensured that the current assets do not include the inventories
---------------------- which are obsolete or non moving and the receivables do not include debts
---------------------- which are outstanding for a very long time and are not provided for which
may be almost non recoverable. If the current assets include these types of
---------------------- assets, for correct computation of current ratio, they may be excluded from
the current assets.
----------------------
3. If current ratio is computed on the basis of Balance Sheet figures, abnormal
---------------------- purchases of inventories or abnormal creation of receivables towards the
end of accounting period should be considered in the right perspective.
----------------------
4. A higher current ratio indicates unnecessarily high investment in current
---------------------- assets in the form of inventories or receivables or both.
---------------------- 2. Liquid Ratio or Acid Test Ratio or Quick Ratio
It is an improved version of current ratio.
----------------------
---------------------- Liquid Assets
---------------------- Liquid Liabilities
---------------------- Components:
---------------------- Liquid Assets include all current assets except inventories and prepaid expenses.
Liquid Liabilities include all current liabilities except bank overdraft or cash
----------------------
credit.
----------------------
----------------------
Indications/Precautions: Notes
Liquid ratio indicates the backing available to liquid liabilities in the form of
----------------------
liquid assets. The term liquid assets indicates the assets which can be converted
in the form of cash, without any reduction in value, almost immediately whereas, ----------------------
the term liquid liabilities indicates the liabilities which are required to be paid
almost immediately. In other words, a higher liquid ratio indicates that there ----------------------
are sufficient assets available with the organisation, which can be converted in
----------------------
the form of cash almost immediately to pay off those liabilities, which are to be
paid off almost immediately. As such, higher the liquid ratio better will be the ----------------------
situation. A liquid ratio of 1:1 is supposed to be standard and ideal.
----------------------
Before drawing any conclusions regarding the indications given by the liquid
ratio, following propositions should be kept in mind: ----------------------
1) Liquid assets exclude the current assets in the form of inventories and ----------------------
prepaid expenses, but include the current assets in the form of receivables.
Whereas the exclusion of prepaid expenses cannot be argued upon as they ----------------------
indicate the assets, which cannot be converted in cash, the exclusion of
inventories and inclusion of receivables may be challenged. There may be ----------------------
some kinds of inventories, which can be disposed off almost immediately, ----------------------
due to their specific nature, and thus may be treated as liquid assets. At
the same time, there may be some receivables outstanding for a very long ----------------------
time and not provided for, which may be almost non-recoverable and thus
ideally will not be in the form of liquid assets. ----------------------
2) Non-consideration of bank overdraft or cash credit as liquid liability can ----------------------

hardly be challenged as by its practical nature, it indicates the liability,
which is not required to be paid immediately. ----------------------
(b) Turnover Group ----------------------

The ratios computed under this group indicate the efficiency of the ----------------------
organisation to use the various kinds of assets by converting them in the
form of sales. As the assets can be basically categorised as Fixed Assets ----------------------
and Current Assets and as the current assets may further be classified
----------------------
according to the individual components of current assets viz. inventory and
receivables (debtors) or as net current assets i.e., current assets less current ----------------------
liabilities viz., working capital, under this group of classification of ratios,
following ratios may be computed: ----------------------
1. Fixed Assets Turnover Ratio: ----------------------
It is calculated as: ----------------------

Net Sales ----------------------
Fixed Assets
----------------------
Components:
----------------------
Net sales include sales after returns, if any, both cash as well as credit. Fixed
assets include net fixed assets i.e., fixed assets after providing for depreciation. ----------------------

Notes Indications / Precautions:
A high fixed assets turnover ratio indicates the capability of the organisation
----------------------
to achieve maximum sales with the minimum investment in fixed assets. It
---------------------- indicates that the fixed assets are turned over in the form of sales more number
of times. As such, the higher the fixed assets turnover ratio, better will be the
---------------------- situation.
---------------------- 2. Current Assets Turnover Ratio:
----------------------
Net Sales
---------------------- Current Assets
---------------------- Components:
---------------------- Net sales include sales after returns, if any, both cash as well as credit.
---------------------- Current Assets include the assets like inventories, sundry debtors, bills
receivables, cash in hand or at bank, marketable securities, prepaid expenses
---------------------- and short-term loans and advances.
---------------------- Indications / Precautions:
A high current assets turnover ratio indicates the capability of the organisation
----------------------
to achieve maximum sales with the minimum investment in current assets.
---------------------- It indicates that the current assets are turned over in the form of sales more
number of times. As such, the higher the current assets turnover ratio, better
---------------------- will be the situation.
---------------------- 3. Working Capital Turnover Ratio:
---------------------- It is calculated as:

Net Sales
---------------------- Working capital
---------------------- Components:
---------------------- Net sales include sales after returns, if any, both cash as well as credit. Working
capital includes difference between current assets and current liabilities.
----------------------
Indications / Precautions:
----------------------
A high working capital turnover ratio indicates the capability of the organisation
---------------------- to achieve maximum sales with the minimum investment in working capital. It
indicates that working capital is turned over in the form of sales more number
----------------------
of times. As such, the higher this ratio, better will be the situation.
---------------------- 4. Inventory / Stock Turnover Ratio:
Cost of goods sold
---------------------- (a)
Average inventory
---------------------- or
Net Sales Notes
(b)
Average inventory
----------------------
or
Cost of goods sold ----------------------
(c)
Cost inventory ----------------------
or
Net Sales ----------------------
(d)
Closing inventory ----------------------
It can be seen from above that the inventory turnover ratio may be expressed ----------------------
in either of the four ways as stated above though alternative ‘a’ may be the best
possible way to express inventory turnover ratio. It is specifically because other ----------------------
alternatives have certain flaws as stated below:
----------------------
i. Alternatives ‘b’ and ‘d’ consider the amount of sales as the numerator,
which includes the amount of profits where as the denominator in the ----------------------
form of either average or closing inventory, is normally valued at costs
----------------------
(assuming market price is more).
ii. Alternatives ‘c’ and ‘d’ consider closing inventory, which ignores the ----------------------
possibility of certain seasonal or abnormal purchases at the end of
----------------------
accounting period, which may increase the closing inventory. Alternative
‘a’ does not have both the above stated limitations. As numerator is in the ----------------------
form of cost of goods sold, it does not consider profit. As denominator is
in the form of average inventory, it considers possibility of seasonal or ----------------------
abnormal purchases at the end of the accounting period. Ideally, average
----------------------
inventory should be the average of monthly inventory specifically when
the size of inventories fluctuates substantially during the year. As such, ----------------------
average inventory may be computed as:
Opening inventory + inventory at the end of every month ----------------------
13 ----------------------
However, in many cases, for convenience purposes, inventory may be computed
as the average of opening and closing inventory only. ----------------------
Indications / Precautions: ----------------------

A high inventory turnover ratio indicates that maximum sales turnover is ----------------------
achieved with the minimum investment in inventory. As such, as a rule, high
inventory turnover ratio is desirable. However, the high inventory turnover ratio ----------------------
should be viewed from some more angles. Firstly, it may indicate that there is
----------------------
an under investment in inventory whereby the organisation may lose customer
patronage if it is unable to maintain the delivery schedule. Secondly, high ----------------------
inventory turnover ratio may not necessarily indicate profitable situation. An
organisation, in order to achieve a large sales volume, may sometimes sacrifice ----------------------
on profits, whereby a high inventory ratio may not result into high amount of
----------------------
profits.
----------------------

Notes On the other hand, a low inventory turnover ratio may indicate over investment
in inventory, existence of excessive or obsolete/non moving inventory,
---------------------- improper inventory management, accumulation of inventories at the yearend in
anticipation of increased prices or sales volume in near future and so on.
----------------------
There can be no standard inventory turnover ratio, which may be considered
---------------------- ideal. It may depend on nature of industry and marketing strategies followed by
the organisation.
----------------------
5. Debtors Turnover Ratio:
----------------------
---------------------- Net Credit Sales
---------------------- Closing Sundry Debtors
This ratio indicates the speed at which the sundry debtors are converted in
----------------------
the form of cash. However, this intention is not correctly achieved by making
---------------------- the calculations in this way. As such, this ratio is normally supported by the
calculations of Average Collection Period, which is calculated as below:
----------------------
(a) Calculation of daily sales:
---------------------- Net Credit Sales
---------------------- Net working days
(b) Calculation of average collection period:
----------------------
Closing Sundry debtors
----------------------
Daily sales
---------------------- Following propositions should be kept in mind:
---------------------- 1. As the concept of sundry debtors does not come into the picture in case of
cash sales, while computing average collection period, only credit sales
---------------------- should be considered. However, in practice, break up of cash sales and
---------------------- credit sales may not be available from the published statement of accounts.
Then the total sales may be considered for the computation of this ratio.
---------------------- 2. While considering the total amount of debtors, the bill receivables should
---------------------- be considered along with the debtors. Further, debtors not arising out of
the regular sales transactions should be excluded as far as possible. For
---------------------- example, debtors for the sale of fixed assets.
---------------------- 3. In some cases, while computing this ratio, average sundry debtors instead
of only closing sundry debtors may be considered.
----------------------
4. For the calculation of daily sales, it is customary to consider 360 days in
---------------------- a year instead of 365 days in a year. In some cases, it is also argued that
weightage should be given to the holidays also when there are no business
---------------------- transactions.
---------------------- The average collection period as computed above should be compared with the
normal credit period extended to the customers. If the average collection period
is more than normal credit period allowed to the customers, it may indicate Notes
over investment in debtors, which may be the result of over-extension of credit
period, liberalisation of credit terms, ineffective collection procedures and so ----------------------
on.
----------------------
However, before drawing the conclusions like this, the factor of distribution of
sales throughout the year should be considered carefully. In other words, if the ----------------------
credit sales are not evenly distributed throughout the year, the result obtained
----------------------
from the computation of average collection period may be misleading. For
example, assume a situation, where the total sales amount to Rs.18 Lakh out of ----------------------
which credit sales are Rs.3.60 Lakh. The organisation rarely sells on credit basis
and the entire amount of credit sales were in the 11th month of the year, with ----------------------
the normal credit period allowed of 60 days. As such, the entire amount of Rs.
----------------------
3.60 Lakh will be outstanding at the yearend in the form of Sundry debtors. The
computation of average collection period will be made as below: ----------------------
(a) Calculation of daily sales: ----------------------
Net Credit Sales
----------------------
No. of working days

Rs. 3,60,000 ----------------------
=
360 ----------------------
= Rs. 1000/ per day
----------------------
(b) Calculation of average collection period:
Closing sundry debtors ----------------------
Daily sales ----------------------

Rs. 3,60,000
= ----------------------
1000
----------------------
= 360 days
The average collection period thus calculated may then be compared with the ----------------------
normal credit period allowed to the customers i.e., 60 days and the conclusion
----------------------
maybe drawn that there is a lapse on the part of collection department to collect
the dues in time which may be a misleading one, as the outstanding sundry ----------------------
debtors represent the debts which are not yet due for payment.
----------------------
6. Capital Turnover Ratio:
Sales ----------------------
Capital Employed
----------------------
Components: ----------------------
The term in denominator i.e., capital employed indicates the long-term funds ----------------------
supplied by creditors and owners of the firms. As such, it can be computed in
two ways. ----------------------

Notes (a) Fixed Assets + Investments + Current Assets - Current Liabilities.
(b) Share Capital + Reserves and Surplus + Long-term Liabilities.
----------------------
----------------------
This ratio indicates the efficiency of the organisation with which the capital
---------------------- employed is being utilised. A high capital turnover ratio indicates the capability
of the organisation to achieve maximum sales with minimum amount of capital
---------------------- employed. It indicates that the capital employed is turned over in the form of
---------------------- sales more number of times. As such the higher the capital turnover ratio, better
will be the situation.
---------------------- (c) Solvency Group
---------------------- The ratios computed under this group indicate the long-term financial
prospects of the company. The shareholders, debenture-holders and other
----------------------
lenders of long-term finance/ term loans may be basically interested in the
---------------------- ratios falling under this group. Following ratios may be computed under
this group:
----------------------
1. Debt Equity Ratio:
---------------------- It may be calculated in two ways:
---------------------- External
(a)
---------------------- Shareholders’ Funds
Long Term Liabilities
---------------------- (b)
Shareholders’ Funds
---------------------- As per expression ‘a’ stated above, the external liabilities include all types
of liabilities viz., long-term, short-term or current.
----------------------
The expression ‘b’ as stated above, considers only long-term liabilities
---------------------- which maybe in the form of debentures, term loans and deferred payment
liabilities.
----------------------
Shareholders’ funds in both the expressions consist of share capital plus
---------------------- reserves and surplus. There are controversial views regarding the treatment of
---------------------- preference shares capital i.e., whether the preference share capital should be
treated as a part of debt or equity. No clear-cut principles are available regarding
---------------------- the treatment of preference share capital. However, generally the following type
of treatment may be given.
----------------------
In case of the redeemable preference share capital, if they are redeemable
---------------------- after the period of 12 years, they may be treated as a part of equity, assuming the
period of 12 years to be a sufficiently longer period. However, if the preference
---------------------- shares are redeemable before the period of 12 years, they may be treated as a
---------------------- part debt.
It should be noted that the treatment given to the preference share capital
---------------------- as described above is only a matter of convention and practice, and not of any
---------------------- principle.
Indications / Precautions: Notes
Debt Equity ratio indicates the stake of shareholders or owners in the
----------------------
organisation vis-à-vis that of the creditors. It indicates the cushion available to
the creditors on liquidation of the organisations. A high debt equity ratio may ----------------------
indicate that the financial stake of the creditors is more than that of the owners.
A very high debt equity ratio may make the proposition of investment in the ----------------------
organisation a risky one. On the other hand, a very low debt equity ratio may
----------------------
mean that the borrowing capacity of the organisation is being underutilised.
In this context, the readers of financial management may remember that to ----------------------
borrow the funds from outsiders is one of the best possible ways to increase
the earnings available to the equity shareholders, basically due to two reasons. ----------------------
Firstly, the expectations of the creditors in the form of return on their investment
----------------------
are comparatively less as compared to the returns expected by the equity
shareholders. Secondly, the return on investment paid to the creditors is a tax- ----------------------
deductible expenditure.
----------------------
2. Proprietary Ratio:
This ratio indicates the relationship between the owners’ funds and total ----------------------
assets. As the assets can be fixed or current, this ratio can be further analysed
----------------------
accordingly. As such, it can be calculated as:
Total Assets ----------------------
(a)
Owners funds ----------------------
or
Fixed Assets ----------------------
(b)
Owners funds ----------------------
or
----------------------
Current Assets
(c)
Owners funds ----------------------
Components: ----------------------
The term in denominator i.e., owners’ funds is the same as the term ‘Equity’ ----------------------
used in Debt Equity Ratio.
----------------------
----------------------
This ratio indicates the extent to which the owner’s funds are sunk in different
kinds of assets. If the owners’ funds exceed fixed assets, it indicates that a part ----------------------
of owners’ funds is invested in the current assets also. If the owners’ funds are
less than fixed assets, it indicates that a part of fixed assets is financed by the ----------------------
creditors-either long-term or short-term. ----------------------
Similarly, the ratio between the current assets to the owner’s funds indicates the
extent to which owners’ funds are locked up in current assets. In some cases, ----------------------
higher proportion of current assets to owners’ funds, as compared to proportion ----------------------
of fixed assets to owners’ funds may be treated as a sign of good health of the
business. ----------------------

Notes 3. Fixed Assets/Capital Employed Ratio:
----------------------
Fixed Assets
X 100
---------------------- Capital Employed
---------------------- Components:
---------------------- The term in denominator i.e., capital employed indicates the long-term funds
supplied by creditors and owners of the firm. As such, it can be computed in
---------------------- two ways.
---------------------- (a) Fixed Assets + Investments + Current Assets – Current Liabilities
(b) Share Capital + Reserves and Surplus + Long-term Liabilities
----------------------
----------------------
This ratio indicates the extent to which the long-term funds are sunk in fixed
---------------------- assets. It has been an accepted principle of financial management that not only
fixed assets should be financed by way of long-term funds but also a part of
---------------------- current assets or working capital should be financed by way of long-term funds,
---------------------- and this part maybe in the form of permanent working capital. A very high trend
of this ratio may indicate that a major portion of long-term funds is utilised for
---------------------- the purpose of fixed assets leaving a small portion for the investment in current
assets or working capital. A very high trend of this ratio coupled with a constant
----------------------
declining trend of current ratio may indicate an urgent need for the introduction
---------------------- of long-term funds for financing the working capital in the business.
4. Interest Coverage Ratio:
----------------------
---------------------- Profits before interest and taxes

---------------------- Interest charges
Components:
----------------------
The numerator considers the profits before interest on both term and working
---------------------- capital borrowings. In this connection, it should be noted that income tax should
be added while computing the profits because it is calculated after paying the
----------------------
interest.
---------------------- The denominator considers the interest charges, which are in the form of interest
---------------------- on long-term borrowing and not the interest on working capital facilities.
Indications / Limitations:
----------------------
This ratio indicates the protection available to the lenders of long-term capital
---------------------- in the form of funds available to pay the interest charges i.e., profits. Normally,
a high ratio will be desirable but too high a ratio may indicate under-utilisation
----------------------
of the borrowing capacity of the organisation, whereas too low a ratio may
---------------------- indicate excessive long-term borrowings or inefficient operations.
----------------------
This ratio suffers from certain limitations. Notes
(a) The fixed obligations in the form of preference dividend or installments of
----------------------
long-term borrowings are not considered.
(b) The funds available for meeting the obligations of interest payments may ----------------------
not be necessarily in the form of profits before interest and taxes only, as the
----------------------
amount of profits so calculated may consider the amount of depreciation
debited to profit and loss account, which does not involve any outflow of ----------------------
funds.
----------------------
5. Debt Service Coverage Ratio (DSCR):
This may be considered one of the most important ratios calculated by the ----------------------
Bankers or Financial Institutions giving long-term finance to the organisation ----------------------
and the intention behind calculating this ratio is to ascertain the capability of the
organisation to repay the dues arising as a result of long-term borrowings. ----------------------
Net profit after Taxes+Depreciation+Interest on Term Loans
----------------------
Interest on Term Loans + Instalments of Term Loans
Indications / Precautions: ----------------------
Considering the intention of computing this ratio is to give indication about the ----------------------
capability of the organisation to meet the obligations of long-term borrowing,
the Banker or Financial Institutions will like to get this indication before the ----------------------
money is lent to the organisation. As such, this ratio calculated on estimated ----------------------
basis is considered by the Bankers or Financial Institutions before granting
the term finance to the borrowing organisations. Too low a DSCR indicates ----------------------
insufficient earning capacity of the organisations to meet the obligations of long-
term borrowings. At the same time, if too high a DSCR is estimated during the ----------------------
currency of the long-term borrowings, it is quite likely that the period of term ----------------------
loan may be reduced from whatever is requested by the borrowing organisation.
(d) Profitability Group: ----------------------
As the name itself suggests, the intention for calculating these ratios is to ----------------------
know the profitability of the organisation. Following ratios may be computed
----------------------
under this group.
1. Gross Profit Ratio: ----------------------
Gross Profit
X 100 ----------------------
Net Sales
----------------------
Components:
The net sales consist of sales after deducting the sales returns if any. ----------------------
The gross profit indicates the difference between net sales on one hand and ----------------------
either of the following on the other hand.
----------------------

Notes (a) Manufacturing cost or factory cost or production cost in the case of
manufacturing concerns.
----------------------
(b) Cost of purchases, expenses directly related to purchases and the
---------------------- adjustments for stock variations if any, in cases of trading concerns.
----------------------
The Gross Profit ratio indicates the relation between production cost and sales
---------------------- and the efficiency with which the goods are produced or purchased. A high gross
profit ratio may indicate that the organisation is able to produce or purchase at a
----------------------
relatively lower cost. As such, a high gross profit ratio will be desirable. Gross
---------------------- profit ratio may be increased by any of the following methods:
---------------------- (a) Increase sales price, production cost remaining the same.
(b) Reduce production cost, sales price remaining the same.
----------------------
(c) Increase sales price, reduce production cost.
----------------------
(d) Increase volume of products having high gross profit margin.
---------------------- An undue increase in gross profit ratio as well as an undue decrease in gross
profit ratio should be carefully investigated.
----------------------
Undue increase in gross profit ratio may indicate:
----------------------
i. Over-valuation of closing stock.
---------------------- ii. Non-consideration of purchase invoices.
---------------------- iii. Consideration of non-sales transactions as sales transactions. For example,
goods sent on consignment basis.
----------------------
Undue decrease in gross profit ratio may indicate
----------------------
i. Under-valuation of closing stock
---------------------- ii. Non-consideration of sales invoices.
---------------------- iii. Inability of management to control the cost or increase the sales.
---------------------- iv. Improper utilisation of infrastructural facilities.
2. Net Profit Ratio:
----------------------
---------------------- Net Profit after Taxes
X 100
---------------------- Net Sales
---------------------- Indication / Precautions:
The Net Profit Ratio indicates that portion of sales available to the owners
----------------------
after the consideration of all types of expenses and costs – either operating or
---------------------- non-operating or normal or abnormal. A high net profit ratio indicates higher
profitability of the business. As such, a high net profit ratio will be desirable.
----------------------
----------------------
3. Operating ratio: Notes
----------------------
Manufacturing cost of goods sold + Operating Expenses
X 100
Net Sales ----------------------
Components: ----------------------
The numerator includes the various operating cost, which a business has to ----------------------
incur in order to earn the profits. Following types of non-operating expenses
are excluded from the numerator viz., Interest, Dividend (On equity as well as ----------------------
preference shares), loss on the sale and assets/investments.
----------------------
----------------------
This ratio indicates the percentage of net sales, which is absorbed by the
operating costs. A high operating ratio indicates that only a small margin of ----------------------
sales is available to meet the expenses in the form of interest, dividend and
other non-operating expenses. As such, a low operating ratio will always be ----------------------
desirable. It can be used to measure the profitability only to a limited extent, ----------------------
as the net profits available to the owners will be considering the non-operating
expenses as well as the non-operating income. ----------------------
(e) Overall Profitability Group: ----------------------
The ratios computed under this group indicate the relationship between the
----------------------
profits of a firm and investment in the firm. These ratios are popularly termed
as Return On Investment (ROI). There can be three ways in which the term ----------------------
‘investment’ may be interpreted i.e., Assets, Capital employed and Shareholders’
Funds. As such, there can be three broad classification of ROI. ----------------------
1. Return On Assets (ROA) ----------------------
2. Return On Capital Employed (ROCE)
----------------------
3. Return On Shareholders’ Funds.
----------------------
1. Return On Asset (ROA):
Net Profit ----------------------
X 100
Assets ----------------------
Components:
----------------------
There can be basically two ways in which the term net profit may be treated.
Sometimes, net profit may be taken to mean net profit after taxes or sometimes ----------------------
it may be taken to mean net profit after taxes plus interest.
----------------------
Similarly, the term assets may also be treated in two ways. Sometimes assets
may mean fixed assets or sometimes they may indicate tangible assets. ----------------------
----------------------
----------------------

Notes Indications / Precautions:
ROA measures the profitability of the investments in a firm. As such, higher
----------------------
ROA will always be preferred. However, ROA does not indicate the profitability
---------------------- of various sources of funds, which finance total assets.
2. Return On Capital Employed (ROCE):
----------------------
---------------------- Net Profit + Interest on Long Term Sources
---------------------- Capital Employed
---------------------- Components:
---------------------- There can be basically two ways in which the term net profit may be treated.
Sometimes, net profit may be taken to mean net profit after taxes or sometimes
----------------------
it may be taken to mean net profit after taxes plus interest. The term capital
---------------------- employed refers to long-term funds supplied by creditors and owners of the
firm. As such, the term capital employed can be computed in two ways.
----------------------
(a) Fixed Assets + Investments + Current Assets – Current Liabilities.
---------------------- (b) Share Capital + Reserves and Surplus + Long-term Liabilities.
---------------------- ROCE measures the profitability of the capital employed in the business. A high
ROCE indicates a better and profitable use of long-term funds of owners and
---------------------- creditors. As such, a high ROCE will always be preferred.
---------------------- 3. Return on Shareholders’ Funds:
This ratio indicates the profitability of a firm in relation to the funds supplied by
----------------------
the shareholders or owners. As the shareholders can be of two broad types i.e.,
---------------------- Equity Shareholders and Preference Shareholders, this ratio can be computed
in two ways.
---------------------- Net Profit after Taxes
(a) X 100
---------------------- Total Shareholders’ Funds
Components:
----------------------
The numerator considers the net profit after taxes before the preference dividend.
---------------------- The denominator considers the equity capital, preference capital and reserves
---------------------- and surplus.
Net Profit after Taxes–Preference dividend
---------------------- (b) X 100
Shareholders’ Funds
---------------------- Components:
---------------------- The numerator considers net profit after taxes as well as preference dividend
as that is the amount, which is available to the equity shareholders for the
---------------------- distribution by way of dividend.
---------------------- The denominators consider the equity capital and reserves and surplus.
Indication / Precautions: Notes
This is the most important ratio to measure whether the firm has earned sufficient
----------------------
returns for its shareholders or not. As such, this ratio is the most crucial one
from the owners/ shareholders point of view. The higher this ratio, the better ----------------------
will be the situation.
----------------------
(f) Miscellaneous Group
1. Capital Gearing Ratio: ----------------------
Fixed Income Bearing Securities
----------------------
Equity Capital
----------------------
Components:
Fixed income bearing securities consist of preference share capital, debentures ----------------------
and long-term loans.
----------------------
Interpretation:
----------------------
A high capital-gearing ratio indicates that in the capital structure, fixed income
bearing securities are more in comparison to the equity capital and in that case, ----------------------
the company is said to be highly geared. On the other hand, if fixed income
bearing securities are less as compared to equity capital, the company is said to ----------------------
be lowly geared. ----------------------
It may be worth recalling here that a company may attempt to employ the fixed
----------------------
income bearing securities in the overall capital structure with the intention to
increase the equity shareholders’ earnings. As such, a high capital gearing ratio, ----------------------
to a certain extent, maybe advantageous from the equity shareholders’ point
of view. But if it is too high, investment in the company may become risky ----------------------
and further borrowing may not be possible for the company. Further, if the
----------------------
income of the company is unstable, a high capital-gearing ratio may prove to
be fatal, especially in the years of reducing income when a major portion of ----------------------
the income will be utilised to meet the obligations towards the fixed income
bearing securities. ----------------------
2. Earnings Per Share (EPS): ----------------------
Net Profit after taxes-Preference Dividend
----------------------
Number of Equity Shares Outstanding
----------------------
It is a widely used ratio to measure the profits available to the equity shareholders ----------------------
on a per share basis. EPS is calculated on the basis of current profit and not on
----------------------
the basis of retained profits. As such, increasing EPS may indicate the increasing
trend of current profits per equity share. However, EPS does not indicate how ----------------------
much of the earnings are paid to the owners by way of dividend and how much
of the earnings are retained in the business. ----------------------

Notes 3. Price Earnings Ratio (P/E Ratio):
----------------------
Market Price Per Share

---------------------- Earning Per Share
---------------------- P/E Ratio indicates the price currently being paid in the market for each rupee
of EPS. It measures the expectation of the investors. A high P/E Ratio may
---------------------- indicate the possibility of increase in EPS. A low P/E Ratio may indicate that
---------------------- there is no possibility of any increase in EPS and the investors will be reluctant
to invest in such shares.
---------------------- This ratio is important from the investors’ point of view. An ideal investor will
---------------------- compare between the current market price and future EPS, as the value of shares
depend upon the future EPS also.
---------------------- 4. Dividend Payment Ratio (D/P Ratio):
---------------------- Dividend Per Share
X 100
Earning Per Share
----------------------
---------------------- It measures the relationship between the earnings belonging to the equity
---------------------- shareholders and the amount finally paid to them by way of dividend. It indicates
the policy of management to pay cash dividend. D/P Ratio, when subtracted
---------------------- from 100, gives the indications about the policy of the management to retain the
profits in the business with the intention to reinvest the same, which is likely to
---------------------- have an effect on future market price of the share.
----------------------
----------------------
---------------------- Fill in the blanks.

1. Ratio analysis is not a ______technique.
----------------------
2. In ratio analysis, we can either make _____ or _______ or _______
---------------------- comparisons.
---------------------- 3. Ratios calculated in liquidity group indicate the _______term position
of the organisation.
----------------------
4. Ratios calculated in liquidity group indicate efficiency with which
---------------------- _______capital is being used.
---------------------- 5. Commercial banks and creditors are basically interested in the _______
ratios.
----------------------
----------------------
State True or False. Notes
1. Liquidity ratio is an improved version of current ratio. ----------------------

2. Debt equity ratio is in the overall profitability group. ----------------------
3. In calculating the interest coverage ratio, fixed obligations in the form
of preference dividend is not considered. ----------------------
Match the following. ----------------------
i. Current ratio a. Net sales/current assets ----------------------
ii. Liquidity ratio b. Net assets/fixed assets
iii. Fixed assets ratio c. Net credit sales/closing debtors ----------------------
iv. Current asset turnover ratio d. Current assets/current liabilities
v. Working capital turnover ratio e. Cost of goods sold/ average ----------------------
inventory
----------------------
vi. Inventory or stock turnover f. Liquid assets/liquid liabilities
ratio ----------------------
vii. Debtor turnover ratio g. External liabilities/ shareholder’s
funds ----------------------
viii. Capital turnover ratio h. Net sales/working capital
----------------------
ix. Debt equity ratio i. Total assets/owners funds
x. Proprietary ratio j. Sales/capital employed ----------------------
xi. Price/earnings ratio k. Fixed income bearing securities/
equity capital ----------------------
xii. Capital gearing ratio l. Net profit + interest on ling term
sources/capital employed ----------------------
xiii. Return on capital employed m. (Net profit after taxes/net sales) X 100 ----------------------
xiv. Net profit ratio n. Market price per share/earnings
per share ----------------------
----------------------
Activity 2 ----------------------
Visit the finance department of an FMCG company and collect the following ----------------------
information:
----------------------
1. Does the company carry out any inter-firm and intra-firm comparisons
based on ratios? Study the reports of various ratios computed by the ----------------------
company. ----------------------
2. Is the analysis of the company’s performance satisfactory to give a
detailed insight into the company performance? Can you suggest any ----------------------
more ratios to be computed by the company? ----------------------
Make a report based on your interpretation of above study as regards the
company’s performance. Present this report to the management. ----------------------
----------------------
----------------------

Notes 4.5 LIMITATIONS OF RATIO ANALYSIS
---------------------- 1. The basic limitation of the technique of ratio analysis is that it may be
difficult to find a basis for making the comparisons. In case of the intra-
---------------------- firm comparison, the performance of an organisation may vary widely
from year to year. In case of the inter-firm comparison, it may become
----------------------
invalid due to various reasons.
---------------------- i. The ratios of other organisations in the same industry may not be
---------------------- readily available.
ii. The constituent organisations in the same industry may vary from
---------------------- each other in terms of age, location, extent of automation, quality of
---------------------- the management and so on.
iii. Different accounting policies may be followed by the constituent
----------------------
organisations in the industry. The accounting policies may be different
---------------------- in the areas of valuation of inventories, provision for depreciation etc.
2. Normally, the ratios are calculated on the basis of historical financial
----------------------
statements. An organisation, for proper decision-making, may need the
---------------------- hint regarding the future happenings rather than transactions in the past.
The management of the organisation may predict the future to some extent
---------------------- based on facts and figures available to it, but the external analyst has to
depend upon the past, which may not necessarily reflect financial position
----------------------
and performance in future.
---------------------- 3. The technique of ratio analysis may prove to be inadequate in some
situations if there is difference of opinion regarding the interpretation of
----------------------
certain items while computing certain ratios. For example, in case of the
---------------------- computation of debt-equity ratio, the opinions may differ as to the treatment
of preference share capital. Some may treat this as a part of debt while the
---------------------- others may treat this as part of equity.
---------------------- 4. As the ratios are computed on the basis of financial statements, the basic
limitation, which is applicable to the financial statements, is equally
---------------------- applicable in case of the technique of ratio analysis. Also, only those
---------------------- facts, which can be expressed in financial terms, are considered by the
ratio analysis. For example, the computation of debt equity ratio of an
---------------------- organisation may show a favourable trend thereby justifying the additional
borrowings, which the organisation may want to make. However, if the
---------------------- attitude of the management is not to meet the outside obligations in time,
---------------------- the lender of the finance may be misled by the computation of debt equity
ratio.
---------------------- 5. The technique of ratio analysis has certain limitations of use in the sense
---------------------- that, it only highlights the strong or problem areas. It does not provide
any solution to rectify the problem areas. Moreover, the technique of
---------------------- ratio analysis may indicate the strong or problem areas and that too only
partially. For the correct and comprehensive analysis of the situations, it is
---------------------- necessary to investigate further in those strong or problem areas.
E.g. a very high current ratio may not necessarily indicate a good situation. Notes
Further investigations are required to be made to ensure that there are no
obsolete or non moving items of stock included in the closing stock or that ----------------------
there are no debts included in sundry debtors, which are outstanding for an
unreasonable period and which may ideally be treated as bad debts. ----------------------
6. Ratio Analysis often gives a misleading indication if the effect of changes ----------------------
in price levels is not taken into account. Two different companies set up in
----------------------
different years and as such, having the infrastructural facilities of different
ages cannot be compared based on financial statements only. This is so, ----------------------
as the company, which has purchased the infrastructural facilities years
ago, may be showing their value at a very lower amount while the other ----------------------
company might have purchased the same facilities at a very higher price.
----------------------
Precautions to be taken:
----------------------
Considering the various limitations in respect of ratio analysis, following
precautions should be taken before using it as a technique for interpretation of ----------------------
financial statements.
----------------------
1. Ratios are computed on the basis of financial statements. If the statements
are reliable, then only the ratios computed therefrom will be meaningful. ----------------------
As such, before using the ratio analysis, the reliability of the financial
statements should be confirmed. ----------------------
2. Ratio should be computed on the basis of inter-related figures, which ----------------------

have a cause and effect relationship. Computation of ratios on the basis of
irrelevant figures may even lead to wrong conclusions. E.g., Ratio between ----------------------
sales and trade investments. ----------------------
3. It should always be remembered that ratios only show symptoms and
the indications given by the ratios can be interpreted correctly only after ----------------------
studying the realities behind the financial statements. E.g., a high current ----------------------
ratio should be treated as a good sign only after confirming the fact that
there are no non-moving or obsolete stocks or non-recoverable debtors. ----------------------
4. If possible, the impact of the inflationary conditions or changing price ----------------------
levels should be taken into account before computing the ratios. This may
be done by using the technique of current purchasing power or current cost ----------------------
accounting.
----------------------
5. In case of inter-firm comparison of ratios, following propositions should
be kept in mind. ----------------------
(a) The constituent units should be comparable in terms of size, age, ----------------------
nature of business, degree of automation, etc.
----------------------
(b) The constituent units must be following similar accounting policies
more particularly in the areas of charging the depreciation and stock ----------------------
valuation.
----------------------
(c) There should not be any holding back of any information or data by
the constituent units. ----------------------

Notes 4.6 ILLUSTRATIVE PROBLEMS
---------------------- 1. The current assets and current liabilities of your company as at 30.6.2018
were Rs. 16 lakh and Rs. 8 lakh respectively. Calculate the effect of each
---------------------- of the following transactions individually and totally on the current ratio of
the company:
----------------------
i. Purchase of new machinery for Rs. 5 lakh by cheque.
----------------------
ii. Purchase of new machinery for Rs. 10 lakh on a Medium Term Loan
---------------------- from your bank with 20% margin.
---------------------- iii. Payment of dividend of Rs. 2 lakh of which Rs. 0.47 lakh was Tax
deducted at source.
----------------------
iv. A shipment of raw materials of landed cost Rs.5 lakh was received
---------------------- against which the Bank finance obtained was Rs. 3 lakh.
Solution:
----------------------
Current Assets
---------------------- Present Current Ratio =
Current Liabilities
---------------------- Rs. 16 Lakhs
= =2:1
---------------------- Rs. 8 Lakhs
Transaction 1
----------------------
Purchase of new machinery by cheque will result into increase in the debit
---------------------- balance of Machinery A/c (a non-current asset) and reduction in bank balance
(a current asset). As such, as a result of this transaction, the cash balance and
---------------------- hence current assets will be reduced by Rs.5 Lakh, current liabilities remaining
---------------------- unaffected. Hence, the revised current ratio will be:
Rs. 16 Lakhs – Rs. 51 Lakhs Rs. 11 Lakhs
---------------------- = = 1.375:1.00
Rs. 8 Lakhs Rs. 8 Lakhs
---------------------- Transaction 2
---------------------- Purchase of new machinery for Rs. 10 Lakh on a Medium Term loan with 20%
margin indicates that the debit balance of Machinery A/C (a non-current asset)
---------------------- will increase by Rs. 10 Lakh and the liability in the form of medium term loan
---------------------- (a non-current liability, ignoring the fact that the installments of loans due
within one year may be treated as a part of current liabilities) will be increased
---------------------- to the extent of Rs. 8 Lakh and the cash balance will be reduced to the extent
of Rs.2 Lakh (assuming that the margin money is paid immediately). As such,
---------------------- this transaction will affect current ratio only in one way i.e. reducing the cash
---------------------- balance by Rs. 2 Lakh, current liabilities remaining unaffected. Hence, the
revised current ratio will be:
----------------------
Rs. 16 Lakhs – Rs. 2 Lakhs Rs. 14 Lakhs
= = 1.75:1.00
---------------------- Rs. 8 Lakhs Rs. 8 Lakhs
----------------------
Transaction 3 Notes
The effect of payment of dividend of Rs.2 Lakh of which Rs. 0.47 Lakh was tax
----------------------
deducted at source, can be viewed from two angles.
(a) Assuming that the tax deducted at source is duly paid to the credit of ----------------------
Central Government, the effective outflow of cash will be Rs.2 Lakh which
----------------------
will reduce the cash balance (a current asset), current liabilities remaining
unaffected. Hence, the revised current ratio will be: ----------------------
Rs. 16 Lakhs – Rs. 2 Lakhs Rs. 14 Lakhs ----------------------
= = 1.75:1.00
Rs. 8 Lakhs Rs. 8 Lakhs
----------------------
(b) Assuming that the tax deducted at source is yet to be paid to the credit of
Central Government, the cash balance (a current asset) will be reduced to ----------------------
the extent of net payment of dividend i.e. Rs. 1.53 Lakh, while the current
----------------------
liabilities will be increased by Rs. 0.47 Lakh. Hence, the revised current
ratio will be: ----------------------
Rs. 16 Lakhs – Rs. 1.53 Lakhs Rs. 14.47 Lakhs ----------------------
= = 1.708:1.00
Rs. 8 Lakhs + 0.47 Lakhs Rs. 8.47 Lakhs
----------------------
Transaction 4
----------------------
A shipment of raw material of landed cost Rs. 5 Lakh received against which the
Bank finance obtained is Rs.3 Lakh, will affect the current ratio in three ways. ----------------------
Assuming that the stock so purchased is still not consumed, it will increase the
stock in trade (a current asset) by Rs. 5 Lakh. The fact that bank finance was ----------------------
obtained to the extent of Rs.3 Lakh indicates that the balance of Rs. 2 Lakh was
----------------------
paid by the company, which will reduce the cash balance (i.e. a current asset).
At the same time, bank finance obtained for the purchase of material will be a ----------------------
working capital facility (i.e. a current liability) assuming that the bank finance
is still unpaid. Hence, the revised current ratio will be: ----------------------
Rs. 16 Lakhs + Rs. 5 Lakhs - Rs. 2 Lakhs Rs. 19 Lakhs ----------------------

= = 1.727:1.00
Rs. 8 Lakhs + 3 Lakhs Rs. 11 Lakhs ----------------------
Combined effect of all transactions:
----------------------
Considering all the transactions together, the current ratio will be affected as
below: ----------------------
(a) Assuming alternate ‘a’ in case of Transaction 3 ----------------------
Rs. 16 Lakhs - Rs. 5 Lakhs (1) - Rs. 2 Lakhs (2) - Rs. 1.53 Lakhs (3) + Rs. 5 Lakhs ----------------------
(4) – Rs. 2 Lakhs (4)
----------------------
Rs. 8 Lakhs + 3 Lakhs (4)
Rs. 10 Lakhs ----------------------
= = 0.909:1.00
Rs. 11 Lakhs ----------------------
----------------------

Notes (b) Assuming alternate ‘b’ in case of Transaction 3
Rs. 16 Lakhs - Rs. 5 Lakhs (1) - Rs. 2 Lakhs (2) - Rs. 1.53 Lakhs (3) + Rs. 5 Lakhs
---------------------- (4) – Rs. 2 Lakhs (4)
---------------------- Rs. 8 Lakhs + 0.47 Lakhs (3) + Rs. 3 Lakhs (4)
---------------------- Rs. 10.47 Lakhs

= = 0.913:1.00
Rs. 11.47 Lakhs
----------------------
Note: Number in bracket indicates the transaction number.
----------------------
2. The following are the figures extracted from the books of XYZ Limited as
---------------------- at 30-9-2018:
---------------------- Particulars Amount (Rs.)

Net sales 24,00,000
---------------------- Operating expenses 18,00,000
Gross Profit 6,00,000
---------------------- Non operating expenses 2,40,000
Net Profit 3,60,000
----------------------
Current Assets 7,60,000
---------------------- Inventories 8,00,000
Fixed Assets 14,40,000
---------------------- Total Assets 30,00,000
Net worth 15,00,000
---------------------- Debt 9,00,000
---------------------- Current Liabilities 6,00,000
Total Liabilities 30,00,000
---------------------- Working Capital 9,60,000
Solution:
----------------------
1. Gross Profit Ratio
----------------------
Gross Profit
X 100
---------------------- Sales
---------------------- 6,00,000
X 100 = 25%
---------------------- 24,00,000
2. Net Profit Ratio
---------------------- Net Profit
X 100
---------------------- Sales
---------------------- 3,60,000
X 100 = 15%
---------------------- 24,00,000
----------------------
----------------------
----------------------
3. Return on Assets Notes
Net Profit
X 100 ----------------------
Total Assets
3,60,000 ----------------------
X 100 = 12%
30,00,000 ----------------------
4. Inventory Turnover ----------------------
Net sales
----------------------
Inventory
24,00,000 ----------------------
= 3
8,00,000 ----------------------
5. Working Capital Turnover ----------------------
Net sales
----------------------
Working Capital
24,00,000 ----------------------
= 2.5
9,60,000 ----------------------
6. Net Worth to Debt ----------------------
Net Worth
----------------------
Debt
15,00,000 ----------------------
= 1:67:1:00
9,00,000 ----------------------
3. From the following information, draw the Balance Sheet of M/s. Ravi and ----------------------
Co. as on 31st March, 2018:
----------------------
Current Ratio 2:1
----------------------
Liquid Ratio 1:1
Return on Capital Employed 10% ----------------------
Fixed Assets Turnover Ratio 8:5 ----------------------

Closing Stock was 12.5% of sales ----------------------
Owners’ Equity to Fixed Assets 8 : 15
----------------------
Average Collection Period 1 Month
----------------------
Debt Equity Ratio 5:4
----------------------
For the year ended 31st March, 2018, M/s. Ravi and Co. made a profit of Rs.
1,00,000 after paying interest of Rs. 1,20,000 on term loan but before tax. Tax ----------------------
paid for the year was Rs. 40,000; Bank Balance stood at Rs. 1,00,000 besides
stock and debtors of the concern. ----------------------
----------------------

Notes Solution:
Balance Sheet as on 31st March, 2018
----------------------
Balance Sheet as on 31st March, 2018
----------------------
Liabilities Rs. Assets Rs.
---------------------- Owners’ Equity 8,00,000 Fixed Assets 15,00,000
---------------------- Debt 10,00,000 Cash and Bank Balance 1,00,000
Current Liabilities 3,00,000 Stock 3,00,000
---------------------- Sundry Debtors 2,00,000
21,00,000 21,00,000
----------------------
Working Notes:
----------------------
Profit Before Tax Rs. 1,00,000
---------------------- Less: Tax Rs. 40,000
---------------------- Hence, Profit After Tax Rs. 60,000
---------------------- Return on Capital Employed is known as 10%
Hence, Profit After Tax + Interest
---------------------- X 100 = 10
Capital Employed
----------------------
---------------------- As Interest is known as Rs. 1,20,000,
---------------------- Profit After Tax + Interest = Rs. 1,80,000.

---------------------- Capital employed
(Profit After Tax + Interest)
---------------------- = X 100
Return on Capital Employed
---------------------- (60,000 + 1,20,000)
= X 100
---------------------- 10
= 18,00,000
----------------------
Hence, Capital Employed will be Rs. 18,00,000.
---------------------- As Debt Equity Ratio is 5: 4
---------------------- Debt 5
=
Equity 4
----------------------
Hence, Debt = 1.25 Equity.
----------------------
As Capital Employed is Rs. 18,00,000
---------------------- Debt + Equity = Rs. 18,00,000
---------------------- Replacing the value of Debt in the above equation, we get,
---------------------- 1.25 Equity + Equity = 18,00,000
----------------------
Hence, 2.25 Equity = 18,00,000 Notes
12,00,000
Equity = ----------------------
2.25
Hence, Equity = 8,00,000 ----------------------
Debt = 1.25 x 8,00,000 ----------------------
Hence, Debt = 10,00,000
----------------------
Owners’ Equity to Fixed Assets is 8: 15
----------------------
As Equity is known as Rs. 8,00,000, Fixed Assets = Rs. 15,00,000
As Fixed Assets Turnover Ratio is 8: 5 ----------------------
Sales / Fixed Assets = 8/5 ----------------------

As Fixed Assets are Rs. 15,00,000, ----------------------
Sales = Rs. 24,00,000
----------------------
Closing Stock is 12.5% of sales
24,00,000 x 12.5 ----------------------
As sales = Rs. 24,00,000, Closing Stock will be = Rs. 3,00,000
100 ----------------------
Average Collection Period is 1 month
----------------------
Assuming that all the sales are credit sales,
Debtors x 12 ----------------------
=1
Credit Sales ----------------------
As Credit Sales are Rs. 24,00,000,
----------------------
Credit Sales x 1
Debtors = ----------------------
12
24,00,000 x 1 ----------------------
=
12 ----------------------
Debtors will be Rs. 2,00,000
Current Ratio is 2: 1, ----------------------
Hence, Current Assets/Current Liabilities = 2 ----------------------

Hence, Current Assets = 2 Current Liabilities ----------------------
Liquid Ratio is 1: 1,
----------------------
It is assumed that there is no cash credit or overdraft.
----------------------
Hence, Current Assets – Stock
=1
Current Liabilties ----------------------
As Stock is known as Rs. 3,00,000 ----------------------
2Current Liabilities – 3,00,000 ----------------------

=1
Current Liabilties ----------------------

Notes This leads us to the conclusion of Current Liabilities = Rs. 3,00,000
Current Assets = Rs. 6,00,000
----------------------
Fixed Assets
---------------------- (3) = 0.75
Proprietory Funds
----------------------
As Proprietory Funds means Net Worth,
---------------------- Fixed Assets
= 0.75
Net Worth
----------------------
...(g)
---------------------- As there are no long term debts, the total liabilities consist of net worth and
---------------------- current liabilities. Total assets consist of fixed assets and current assets.
As Total Assets = Total Liabilities
----------------------
Net Worth + Current Liabilities = Fixed Assets + Current Assets
---------------------- ∴ Net Worth = Fixed Assets + (Current Assets – Current Liabilities)
---------------------- We know that working capital = Rs. 60,000
∴ Net Worth = Fixed Assets + 60,000
----------------------
Replacing above value of net worth in (g)
---------------------- Fixed Assets
= 0.75
---------------------- Fixed Assets + 60,000
Fixed Assets = 0.75
----------------------
Fixed Assets + 60,000
---------------------- ∴ Fixed Assets = 0.75 (Fixed Assets + 60,000)
---------------------- ∴ Fixed Assets = 3/4 Fixed Assets + 45,000
∴ 1/4 Fixed Assets = 45,000
----------------------
∴ Fixed Assets = 1,80,000 ...(h)
---------------------- Fixed Assets
Net Worth =
---------------------- 0.75
1,80,000
=
---------------------- 0.75
---------------------- ∴ Net Worth = 2,40,000 ...(i)
We know that Reserves and Surplus are Rs. 40,000
----------------------
∴ Share Capital = 2,00,000 ...(j)
----------------------
----------------------
----------------------
----------------------
----------------------
Notes
----------------------
1. Every high current ratio may not necessarily indicate a good situation.
----------------------
2. Ratio analysis gives misleading indication if the effect of changes in
price level is not taken into account. ----------------------
3. Ratio should be calculated on the basis of inter related figures, which ----------------------
have cause and effect relations.
----------------------
4. Ratios are computed on the basis of costing accounting statements.
5. Ratios only show symptoms and the reality behind the financial ----------------------
statements. ----------------------
----------------------
Activity 3
----------------------
Obtain the financial statements of any two companies belonging to the ----------------------
same sector such as steel industry, automotive industry, engineering goods,
cement etc. Compute the following ratios and compare them. Present your ----------------------
inferences on the basis of the comparison.
----------------------
a. Current ratio
----------------------
b. Working capital turnover ratio
c. Capital gearing ratio ----------------------
d. Earnings per share ----------------------
e. Debt service coverage ratio ----------------------
----------------------
Summary
----------------------
• The technique of ratio analysis as technique for interpretation of financial
statements deals with computation of various ratios, by grouping or ----------------------
regrouping the various figures and/or information appearing on the financial ----------------------
statements.
• Ratio Analysis aids in assessing the firm in terms of their profitability and ----------------------
efficiency of performance, either individually or in relation to those of ----------------------
other firms in the same industry.
• The ratios are broadly classified in six groups i) Liquidity Group: the ----------------------
ratios computed under this group indicate the short-term position of the ----------------------
organisation and also indicate the efficiency with which the working capital
is being used. ii) Turnover Group: the ratios computed under this group ----------------------
indicate the efficiency of the organisation to use the various kinds of assets
----------------------

Notes by converting them in the form of sales. iii) Solvency Group: the ratios
computed under this group indicate the long-term financial prospects of the
---------------------- company. iv) Profitability Group: these ratios are calculated to know the
profitability of the organisation. v) Overall Profitability Group: the ratios
---------------------- computed under this group indicate the relationship between the profits of
---------------------- the firm and investment in the firm. vi) Miscellaneous Group: this group
includes Capital Gearing ratio, Earning Per Share, Price Earning Ratio,
---------------------- Dividend Payment Ratio.
----------------------
Keywords
----------------------
• Ratio Analysis: Technique for interpretation of financial statements.
----------------------
• Debt Equity Ratio: Long Term Liabilities/ Shareholders’ Funds
----------------------
---------------------- 1. Explain the term ratio analysis and outline the role of ratio analysis in the
interpretation of financial statements.
----------------------
2. Write short notes.
---------------------- a. Solvency Group of Ratios
---------------------- b. Liquidity Group of Ratios
---------------------- c. Turnover Group of Ratios

3. What is the significance of Current Ratio and Liquid ratio?
----------------------
4. What precautions should be taken before using ratio analysis for the
---------------------- interpretation of financial statements?
---------------------- 5. Give the indications of Current Ratio.
---------------------- 6. How can you interpret Capital Gearing Ratio?

---------------------- 1. True
2. False
----------------------
3. True
----------------------
4. True
---------------------- 1. Ratio implies
2. When ratios of an organisation are compared with the same organisation, it Notes
is called
----------------------
ii. Intra firm comparison
Fill in the blanks. ----------------------
1. Ratio analysis is not a creative technique. ----------------------
2. In ratio analysis, we can either make inter-firm or intra-firm or comparison
for standards comparisons. ----------------------
3. Ratios calculated in liquidity group indicate the short-term position of the ----------------------
organisation.
----------------------
4. Ratios calculated in liquidity group indicate efficiency with which working
capital is being used. ----------------------
5. Commercial banks and creditors are basically interested in the liquidity ----------------------
ratios.
----------------------
1. True ----------------------
2. False ----------------------
3. True ----------------------
----------------------
i. d
----------------------
ii. f
iii. b ----------------------
iv. a ----------------------
v. h ----------------------
vi. e
----------------------
vii. c
----------------------
viii. j
ix. g ----------------------
x. i ----------------------
xi. n ----------------------
xii. k
----------------------
xiii. l
----------------------
xiv. m
----------------------
----------------------

----------------------
1. True
----------------------
2. True
---------------------- 3. True
---------------------- 4. False
---------------------- 5. True
----------------------
Suggested Reading
----------------------
1. Kaplan & Atkinson. Advanced Management Accounting Book.
---------------------- 2. Kumar & Sharma. Auditing: Principles and Practice.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Interpretation of Financial Statements (Funds Flow/
Cash Flow Statements) UNIT
Structure: 5
5.1 Introduction
5.2 Concept of Funds
5.3 Construction of Funds Flow Statement
5.4 Cash Flow Statement
5.4.1 Key Difference between Funds Flow and Cash Flow Statements
5.6 Interpretation of Funds Flow Statement
Summary
Key Words
Suggested Reading
Interpretation of Financial Statements (Funds Flow/Cash Flow Statements) 89

Notes
Objectives
----------------------
----------------------
• State the meaning of the term funds
----------------------
• Construct a funds flow statement
---------------------- • Construct a cash flow statement
---------------------- • Analyse funds flow statement and cash flow statement
----------------------
5.1 INTRODUCTION
----------------------
The traditional financial statement in the form of Balance Sheet gives the
---------------------- information of the assets and liabilities of a business as at a particular date.
However, the Balance Sheet itself does not take into consideration the fact
---------------------- that there exists certain fruitful relationship between the Balance Sheet at the
---------------------- beginning of a particular time and at the end of the said time. In order to locate
this fruitful relationship, the knowledge of the techniques of the preparation
---------------------- of funds flow statements (also known as sources and application of funds
statement) is a must. Statutorily it is not required to prepare this statement,
---------------------- however considering the usefulness of the same, now-a-days many companies
---------------------- not only prepare them but also include the same as a part of its Annual Statement
of Accounts.
----------------------
----------------------
----------------------
----------------------
---------------------- [Source: http://takcreditmanagement.files.wordpress.com/2010/11/cashflow-cartoon-1.jpg]
----------------------
5.2 CONCEPT OF FUNDS
----------------------
The term fund is interpreted in many ways:
----------------------
1 Sometimes the term ‘funds’ means ‘cash’ and the funds flow statement
---------------------- prepared on this basis is in the form of a cash flow statement. In other
words, cash flow statement is nothing else but the summary of Cash Book
---------------------- or Receipts and Payments Statement.
---------------------- 2. Sometimes the term ‘fund’ is interpreted as cash equivalent i.e. cash and
marketable securities.
----------------------
3. The most accepted interpretation of the term ‘funds’ is in the form of
---------------------- working capital or net current assets. It means that all those transactions,
which affect either the current assets or current liabilities, will find the
---------------------- place in the funds flow statement.
4. A wider connotation of the term fund is found in the interpretation of the Notes
term ‘funds’ as a Resources Concept. This considers all the assets and all
the liabilities in which funds are blocked. ----------------------
Uses / Advantages ----------------------
1. Funds flow statement determines the financial consequences of the business
----------------------
operations. A business may be earning profits year by year still its liquidity
position may deteriorate every year, which may prove to be fatal for the ----------------------
business. The preparation of funds flow statement may provide an answer
to this critical position. ----------------------
2. The basic financial management principle is that the long-term requirements ----------------------
of funds should be met out of long-term sources of funds. Short-term
requirements of funds can be met out of long-term sources of funds, ----------------------
however under no circumstances, long-term requirements of funds should
----------------------
be met out of short-term sources of funds. From this context, funds flow
statement may provide the answers to certain basic questions like: ----------------------
(a) Where did the profits earned go? ----------------------
(b) How was the increase in working capital financed?
(c) How were the capital assets financed? ----------------------
(d) What happened to sale proceeds of assets? ----------------------
(e) What happened to proceeds of issue of the shares/debentures?
----------------------
3. Now-a-days, obtaining the finance from Banks or Financial Institutions
has become inevitable. For this purpose, they have to be convinced about ----------------------
the repayment capacity of the company. The questions can be properly
----------------------
answered with the help of funds flow statement.
4. Funds flow statement prepared on estimated basis for the future period ----------------------
enables the firm to plan its financial resources properly. The firm can know
----------------------
how much funds it requires, how much can be raised internally and how
much has to be arranged externally. ----------------------
5. The funds flow statement prepared on the estimated basis, before the ----------------------
commencement of the year when compared with the actual funds flow
statement can render useful indication about the fact that whether the firm ----------------------
is using its resources in the planned manner or not.
----------------------
6. Funds flow statement covering several years of operations of a company,
enables the reader to know about the financial policies followed by the ----------------------
company in the past, contributions of funds from the operations for the
growth of the company etc. It helps as a reliable guide for the future ----------------------
requirement of funds. ----------------------
Limitations:
----------------------
1. It is argued that funds flow statement does not provide any new information
but only rearranges the various facts which already appear in the financial ----------------------
statements.
----------------------
2. It does not consider non-fund transactions.

Notes
----------------------

1. ‘Funds’ means nothing more than ‘cash’
----------------------
2. Balance sheet prepared at the end of the year does not consider the
---------------------- fruitful relationship with balance sheet prepared at the beginning of the
year.
----------------------
3. Preparation of funds flow statement is statutorily obligatory.
----------------------
4. A business may be earning profits but its liquidity position may be
---------------------- deteriorating year by year.
---------------------- 5. Long-term requirements of funds must be met by short-term sources of

funds.
----------------------
6. Funds flow statements do not provide any new information but
---------------------- only rearrange various facts, which already appear in the financial
statements.
----------------------
7. Funds flow statements do consider non-fund transactions.
----------------------
---------------------- 5.3 CONSTRUCTION OF FUNDS FLOW STATEMENT

---------------------- (a) Basic Principles:
---------------------- Following are the basic principles on which the construction of funds flow
statement rests:
----------------------
1. Any increase in Assets involves outflow of funds.
---------------------- 2. Any decrease in Assets involves inflow of funds.
---------------------- 3. Any increase in Liabilities involves inflow of funds.
---------------------- 4. Any decrease in Liabilities involves outflow of funds.

(b) Process of Construction:
----------------------
The basic statements which are used while preparing the funds flow
---------------------- statement are the comparative Balance Sheets as on two different dates.
The funds flow statement, arranges the amounts appearing on the Balance
----------------------
Sheets, after some eliminations, combinations and reclassifications, into
---------------------- two main groups.
(a) Sources of funds.
----------------------
(b) Application of funds.
----------------------
----------------------
----------------------
Following is the proforma in which funds flow statement can be prepared: Notes
Sources Applications
----------------------
1) Issue of Shares 1) Redemption of Shares
----------------------
2) Issue of Debentures 2) Redemption of Debentures
3) Receipt of Term Loans 3) Term Loan Repayments ----------------------
4) Receipts of Fixed Deposits/Loans 4) Purchase of Fixed Assets ----------------------
5) Sale of Fixed Assets 5) Purchase of Investments
6) Sale of Investments 6) Repayment of Deposits/Loans ----------------------
7) Non Operating Income 7) Non Operating Expenses ----------------------
Sources Applications ----------------------

8) Operating Profit 8) Operating Loss
----------------------
9) Decrease in working capital 9) Dividends
OR 10) Increase in working capital ----------------------
Decrease in Current Assets OR ----------------------
OR Increase in Current Assets
----------------------
Increase in Current Liabilities OR
Decrease in Current Liabilities ----------------------
Total . . . Total . . . ----------------------
Treatment of Special items :
----------------------
A) Operating Profit/Loss: ----------------------
It is calculated as below. Net Profit as per Profit and Loss Account.
----------------------
Add: 1) Depreciation on Fixed Assets
----------------------
2) Preliminary Expenses written off
3) Goodwill written off ----------------------
4) Loss on sale of Fixed Assets ----------------------
5) Loss on sale of Investment ----------------------
6) Non-cash expenses or write offs
----------------------
7) Non-recurring or Abnormal expenses
----------------------
8) Non-operating expenses
Less: 1) Profit on Sale of Fixed Assets ----------------------
2) Profit on Sale of Investment ----------------------
3) Non-recurring or Abnormal income ----------------------
4) Non-operating income.
----------------------
----------------------

Notes Note:
If the net profit is taken as profit after amounts of transfer to reserves and
----------------------
dividends, those amount should also be added back as it is a non-cash adjustment
---------------------- where fund flow is not affected.
(B) Statement showing changes in working capital:
----------------------
While preparing the funds flow statement, it is customary not to show the
---------------------- variation in the items of current assets and current liabilities individually,
but to show the net increase or decrease in the net current assets (i.e. working
----------------------
capital or current assets less current liabilities) over a period of time. This
---------------------- total variation is verified by calculating the variations in individual items
of current assets and current liabilities also.
----------------------
A proforma is given below.
---------------------- Particulars Balance at Balance Increase Decrease
---------------------- beginning at end
A) Current Assets
---------------------- Stock
Debtors
----------------------
Bills Receivables
---------------------- Cash Balance
Bank Balance
---------------------- Prepaid Expenses
---------------------- Advances
Marketable Securities
---------------------- B) Current Liabilities
Creditors
----------------------
Bills Payable
---------------------- Outstanding Expenses
Provisions
----------------------
C) Net Working Capital
---------------------- (A – B)
---------------------- D) Net Increase/Decrease

during the year
----------------------
Following principles should be remembered:
----------------------
1) An increase in current assets increases working capital.
---------------------- 2) An increase in current liabilities decreases working capital.
---------------------- 3) A decrease in current assets decreases working capital.
---------------------- 4) A decrease in current liabilities increases working capital.
----------------------
----------------------
C) Provision for Tax or Advance Tax: Notes
There can be two options to deal with this item.
----------------------
1. Provision for tax may be treated as an item of current liabilities and
advance tax as an item of current assets. Both these items will be ----------------------
routed through the statement showing changes in working capital. As
----------------------
such, the payment of tax made during the year will not be shown as
application of funds. ----------------------
2. Provision for tax may be added back to the profit as per Profit and
----------------------
Loss Account to arrive at the operating profits. Actual tax payments
will be shown as application of funds. Neither the provision for tax ----------------------
nor Advance Tax will appear as the items of working capital while
preparing the statement showing changes in working capital. ----------------------
D) Dividend–Interim and Final: ----------------------
There can be two options to deal with this item. ----------------------
1. Provision for proposed dividend may be treated as an item of current
liability and will be considered for preparing statement showing ----------------------
changes in working capital. The operating profit will be shown as ----------------------
source of funds net of proposed dividend.
----------------------
2. Provision for proposed dividend and Interim dividend is added back
to the profit as per Profit and Loss Account to arrive at the operating ----------------------
profits. Actual dividend paid (Interim as well as Dividend for the
previous year) will be shown as application of funds. ----------------------
E) Non-Recurring / Abnormal Income / Expenses: ----------------------
These items may involve flow of fund. However, for clear disclosure purposes,
----------------------
they are shown separately on funds flow statement. As such, non-recurring/
abnormal income and non-recurring/abnormal expenses are shown as sources ----------------------
and applications respectively. However, while computing operating profit,
non-recurring/abnormal income is deducted from and non-recurring/abnormal ----------------------
expenses are added back to profit as per Profit and Loss Account.
----------------------
5.4 CASH FLOW STATEMENT ----------------------
“Customer satisfaction, Employee satisfaction and Cash flow are the three ----------------------
most important indicators for a business” — Jack Welch ----------------------
Organizations offering very different products and services have similar ----------------------
requirements when it comes to cash. Cash is required to pay for raw material,
human resources and other expenses for routine functioning. Cash is also ----------------------
needed to invest in assets and give some returns to the investors.
----------------------
A Cash Flow statement is an invaluable tool, which shows changes in
the cash position of an enterprise from one period to another. It is different ----------------------
from a mere Cash Book, which records cash (and bank) receipts, payments
----------------------
and gives us the opening and closing cash balance. What it does is to classify

Notes and summarise all incoming and outgoing cash transactions into three major
categories: Operating, Investing and Financing.
----------------------
Along with Profit and Loss A/c and Balance Sheet, Cash flow statement is
---------------------- the other important statement found in the Annual Report of a Public limited
company. Indian Accounting Standard 3 and International Accounting Standard
---------------------- 7 prescribe the publishing of Cash flow statement in the Company Annual
reports.
----------------------
Profits are an opinion; cash is a fact.
----------------------
Benefits of preparing a cash flow statement:
----------------------
• Gives the readers of financial statements an idea of which major activities
---------------------- are generating cash and where it is flowing. A healthy cashflow from
Operating activities is a significant indicator of company health.
----------------------
• Provides a more accurate measure of the liquidity position of the company,
---------------------- as compared to the funds flow statement, which also considers non-cash
transactions.
----------------------
• Helps forecast short- and long-term requirement of cash by each activity.
---------------------- Also helps in planning how to use the net surplus cash generated by an
activity.
----------------------
• Facilitates inter-company comparison, due to standard method of
---------------------- preparation of the statement based on the P&L A/c and Balance Sheet.
---------------------- Components of a Cash flow statement

• Cash Flows from operating activities
----------------------
This category shows net cash from operations. The major operating cash
---------------------- inflows would be from cash sales of goods and services and collections
from debtors in case of credit sales. Conversion of inventory into sales
----------------------
would release locked up cash and thus also result in a positive cashflow.
---------------------- Cash outflow would be payment for raw material or goods and other
services purchased for day-to-day operations. A consistently positive
----------------------
cashflow from operations indicates the company is performing well in its
---------------------- core business area.
---------------------- Companies in the rapid growth phase might show negative operating cash
flow in the initial years. However, once they reach steady state, it would be
---------------------- best reflected by a positive cashflow from operating activities.
---------------------- • Cash Flows from investing activities

Cash inflows in this category would mainly arise from sale proceeds of fixed
---------------------- asset sale, interest or dividend received as return on the investment made
---------------------- in other companies or receipt of principal amount so invested. Investment
in fixed assets, bonds and debentures of other companies, acquisitions of
---------------------- business of another firm- all would result in investing cash outflows.
----------------------
• Cash Flow from financing activities Notes
Financing refers to the raising of finance for the short- and long-term
----------------------
company operations and growth. When a company issues shares or
debentures or takes a bank overdraft, the money it receives is a Financing ----------------------
cash inflow. Repayment of such loans, redemption of debentures forms
an outflow. The cost of using such finance, i.e. the interest paid on fixed ----------------------
deposits with the company or dividend paid on the equity shares of the
----------------------
company is a cash outflow to be considered in this category.
Definitions related to cash-flow statements ----------------------
• Cash: Cash on hand and demand deposits with banks. ----------------------
• Cash flows: Inflows and outflows of cash and cash equivalents. ----------------------
• Cash equivalents
----------------------
– Short-term investments (less than 3 months maturity)
----------------------
– Highly liquid, i.e. can be converted quickly into cash
– Carrying negligible risk of change in value ----------------------
5.4.1 Key Difference between Funds Flow and Cash Flow Statements ----------------------
Funds flow statement depicts the reasons for changes in net working ----------------------
capital and also includes non-cash transactions that generate funds. Cash flow
statement shows whether cash has come or gone due to operating, financing or ----------------------
investing activities and is aligned to the opening and closing cash balance of the
organisation. Since cash is a fact and there is no ambiguity about what is cash, ----------------------
this statement is now considered as more useful than a funds flow statement. ----------------------
Cash Flow statement: Summary
----------------------
Cash Flow Statement for year ended … Amt. Rs.
Cash flow from operating activities (A) -------- ----------------------
Cash flow from investing activities (B) --------
----------------------
Cash flow from financing activities (C) --------
Net increase / (decrease) in ----------------------
Cash flow for the period --------
Add: Op. Balance of cash & cash equivalents -------- ----------------------
Closing bal. of Cash & cash equivalents =
* to disclose significant non-cash transactions as footnote ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes Illustration: Problem
In the books of Joy Appliances Ltd.
----------------------
Profit & Loss A/c for the year ended 31.03.2018
----------------------
Dr. Cr.
---------------------- Particulars Amount Rs. Particulars Amount Rs.
To Opening Stock 315,000 By Sales 1,848,000
---------------------- Purchases 1,282,000 Closing Stock 349,000
Gross Profit c/d 600,000
----------------------
2,197,000 2,197,000
----------------------
To Rent 120,000 By Gross Profit b/d 600,000
---------------------- Salaries 214,000
Advertising expenses 30,000
---------------------- Misc. expenses 13,000
---------------------- Depreciation- Furniture 27,000
Provision for Income- 98,000
---------------------- Tax
Net Profit c/d 98,000
---------------------- 600,000 600,000
P&L A/c surplus bal. b/d 18,000
----------------------
To Proposed Dividend 75,000 Net profit b/d 98,000
---------------------- Transfer to General 20,000
Reserve
---------------------- To bal. c/d 21,000
116,000 116,000
----------------------
Balance Sheet as at 31.03.2018
---------------------- Liabilities 2016-17 2017-18 Assets 2016-17 2017-18
Particulars Amount Amount Particulars Amount Amount
----------------------
Rs. Rs. Rs. Rs.
---------------------- Share capital 500,000 500,000 Furniture 300,000 270,000
(Op.W.D.V.)
---------------------- General Reserve 100,000 120,000 less: Depreciation (30,000) (27,000)
P&L A/c surplus 18,000 21,000 Closing W.D.V. à 270,000 243,000
---------------------- Creditors 66,300 84,200 Inventory 315,000 349,000
Outstanding 1,700 1,800 Trade Receivables 83,000 81,000
---------------------- expenses
Provision for I-Tax 94,000 98,000 Cash on hand 2,000 5,500
---------------------- Proposed Dividend 75,000 75,000 Cash at bank 90,000 120,000
Prepaid expenses - 1,500
---------------------- Advance I-Tax paid 95,000 100,000
855,000 900,000 855,000 900,000
----------------------
Additional information:
---------------------- 1. Tax refund for financial year 2016-17 received Rs.1,000/-
---------------------- 2. Advance tax paid during the year is Rs.1 lac
---------------------- 3. Dividend declared for 2016-17 was paid in the current year
Prepare the Cash Flow statement Notes
Solution:
----------------------
i. By Direct Method
----------------------
In the books of Joy Appliances Ltd.
Rs. in ‘000s ----------------------
Cash flow statement for the year ended 31.03.2018 ----------------------
Working notes:
Summary of receipts and payments ----------------------
Receipts from customers: (cash sales + debtors collection)
Sales 1,848.00 ----------------------
Op. Debtors 83.00
----------------------
Cl. Debtors (81.00)
1,850.00 ----------------------
Payments to suppliers for goods and expenses:
Purchases (cash purchases + payment to creditors) ----------------------
Purchases: 1,282.00
Op. Creditors 66.30 ----------------------
Cl. Creditors (84.20) ----------------------
1,264.10
Expenses: Rent 120.00 ----------------------
Salaries 214.00
Advertising 30.00 ----------------------
Misc. expenses 13.00
----------------------
377.00
Outstanding (0.10) ----------------------
Prepaid 1.50
378.40 ----------------------
Particulars Rs. in ‘000s ----------------------

Cash flow from operating activities
Inflows : ----------------------
Receipts from customers 1,850.00 ----------------------
Outflows:
Payment for goods (1,264.10) ----------------------
Payment for expenses (378.40)
Cash from operations 207.50 ----------------------
Tax Adjustment:
----------------------
Tax paid (100.00)
Tax refund received 1.00 ----------------------
Net cashflow from operations ---> 108.50
Cashflow from financing activities: ----------------------
dividend paid (75.00)
Net increase in cash and cash equivalents 33.50 ----------------------
Cash and cash equivalents as on 31.03.2017 92.0 ----------------------
Cash and cash equivalents as on 31.03.2018 125.50
----------------------

Notes ii. By Indirect Method
Cash flow statement for the year ended 31.03.2018 Rs. in ‘000s
----------------------
Net profit before taxation and extraordinary items ( 98 + 98 ) 196.00
---------------------- Add: Non-cash charges
Depreciation on furniture 27.00
---------------------- Operating profit before working capital adj. --> 223.00
Add: Increase in Curr. Liab; Decrease in Curr. Assets
---------------------- Creditors 17.90
---------------------- Outst. exp. 0.10
debtors 2.00 20.00
---------------------- Less: Decrease in Curr. Liab; Increase in Curr. Assets
Stock (34.00)
---------------------- Prepaid exp. (1.50) (35.50) (15.50)
Cash from operations 207.50
----------------------
Tax Adjustment:
---------------------- Less: Tax paid (100.00)
Tax refund received 1.00 (99.00)
---------------------- Net cash from operating activities (a) 108.50
Cash flow from Investing activities (b) NIL
---------------------- Cash flow from Financing activities: ( c)
---------------------- Dividend paid (75.0)
Net increase in cash and cash equivalents (a+b+c) 33.5
---------------------- Cash and cash equivalents as on 31.03.2017 92.0
Cash and cash equivalents as on 31.03.2018 125.50
----------------------

---------------------- 1. When assets _____ and liabilities _____, it results in cash inflow.
---------------------- 2. When assets _______ and liabilities ______, it results in cash outflow.
3. ‘Proceeds from issue of shares’ is classified as ______ activity.
----------------------
4. Dividend received from investment in shares of another company is
---------------------- classified as ______ activity.
---------------------- 5. Tax refund received is classified as cash inflow under _______ activity.

1. Issue of debentures for fixed asset acquired is a cash inflow.
----------------------
2. Redemption of shares is a source of cash.
----------------------
3. Depreciation is added back to profit before tax to arrive at operating
---------------------- cash flow.
4. Dividend proposed on equity shares of the company is a cash outflow.
----------------------
5. Reduction in Trade Receivables indicates an inflow of cash.
----------------------

Notes
Activity 1
----------------------
Go through the annual report of a public limited company and study the ----------------------
cash flow statement. Write your observations regarding cash generating
activities, how cash has been used during the year and the liquidity position ----------------------
of the company.
----------------------
----------------------
5.5 ILLUSTRATIVE PROBLEMS
----------------------
1. Given below are the Balance Sheets of Liquid Ltd.
2016-17 2017-18 2016-17 2017-18 ----------------------
Equity Capital 30,000 35,000 Fixed Assets 51,000 62,000
----------------------
9% Preference 20,000 10,000 Investment 3,000 8,000
Capital ----------------------
Debentures 10,000 20,000 Current Assets 24,000 37,500
Reserves 11,000 27,000 Preliminary 1,000 500 ----------------------
Expenses
R.D.D. 1,000 1,500 ----------------------
Current Liabilities 7,000 14,500
79,000 1,08,000 79,000 1,08,000 ----------------------
You are also informed that during 2017-18 ----------------------
1) A machine costing Rs. 7000 (Book Value Rs. 4000) was sold for Rs. 2,500. ----------------------
2) 15% dividend was paid on equity capital in addition to preference dividend
----------------------
on opening balance of capital.
3) The preference shares were redeemed at the end of the year at 5% premium. ----------------------
4) Depreciation written off Rs. 7000 on fixed assets. ----------------------
Prepare Funds Flow Statement. ----------------------
Solution:
----------------------
Funds Flow Statement of Liquid Ltd. for 2017-18
----------------------
Sources Rs. Applications Rs.
Issue of Redemption of Preference Shares 10,000 ----------------------
Equity Shares 5.000 Premium on redemption of 500
Debentures 10,000 Preference Shares ----------------------
Sale of Fixed Assets 2,500 Purchases of Fixed Assets 22,000
----------------------
Operating Profit 31,800 Purchases of Investments 5,000
Dividend ----------------------
Equity Capital 4,500
Preference Capital 1,800 ----------------------
Increase in Working capital 5,500
49,300 49,300 ----------------------
----------------------

Notes Statement showing changes in working capital
2016-17 2017-18 Increase Decrease
----------------------
Rs. Rs. Rs. Rs.
---------------------- (A) Current Assets 24,000 37,500 13,500 –
(B) Current Liabilities
---------------------- Current Liabilities 7,000 14,500 – 7,500
R.D.D. 1,000 1,500 – 500
---------------------- 8,000 16,000 13,500 8,000
---------------------- (C) Increase in working capital 5,500
Working Notes :
---------------------- (I) Fixed Assets A/c
---------------------- Rs. Rs.
To, Balance b/fd 51,000 By, Cash (Sale Proceeds) 2,500
---------------------- To, Cash 22,000 By, Loss on sale of Assets 1,500
(Fresh purchases) By, Depreciation 7,000
---------------------- By, Balance c/fd 62,000
73,000 73,000
---------------------- Reserves A/c
---------------------- Rs. Rs.
To, Depreciation 7,000 By, Balance b/fd 11,000
---------------------- To, Loss on sale of assets 1,500 *By Operating
To, Dividend Profit 31,800
---------------------- Equity Capital 4,500
Preference Capital 1,800
---------------------- To, Preliminary Expenses 500
Written off
---------------------- To Premium on redemption 500
---------------------- of Preference shares
To, Balance c/fd 27,000
---------------------- 42,800 42,800
*Balancing figure
---------------------- Note:
---------------------- As per the provisions of Companies Act, 2013, at the time of redemption of
preference shares, the equivalent amount is required to be transferred to Capital
---------------------- Redemption Reserve A/c. for want of specific information. It is assumed that
the amount of Capital Redemption Reserve is included in the reserve amount.
---------------------- Further, it is assumed that the premium on redemption of preference shares is
---------------------- written off to Profit and Loss Account.
----------------------
----------------------
----------------------
----------------------
----------------------

5.6 INTERPRETATION OF FUNDS FLOW STATEMENT Notes
For the correct interpretation of the funds flow statement, the sources and ----------------------
application of funds can be categorised as below.
----------------------
(a) Sources :
----------------------
i) Long Term sources – Following types of sources may be treated as
long term sources. ----------------------
– Issue of shares/debentures. ----------------------
– Long Term borrowing of funds.
----------------------
– Operating Profit.
----------------------
– Sale of fixed assets.
ii) Short Term sources – Following types of sources may be treated as ----------------------
short term sources. ----------------------
– Short term borrowing of funds.
----------------------
– Increase in current liabilities.
----------------------
– Decrease in current assets.
(b) Applications : ----------------------
i) Long Term applications – Following types of applications may be ----------------------

treated as long term applications.
----------------------
– Purchases of fixed assets.
----------------------
– Redemption of preference shares/debentures.
– Repayment of long term borrowings. ----------------------
ii) Short Term applications – Following types of applications may be ----------------------
treated as short term applications.
----------------------
– Increase in current assets.
– Decrease in current Liabilities. ----------------------
– Repayment of short term loans/deposits ----------------------

– Dividends/Taxes. ----------------------
After catagorising the sources and applications as above, a proper interpretation
----------------------
of the funds flow statement can be carried out after keeping in mind the following
propositions. ----------------------
1) Generally, long term sources of funds should be used for long term ----------------------
applications.
2) Generally, short term sources of funds should be used for short term ----------------------
applications. ----------------------
----------------------

Notes 3) In some cases, the long term sources of funds can be used for short term
applications (e.g. investment in core current assets), however under no
---------------------- circumstances, short term sources of funds should be used for long term
applications. If the short term sources of funds are used for long term
---------------------- applications, it results into diversion of funds. It indicates that the funds
---------------------- raised are not utilised for the purpose for which they are intended. It indicates
that the funds which are repayable or adjustable in the immediate future, are
---------------------- applied for such purposes, the returns from which are not likely to be received
in the immediate future but are likely to be spread over a longer period of
---------------------- time. This indicates financial imprudency on the part of the organisation.
----------------------
----------------------
---------------------- 1. Issue of shares

i. Long-term source
---------------------- ii. Short-term source
---------------------- 2. Long-term borrowings of funds
i. Long-term source
----------------------
ii. Short-term source
---------------------- 3. Short-term borrowing of funds
---------------------- i. Long-term source
---------------------- 4. Operating profit
----------------------
5. Purchase of fixed assets
---------------------- i. Long-term application of funds
---------------------- ii. Short-term application of funds
6. Redemption of preference shares/debentures
----------------------
i. Long-term application of funds
7. Increase in current asset
----------------------
----------------------
----------------------
----------------------
----------------------

Summary Notes
• Funds Flow Statement summarises for a particular period the resources made ----------------------
available to finance the operations of an enterprise and the uses to which
----------------------
such resources have been put.
• C
ash Flow Statements are used to explain the cash movements between two ----------------------
points of time. ----------------------
• W
hereas the funds flow statement usually considers the transactions affecting
the movement of working capital (i.e. either Current Assets or Current ----------------------
Liabilities or both), the cash flow statement considers the movement only ----------------------
in respect of cash. Funds Flow or Cash Flow Statements may serve as
supplementary financial information to the users. ----------------------
Keywords ----------------------
• Non-Recurring / Abnormal Income / Expenses: These items may ----------------------

involve flow of fund. However, for clear disclosure purposes, they are ----------------------
shown separately on funds flow statement.
• Cash: Cash on hand and demand deposits with banks. ----------------------
• Cash flows: Inflows and outflows of cash and cash equivalents. ----------------------
Self-Assessment Questions ----------------------
1. Explain the process of preparation of Funds Flow Statement. ----------------------

2. What are the uses of Funds Flow Statement? ----------------------
3. What is the difference between a Funds Flow Statement and a Cash Flow
Statement? ----------------------
4. Explain how a Cash Flow Statement is prepared. ----------------------
5. What is the information conveyed by a Cash Flow Statement?
----------------------
Answers to Check your Progress ----------------------

1. True
----------------------
2. True
----------------------
3. False
4. True ----------------------
5. False ----------------------
6. True ----------------------
7. True
----------------------

Fill in the blanks.
----------------------
1. When assets decrease and liabilities increase, it results in cash inflow.
----------------------
2. When assets increase and liabilities decrease, it results in cash outflow.
---------------------- 3. Proceeds from issue of shares’ is classified as financing activity.
---------------------- 4. Dividend received from investment in shares of another company is
classified as investing activity.
----------------------
5. Tax refund received is classified as cash inflow under operating activity.
----------------------
---------------------- 1. False
---------------------- 2. False
---------------------- 3. True
4. False
----------------------
5. True
----------------------
---------------------- Multiple Choice Single Response
---------------------- 1. Issue of shares

2. Long-term borrowings of funds
----------------------
i. Long-term source
----------------------
3. Short-term borrowing of funds
---------------------- ii. Short-term source
---------------------- 4. Operating profit

5. Purchase of fixed assets
----------------------
----------------------

---------------------- 1. Kaplan & Atkinson. Advanced Management Accounting Book.
---------------------- 2. Kumar & Sharma. Auditing: Principles and Practice.
----------------------
----------------------
----------------------

Capitalisation
UNIT
6
Structure:
6.1 Introduction
6.2 Theories of Capitalisation
6.3 Overcapitalisation
6.4 Undercapitalisation
6.5 Overcapitalisation vs. Undercapitalisation
6.6 Watered Stock/Watered Capital
6.7 Watered Capital vs. Overcapitalisation
Summary
Key Words
Suggested Reading
Capitalisation 107
Notes
Objectives
----------------------
----------------------
• Determine the amount of funds an entity should deploy for its
---------------------- business operations
---------------------- • Explain the theories of capitalisation
• Analyse the concepts of overcapitalisation and undercapitalisation
----------------------
• Define the meaning of altered stock
----------------------
• Differentiate between overcapitalisation and undercapitalisation
----------------------
6.1 INTRODUCTION
----------------------
---------------------- The assessment of the funds needed by the company should be done in
such a way that the total amount of funds available should be neither too large
---------------------- nor too less. As such, one of the most important financial decisions becomes
the determination of the amount, which the company should have at its disposal
---------------------- (which may consist of funds required for fixed assets as well as the portion of
---------------------- current assets to be financed by the company out of long-term sources.) This is
capitalisation.
---------------------- Thus, the term capitalisation means total amount of long-term funds
---------------------- available to the company. In the words of Dewing, “Capitalisation includes
capital stock and debt”. Therefore, capitalisation includes shares and debentures
---------------------- issued by the company and also the long-term loans taken from the financial
institutions. The question arises regarding the inclusion of non-distributed profit
---------------------- in the capitalisation.
---------------------- As far as earned profits remained to be distributed (i.e. Reserves and
Surplus) are concerned, it is necessary to classify them as either capital surplus
---------------------- or revenue surplus. Capital Surplus will always be a part of total capitalisation,
---------------------- though it is available for cash dividend under certain circumstances. Revenue
Surplus will be a part of capitalisation, if the management wants to retain it in
---------------------- the business.
---------------------- The importance of the determination of amount of capitalisation need not
be overemphasised. The amount of capitalisation should be only that much
---------------------- which could be justified by its profits and by the normal rate of return for the
industry concerned. If the company earns less than the other companies in the
----------------------
same industry, value of the shares of company will reduce and the company will
---------------------- suffer.
For example, if the company earns an after tax profit of Rs. 20 lakh and
----------------------
the other companies in the same industry earn after tax return of 10% on their
---------------------- capitalisation, the expectation of investors will be the same from the company.
As such, the ideal capitalisation for the company will be Rs. 200 lakh. If the
---------------------- actual capitalisation is Rs. 250 lakh, the after tax return for the company becomes

8%, which is less than the industry standards. As a result, price of the shares of Notes
the company will be less than that of other companies in the same industry.
----------------------
6.2 THEORIES OF CAPITALISATION ----------------------
There are two important theories that act as guidelines for determining the ----------------------
amount of capitalisation.
1. Cost Theory: ----------------------
Cost theory of capitalisation considers the amount of capitalisation on ----------------------

the basis of cost of various assets required to set up the organisation. It
----------------------
gives more stress on current outlays than on the requirements, which are
necessary to accommodate the investment on a going concern basis. The ----------------------
company may need the funds to invest in fixed and current assets and also
to meet promotional and organisational expenses. The total sum required ----------------------
for all these purposes gives the amount of capitalisation. The cost theory of
----------------------
capitalisation seems to be ideal as it considers the actual funds to acquire
various assets, but it does not consider the earnings capacity of these assets. ----------------------
If the amount of capitalisation arrived at on this basis includes the cost of
assets acquired at inflated costs or the cost of idle and obsolete assets, the ----------------------
earnings are bound to be low which will not be able to pay favourable return
----------------------
on the cost of assets and this will result into over-capitalisation. Similarly,
cost theory of capitalisation may not be useful in case of a company with ----------------------
irregular earnings.
----------------------
2. Earnings Theory:
Earnings theory of capitalisation considers the amount of capitalisation on ----------------------
the basis of expected future earnings of the company, by capitalising the
----------------------
future earnings at the appropriate capitalisation rate. Thus, for determining
the amount of capitalisation, it is necessary to take the following steps: ----------------------
(a) To decide future earnings: ----------------------
Estimations of future earnings may be comparatively an easy task in
case of established concerns as there can be some basis of past data. In ----------------------
case of new concerns, estimating the future earnings is a difficult task. ----------------------
While estimating future earnings, the following factors should be kept
in mind. ----------------------
i. The smaller the period, the more accurate will be the estimations ----------------------
of future earnings. While estimating future earnings on the basis
of past earnings, weighted average of past earnings may be ----------------------
considered giving maximum weightage to recent earnings.
----------------------
ii. While considering future earnings on the basis of past earning,
care should be taken to adjust the earnings on account of non- ----------------------
recurring factors. Moreover, adjustments should be made for
----------------------
known factors in future.
----------------------
Capitalisation 109
Notes iii. In case of new concerns, the estimations of future earnings depend
upon correct estimation of future sales (which in turn should be
---------------------- based upon proper sale forecast) and future costs. Allowance
should be made for contingencies.
----------------------
(b) To determine Capitalisation rate:
----------------------
This is the most tricky and delicate issue and is entirely a subjective
---------------------- concept. The concepts of capitalisation rate may take any of the
following forms:
----------------------
i. The rate of return is required to attract investors to the particular
---------------------- organisation.
---------------------- ii. It is the cost of capital.

iii. It is the rate of earnings of similar organisations in the same
---------------------- industry.
---------------------- (c) To capitalise the future earnings at the decided rate of Capitalisation:
---------------------- Following example will illustrate the working of earnings theory of capitalisation.
Illustration:
----------------------
Expected future earnings of A Ltd. are Rs. 3,00,000. Find out the amount of
---------------------- capitalisation, if rate of return earned by similar types of companies is 15%.
---------------------- 100
Amount of capitalisation = Rs. 3,00,000 X
15
---------------------- = Rs. 20,00,000
---------------------- The earnings theory of capitalisation is ideal in the sense that it considers
earnings capacity of the organisation. But it has limitations in the sense that it
----------------------
involves the estimation of two variables i.e. future earnings and capitalisation
---------------------- rate, which are too difficult to ascertain.
As such, in case of established concerns, earnings theory may be useful, whereas
----------------------
new concerns may prefer cost theory to decide the amount of capitalisation.
----------------------
----------------------

---------------------- 1. Capitalisation includes ______and _______.
2. The term capitalisation means the total amount of ______funds
----------------------
available to the company.
---------------------- 3. Earned profits include ________and ___________.
---------------------- 4. _____ surplus will always be a part of total capitalisation.
---------------------- 5. ______ surplus will be a part of capitalisation if the management wants

to retain it in business.
----------------------

State True or False. Notes
1. The smaller the period, the more accurate will be the estimations of ----------------------
future earnings.
----------------------
2. Estimation of future earnings is easy for a newly formed company and
is difficult for an existing company. ----------------------
3. Capitalisation does not include shares and debentures. ----------------------
----------------------
Activity 1
----------------------
Meet the finance manager of any firm having more than one manufacturing ----------------------
units. Discuss with him the basis on which capital deployed in the business
----------------------
is decided.
----------------------
6.3 OVERCAPITALISATION ----------------------
In simple terms, overcapitalisation means existence of excess capital as ----------------------
compared to the level of activity and requirements. For example, if a company
is earning a profit of Rs. 50,000 and the normal rate of return applicable for the ----------------------
same industry is 10%, it means that the amount of shares and debentures should ----------------------
be Rs. 5,00,000. If the amount of shares and debentures issued by the company
is more than Rs. 5,00,000, then the company will be said to be overcapitalised. ----------------------
The term overcapitalisation should not be taken to mean excess funds. ----------------------
There can be a situation of overcapitalisation; still the company may not be
having sufficient funds. Similarly, the company maybe having more funds and ----------------------
still maybe having a low earning capacity thus resulting into overcapitalisation.
----------------------
Causes of overcapitalisation:
----------------------
The situation of overcapitalisation may arise due to various reasons as stated
below: ----------------------
1. The assets might have been purchased during the inflationary situations.
----------------------
As such, the real value of the assets is less than the book value of the assets.
2. Adequate provision might not have been made for depreciation on the ----------------------
assets. As such, the real value of the assets is less than the book value of
----------------------
the assets.
3. The company might have spent huge amounts during its formation stage or ----------------------
might have spent huge amounts for the purchase of intangible assets like ----------------------
goodwill, patents, trademarks, copyrights and designs etc. As a result, the
earning capacity of the company may be adversely affected. ----------------------
4. The requirement of funds might not have been properly planned by the ----------------------
company. As a result, the company may have shortage of capital and to
overcome the situation of shortage of capital, the company may borrow the ----------------------
Capitalisation 111
Notes funds at unremunerative rates of interest, which in its turn will reduce the
earnings of the company.
----------------------
5. The company might have followed the lenient dividend policy without
---------------------- bothering much about building up the reserves. As a result, the retained
profits of the company may be adversely affected.
----------------------
6. If there is a very high rate of taxation for companies, the company may
---------------------- not be having sufficient funds left with it for modernisation or renovation
programmes. As such, the real value and the earning capacity of the assets
---------------------- will be lower.
---------------------- 7. There may be many instances, where the management of the company may
raise large amounts by issuing securities, irrespective of the fact whether
---------------------- they are really required or not, in order to take benefit of favourable capital
market conditions. As a result, only the liability of the company increases
----------------------
but not the earning capacity.
---------------------- 8. According to the earnings theory of capitalisation, the capitalisation is the
---------------------- amount of earnings capitalised at a representative rate of return. As such, if
the capitalisation rate is wrong, the amount of capitalisation will be wrong,
---------------------- in such a way that lower the rate of capitalisation, higher will be amount of
capitalisation.
----------------------
Effects of Overcapitalisation:
---------------------- 1. On Company:
---------------------- The real value of the business and its earning capacity reduces with the
adverse affect on market value of shares. Credit standing of the company
----------------------
in the market falls down and it is difficult to raise further capital. The
---------------------- temporary means like lower amount of depreciation and maintenance
charges are followed to improve the earnings, which aggravates the
---------------------- situation further.
---------------------- 2. On Shareholders:
---------------------- This is the worst affected class. The shares held by them are not having any
backing of tangible assets. Due to the reduced market values, the shares
---------------------- become nontransferable or are required to be transferred at extremely low
prices.
----------------------
3. On Consumers:
---------------------- To overcome the situation of overcapitalisation and to improve the
---------------------- earnings, the company may be tempted in increasing the selling price,
more particularly in monopoly conditions. Due to this, the quality of the
---------------------- products may also be affected.
---------------------- 4. On Society at Large:
The increasing selling prices and reducing quality cannot be continued for a
----------------------
very long time due to the competition existing in the market. This situation
---------------------- means losing the backing of the shareholders as well as the consumers. As

a result, the company is dragged towards the winding up which ultimately Notes
affects the society at large in an adverse way in terms of lost industrial
production, unemployment generated, unrest among the workers as a part ----------------------
of society etc.
----------------------
Remedies Available:
----------------------
In order to overcome the situation of overcapitalisation, the company may resort
to any of the following remedial measures: ----------------------
1. To reduce the debts by repaying them. But the debts should be repaid out
----------------------
of the own earnings of the company. There is no point in repaying the debts
out of the fresh issue of shares or debentures, as it does not reduce the ----------------------
amount of capitalisation.
----------------------
2. To redeem the preference shares if they carry too high rate of dividend.
3. The persons holding the debentures may be persuaded to accept new ----------------------
debentures, which carry lower rate of interest. ----------------------
4. The par value of the equity shares may be reduced but this also will have
to be done only after taking the shareholders into confidence. ----------------------
5. The number of equity shares may be reduced but this also will have to be ----------------------
done only after taking the shareholders into confidence.
----------------------
6.4 UNDERCAPITALISATION ----------------------
As against the indication of overcapitalisation, the situation of ----------------------

undercapitalisation indicates the excess of real worth of the assets over the
aggregate of shares and debentures outstanding. Thus, if a company succeeds ----------------------
in earning abnormally high income continuously for a very long period of time, ----------------------
it indicates symptoms of undercapitalisation. As such, undercapitalisation is an
indication of effective and proper utilisation of funds employed in the business. ----------------------
It also indicates sound financial position and good management of the company.
Hence, it is said, “undercapitalisation is not an economic problem but a problem ----------------------
in adjusting capital structure”. ----------------------
Causes of Undercapitalisation:
----------------------
The situation of undercapitalisation may arise due to various reasons as stated
below: ----------------------
1. Sometimes, it may so happen that while deciding the amount of shares ----------------------
and debentures to be issued, the future earnings may be underestimated.
As a result, if the actual earnings turn out to be higher, capitalisation of ----------------------
these earnings may result into undercapitalisation. Similarly, use of low ----------------------
rate of capitalisation for capitalising the future earnings may also result in
undercapitalisation. ----------------------
2. There may be cases where the earnings of the business come as a windfall. ----------------------
This may arise during transition from depression to boom. Thus, while
recovering from depression, the companies may find their earnings too ----------------------
high to result into the state of undercapitalisation.
Capitalisation 113
Notes 3. Sometimes, the company may follow a conservative policy for paying the
dividends keeping aside more and more profit for making further additions
---------------------- and investments. As a result, the company may find itself to be in too high
profits and thus undercapitalisation.
----------------------
4. The company may be in the position to improve its efficiency through
---------------------- constant modernisation programmes financed out of its own savings. As
such, the earnings capacity of the company may increase to such an extent
----------------------
that the real value of the assets is much more than the book value, which
---------------------- results into the state of undercapitalisation.
Effects of Undercapitalisation:
----------------------
1. On Company:
----------------------
Financial stability and solvency of the company is not affected due to
---------------------- undercapitalisation, but it still affects the company adversely.
---------------------- (a) As earnings per share ratio is very high, it increases the competition
unduly by creating a feeling that the line of business is very lucrative.
---------------------- (b) Increasing amounts of profits increases the tax liability of the company.
---------------------- (c) Marketability of the shares of the company gets restricted due to very
high market prices of shares.
----------------------
(d) Very high profitability of the company induces the employees to
---------------------- demand increase in wages, reduced working hours, more welfare
schemes and more social amenities.
----------------------
(e) Very high profitability of the company creates a feeling among the
---------------------- customers that the company is charging very high prices for its
---------------------- products. They try to bring pressure on the company for reducing the
prices of the product.
---------------------- (f) Increasing profitability coupled with unrest among the employees as
---------------------- well as consumers increases the possibility of Government control
and intervention over such companies. This proves to be quite
---------------------- embarrassing for the company.
---------------------- 2. On Shareholders:
Generally, the shareholders of undercapitalised concerns are benefited.
----------------------
Firstly, they get a very high dividend income regularly. Due to the
---------------------- increasing share prices, the investment of shareholders in the company
appreciates considerably which can be encashed at any time. Secondly,
---------------------- in times of need, the shareholders may get loans on the security of these
shares on easy terms due to high credit standing of the company in market.
----------------------
However, the shareholders of the undercapitalised concerns may suffer in
---------------------- the sense that the market for the shares is limited due to very high market
prices of the shares.
----------------------
----------------------

3. On Society: Notes
The effects of undercapitalisation on the society as a whole may not
----------------------
necessarily be adverse ones. It may encourage new entrepreneurs to start
new ventures or existing ones to expand. This may increase the industrial ----------------------
production and reduce the unemployment problems. The consumers may
get a variety of products at competitive prices. ----------------------
However, society may not be benefited if the state of undercapitalisation is ----------------------
not taken into right spirit. If the feeling is developed among the workers and
consumers that they are being exploited due to ever-increasing profitability ----------------------
of the undercapitalised company, it may disturb not only the company itself
----------------------
but also the society as a whole. Possibility of Government intervention and
introduction of various control measures (say in the form of price control, ----------------------
dividend ceiling and dividend freeze) increases.
----------------------
Remedies Available:
The main indication of existence of a situation of undercapitalisation is the ever- ----------------------
increasing amount of earnings per share. If the situation of undercapitalisation ----------------------
is to be resolved, the company can take any of the following two measures in
order to reduce the amount of earnings per share. ----------------------
1. Issue of Bonus Shares: ----------------------
If the company has sufficient amount of reserves and surplus in hand,
----------------------
whole or a part of reserves and surplus may be capitalised by way of bonus
shares. As a result, number of shares as well as amount of share capital will ----------------------
increase and amount of reserves and surplus will be reduced. It should be
noted that it will affect neither the amount of capitalisation nor the total ----------------------
income of the shareholders. But it will reduce the amount of earnings per
----------------------
share.
For example, Suppose that the present capitalisation of the company ----------------------
comprise of Equity Share Capital of Rs. 1,00,000 (divided into 1000
----------------------
Equity Shares of Rs. 100/- each) and reserves of Rs. 75,000. If the present
earnings are Rs. 50,000, the present earnings per share will Rs. 50 i.e. ----------------------
Rs. 50,000/1000 equity shares. The company decides to issue 500 equity
shares of Rs. 100/- each as bonus shares. As such, the equity share capital ----------------------
will increase to Rs. 150,000 and reserves will reduce to Rs. 25,000. The
----------------------
earnings of the company will be considered against total of 1500 equity
shares and as such, earnings per share will reduce to Rs. 33.33 i.e. Rs. ----------------------
50,000/ 1500 Equity Shares.
----------------------
2. Splitting the Shares:
To overcome the situation of undercapitalisation, the company may decide ----------------------
to split the shares in order to spread the earnings over a greater number of ----------------------
shares so that the earnings per share may be reduced.
For example, suppose that the present capitalisation of the company ----------------------
consists of equity share capital of Rs. 1,00,000 (divided into 1000 equity ----------------------
Capitalisation 115
Notes shares of Rs. 100/- each) and its present earnings are Rs. 50,000. As such,
present earning per share will be Rs. 50, i.e. 50,000/1000 equity shares.
---------------------- The company decided to reduce per value of shares by 50% and increase
the number of shares in the same proportion. As such, now the number of
---------------------- equity shares will become 2,000 and the earnings of Rs. 50,000 will be
---------------------- distributed over 2,000 equity shares of Rs. 50/- each and earnings per share
will reduce to Rs. 25/- i.e. Rs. 50,000/2,000 equity shares.
----------------------
----------------------

---------------------- 1. Over capitalisation means existence of deficit capital as compared to
the level activity and requirements.
----------------------
2. Profits Rs.50,000. Rate of return applicable for the same industry is
---------------------- 10% and the total amount of shares and debentures is Rs.5,25,000. So
this company is overcapitalised.
----------------------
3. Capitalisation means existence of excess funds.
----------------------
4. When the real value of the assets is less than the book value of the
---------------------- assets, there is over capitalisation.
5. Due to overcapitalisation, the credit standing of the company increases.
----------------------
----------------------
i. Remedy for overcapitalisation a. High earnings, low capital
---------------------- ii. Overcapitalisation b. Issue shares and debentures
iii. Undercapitalisation c. Reduce face value of shares
---------------------- iv. Remedy for undercapitalisation d. Very low earnings, high capital
----------------------
---------------------- 6.5 OVERCAPITALISATION VS. UNDERCAPITALISATION

---------------------- If effects of both of these situations of overcapitalisation and
undercapitalisation are studied and observed carefully, one will find that both
---------------------- the situations are having bad effects. But the effects of overcapitalisation are
---------------------- more serious which affect the company, shareholders, consumers and society at
large in an adverse way and the ultimatum involved with this situation is only
---------------------- the liquidation and winding up of the company, which is a very high cost for
the company to pay. Situation of undercapitalisation increases the competition
---------------------- for the company, there is discontentment on the part of the employees and the
---------------------- consumers get the feeling that they are being exploited. But the fact remains
that the shareholders and the society at large are benefited due to the increased
---------------------- prosperity of the company. Naturally, if the choice is to be made between these
two situations, undercapitalisation will be a preferable situation. As such a
---------------------- statement is usually made – “Both overcapitalisation and undercapitalisation
---------------------- are undesirable. Of the two, however, overcapitalisation is more fatal and
dangerous”.
However, ideally the company should try to avoid both the extremes of Notes
overcapitalisation as well as undercapitalisation. It should ideally aim at fair
capitalisation or balanced capitalisation. ----------------------
----------------------
----------------------
Fill in the blanks.
----------------------
1. When share capital is not represented by the assets of equal value, the
situation may mean introduction of _____ in the capital. ----------------------
2. When the service of promoters is valued highly, they are generally ----------------------
paid in the form of shares. As such, ______is increased but it is not
supported by an increase in _________. ----------------------
3. When the purchase price of an asset is more than the worth of the asset, ----------------------
________ situation is created.
----------------------
4. The concept of watered capital is confined to the time of _____ of the
company. ----------------------
5. If the asset is purchased at high price and it is proved to be worthless, ----------------------
the _____ situation may arise.
----------------------
Activity 2 ----------------------
----------------------
Obtain the financial statements of any two or more companies belonging
to the same industrial sector having similar levels of activity in terms of ----------------------
sales. Study the capital structure of both the companies. Do you feel that the ----------------------
capital deployed by each of the companies is commensurate with the level
of its operations? Is one of the companies overcapitalised as compared to ----------------------
the other? Give your analysis.
----------------------
6.6 WATERED STOCK/WATERED CAPITAL ----------------------
When share capital is not represented by the assets of equal value, the situation ----------------------
may mean introduction of water in the capital or watered capital. ----------------------
This situation may arise due to following reasons:
----------------------
1. The services of the promoters are valued highly and they are paid usually
in the form of shares of the company. As such, share capital is increased ----------------------
but no assets are created.
----------------------
2. Sometimes, the company pays higher price to the vendors of the assets
transferred i.e., the price which is more than the worth of the assets. ----------------------
As such, possibility of the existence of the watered stock or watered capital can
----------------------
be traced to the intention of the promoters who sell the shares. If the promoters
deliberately acquire the assets at inflated prices, the situation of watered capital ----------------------
may exist.
Capitalisation 117
Notes 6.7 WATERED CAPITAL VS. OVERCAPITALISATION
---------------------- Sometimes, the terms watered capital and overcapitalisation are confused
with each other, but it is not true. The concept of watered capital is confined
---------------------- to the time of promotion of the company. Thus, at the time of promotion, the
company is expected to acquire the assets at a price, which justifies its real
---------------------- worth. If the assets prove to be worthless or are bought at an inflated price, the
situation of watered capital may exist.
----------------------
On the other hand, if the company has worked for several years and during
---------------------- these years has failed to earn sufficient earnings to justify the amount of its
capital, the company will be in the state of overcapitalisation.
----------------------
Thus, the existence of watered capital may be one of the causes of
---------------------- overcapitalisation, but it is not inevitably the cause of overcapitalisation as the
subsequent earnings may justify the amount of capitalisation though the capital
---------------------- may remain watered.
---------------------- The following illustration may make the relationship between watered
capital and overcapitalisation clearer:
----------------------
Suppose, that a company issues and subscribes for 1000 equity share of Rs.
---------------------- 100 each (i.e., total equity share capital is Rs. 1,00,000). This amount has been
used to purchase the fixed assets of the company, the real value of which is only
---------------------- Rs. 75,000. It means that the company is watered to the tune of Rs. 25,000.
---------------------- The company operates for six years during which it has earned the average
profits of Rs. 16,000. If the earnings are capitalised at the rate of 5%, the
---------------------- capitalised value of earnings will be Rs. 3,20,000. It means that the company
will be having watered capital but it will not be overcapitalised.
----------------------
Now suppose, that the original amount of Rs. 1,00,000 is used by
---------------------- the company to purchase fixed assets, the real worth of which is really Rs.
1,00,000. It means that there is no watered capital. However, after operating for
---------------------- six years the company is able to earn the average profits of only Rs. 3,000. If the
earnings are capitalised at the rate of 5%, the capitalised value of the earnings
---------------------- will be Rs. 60,000. It means that the company has no water in capital but it is
overcapitalised.
----------------------
---------------------- Summary
---------------------- • Capitalisation refers to the total amount of funds, which a company should
possess for conducting its business activities.
----------------------
• The Capital available with the company should be justified by its profits as
---------------------- well as the normal rate of return for the industry concerned.
• Cost theory of capitalisation considers the amount of capitalisation based
----------------------
on cost of various assets required to set up and run the business activity.
---------------------- • Earnings theory of capitalisation considers the amount of capitalisation on
the basis of expected future earnings of the company, by capitalising the
---------------------- future earnings at the appropriate capitalisation rate.
---------------------- • Overcapitalisation means existence of excess capital as compared to the
level of activity and requirements.
• Undercapitalisation indicates the excess of real worth of the assets over the Notes
aggregate of shares and debentures outstanding.
• Both overcapitalisation and undercapitalisation are undesirable. Of the ----------------------
two, however, overcapitalisation is more fatal and dangerous. ----------------------
• When share capital is not represented by the assets of equal value, the
situation may mean introduction of water in the capital or watered capital. ----------------------
----------------------
Keywords
----------------------
• Cost Theory: Cost theory of capitalisation considers the amount of
capitalisation on the basis of cost of various assets required to set up the ----------------------
organisation.
----------------------
• Earnings Theory: Earnings theory of capitalisation considers the amount
of capitalisation on the basis of expected future earnings of the company, ----------------------
by capitalising the future earnings at the appropriate capitalisation rate.
----------------------
1. “As between under and apitalizedntio, the former is the lesser evil of ----------------------
the two but still both should be discouraged and the ideal should be fair
apitalizedn.” Comment. ----------------------
2. What are the causes of apitalizedntio? State the dangers of apitalizedntio to ----------------------
the society. How will you secure balanced apitalizedn?
3. Discuss the symptoms, causes and remedies of apitalizedntio. ----------------------
4. What are the causes of apitalizedntion? State the dangers and disadvantages ----------------------
of apitalizedntion.
----------------------
5. Write short notes on:
a. Balanced Capitalisation ----------------------
b. Undercapitalisation
----------------------
c. Watered Capital
d. Earnings Theory of Capitalisation ----------------------
e. Theories of Capitalisation ----------------------
f. Overcapitalisation
----------------------
----------------------
----------------------
Fill in the blanks.
----------------------
1. Capitalisation includes capital stock and debts.
2. The term capitalisation means the total amount of long-term funds available ----------------------
to the company. ----------------------
3. Earned profits include reserves and surplus.
----------------------
4. Capital surplus will always be a part of total apitalizedn.
Capitalisation 119
Notes 5. Revenue surplus will be a part of apitalizedn if the management wants to
retain it in business.
---------------------- 1. True
2. True
----------------------
3. False
----------------------
---------------------- 1. False
2. True
----------------------
3. False
---------------------- 4. True
---------------------- 5. False
----------------------
i. c
---------------------- ii. a
---------------------- iii. d
iv. b
----------------------
----------------------
Fill in the blanks.
---------------------- 1. When share capital is not represented by the assets of equal value, the
situation may mean introduction of water in the capital.
----------------------
2. When the service of promoters is valued highly, they are generally paid in
---------------------- the form of shares. As such, share capital is increased but it is not supported
by an increase in assets.
----------------------
3. When the purchase price of an asset is more than the worth of the asset,
---------------------- watered stock/watered capital situation is created.
4. The concept of watered capital is confined to the time of promotion of the
----------------------
company.
---------------------- 5. If the asset is purchased at high price and it is proved to be worthless, the
watered capital/watered stock situation may arise.
----------------------
---------------------- 1. Eugene Brigham, Michael Ehrhardt. Financial Management: Theory &

Practice
---------------------- 2. I.M. Pandey. Financial Management
----------------------
----------------------

Sources of Long-Term and Medium Term Finance
UNIT
7
Structure:
7.1 Introduction
7.2 Shares
7.3 Debentures
7.4 Term Loans
7.5 Public Deposits
7.6 Lease Financing
7.7 Hire Purchasing
7.8 Retained Earnings
Summary
Key Words
Suggested Reading
Sources of Long-Term and Medium Term Finance 121

Notes
Objectives
----------------------
----------------------
• State the concept of share capital and its types
----------------------
• Define the concept of debentures
---------------------- • Explain the different sources of long-term and medium-term finance
---------------------- • Compare the nature of lease finance and hire purchase transactions
----------------------
7.1 INTRODUCTION
----------------------
While discussing about apitalizedn, we have seen that the amount of
---------------------- long-term capital should not be less than requirement nor it should be more
than requirement. There should be a situation of what can be called as fair
---------------------- apitalizedn. The next question that arises is what should be the various sources
from which the long-term capital may be raised?
----------------------
The various sources from which a company may meet its long-term and
---------------------- medium term requirement of funds are discussed under the following headings:
----------------------
7.2 SHARES
----------------------
A share indicates a smaller unit into which the overall requirement of
---------------------- capital of a company is subdivided. For example, if the capital required by a
company is Rs. 10 Crore, it can be subdivided into 1 crore smaller units called
----------------------
as ‘Shares’, each one of the units having the value of Rs.10 each, which in
---------------------- technical words is referred to as ‘Face Value’ or ‘Nominal Value’. In the Indian
circumstances, the Face Value or Nominal Value can be decided by the company
---------------------- on its own. Generally, found face value or nominal value is Rs. 10 or Rs. 100
each share.
----------------------
In the Indian circumstances, a company can raise the long-term funds by issuing
---------------------- two types of shares.
---------------------- a. Equity Shares
---------------------- These are the cornerstones of the financial structure of the company. On
the strength of these shares, the company procures other sources of capital.
---------------------- Equity Shares as a source of long-term funds for the company has the following
characteristic features:
----------------------
1 Investors in the equity shares are the real owners of the company. As
---------------------- such, the investors in equity shares are entitled to the profits earned by the
company or the losses incurred by the company.
----------------------
2 Funds raised by the company by way of equity shares are available on
---------------------- permanent basis. In other words, funds raised by the company by way
of equity shares are not required to be repaid by the company during the
----------------------

lifetime of the company. They are required to be repaid only at the time of Notes
closing down of the company i.e. winding up of the company.
----------------------
3 Funds raised by the company by way of equity shares are available to the
company on unsecured basis i.e. the company does not offer any of its ----------------------
assets by way of security to the investors in equity shares.
----------------------
4 Return that the company pays on equity shares is in the form of dividend.
The rate of dividend is not fixed. It generally depends upon the profits ----------------------
earned by the company. However, a profit making company is under no
obligation to pay dividend on equity shares. ----------------------
5 Equity shares, as a source of raising the long-term funds, is a risk free ----------------------
source for the company, as the company does not commit anything on
equity shares. ----------------------
6 Equity shares, as an investment, is very risky for the investors. As such, ----------------------
the investors are granted the voting rights. By exercising the voting rights,
the investors can participate in the affairs regarding the business of the ----------------------
company. These voting rights are generally proportionate voting rights,
----------------------
in the sense the voting rights of the investors are in proportion to their
investment on the overall capital of the company. However, it should be ----------------------
noted that due to some recent amendments to the Companies Act, 1956,
it may be possible for the companies to issue the equity shares with ----------------------
disproportionate voting rights.
----------------------
7 Equity shareholders may not be able to compel the company to pay the
dividend, but they enjoy the right to maintain the proportionate interest in ----------------------
profits, assets and control of the company. As such, if the company wants
to issue additional equity shares, it is under legal obligation to offer these ----------------------
equity shares to the existing shareholders first, before going to the open ----------------------
market as a general offer. This right of equity shareholders is called ‘Pre-
emptive Right’. ----------------------
8 In financial terms, equity shares, as a source of raising the funds, is a costly ----------------------
source available to the company. The reasons for this will be discussed in
the following paragraphs. ----------------------
Advantages of Equity Shares ----------------------
To the Company
----------------------
While issuing the equity shares, the company does not accept any obligation of
any type. The company neither offers any security to the investors in the form ----------------------
of assets of the company nor commits the repayment of these shares during
----------------------
the lifetime of the company nor commits the payment of any dividend to the
shareholders. This is a total risk free source of capital for the company. ----------------------
To the Investors ----------------------
a. As per the law, the liability of the equity shareholders is restricted only
to the extent of face value of the shares purchased by the investors. The ----------------------
personal properties of the investors are not at stake even if the company ----------------------
fails to fulfil its contractual obligations.

Notes b. Possibility of getting higher returns is always there in case of equity shares.
The investors can gain from equity shares in two forms. Firstly, the regular
---------------------- dividend paid by the company in the form of cash or by way of bonus
shares. Secondly, the capital appreciation received by the investors by
---------------------- selling the equity shares in the secondary market, i.e. stock exchanges.
---------------------- As such, equity shares are a good investment attracting the risk taking
investors.
----------------------
Disadvantages of Equity Shares
---------------------- a. As the investors in equity shares enjoy the voting powers to control
the affairs of the company, the management of the company is always
----------------------
under constant danger of being interfered and disturbed in the regular
---------------------- administration.
b. The cost associated with the equity shares is on the higher side as compared
----------------------
to the borrowed capital. By issuing more and more equity shares, the
---------------------- company loses the cost advantage.
---------------------- c. Many categories of investors, i.e. institutional investors may not be able to
invest in the equity shares due to various statutory restrictions.
---------------------- d. The excessive issue of equity shares may result in over capitalisation to be
---------------------- realised in future.
b. Preference Shares
----------------------
These are the shares, which enjoy preferential treatment as compared to the
---------------------- equity shares in respect of the following factors:
---------------------- a. Unlike in case of equity shares, the preference shares carry the dividend
at a fixed rate which is payable even before any dividend is paid on equity
---------------------- shares.
---------------------- b. In the case of winding up of the company, preference shareholders are paid
back their investment even before the investment of equity shareholders is
---------------------- paid off.
---------------------- Preference Shares as a source of funds for the company involves the following
characteristic features:
----------------------
1. Investors in preference shares are not the absolute owners of the company.
----------------------
2. Funds raised by the company by way of preference shares are required to
---------------------- be repaid during the existence of the company. As per the provisions of
Section 80 of the Companies Act, the company can issue the preference
---------------------- shares maximum for the duration of 20 years. As such, unlike equity shares,
preference share is not a permanent capital available for the company.
----------------------
3. Like in case of equity shares, funds raised by the company by way of
---------------------- preference shares are available to the company on unsecured basis i.e. the
company does not offer any of its assets by way of security to the investors
----------------------
in preference shares.
----------------------

4. Return which the company pays on preference shares is also in the form Notes
of dividend which is payable by the company out of the profits earned.
However, unlike in case of equity shares, the rate of dividend is prefixed ----------------------
and pre-communicated to the investors.
----------------------
5. As compared to equity shares, risk on the part of company is more in case
of preference shares. ----------------------
6. Preference shares, as an investment, is comparatively less risky for the ----------------------
investors. As such, generally, preference shares do not carry any voting
rights and hence they do not have any say in controlling the affairs of the ----------------------
company. However, Companies Act, 1956 provides for voting rights to
----------------------
preference shareholders in the following circumstances.
a. If any resolution directly affecting the rights of the preference ----------------------
shareholders is discussed by the equity shareholders (For example,
----------------------
winding up of the company or reduction of share capital etc.), the
preference shareholders can vote on such resolutions. ----------------------
b. If the dividend has not been paid on the preference shares, in case of ----------------------
cumulative preference shares for an aggregate period of two years and
in case of noncumulative preference shares, either for a period of two ----------------------
consecutive years or for an aggregate period of three years out of the
six preceding years, then the preference shareholders can vote on all ----------------------
the matters placed before the company in the meeting of the equity ----------------------
shareholders.
Types of Preference Shares ----------------------
If the company wants to issue the preference shares, they can be of different varieties. ----------------------
1. Convertible Vs. Non-convertible ----------------------
Convertible Preference Shares are those which can be converted in
----------------------
the equity shares at a later date, the terms of conversion (i.e. when the
conversion will take place, at what rate it will take place etc.) being known ----------------------
to the investors in the beginning only.
----------------------
Non-convertible Preference Shares are those which cannot be converted
in the form of equity shares. They are issued as preference shares and they ----------------------
remain the preference shares.
----------------------
2. Cumulative Vs. Non-cumulative
Preference Shares are to be paid dividend at a fixed rate. However, dividend ----------------------
is payable only if there are profits. The question arises as to what happens ----------------------
if the company is unable to pay dividend, as there are no profits earned by
the company. It depends upon the types of preference shares. ----------------------
If the preference shares are cumulative preference shares and the company ----------------------
is unable to pay the dividend in a certain year due to non-availability of profits,
the arrears of dividend go on accumulating till the company earns the profits ----------------------
and once the company earns the profits, the arrears of preference dividend are
----------------------
required to be paid first, then only the dividend can be paid on equity shares.

Notes If the preference shares are non-cumulative preference shares and the
company is unable to pay the dividend in a certain year due to non-availability
---------------------- of profits, the arrears of preference dividend do not accumulate. The dividend
lapses in the year of loss.
----------------------

----------------------
Fill in the blanks.
---------------------- 1. A share means a ____ in the capital of the company.
---------------------- 2. The value printed on the share certificate is called _____ or _____ value.
3. The value at which the share is sold by the company for the first time
---------------------- in the life of the share is called ______ price.
---------------------- 4. The value at which the share is traded in the market is called _____ value.
5. Equity shareholders are _____ of the company.
----------------------
6. Funds raised by the company by way of equity shares are available on
---------------------- ______ basis and on _____ basis.
7. Returns on equity are called _______.
----------------------
8. The rate of equity dividend is _________.
---------------------- 9. Payment of dividend on equity shares is not _____ but is ______.
---------------------- 10. Right to receive newly issued shares before they are offered to outsiders
is called the right of _______.
---------------------- 11. Preference shares have a preferential treatment for receiving ____ and
---------------------- ______.
12. The rate of dividend on preference shares is ________.
---------------------- 13. Investors in preference shares are not ______ owners of the company.
---------------------- 14. Funds raised through preference shares are required to be _____ during
the life of the company.
----------------------
---------------------- 1. Equity shares is a costly source of financing.
---------------------- 2. Liability of the investor in equity shares is restricted to the market
value of equity shares that he holds.
---------------------- 3. Voting rights enjoyed by the equity shareholders makes the equity
---------------------- share source of capital risky.
4. Preference shareholders have a right to dividend.
----------------------
5. Preference shareholders have a right to receive dividend first.
----------------------
----------------------
----------------------
----------------------

Notes
Activity 1
----------------------
Meet the company secretary of a public limited company. Obtain details of ----------------------
the capital structure of the company. Write a report on the amount of equity
capital and preference share capital raised by the company. ----------------------
----------------------
7.3 DEBENTURES ----------------------
In simple words, Debenture means a document containing an acknowledgement ----------------------
of indebtedness issued by a company and giving an undertaking to repay the
debt at a specified date or at the option of the company and in the meantime to ----------------------
pay the interest at a fixed rate and at the intervals stated in the debenture.
----------------------
The above description of debentures indicates the following characteristic
features of debentures. ----------------------
1 Investors who invest in the debentures of the company are not the owners ----------------------
of the company. They are the creditors of the company or in other words,
the company borrows the money from them. ----------------------
2 Funds raised by the company by way of debentures are required to be repaid ----------------------
during the lifetime of the company at the time stipulated by the company.
As such, debentures are not a source of permanent capital. Debentures can ----------------------
be considered to be a long-term source.
----------------------
3 In practical circumstances, debentures are generally secured i.e. the
company offers some of the assets as security to the investors in debentures. ----------------------
4 Return paid by the company is in the form of interest. Rate of interest is ----------------------
predetermined, but the same can be freely decided by the company. The
interest on debenture is payable even if the company does not earn the ----------------------
profits. ----------------------
5 Debentures as a source of raising long-term funds are very risky from the
company’s point of view. The risk accepted by the company in case of ----------------------
debentures is twofold. First, to pay the interest at the predefined rate and ----------------------
at predefined time intervals irrespective of non-availability of profits and
second, to repay the principal amount of debentures during the lifetime of ----------------------
the company.
----------------------
6 Risk on the part of investors is very less in case of debentures. The
investors in debentures being the creditors of the company, they cannot ----------------------
control the affairs of the company. As such, the debentures do not carry any
----------------------
voting rights. However, in the event of non-payment of interest or principal
amount, they can interfere in the operations of the company by taking legal ----------------------
action.
----------------------
7 In financial terms, debentures prove to be a cheap source of funds from
the company’s point of view. The reasons for this will be discussed in the ----------------------
following paragraphs.
Notes Types of Debentures
A Company can issue debentures of different varieties as described below:
----------------------
a. Registered Vs. Bearer
----------------------
Registered Debentures are those the holders of which are registered in
---------------------- the company as debenture holders and those can be transferred to another
person only through the company. Holders of bearer debentures are not
---------------------- registered with the company and can be transferred to anybody by mere
delivery.
----------------------
b. Convertible Vs. Non-Convertible
----------------------
Convertible Debentures are the debentures, which have the right to
---------------------- be converted into the equity shares of the company. Non-Convertible
Debentures do not enjoy such right.
----------------------
Based upon the conversion criteria, debentures can be classified as below –
----------------------
i. Fully Convertible Debentures (FCD)
---------------------- ii. Partly Convertible Debentures (PCD)
---------------------- iii. Non-Convertible Debentures (NCD)
---------------------- iv. Optionally Convertible Debentures

FCDs are the debentures, which are entirely convertible in the form of equity
---------------------- shares of the company. For example, the terms of issue may provide that the
---------------------- face value of the debenture is Rs. 100. At the end of 5 years, the investors will
get one equity share of the company. This is the case of FCD.
----------------------
PCDs are the debentures, which are partly convertible in the form of equity
---------------------- shares of the company. For example, the terms of issue may provide that the
face value of the debenture is Rs. 200. At the end of 5 years, the investors will
---------------------- get one equity share of Rs. 100 each while the remaining amount of Rs. 100 will
be repaid at the end of 7 years. This is the case of PCD.
----------------------
NCDs are the debentures, which are not convertible in the equity shares of the
---------------------- company. They are issued as debentures and they are repaid as debentures.
---------------------- In case of optionally convertible debentures, the investors are given the option
to convert their investment in the form of equity shares of the company.
----------------------
Advantages of Debentures
----------------------
To the company
---------------------- a. By issuing the debentures, the controlling position of the existing equity
shareholders does not get affected as the debentures do not carry any voting
----------------------
rights.
---------------------- b. Cost associated with debentures is comparatively less than the cost
associated with the equity shares. As such, it is economical for the company
----------------------
to issue debentures.
----------------------

c. During the period of depression, when the investors are not prepared to Notes
take much of risk, the company may be compelled to issue debentures as a
source of raising long-term capital. ----------------------
d. The company might have borrowed various small amounts of debts of short ----------------------
duration, which may prove to be costly and burdensome for the company.
All these small debts may be converted into a single issue of debentures, ----------------------
which may prove to be less costly for the company.
----------------------
To the investors
----------------------
Debentures prove to be a good investment option for the conservative investors
as well as the institutional investors, mainly due to the following two reasons: ----------------------
a. Fixed rate of interest payable by the company irrespective of non- ----------------------
availability of profits.
b. Security available for the investment. ----------------------
Disadvantages of Debentures ----------------------

a. By issuing the debentures, the company accepts the risk of two types- ----------------------
one, to pay the interest at a fixed rate, irrespective of the non-availability
of profits and second, repayment of principal amount at the predecided ----------------------
time. If earnings of the company are not stable or if the demand for the
----------------------
products of the company is highly elastic, debentures prove to be a very
risky proposition for the company. Any adverse change in the earnings or ----------------------
demand may prove to be fatal for the company.
----------------------
b. Debentures are usually a secured source for raising the long-term
requirements of funds and usually the security offered to the investors is ----------------------
the fixed assets of the company. A company that requires less investment
in fixed assets, viz. A trading company may find debentures as a wrong ----------------------
source for raising the long-term requirement of funds, as it does not have
----------------------
sufficient fixed assets to offer as security.
Protection of interests of Debenture holders ----------------------
Recent amendments to Companies Act, 1956 have made some provisions with ----------------------
the intention to protect the interests of the debenture holders.
----------------------
a. A Company accepting the funds from debenture holders shall appoint one
or more debenture trustees and in Prospectus or the Letter of Offer, the ----------------------
company should state that the debenture trustee or trustees have given their
consent to the company to act in the same capacity. The debenture trustee ----------------------
will be primarily responsible to ensure that the interests of the debenture ----------------------
holders are protected (including the creation of security) and the grievances
of the debenture holders are effectively redressed. To be more specific, the ----------------------
debenture trustee should take the following effective steps:
----------------------
i) To ensure that the assets of the company and of the guarantors
are sufficient to discharge the principal amount at all times. If it is ----------------------
concluded that the assets of the company are insufficient to discharge
----------------------

Notes the principal amount, the trustees may file a petition before the
Company Law Board who, after hearing both the parties, may impose
---------------------- restrictions on the incurring of any further liabilities by the company.
---------------------- ii) To satisfy himself that the prospectus or the letter of offer does not
contain any matter inconsistent with the terms of debentures or with
---------------------- the trust deed.
---------------------- iii) To ensure that the company does not commit any breach of the
provisions of the trust deed.
----------------------
iv) To take steps to remedy any breach of the provisions of trust deed or
---------------------- terms of issue of debentures.
---------------------- v) To take steps to call meeting of the debenture holders as and when
required.
---------------------- b. The trust deed for securing the issue of debentures should be executed in
---------------------- the prescribed form and within stipulated period. This trust deed shall be
open for inspection by any member or debenture holder of the company
---------------------- and he can take the copies of the same on the payment of prescribed fees. If
the trust deed is not made available to the member or the debenture holder,
---------------------- the company and every responsible officer shall be punishable with a fine,
---------------------- which may extend to Rs. 500 per day during which the offence continues.
c. A company issuing debentures is required to create debenture redemption
---------------------- reserve for the redemption of debentures and every year adequate amount
---------------------- should be credited to this reserve out of the profits until such debentures
are redeemed. The amount standing to the credit of debenture redemption
---------------------- reserve shall be available only for the redemption of debentures. If the
company fails to redeem the debentures on the date of maturity, on the
---------------------- application of any or all the debenture holders, the Company Law Board
---------------------- can order the company to pay the principal amount of debentures and the
interest thereon. In case of any default in complying with the order of
---------------------- Company Law Board, every responsible officer shall be punishable with
a fine, which may extend to Rs. 500 per day during which the offence
---------------------- continues.
----------------------
7.4 TERM LOANS
----------------------
Term Loans indicate liabilities accepted by the company, which are for
---------------------- the purpose of purchasing the fixed assets, and are repayable over a period
---------------------- of 3 to 10 years. The term loans may be granted by the Banks (nationalised,
cooperative, rural etc.) or the Financial Institutions like Industrial Development
---------------------- Bank of India (IDBI), Industrial Credit and Investment Corporation of India
(ICICI), Industrial Finance Corporation of India (IFCI) etc.
----------------------
Features of Term Loans
----------------------
1. Banks or Financial Institutions granting the term loans are not at all the
---------------------- owners of the company. They are creditors of the company. They lend the
funds to the company.
2. Term Loans are required to be repaid during the lifetime of the company Notes
at the predecided intervals say monthly, quarterly, yearly etc. The initial
gap after which the repayment of term loan starts (technically referred to ----------------------
as the moratorium period) also depends upon the agreement between the
borrowing company and the lending bank or financial institution. ----------------------
3. The term loans may be secured or unsecured, though normally all the ----------------------
term loans are secured. The security offered for the term loans is the
----------------------
hypothecation or mortgage of the fixed assets purchased with the help of
term loans. ----------------------
4. Return payable by the company on term loans is in the form of interest,
----------------------
which may be calculated on monthly or quarterly or half-yearly basis at a
predecided rate on the outstanding balance of the term loan. The interest on ----------------------
term loan is payable despite the non-availability of profits.
----------------------
5. Term Loans as a source of raising long-term funds is very risky from the
company’s point of view. The risk accepted by the company in case of ----------------------
term loans is twofold- one, to pay the interest at the predecided rate and
at predecided time intervals irrespective of non-availability of profits and ----------------------
Second, to repay the principal amount of term loans.
----------------------
6. Risk on the part of lending bank or financial institution is very less in
case of term loans. The banks or financial institutions being the creditors ----------------------
of the company, they cannot control the affairs of the company. As such, ----------------------
they do not have any voting rights. However, in the event of non-payment
of interest or principal amount, they can interfere in the operations of the ----------------------
company by taking legal action.
----------------------
7. In financial terms, as in case of debentures, term loans also prove to be a
cheap source of funds from the company’s point of view. The reasons for ----------------------
this will be discussed in the following paragraphs.
----------------------
Operational Formalities
----------------------
Term Loans is a contract between the borrowing company and lending bank or
financial institution. This contract is a written contract referred to as ‘term loan ----------------------
agreement’. The term loan agreement stipulates the various terms and conditions
on which the relationship between the borrowing company and lending bank or ----------------------
financial institution is regulated. Term Loan agreement has various clauses.
----------------------
1. Amount of loan and the period of repayment
----------------------
2. Rate of interest payable and the method of payment of interest
3. Nature of security offered ----------------------
In addition to the general security offered for the term loan, the agreement ----------------------
may provide for certain additional covenants in order to protect the interests of
the lender. These covenants may take various forms, some of which are stated ----------------------
below: ----------------------
1. That the borrowing company will submit the copy of Annual Accounts to
----------------------
the lender, soon after they are finalised.

Notes 2. That the assets purchased with the help of term loans will be properly
maintained and insured by the borrowing company.
----------------------
3. That the lender may have a representative on the Board of Directors of the
---------------------- company ( viz. Nominee Director) if the loan amount is sizeable.
4. The lender will like to ensure that the borrowing company has the liquid
----------------------
resources in its hands whenever the interest or the installments of the
---------------------- term loans are due. As such, the lender will like to confirm that the liquid
resources of the company are not blocked for unnecessary purposes. Hence,
---------------------- the agreement may stipulate that,
---------------------- a. The company will not pay dividend without the consent of the lender.
---------------------- b. The company will not make long-term loans to directors/officers.

c. The company will not invest in outside corporate securities.
----------------------
d. The company will not redeem the debt before maturity.
----------------------
----------------------

---------------------- 1. Debenture means a document containing an ______ of _______ issued
by a company.
----------------------
2. Debenture is an undertaking issued by the company to ____ the debt
---------------------- at a specified _____ or at the ____ of the company.
---------------------- 3. Debentures carry ______ at a _____ rate.
4. Interest is _______ on profits.
----------------------
5. Debentureholder is not an ________ but a ______of the company.
----------------------
6. Generally, debentures are ______ so investors are assured of getting
---------------------- their money back.

1. Generally, debentures are unsecured.
----------------------
2. Interest is predetermined but the same can be freely decided by the
---------------------- company.
---------------------- 3. Debenture, as a source of financing, is very safe.
4. Risk on the part of investors is less in case of debentures.
----------------------
5. Bearer debentures are freely transferable.
----------------------
6. Bearer debentures are unlike bearer cheques.
----------------------
----------------------
----------------------

Notes
Activity 2
----------------------
1. Meet the company secretary of a company that has issued debentures. ----------------------
Obtain details of debenture issue. What are the terms and conditions of
the debenture issue? ----------------------
2. Meet the branch manager of a bank. Obtain details of various loan ----------------------
facilities offered by the bank. Write a report on eligibility requirements
for obtaining such loans and the terms and conditions subject to which ----------------------
these loans are sanctioned.
----------------------
----------------------
7.5 PUBLIC DEPOSITS
----------------------
In the recent past, Public Deposits has become one of the most important
sources available to the companies for meeting the medium term requirement ----------------------
of funds. The companies find public deposits as an attractive source mainly due
to the following reasons: ----------------------
a. Raising the funds in the form of public deposits is more convenient than ----------------------
borrowing the funds from banks and financial institutions. Borrowing
the funds from banks or financial institutions is a tedious job involving ----------------------
the compliance with many procedural requirements like margin money ----------------------
stipulations, security requirements, submission of periodical statements
etc. None of these procedural requirements is to be complied with in case ----------------------
of public deposits.
----------------------
b. The rate of interest, which the company is required to pay on public
deposits is comparatively less than the rate of interest payable on the funds ----------------------
borrowed from banks or financial institutions.
----------------------
c. Public Deposits are unsecured borrowings for the company.
----------------------
d. The company can raise the funds in the form of public deposits which can
be used for any purpose. The end use of the funds raised in the form of ----------------------
public deposits is not committed by the company.
----------------------
e. In the situations of credit squeeze introduced by the banks, public deposits
plays a ery important role. ----------------------
Applicability: ----------------------
In the word ‘deposits’, all types of loans and deposits are covered, however the
----------------------
following deposits are excluded.
a. Any amount received from the Government, Local Authority and Foreign ----------------------
Government/ Citizens/Authority/Person and any amount whose repayment
----------------------
is guaranteed by the Government.
b. Any loans from Banks/Financial Institutions. ----------------------
c. Amount received by a company from another company. ----------------------

Notes d. Security deposits from employees.
e. Advance for purchase or sales.
----------------------
f. Amounts received for subscribing to shares/debentures pending allotment.
----------------------
g. Amounts received in trust or amounts in transit.
---------------------- h. Amounts received from directors or from shareholders of a Private Limited
---------------------- Company.
Acceptance of deposits:
----------------------
While accepting the deposits, the company will have to comply with the
---------------------- following requirements.
---------------------- a) No company shall accept any deposit that is repayable on demand.
b) Minimum period for which any deposit can be accepted will be 6 months
----------------------
and the maximum period will be 36 months.
---------------------- Note: A company, may, for the purpose of meeting its short-term
---------------------- requirement of funds, accept the deposits for a period of less than 6 months
but not less than 3 months, but their amount should not exceed 10% of paid
---------------------- up share capital and free reserves.
---------------------- c) The maximum amount of deposits which a company may accept will be
25% of the aggregate of paid up share capital and free reserves out of
---------------------- which not more than 10% should be from a shareholder of non-private
limited companies or should be guaranteed by any director.
----------------------
d) The maximum interest, which a company can pay on its deposits, depends
---------------------- upon the maximum rate of interest prescribed by the Reserve Bank of India
that the Non-Banking Finance Companies can pay on their public deposits
---------------------- per annum at rests, which shall not be shorter than monthly rests.
---------------------- Maintenance of liquid assets:
---------------------- Every company, before 30th day of April every year should deposit or invest,
a sum equal to at least 15% of the deposits maturing during the year ending on
---------------------- 31st March next following in the form of:
---------------------- i. Current or other deposit account with any Scheduled Bank.
---------------------- ii. Central or State Government Securities.

iii. Bonds issued by Housing Development Finance Corporation Limited.
----------------------
The amount so deposited or invested shall not be utilised for any purpose other
---------------------- than repayment of deposits maturing during the year.
---------------------- Advertisement:
If a company decides to invite the public deposits, it should publish an
----------------------
advertisement in a leading English newspaper and in one local newspaper
---------------------- circulating in the state in which the registered office of the company is situated.
Such advertisement should be issued on the authority and in the name of the
---------------------- Board of Directors of the company and should contain a reference to the date

on which the Board of Directors has approved the text of the advertisement. The Notes
advertisement should contain the following details:
----------------------
a) Name of the company.
b) Date of incorporation of the company. ----------------------
c) Business carried on by the company and its subsidiaries with the details of ----------------------
its branches or units, if any.
----------------------
d) Brief particulars of management of the company.
e) Names, addresses and occupations of the Directors. ----------------------
f) Profits before tax and profits after tax, for the three financial years ----------------------
immediately preceding the date of advertisement.
----------------------
g) Summarised financial position of the company (in the form prescribed by
Schedule VI of the Companies Act, 1956, as in the two audited balance ----------------------
sheets immediately preceding the date of advertisement.
----------------------
h) The amount of deposits, which can be raised by the company, and the
aggregate of deposits actually held on the last day of the immediately ----------------------
preceding financial year.
----------------------
i) A statement to the effect that on the date of advertisement, the company
has no overdue deposits other than the unclaimed deposits or a statement ----------------------
showing the amount of such overdue deposits. ----------------------
j) A declaration to the effect –
----------------------
i) That the company has complied with the provisions of these rules.
----------------------
ii) That the compliance with these rules does not imply that repayment of
deposits is guaranteed by the Central Government. ----------------------
iii) That the deposits accepted by the company are unsecured and rank
----------------------
pari passu with the other unsecured liabilities.
iv) That the company is not in default in the repayments of deposits and ----------------------
interest thereupon in accordance with the terms and conditions of such
----------------------
deposits.
Before the advertisement is issued, a copy of the same, signed by a majority ----------------------
of the Directors, should be delivered to the Registrar of Companies. ----------------------
The advertisement so issued shall be valid until the expiry of six months
from the date of closure of the financial year in which it is issued or the date on ----------------------
which balance sheet is laid before the company in a general meeting, and if the ----------------------
Annual General Meeting has not been held, the latest day on which the meeting
should have been held, whichever is earlier. ----------------------
If a company wants to accept the deposits without making public invitation, ----------------------
before accepting the deposits it should deliver a statement in lieu of advertisement
to the Registrar of Companies. Such statement in lieu of advertisement attracts ----------------------
the same provisions as applicable to the advertisement as to the contents and the
validity. ----------------------

Notes Application Form
A Company can accept or renew deposits, only on application being made
----------------------
by the intending depositor. Such application form shall be accompanied by a
---------------------- statement made by the company containing all the particulars stated under the
head ‘Advertisement’ as stated above.
----------------------
Deposit Receipt:
---------------------- After accepting the deposits, every company should furnish to the depositor,
within the period of 8 weeks from the date of receipt of money or realisation of
----------------------
cheques, the deposit receipt containing the following particulars:
---------------------- i. Date of deposit
---------------------- ii. Name and address of depositor
---------------------- iii. Amount of deposit

iv. Rate of interest
----------------------
v. Date of maturity
----------------------
Deposit Register:
---------------------- Every company accepting the deposits should maintain registers, at the
---------------------- registered office, showing the following particulars:
i. Name and address of depositor
----------------------
ii. Date and amount of deposit
----------------------
iii. Duration of deposit
---------------------- iv. Date of repayment
---------------------- v. Rate of interest
---------------------- vi. Date or dates on which interest is payable

vii. Any other particulars
----------------------
Prepayment of deposits:
----------------------
If a deposit is repaid after 6 months from the date of deposit but before its
---------------------- expiry, the rate of interest on such a deposit shall be reduced by 1% from the
rate, which the company would have paid, had the deposit been accepted for the
----------------------
period for which such deposit had run.
---------------------- Annual Returns:
---------------------- The companies to whom these rules apply are required to file with the
Registrar of Companies, a return in prescribed form, on or before 30th June
---------------------- every year and the return should contain information of deposits as on 31st
---------------------- March of that year. Such return should be duly certified by the auditor of the
company. A copy of this return is required to be sent to Reserve Bank of India.
----------------------
----------------------

Protection of interests of depositors: Notes
Companies Act, 2013, makes the provision for the protection of interests of
----------------------
depositors. The said section provides that if a company fails to repay any deposit
or any part thereof as per its terms and conditions, the Company Law Board has ----------------------
been empowered to order the company to make the repayment of such deposit
or the part thereof forthwith or within such time and subject to such conditions ----------------------
as may be prescribed. Such action can be taken by the Company Law Board on
----------------------
its own motion or on the application of the depositors. However, before making
the order, company Law Board should give reasonable opportunity of being ----------------------
heard to the company and other interested persons.
----------------------
It is further provided that whosoever fails to comply with the order of
the Company Law Board Shall be punishable with imprisonment which may ----------------------
extend to three years and shall also be liable to a fine of not less than Rs. 500
per day during which such non-compliance continues. ----------------------
Provisions to protect the interests of small depositors: ----------------------
Companies Amendment Act, 2000 has made certain provisions to protect ----------------------
the interests of small depositors. A ‘small depositor’ means a depositor who has
deposited in a financial year a sum not exceeding Rs. 20,000 in a company. ----------------------
The provisions are stated below: ----------------------
a. Every company accepting deposits from the small depositors shall inform
the Company Law Board of any default made by it in respect of repayment ----------------------
of deposit or interest thereon. ----------------------
b. A Company shall not accept any further deposit from the small depositor
----------------------
unless each small depositor whose deposit has matured has been paid the
amount of his deposit and interest thereon. ----------------------
c. Every company who has defaulted in the repayment of deposit or the
----------------------
payment of interest thereon to a small depositor, shall state, in every further
advertisement and application form inviting deposits from the public, the ----------------------
total number of small depositors and the amount due to them in respect of
which default has been made. ----------------------
d. If any interest accrued on the deposits of small depositors has been waived, ----------------------
the fact of such waiver shall be mentioned by the company in every
advertisement and application form inviting deposits issued after such ----------------------
waiver.
----------------------
e. Every application form issued by the company to a small depositor shall
contain a statement stating that the applicant has been appraised of – ----------------------
i. Every past default of the company in the repayment of deposit or ----------------------

interest thereon, if any such default has taken place.
----------------------
ii. The waiver of interest, if any, and reasons thereof.
----------------------
----------------------

Notes f. If anybody knowingly fails to comply with the above requirements or fails
to comply with any order of Company Law Board, he shall be punishable
---------------------- with the imprisonment up to three years and shall be liable to pay fine of
not less than Rs. 500 per day during which default continues.
----------------------
Point to be noted here is that the above provisions apply only in case of small
---------------------- depositors and not in case of large depositors.
----------------------
7.6 LEASE FINANCING
----------------------
In the recent years, the lease financing has emerged as one of the most
---------------------- important sources of long-term financing. Under the leasing agreements, the
company acquires the right to use the asset without holding the title to it. Thus,
---------------------- it is the written agreement between the owner of the assets, called ‘the lessor’,
---------------------- and the user of the assets, called ‘the lessee’ whereby the lessor permits the
lessee to economically use the asset for a specific period of time but the title of
---------------------- the asset is retained by the lessor. This economical use of the asset is permitted
by the lessor on the payment of periodical amount, which is in the form of
---------------------- ‘lease rent’.
---------------------- Lease Agreement or Lease Deed:
---------------------- Lease agreement/deed is the most important document in any leasing activity as
it starts the legal relationship between the lessor and lessee.
----------------------
The usual contents of the lease agreement/deed are as stated below :
---------------------- 1) Description and cost of equipment to be acquired.
---------------------- 2) Commencement date for lease contract.
3) Amount of lease rentals and mode of payments.
----------------------
4) Fixed period of lease, renewal options and the terms during secondary
---------------------- period as to the amount of lease rentals or purchase option.
---------------------- Note: After the fixed period of lease, the lessee is usually given the option
either to renew the lease from time to time at a nominal lease rental or to
---------------------- purchase the asset at a price, which is reasonably lower than the fair value
of the asset.
----------------------
5) Guarantee for payment of lease rental by lessee.
---------------------- 6) Variation of lease rentals.
---------------------- 7) Termination of the lease agreement in the event of certain occurrences.
---------------------- 8) In order to protect the interests of the lessor and lessee, certain covenants
as stated below may also be incorporated as a part of the lease deed.
---------------------- i) That lessee will maintain the asset in good working condition and pay
---------------------- all taxes, insurance etc.
ii) That lessee will not sell or mortgage or charge the land or building on
---------------------- which equipment is installed without notifying the lessor.
---------------------- iii) That lessee will not claim any grant or relief available to the lessor.

iv) That lessee will not alter or modify equipment without the lessor’s Notes
knowledge.
v) That lessee will accept the lessor’s right to inspect the equipment. ----------------------
Advantages of Leasing for the Lessee: ----------------------

1. Risks of ownership: Leasing facilitates lessee to avoid the risks attached ----------------------
with the ownership of the equipments, say risk of obsolescence in the area
of ever-changing technologies. ----------------------
2. Saving of capital outlay: Leasing enables lessee to make full use of the ----------------------
asset without making immediate payments of the purchase price which
otherwise would be payable by him. Some lessors may also finance to the ----------------------
extent of 100% of the cost of the equipment where lessee is not required to
----------------------
make any provision for asset acquisition.
3. Tax advantages: Under the leasing propositions, the payment of lease ----------------------
rents is the tax-deductible expenditure. On the other hand, if the company
----------------------
decides to own the same asset by resorting to the borrowing, the expenses,
which are available for deduction for tax purposes, are in the form of ----------------------
depreciation and interest on borrowing.
----------------------
4. Structuring of lease rents: Lessor may structure the payments of lease
rents in such a way that it matches the revenue expectations of the lessee ----------------------
from the equipments, which may not be possible if the lessee resorts to
borrowing for owning the asset. ----------------------
5. No effect on borrowing power: As the obligations accepted by the lessee ----------------------

under the lease deed appear nowhere on the balance sheet as debt, the
borrowing power of the lessee still remains unaffected. The lessee may still ----------------------
resort to debt capital provided equity base of the company permits further ----------------------
borrowing.
----------------------
6. Convenience: Leasing is the quickest method of financing the requirements
of long-term capital and lessee is relieved from the rigid and time ----------------------
consuming procedures and terms and conditions involved in other forms
of term borrowings say term loans. ----------------------
Evaluation of lease financing: ----------------------
The alternative of leasing can be evaluated under the following headings:
----------------------
a) Does leasing increase borrowing capacity of a firm? The answer to this
question is yes, For example, suppose that at present a company is having ----------------------
the fixed assets the cost of which is Rs. 200 lakh which are financed by way ----------------------
of equity shares of Rs. 100 lakh and Rs. 100 lakh by way of debentures.
As such, the present debt equity ratio is 1:1. Now, if the company wants to ----------------------
acquire further fixed assets worth Rs. 100 lakh, it can purchase it outright
by financing the same out of debt capital in which case, the debt equity ----------------------
ratio will be 2:1, which will inevitably mean reduced borrowing capacity. ----------------------
If the company decides to take these assets on lease, its debt equity ratio
will remain unaffected as it gets only the right to use the assets and not ----------------------

Notes the ownership of the assets. As such, due to lease transactions, the debt
equity ratio of the company remains unaffected, which indicates increased
---------------------- borrowing capacity. However, with greater sophistication in financial
appraisal and improved financial disclosure practices, leases are likely to
---------------------- be viewed as debts.
---------------------- b) Does leasing release the firm from bad investment. An investment may
turn out to be bad if the basic purpose for which it is made is defeated. For
----------------------
example, investment made by a company in a machine may turn out to be
---------------------- bad if the machine becomes obsolete or non-usable in terms of the rapid
technological development. Under these circumstances, it can be said that
---------------------- leasing releases a firm from bad investment as in case of leasing, the risk
of obsolescence is transferred to the lessor i.e. the owner of the asset, and
----------------------
the funds of the firm may be used for more profitable purposes.
---------------------- However, this argument may not be valid under all the circumstances. Lessor,
if aware of the risk of obsolescence, may charge the lessee for bearing the risk
----------------------
and it will be in the form of higher amount of lease rentals. In that case, the
---------------------- lessee will not be really released from the risk of bad investment unless the risk
of obsolescence on the assets is greater than as estimated by the lessor and as
---------------------- recovered by way of lease rentals.
---------------------- Types of Leases:
---------------------- a) Financial Lease:

In this type of lease, the lessor acts as a financier. Lessee selects the asset
---------------------- and bears the cost of repairs, maintenance and insurance of the asset.
---------------------- Lessor reserves the right to confiscate the asset in the event of any default
on the part of lessee. The lessor recovers a major part of the cost of asset
---------------------- by way of lease rent during the lease period; the lessor agrees to transfer
the ownership of the asset to the lessee by paying a nominal price, which
---------------------- is referred to as ‘repurchase price’. This type of lease is also referred to as
---------------------- ‘capital lease’.
b) Operating Lease:
----------------------
In this type of lease, the lessee gets a limited right to use the asset. Lessor
---------------------- selects and purchases the asset and leases the same to the lessee. Lessor
bears the cost of repairs, maintenance and insurance of the asset. Operating
----------------------
lease is for a smaller duration of time and imposes no long-term obligation
---------------------- either on the lessor or on the lessee. The lease rent paid by the lessee does
not contain any part towards the cost of the asset. After the lease period is
---------------------- over, the possession of the asset reverts back to the lessor who can lease
out the asset to another party. The lease deed is cancellable at the option of
----------------------
the lessor or the lessee after giving specific notice.
----------------------
----------------------
----------------------

c) Sale and Lease Back: Notes
In this type of lease, the lessee purchases the asset of his own choice and then
----------------------
sells the same to the lessor. On the sale of asset to the lessor, the ownership
of the asset is transferred to the lessor. Lessor then leases out the same asset ----------------------
to the lessee. After this stage, it becomes a routine lease transaction both
for the lessor as well as for the lessee. In practical circumstances, this type ----------------------
of lease is very regularly found in case of some old asset, which is used
----------------------
by an organisation for a certain duration of time. To explain the concept of
sale and lease back, let us take an example. ----------------------
Company A has purchased an equipment 10 years back for an amount of
----------------------
Rs. 5,00,000 and has been using the same since then. After providing for
depreciation for the last 10 years, written down value of the equipment in ----------------------
the books of the company is only Rs. 15,000. This equipment is sold by
the company to a leasing company for an amount of Rs. 5,00,000. Leasing ----------------------
company pays the purchase consideration of Rs. 5,00,000 to the company
----------------------
and leases back the same equipment to the company. In this arrangement,
the company as well as the lessor is benefited. The company is benefited ----------------------
as the company receives an amount of Rs. 5,00,000 for an equipment,
which is 10 years old without parting with the equipment. For lessor, it is ----------------------
a business proposition. Being a lease transaction, the lessor can claim the
----------------------
depreciation on the asset leased out by him. Under ideal circumstances,
lessor should be able to claim the depreciation on Rs. 5,00,000 being the ----------------------
consideration paid by the lessor to the company. However, in the light of
recent amendments made to the Income Tax Act, 1961, the lessor can claim ----------------------
the depreciation on Rs. 15,000 only, which is the written down value of the
----------------------
asset in the books of the company at the time of transfer of the asset to the
lessor. ----------------------
----------------------
Fill in the blanks.
----------------------
1. Lease financing is a source of financing ______ financing.
----------------------
2. Under the leasing agreement, the company acquires a _____ to use the
asset without holding the title to it. ----------------------
3. In lease financing, the owner of the asset is called _____, the user of
----------------------
the asset is called ____ and the amount paid by the user to the owner is
called ____. ----------------------
4. ________ is an important document in lease agreements.
----------------------
5. Payment of ______ is a tax-deductible item of expenditure.
----------------------
6. In case of _______ type of lease, the lesser acts as a financer.
7. In ______ type of lease, the lesser gets to use the asset. ----------------------
----------------------

Notes
Activity 3
----------------------
---------------------- Meet the accounts officer of a company that has issued public deposits.
Obtain details of the procedure followed by the company while accepting
---------------------- public deposits. Study the format of application form, deposit receipt and
deposit register.
----------------------
----------------------
7.7 HIRE PURCHASING
----------------------
Now-a-days, in addition to Lease Financing, Hire Purchasing is also
---------------------- emerging as a popular source of long-term financing whereby the company can
acquire long-term infrastructural facilities, say fixed assets. It will be pertinent
---------------------- to note here the relationship between lease financing and hire purchasing.
---------------------- Hire purchase indicates an agreement between the owner of goods, called
as ‘the hiree’ and the user of the goods, called as ‘the hirer’ whereby the hiree
---------------------- deliver the goods to the hirer but the ownership of the goods remains with
---------------------- the hiree. In return, the hirer makes the periodical payments of hire charges,
which are partly against the capital repayment and partly against the interest
---------------------- payable. For accounting and tax purposes, only the interest is treated as revenue
expenditure and is considered to be a tax-deductible expenditure. The hirer
---------------------- capitalises the asset purchased under the hire purchase agreement though
---------------------- he is not the owner of the assets. Depreciation is considered by the hirer as
expenditure, debiting the same to profit and loss account and hence becomes
---------------------- the tax-deductible expenditure. The further hire purchase installments towards
capital, which are not yet due, are shown as liability on the Balance Sheet.
----------------------
After the hire charges are paid by the hirer in full, he gets an option of
---------------------- purchasing the asset entirely in which case the installments paid earlier are
converted into the purchase price and the ownership of the asset is transferred
---------------------- to the hirer. If the hirer fails to pay any installment, hiree can take the possession
---------------------- of the asset without refunding any installment paid earlier. It is the duty of the
hirer to keep the asset in good condition. As such, the hiree may stipulate that
---------------------- the assets should be properly insured, the premium being paid by the hirer.
Further, it may also be stipulated that the hirer will not sell or exchange the asset
---------------------- till he becomes the owner of the asset. The hirer has a right to put an end to the
---------------------- agreement before the last installment is paid, but the installments paid by him
previously are not refunded to him.
----------------------
Accounting for Leasing and Hire Purchase:
---------------------- It can be seen from the above discussion that leasing and hire purchase are
similar to each other in certain respects. In both the cases, right to use the asset
----------------------
is available to the lessee or hirer but ownership of the asset remains with the
---------------------- lessor or hiree.
----------------------

Accounting of lease transactions from Lessee’s point of view: Notes
Accounting implications of lease transactions need to be considered from
----------------------
financial accounting point of view as well as from income tax point of view.
For financial accounting, the provisions of Accounting Standard 19 (AS19) ----------------------
are relevant.
----------------------
From financial accounting point of view, the lease rent paid by the lessee
in respect of the operating lease is treated as revenue expenditure and is debited ----------------------
to Profit and Loss Account. For income tax purposes, also the same is treated as
----------------------
revenue expenditure, which reduces the taxable profits of the lessee.
From financial accounting point of view, the lease rent paid by the lessee in ----------------------
respect of the financial lease is split into two parts – finance charges and principal ----------------------
amount. The finance charges are treated as revenue expenditure and debited to
Profit and Loss Account and principal amount is used to reduce the liability, ----------------------
which is created at the time of inception of lease. At the time of inception, the
asset is capitalised in the books of the lessee at the present value of committed ----------------------
lease rent and the said is matched by a corresponding liability on the balance ----------------------
sheet. Depreciation is calculated by the lessee as per his depreciation policy.
For income tax purposes, the lease rent paid by the lessee is treated as revenue ----------------------
expenditure, which reduces the taxable profits of the lessee.
----------------------
Accounting of hire purchase transactions:
a) Entire amount of hire charges paid by the hirer to the hiree are not ----------------------
considered to be revenue expenditure in the books of hirer. The hire charges ----------------------
paid by the hirer are split as the payment against capital repayment and the
payment against the interest. The component of interest payment only is ----------------------
debited to Profit and Loss account, whereas the payment against the capital
repayment reduces liability for the hirer. ----------------------
b) Asset taken by the hirer on hire is capitalised in the books of the hirer, ----------------------
though the ownership does not transfer to the hirer till the last installment
----------------------
of hire charges is paid by him. Only the payment against interest payment
is a tax-deductible expenditure for the hirer. Similarly, liability for the ----------------------
future hire charges is also disclosed as the liability on the balance sheet of
the hirer. Hirer claims the depreciation on the asset taken by him on hire ----------------------
purchase and the same is treated as a tax-deductible expenditure for the
----------------------
hirer. Thus, unlike in case of leasing transactions, hire purchase is not a ‘off
the balance sheet mode of financing’ for the hirer. ----------------------
7.8 RETAINED EARNINGS ----------------------
Retained earnings or ploughed back profits is one of the best sources of ----------------------
raising long-term funds for the company. It indicates that whatever profits are ----------------------
earned by the company are not distributed by it by way of dividend but are kept
aside for being used in future for expansion or other purposes. If the company ----------------------
follows a regular policy of ploughing back of profits, i.e. keeping aside profits
without distributing them, the shareholders may resent this policy. As such, ----------------------

Notes while deciding the amount of profits to be retained, the company has to be very
careful, about its consequences on the expectations of shareholders and also on
---------------------- the prices of the shares.
----------------------
----------------------
Fill in the blanks.
----------------------
1. In case of higher purchasing, ______ is transferred to the buyer but not
---------------------- the _______.
---------------------- 2. In hire purchase, the owner of the asset is called _____ and the user is
called ____.
----------------------
3. For lease accounting, the provisions of Accounting Standard ____ are
---------------------- applicable.
---------------------- 4. The entire amount of hire charges paid by the hirer to the hiree is not
considered to be ______expenditure in the books of hirer.
----------------------
5. Retained earnings is also called ______back of profits.
----------------------
---------------------- Activity 4
----------------------
Meet the manager of a finance company and obtain the information regarding
---------------------- the lease financing products of the company. Also, obtain a sample copy of
lease agreement and hire purchase agreements.
----------------------
---------------------- Summary
----------------------
• Long-term finance refers to the permanent source of finance or finance
---------------------- available for a long period such as more than 10 years.
• The financial sources are broadly classified into share capital (both equity
----------------------
and preference) and debt (including debentures, long-term borrowings or
---------------------- other debt instrument).
---------------------- • Equity shareholders are the owners of the company and Company pays
dividend to equity shareholders as consideration for the risk.
---------------------- • Preference shareholders are not the absolute owner of the company but they
---------------------- have the preferential right of receiving dividend over equity shareholders.
Preference shares are to be paid dividend at a fixed rate. These shareholders
---------------------- have no voting rights.
---------------------- • Debenture refers to a document containing an acknowledgement of

indebtedness issued by the company and a fixed rate of interest. Generally,
---------------------- debentures are secured against the asset of the company.
----------------------

• A public limited company can only accepts deposits from public. Public Notes
deposits are unsecured borrowing for the company.
----------------------
• In lease financing, the company acquires the right to use the asset without
holding the title to it and lease agreement or lease deed is the document in ----------------------
leasing activity.
----------------------
• In hire purchase agreement, the ownership is not transferred but goods are
transferred for use to the other party against a periodical payment of hire ----------------------
charges.
----------------------
• Retained earnings indicates that whatever profits are earned by the company
are not distributed by it by way of dividend but are kept aside for being ----------------------
used in future for expansion or other purposes.
----------------------
Keywords ----------------------
• Equity Shares: These are the cornerstones of the financial structure of ----------------------
the company. On the strength of these shares, the company procures other
sources of capital. ----------------------
• Preference Shares: These are the shares, which enjoy preferential ----------------------
treatment in payments of dividends.
----------------------
1. Examine critically ‘Debentures’ as a source of corporation finance. ----------------------
2. Examine the comparative merits and demerits of the following methods of ----------------------
raising additional finance required by a joint stock company.
----------------------
a. Redeemable Preference Shares
----------------------
b. Debentures
c. Public Deposits ----------------------
3. Critically appraise the preference shares as a source of finance in the Indian ----------------------
corporate sector.
----------------------
4. Does leasing increase a firm’s borrowing capacity? Does it release the firm
from bad investment and freeing of funds for more profitable uses? ----------------------
5. Account for the growing amount of public deposits with corporate ----------------------
organisations.
----------------------
6. Explain the control and regulations of public deposits.
7. What is meant by lease financing? State and explain the different types of ----------------------
lease.
----------------------
----------------------
----------------------

Notes 8. Write short notes:
a. Public deposits
----------------------
b. Regulation of public deposits
----------------------
c. Convertible Debentures
---------------------- d. Lease financing
----------------------
----------------------
----------------------
Fill in the blanks.
---------------------- 1. A share means a share in the capital of the company.
---------------------- 2. The value printed on the share certificate is called face or nominal value.
---------------------- 3. The value at which the share is sold by the company for the first time in the
life of the share is called issue price.
----------------------
4. The value at which the share is traded in the market is called market value.
---------------------- 5. Equity shareholders are owners of the company.
---------------------- 6. Funds raised by the company by way of equity shares are available on
permanent basis and on unsecured basis.
----------------------
7. Returns on equity are called dividend.
----------------------
8. The rate of equity dividend is fluctuating.
---------------------- 9. Payment of dividend on equity shares is not compulsory but is optional.
---------------------- 10. Right to receive newly issued shares before they are offered to outsiders is
called the right of pre-emption.
----------------------
11. Preference shares have a preferential treatment for receiving dividend and
---------------------- repayment of capital.
---------------------- 12. The rate of dividend on preference shares is fixed.

13. Investors in preference shares are not absolute owners of the company.
----------------------
14. Funds raised through preference shares are required to be repaid during the
---------------------- life of the company.
---------------------- 1. False
2. False
----------------------
3. True
----------------------
4. False
---------------------- 5. True
----------------------

Fill in the blanks.
----------------------
1. Debenture means a document containing an acknowledgement of
indebtedness issued by a company. ----------------------
2. Debenture is an undertaking issued by the company to repay the debt at a ----------------------
specified time or at the option of the company.
----------------------
3. Debentures carry interest at a fixed rate.
4. Interest is charge on profits. ----------------------
5. Debentureholder is not an owner but a creditor of the company. ----------------------

6. Generally, debentures are secured so investors are assured of getting their ----------------------
money back.
----------------------
1. False ----------------------
2. False ----------------------
3. False ----------------------
4. True
----------------------
5. True
----------------------
6. True
1. Lease financing is a source of financing long-term financing. ----------------------
2. Under the leasing agreement, the company acquires a right to use the asset
----------------------
without holding the title to it.
3. In lease financing, the owner of the asset is called the lessor, the user of the ----------------------
asset is called the lessee and the amount paid by the user to the owner is
----------------------
called Lease rent.
4. Lease Agreement or Lease deed is an important document in lease ----------------------
agreements.
----------------------
5. Payment of lease rent is a tax-deductible item of expenditure.
----------------------
6. In case of financial type of lease, the lesser acts as a financer.
----------------------
7. In operating lease type of lease, the lesser gets to use the asset.
----------------------
----------------------
----------------------
----------------------

Fill in the blanks.
----------------------
1. In case of higher purchasing, possession is transferred to the buyer but not
---------------------- the ownership.
---------------------- 2. In hire purchase, the owner of the asset is called hiree and the user is called
hirer.
----------------------
3. For lease accounting, the provisions of Accounting Standard AS 19 are
---------------------- applicable.
---------------------- 4. The entire amount of hire charges paid by the hirer to the hiree is not
considered to be revenue expenditure in the books of hirer.
---------------------- 5. Retained earnings is also called ploughing back of profits.
----------------------
Suggested Reading
----------------------
Practice
---------------------- 2. I.M. Pandey. Financial Management
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Capital Structure
UNIT
8
Structure:
8.1 Introduction
8.2 Goals/Principles of Capital Structure Management
8.3 Factors affecting Capital Structure
8.4 Cost of Capital
8.5 Importance and Measurement of Cost of Capital
8.6 Composite Cost of Capital
Summary
Key Words
Suggested Reading
Capital Structure 149

Notes
Objectives
----------------------
----------------------
• State the principles of capital structure management
----------------------
• Explain the factors affecting capital structure
---------------------- • Define the concept of cost of capital
---------------------- • Identify different ways of measuring the cost of capital
---------------------- • Compute the composite cost of capital
---------------------- 8.1 INTRODUCTION

---------------------- After considering the various sources in which the long-term requirements
of the funds can be met, the next question, which arises, is that what should be
---------------------- the proportion in which the various sources of long-term finance should be used
---------------------- in order to raise the required amount of capital. Here comes into the picture
the decision regarding capital structure. Capital structure refers to the mix of
---------------------- sources from which the long-term funds required by a business are raised, i.e.,
what should be the proportion of equity share capital, preference share capital,
---------------------- internal sources, debentures and other sources of funds in the total amount of
---------------------- capital which an undertaking may raise for establishing its business.
---------------------- 8.2 GOALS/PRINCIPLES OF CAPITAL STRUCTURE

---------------------- MANAGEMENT
For considering the suitable pattern of capital structure, it is necessary to
---------------------- consider certain basic principles, which are related to each other. It is necessary
---------------------- to find a golden mean by giving proper weightage to each of them.
1. Cost Principle: According to this principle, ideal capital structure should
----------------------
minimise cost of financing and maximise earnings per share. Debt capital
---------------------- is a cheaper form of capital due to two reasons. First, the expectations of
returns of debt capital holders are less than those of equity shareholders.
---------------------- Secondly, interest is a deductible expenditure for tax purposes whereas
dividend is an appropriation of profits.
----------------------
2. Risk Principle: According to this principle, ideal capital structure should
---------------------- not accept unduly high risk. Debt capital is a risky form of capital, as it
involves contractual obligations as to the payment of interest and repayment
----------------------
of principal sum, irrespective of profits or losses of the business. If the
---------------------- organisation issues large amount of preference shares, out of the earnings
of the organisation, less amount will be left for equity shareholders as
---------------------- dividend on preference shares are required to be paid before any dividend
is paid to equity shareholders. Raising the capital through equity shares
----------------------
involves least risk, as there is no obligation as to the payment of dividend.
----------------------

3. Control Principle: According to this principle, ideal capital structure should Notes
keep controlling position of owners intact. As preference shareholders and
holders of debt capital carry limited or no voting rights, they hardly disturb ----------------------
the controlling position of residual owners. Issue of equity shares disturb
the controlling position directly as the control of the residual owners is ----------------------
likely to be diluted. ----------------------
4. Flexibility Principle: According to this principle, ideal capital structure
----------------------
should be able to cater to additional requirements of funds in future, if any.
E.g. If a company has already raised too heavy debt capital, by mortgaging ----------------------
all the assets, it will be difficult for it to get further loans in spite of good
market conditions for debt capital and it will have to depend on equity ----------------------
shares only for raising further capital. Moreover, organisation should avoid
----------------------
capital on such terms and conditions, which limit the company’s ability to
procure additional funds. E.g. If the company accepts debt capital on the ----------------------
condition that it will not accept further loan capital or dividend on equity
shares will not be paid beyond a certain limit, then it loses flexibility. ----------------------
5. Timing Principle: According to this principle, ideal capital structure ----------------------
should be able to seize market opportunities, should minimise cost of
raising funds and obtain substantial savings. Accordingly, during the ----------------------
days of boom and prosperity, company can issue equity shares to get the
----------------------
benefit of investors’ desire to invest and take the risk. During the days of
depression, debt capital may be used to raise the capital, as the investors ----------------------
are afraid to take any risk.
----------------------
1. Capitalisation refers to sources of procurement of _____term finance ----------------------

and capital structure refers to the ______, in which the various sources
_____term finance should be used. ----------------------
2. Capital structure means deciding ____of sources from which the funds ----------------------
required by a business are raised.
----------------------
3. Funds can be procured from _____sources and ______sources.
----------------------
4. Debt capital involves ______ obligation as to the payment of interest
and repayment of capital sum. ----------------------
5. Interest must be paid irrespective of ______. ----------------------
----------------------
----------------------
----------------------
----------------------

Notes
---------------------- 1.
Capitalisation and capital structure are diagrammatically opposite
concepts.
----------------------
2. When there is a loss, interest payment can be skipped.
----------------------
3. Dividend payment is not statutorily obligatory.
---------------------- 4. Dividend is an apportionment of profit.
---------------------- 5. Interest is an apportionment of profit and dividend is a charge on
profits.
----------------------
----------------------
i. Debt capital is risky capital a. Cost principle
---------------------- ii. Cater to the additional requirements of funds b. Risk principle
iii. Size market opportunities c. Control principle
---------------------- iv. Maximum EPS minimum investments d. Flexibility principle
v. Keep controlling position of owners intact e. Timing principle
----------------------
----------------------
Activity 1
----------------------
---------------------- Refer to any reference book and find out the advantages and limitations of
issuing of preference shares and debentures.
----------------------
----------------------
8.3 FACTORS AFFECTING CAPITAL STRUCTURE
----------------------
Before deciding the mix of various long-term sources of funds, it is necessary
---------------------- for the company to take into consideration various factors, which can be broadly
classified as below:
----------------------
Internal Factors
----------------------
1. Cost Factor
---------------------- Cost Factor as the factor affecting the capital structure decisions refers
to the cost associated with the process of raising the various long-term
----------------------
sources of funds, which is referred to as Cost of Capital. While deciding
---------------------- the capital structure, it should be ensured that the use of capital is capable
of earning enough revenue to justify the cost of capital associated with it.
---------------------- It should be noted that the borrowed capital is a cheaper form of capital for
the company and this is due to the following reasons:
----------------------
a. The expectations of the lenders of borrowed funds (viz. debentures,
---------------------- term loans etc.) are less than the expectations of the investors who
invest in the own capital of the company (viz. shares). This is because
----------------------
the risk on the part of lenders of borrowed funds is comparatively less
---------------------- than the risk on the part of investors in own funds.

b. The return, which the company pays on borrowed funds (i.e. interest), Notes
is an income tax deductible expenditure for the company whereas
the return paid on own capital (i.e. dividend) is not an income tax ----------------------
deductible expenditure for the company. As such, when the company
pays the interest on borrowed capital, its tax liability is reduced, ----------------------
whereas payment of dividend does not affect the tax liability of the ----------------------
company as the same is paid out of profit after taxes.
----------------------
2. Risk Factor
In financial terms, risk and return always go hand in hand. Whichever ----------------------
capital is cheap for the company is risky for the company. Cost associated
----------------------
with the borrowed funds may be less, but the borrowed capital is more
risky for the company. This is due to the following reasons. ----------------------
a. Payment of interest at the predetermined rate of interest at the
----------------------
predetermined time intervals irrespective of non-availability of profits
is a contractual obligation for the company. ----------------------
b. The company is required to repay the principal amount of borrowed ----------------------
capital at the predetermined maturity date.
c. Borrowed capital is usually secured capital. If the company fails to ----------------------
meet its contractual obligations, the lenders of borrowed funds may ----------------------
enforce the sale of assets offered to them as security.
Cost associated with own funds may be more for the company, but the risk ----------------------
associated with them is less. This is due to the following reasons: ----------------------
a. As the return paid on own capital i.e. dividend is the appropriation of
----------------------
profits, the company is not bound to pay any dividend unless there are
profits. There are many companies who have not paid any dividend on ----------------------
equity shares for years together due to non-availability of profits.
----------------------
b. The company is not expected to repay the own capital during the
lifetime of the company. ----------------------
c. Own capital is an unsecured capital. As such, none of the assets of the ----------------------
company are offered as a security to the investors in own funds.
3. Control Factor ----------------------
While planning the capital structure and more particularly while raising ----------------------
additional funds required by the company, the control factor essentially
becomes an important factor to be considered, specifically for the closely ----------------------
held private limited companies. Control factor refers to the capacity of ----------------------
the existing owners of the company to retain control over operations of
the company. If the company decides to meet the additional requirements ----------------------
of funds by issuing the equity shares or preference shares, the controlling
interest of the existing owners is likely to be diluted as the investors in equity ----------------------
shares enjoy the absolute voting rights while investors in preference shares ----------------------
enjoy limited voting rights. If the company decides to meet the additional
requirement of funds by way of borrowed capital, the controlling interest ----------------------

Notes of the existing owners remains intact, as the lenders of borrowed funds do
not enjoy any voting rights. However, it should be remembered here that
---------------------- if the existing owners contribute to the rights shares which indicate the
additional shares offered to the existing owners in the existing proportion,
---------------------- their controlling interest may not get affected. Similarly, while raising the
---------------------- additional requirements of funds by way of borrowed capital, the existing
owners of the company need to remember that their controlling interests
---------------------- may be indirectly affected if the lending Bank or Financial Institutions
appoint their representatives as Nominee Directors on the Board of
---------------------- Directors of the borrowing company.
---------------------- 4. Objects of the Capital Structure Planning
---------------------- While planning the capital structure, following objects of the capital
structure planning come into play.
----------------------
a. To maximise the profits available to the owners of the company. This
---------------------- can be ensured by issuing the securities carrying less cost of capital.
---------------------- b. To issue the securities which are easily transferable. This can be
ensured by listing the securities on the stock exchange.
---------------------- c. To issue further securities in such a way that the value of shareholding
---------------------- of present owners is not adversely affected.
d. To issue the securities which are understandable by the investors.
----------------------
e. To issue the securities which are acceptable to the lenders or investors.
----------------------
External Factors
---------------------- 1. General Economic Conditions
---------------------- While planning the capital structure, the company needs to consider the
general conditions existing in the economy. If the economy is in boom
---------------------- and the interest rates are likely to decline, the company will like to raise
---------------------- equity capital immediately, leaving the borrowed capital to be considered
in future. It may also be possible to raise more equity capital in a boom,
---------------------- as the investors may be ready to take risk and to invest. If the economy is
in depression, the company will like to go for equity capital as it involves
---------------------- less amount of risk. However, it may not be possible to raise the capital by
---------------------- way of equity during the period of depression, as the investors may not be
willing to take the risk. Under such circumstances, the company may be
---------------------- required to go for borrowed capital.
---------------------- 2. Behaviour of Interest Rates

While planning the capital structure, the company may be required to take
----------------------
into consideration the likely behaviour of interest rates in the economy.
---------------------- If the interest rates in the economy are likely to decline, depending more
upon the long-term sources carrying fixed rate of return (viz. debentures,
---------------------- preference shares) will prove to be dangerous for the company. If the
interest rates in the economy are likely to increase, the company will be
----------------------
benefited by issuing the long-term securities carrying fixed rate of return.

3. Policy of the Lending Institutions Notes
If the policy of the lending banks or financial institutions is too harsh
----------------------
or rigid, it will be advisable not to go for borrowed funds. Instead, the
company will like to go for more convenient sources such as leasing or hire ----------------------
purchase, though they are more costly propositions.
----------------------
4. Taxation Policy
Taxation policy as a factor affecting the capital structure decisions needs to ----------------------
be viewed from the angle of the company as well as the investor.
----------------------
As far as interest is concerned, from company’s point of view, the return
paid on the borrowed capital i.e. interest is a tax-deductible expenditure. ----------------------
From investor’s point of view, return received by him on the funds lent to ----------------------
the company is a taxable income. Further, if the interest on debentures/
bonds exceeds Rs. 2,500, the paying company is required to deduct the tax ----------------------
at source and pay the same to the Central Government.
----------------------
As such, income received by the investors in their hands is reduced to the
extent of tax deducted at source. ----------------------
As far as dividend is concerned, as per the provisions of Section 10(36) ----------------------
of the Income Tax Act, 1961, dividend received by the shareholders,
whether interim or final, is not taxable in their hands. However, as per the ----------------------
provisions of Section 115-O of the Income Tax Act, 1961, the company
paying the dividend is required to pay additional tax (over and above the ----------------------
normal income tax payable on the taxable profits of the company). This ----------------------
tax is in the form of ‘tax on distributable profits’ and the same is popularly
referred to as ‘dividend tax’. ----------------------
5. Statutory Restrictions ----------------------
The statutory restrictions prescribed by the Government and various other
----------------------
statutes are required to be taken into consideration before the capital
structure is planned by the company. The company has to decide the capital ----------------------
structure within the overall framework prescribed by the Government or
various other statutes. ----------------------
General Factors ----------------------
1. Constitution of the Company ----------------------
While deciding the capital structures, constitution of the company plays a
very important role. If the company is a private limited company or a closely ----------------------
held company, control factor may play a dominant role. If the company is ----------------------
a public limited company or a widely held company, cost factor may play
a dominant role. ----------------------
2. Characteristics of the Company ----------------------
Characteristics of the company in terms of its size, age and credit standing
----------------------
play a very important role in the capital structure decisions. Very small
companies and the companies in their early stage of life have to depend ----------------------

Notes more upon the equity capital, as they have limited bargaining capacity and
they do not enjoy the confidence of the investors. As such, it is better for
---------------------- these companies to go for equity capital in the early years of life, increase
the capital base, increase the bargaining capacity and then go for borrowed
---------------------- capital in the later years of their life. Similarly, the companies having good
---------------------- credit standing in the market may be in the position to tap the source of
their own choice, whereas the choice may not be available to the companies
---------------------- having poor credit standing in the market.
---------------------- 3. Stability of Earnings
If sales and earnings of the company are stable and predictable in future,
----------------------
the company does not mind taking the risk and it can borrow the funds,
---------------------- as cost factor and control factor will play more important role. However,
if the sales and earnings are not likely to be stable and predictable over a
---------------------- period of time and are likely to be subject to wide fluctuations, the risk
factor plays an important role and the company will not like to have more
----------------------
borrowed capital in its capital structure.
---------------------- 4. Attitude of the Management
---------------------- If the management attitude is conservative, the control factor and risk
factor may play an important role in the capital structure decisions. If the
---------------------- management attitude is aggressive, cost factor may play an important role.
----------------------
8.4 COST OF CAPITAL
----------------------
In the previous chapter, we discussed about the various sources from which
---------------------- the long-term requirement of the capital can be met. Each of these sources
involves some cost. The cost of capital can be defined as “the rate at which an
----------------------
organisation must pay to the suppliers of capital for the use of their funds”.
---------------------- In economic terms, the cost of capital is viewed from two different angles.
---------------------- 1. The cost of raising funds to finance a project. This cost may be in the form
of the interest, which the company may be required to pay to the suppliers
---------------------- of funds. This may be the explicit cost attached with the various sources of
---------------------- capital.
2. The cost of capital may be in the form of opportunity cost of the funds
---------------------- of company, i.e. rate of return, which the company would have earned
---------------------- if the funds are not invested. For example, suppose that a company has
an amount of Rs. 1,00,000, which either may be utilised for purchasing
---------------------- a machine or may be invested with a bank as fixed deposit carrying the
interest 10% p.a. If the company decides to use the amount for purchasing
---------------------- the machine, obviously it will have to forgo the interest, which it would
---------------------- have earned by investing the same in fixed deposit with the bank. Thus, the
cost of capital of this capital of Rs. 1,00,000 is 10%.
----------------------
----------------------

Concepts of Cost of Capital Notes
Besides the general concept of cost of capital, the following concepts are also
----------------------
used frequently.
(a) Component Cost and Composite Cost ----------------------
Component cost refers to the cost of individual components of capital viz. ----------------------
equity shares, preference shares, debentures and so on. Composite cost of
capital refers to the combined or weighted average cost of capital of the ----------------------
various individual components. For capital budgeting decisions, it is the
----------------------
composite cost of capital, which is considered.
(b) Average Cost and Marginal Cost ----------------------
The average cost refers to the weighted average cost of capital. Marginal ----------------------
cost refers to the incremental cost attached with new funds raised by the
company. ----------------------
(c) Explicit Cost and Implicit Cost ----------------------

Explicit cost is the one, which is attached with the source of capital explicitly ----------------------
or apparently. Implicit cost is the hidden cost that is not incurred directly.
E.g. In case of the debt capital, the interest that the company is required ----------------------
to pay on the same is explicit cost of capital. However, if the company
----------------------
introduces more and more doses of debt capital in the overall capital
structure, it makes the investment in the company a risky proposition. ----------------------
As such, the expectations of the investors in terms of return on their
investment may increase and share prices of the company may decrease. ----------------------
These increased expectations of the investors or the decreased share prices
----------------------
may be considered the implicit cost of debt capital.
----------------------
----------------------
1. The company must be earning enough revenue to justify the cost of ----------------------
capital associate.
2. Payment of interest at contractual rate and time is not a contractual ----------------------
obligation. ----------------------
3. Owned capital need not be repaid during the lifetime.
----------------------
4. Interest on borrowed capital is flexible.
----------------------
5. Equity shares are non-redeemable and preference shares are redeemable.
----------------------
----------------------
----------------------
----------------------

Notes 8.5 IMPORTANCE AND MEASUREMENT OF COST OF
CAPITAL
----------------------
Importance of cost of capital
----------------------
The term cost of capital is important for a company basically for the following
---------------------- purposes:
---------------------- 1. The concept of cost of capital is used as a tool for screening the investment
proposals. (The various methods for appraising investment proposals
---------------------- are discussed in details in the following chapters.) E.g. In case of the net
present value method, the cost of capital is used as the discounting rate for
----------------------
discounting the future inflow of funds. Any project resulting into positive
---------------------- net present value only will be accepted. All other projects will be rejected.
Similarly, in case of Internal Rate of Return Method (IRR), the resultant
---------------------- IRR is compared with the cost of capital. It is expected, that if a project
is to be accepted, IRR resulting from the same should be more than cost
----------------------
of capital. If project generates IRR, which is less than cost of capital, the
---------------------- project will be rejected.
---------------------- 2. The cost of capital is used as the capitalisation rate to decide the amount of
capitalisation in case of a new concern.
---------------------- 3. The concept of cost of capital provides useful guidelines for determining
---------------------- the optimal capital structure (This concept is discussed in details in the
following pages). Optimal capital structure is the one where overall cost of
---------------------- capital is minimum and the overall valuation of the firm is maximum.
---------------------- Measurement of Cost of Capital

(a) Cost of Debt: The debts may be either short-term debts or long-term debts.
----------------------
Very naturally, the cost of capital in the form of debt is the interest, which
---------------------- the company has to pay. But this is not the real cost attached with debt
capital. The real cost is something less than the rate of interest which the
---------------------- company has to pay. This is because the interest on debt is a tax-deductible
expenditure. If the amount of interest is considered as a part of expenses,
----------------------
the tax liability of the company reduces proportionately. As such, while
---------------------- computing the cost of debt, adjustments are required to be made for its tax
impact. For example, suppose a company issues the debentures having the
---------------------- face value of Rs. 100 and bearing the rate of interest of 10% p.a. If the tax
rate applicable to the company is 50%, the cost of debentures is not 10%,
----------------------
which is the rate of interest, but it is to be duly reduced by the tax benefit
---------------------- available for this interest. The tax benefit is 50% of 10%, hence the cost of
debentures is only 5%. Further, the interest payable on the debentures has
---------------------- to be viewed from the angle of the amount actually received on their issue.
E.g. A company issues 1000 debentures of Rs. 100 each bearing interest
----------------------
@8% p.a. Company incurs the expenses in connection with the issue of
---------------------- debentures to the extent of Rs. 10,000 (These expenses may be in the form
of discount allowed, underwriting commission, advertisement etc.) Thus,
---------------------- the company will have to pay the annual interest of Rs. 8,000 on the net

amount received to the extent of only Rs. 90,000 (i.e. Rs. 1,00,000 minus Notes
Rs. 10,000). Cost of debentures in this case works out to around 8.89% and
assuming that the tax rate applicable is 50%, the tax benefit makes the cost ----------------------
of debentures equal to 4.45%. However, the debt capital has a hidden cost
also. If the debt content in the capital structure of a company exceeds the ----------------------
optimum level, the investors start considering company as too risky and ----------------------
their expectations from equity shares increase. This is the hidden cost of
debt. ----------------------
(b) Cost of Preference Shares: The cost of capital preference shares is the ----------------------
dividend rate payable on them. As in case of debentures, the cost capital is
adjusted for the amount excess or less received on the issue of preference ----------------------
shares. For example, suppose, a company issues 1,000 preference shares
----------------------
of Rs. 100 each at the value of Rs. 105 each. Rate of dividend is 10% and
the expenses involved with the issue of preference shares amount to Rs. ----------------------
10,000. Thus, the net amount received works out to Rs. 95,000 whereas the
amount of the dividend is Rs. 10,000. Here, the cost of capital works out to ----------------------
Rs. 10,000 x 100 ----------------------
= 10.53%
Rs. 95,000
----------------------
As the amount of dividend payable on preference shares is not a tax-
deductible expenditure, there is no question of further adjustment for the ----------------------
tax benefit.
----------------------
(c) Cost of Equity Shares: Computation of cost of equity shares is the most
complex procedure. It is because unlike preference shares or debentures, ----------------------
equity shares do not have either the interest or dividend to be paid at a fixed
----------------------
rate. The cost of equity shares depends upon the expectations of the equity
shareholders. There are the following approaches to compute the cost of ----------------------
equity shares.
----------------------
1. D/P Approach: According to this approach, before an investor
pays certain price for purchasing equity shares of the company, he ----------------------
expects certain return on the investment, which is in the form of the
dividend. The expected rate of dividend is the cost of equity shares. ----------------------
This means, that the investor calculates the market price of the shares ----------------------
by capitalising the present dividend rate, which is expected to be same
for all times to come at a given level. E.g. If the market price of Equity ----------------------
shares of a company (Face value Rs. 10) is Rs. 15 and if the company
at present is paying the dividend @ 20%, which is expected to be ----------------------
continued in future also, the cost of Equity Shares will be ----------------------
20% of Rs. 10
x 100 = 13.33% ----------------------
Rs. 15
However, it can also be argued that the cost of equity shares may be ----------------------
20%, because on the expectation of rate of dividend at 20%, market
----------------------
price of the shares is Rs. 15.
----------------------

Notes This approach is objected on certain grounds. Firstly, this presupposes
that an investor looks forward only to receive dividend on equity
---------------------- shares. This may not always be correct. He may also look forward to
capital appreciation in the value of his shares. Secondly, this approach
---------------------- assumes that the company will not earn on its retained earnings and
---------------------- that the retained earnings will not result in either appreciation of the
market price or increase in dividends. This assumption can be a wrong
---------------------- assumption that may lead to wrong conclusions.
---------------------- 2. E/P Approach: According to this approach, the cost of equity shares
is based upon the stream of unchanged earnings earned by a company.
---------------------- This approach holds that each investor expects a certain amount of
earnings whether distributed by way of dividend or not, from the
----------------------
company in whose shares he invests.
---------------------- Thus, if an investor expects that the company in which he is investing
should have at least 20% rate of earnings, cost of equity shares will be
----------------------
calculated on that basis. If a company is expected to earn 30%, he will
---------------------- be prepared to pay Rs. 150 for one share of Rs. 100 each.
This approach can be objected on the following grounds. Firstly, it
----------------------
wrongly assumes that the earnings per share will remain constant
---------------------- in future. Secondly, the market prices of the shares will not remain
constant, as the shareholders will expect capital gains as a result of
---------------------- reinvestment of retained earnings. Thirdly, all the earnings may not be
distributed among the shareholders by way of dividend.
----------------------
3. D/P + G Approach: According to this approach, the investor is
---------------------- prepared to pay the market price of the shares, as he expects not only
---------------------- the payment of the dividend but also expects a growth in the dividend
rate at uniform rate perpetually.
---------------------- Thus, the cost of equity shares can be calculated as
---------------------- D
+ G where
P
----------------------
D = Expected dividend per share; P = Market price per share; G =
---------------------- Growth in expected dividends
---------------------- For example, if the dividend per share is Rs. 1 with the expected
growth of 6% per year perpetually, the cost of equity shares, with the
---------------------- assumed market price of the share of Rs. 25, will be
---------------------- (
Rs. 1 x 0.06
Rs. 25
)
x 100
----------------------
= (0.04+0.06) x 100 = 0.10 x 100
---------------------- = 10%
---------------------- This approach involves the difficulty of determining the growth rate.
----------------------

4. Realised Yield Approach: According to this approach, the cost of Notes
equity shares may be decided based on yields actually realised over
the period of past few years, which may be expected to be continued ----------------------
in future also. This approach basically considers D/P + G approach,
but instead of considering the future expectations of dividends and ----------------------
growth factor, the actual yields in past are considered. ----------------------
(d) Cost of Retained Earnings: Many a times, it is argued that the retained
----------------------
earnings do not cost anything to the company. The reason is that as there is
no obligation, either formal or implied, to pay return on retained earnings ----------------------
even though they constitute one of the major sources of funds for the
company. In case of debt, the company has fixed obligation to pay interest ----------------------
on it. Almost similar obligation exists in case of preference share also. In
----------------------
case of equity shares, though there is no legal obligation, the expectations
of the shareholders at least provides a starting point for computing the ----------------------
cost of equity shares. The retained earnings do not involve any of such
obligations, either, formal or implied. As such, it may be felt that retained ----------------------
earnings involve no cost, as they are not raised from an outside source. But
----------------------
this contention is not correct. Retained earnings involve cost and this cost
is in the form of the opportunity cost in terms of dividend foregone by or ----------------------
withheld from the equity shareholders.
----------------------
For example, assume that the profits earned by the company are not retained
but are distributed among shareholders by way of dividend. These amounts ----------------------
of dividends which would have been received by the shareholders, after
due adjustments for tax deducted at source, could have been invested by ----------------------
the shareholders elsewhere to earn some return. The company, by retaining
----------------------
the profits, prohibits the shareholder from earnings these returns. As such,
the company is required to earn on the retained earnings at least equal to ----------------------
the rate, which would have been earned by the shareholders if they were
distributed to them. This is the cost of retained earnings. ----------------------
----------------------
8.6 COMPOSITE COST OF CAPITAL
----------------------
After ascertaining the cost of each source of the capital constituting the
capital structure, the next step is to compute the composite cost of capital, which ----------------------
is defined as the weighted average of the cost of each specific type of capital.
----------------------
The reason behind considering weighted average and not the simple average is
to give consideration to the proportion of various sources of funds in the capital ----------------------
structure of the company. Thus, the process of computing the composite cost of
capital is carried on by following the steps stated below. ----------------------
The above process can be explained with the help of the following illustrations. ----------------------
----------------------
----------------------
----------------------

Notes Illustration I:
The capital structure of a company and the cost of specific sources of funds are
----------------------
as below:
---------------------- Sources of funds Book value Specific Weighted cost
(weights) Rs. Cost Rs.
----------------------
1 2 3 (1 x 2)
---------------------- Debentures 1,50,000 5% 7,500
Preference shares 50,000 9% 4,500
---------------------- Equity shares 2,00,000 15% 30,000
Retained earnings 1,00,000 8% 8,000
---------------------- 5,00,000 50,000
---------------------- Total weighted costs x 100
Composite cost of capital = x 100
Total weights
----------------------
50,000
---------------------- = x 100
5,00,000
---------------------- = 10%
---------------------- Illustration II:

---------------------- From the information given below, calculate the weighted cost of capital (before
tax) for Z Ltd.
----------------------
Rs. in Lakhs
---------------------- 1. Shareholders’ funds
---------------------- Share Capital – Equity 500
– Preference 100
---------------------- Retained Earnings 300
2. Loan Funds
---------------------- Secured Loans 800
Unsecured Loans (Incl. intercorporate deposit) 700
----------------------
2,400
---------------------- (a) Normal yield on Equity shareholders’ fund anticipated at 15%.
---------------------- (b) Dividend rate on preference shares - 12%.
(c) Tax rate for Z Ltd. - 60%
----------------------
(d) Interest on secured loans - 16.25%
----------------------
(e) Interest on unsecured loans - 20%
----------------------
----------------------
----------------------
----------------------
----------------------

Solution: Notes
Computation of after tax cost of capital:
----------------------
Source Book value Tax Adjusted Weighted Cost
(weights) Cost ----------------------
1 2 3 4 i.e. 2 x 3
----------------------
Equity shares 500 15% 75
Preference shares 100 12% 12 ----------------------
Retained Earnings 300 15% 45
Secured Loans 800 6.50% i.e. 52 ----------------------
40% of 16.25%
Unsecured loans 700 8% i.e. 56 ----------------------
40% of 20% ----------------------
2400 240
Weighted costs ----------------------
Weighted Average Cost = x 100
Total weights ----------------------
240
= x 100 ----------------------
2,400
= 10% ----------------------
----------------------
1. While assigning weights to various sources of funds, weights may be ----------------------

in the form of _____ of funds or ____ of funds.
----------------------
2. For calculation of composite cost of capital, _____ of funds and
_______ are required to be multiplied. ----------------------
3. The composite cost is calculated by dividing total _____ cost by the ----------------------
total _______.
----------------------
4. If total of weighted cost is Rs.50,000 and total of weights is Rs.5,00,000,
then the composite cost is ________%. ----------------------
----------------------
1. Capital structure refers to the mix of sources of long-term funds
required in a business. ----------------------
2. Cost principle aims at maximising the cost of capital. ----------------------

3. Risk principle aims not accepting unduly risky capital. ----------------------
4. Control principle aims at diluting the control of the existing equity
----------------------
shareholders.
5. Flexibility principle aims to cater additional requirement of funds in future. ----------------------
----------------------

Notes 8.7 ILLUSTRATIVE PROBLEMS
---------------------- 1. In considering the most desirable capital for a company, the following
estimates of the cost of debt and equity capital (after tax) have been made
---------------------- at various levels of debt-equity mix.
---------------------- Debt as % of total Cost of debt Cost of equity
capital employed % %
---------------------- 0 7.0 15.0
---------------------- 10 7.0 15.0
20 7.0 15.5
---------------------- 30 7.5 16.0
40 8.0 17.0
---------------------- 50 8.5 19.0
60 9.5 20.0
----------------------
You are required to determine the optimal debt equity mix for the company by
---------------------- calculating composite cost of capital.
---------------------- Solution:
---------------------- Calculation of composite cost of capital

Debt as % of total Cost of Cost of Composite cost of capital
----------------------
capital employed debt equity %
---------------------- 0 7.0 15.0 7.0 x 0.0 + 15.0 x 1.0 = 15.00
10 7.0 15.0 7.0 x 0.1 + 15.0 x 0.9 = 14.20
---------------------- 20 7.0 15.5 7.0 x 0.2 + 15.5 x 0.8 = 13.80
30 7.5 16.0 7.5 x 0.3 + 16.0 x 0.7 = 13.45
---------------------- 40 8.0 17.0 8.0 x 0.4 + 17.0 x 0.6 = 13.40
---------------------- 50 8.5 19.0 8.5 x 0.5 + 19.0 x 0.5 = 13.75
60 9.5 20.0 9.5 x 0.6 + 20.0 x 0.4 = 13.70
---------------------- It can be seen from the above that composite cost of capital is minimum i.e.
13.40% when capital structure is as below:
----------------------
40% debt
----------------------
60% equity
---------------------- 100%
---------------------- Hence, that is the optimal debt-equity mix.
---------------------- 2. Following items have been extracted from the liabilities side of XYZ
company, as at 31st March, 2008:
---------------------- Paid-up Capital Rs.
---------------------- 4,00,000 Equity shares of Rs. 10 each 40,00,000
Reserves and Surplus 60,00,000
----------------------
Loans
----------------------
15% Non-convertible Debentures 20,00,000
---------------------- 14% Institutional Loans 60,00,000

Other information about the company as relevant is given below: Notes
Year ended Dividend per Earnings per share Average market
----------------------
31st March share price per share
Rs. Rs. Rs. ----------------------
2008 4.00 7.50 50.00
2007 3.00 6.00 40.00 ----------------------
2006 4.00 4.50 30.00
----------------------
You are required to calculate the weighted average cost of capital, using book
values as the weights and Earnings/Price (E/P) ratio as the basis of cost of ----------------------
equity.
----------------------
Assume Income Tax Rate at 50%.
----------------------
Solution:
Calculation of Cost of Capital ----------------------
Sources of Funds Book Value Tax Adjusted Weighted ----------------------

(Weights) Cost Cost
Equity Shares 40,00,000 15% 6,00,000 ----------------------
Reserves and Surplus 60,00,000 15% 9,00,000 ----------------------
Non-convertible Debentures 20,00,000 7.5% 1,50,000
Institutional Loans 60,00,000 7% 4,20,000 ----------------------
1,80,00,000 20,70,000
----------------------
Weighted average cost of capital
20,70,000 ----------------------
= x 100
1,80,00,000 ----------------------
= 11.5%
----------------------
Working Notes:
----------------------
(a) It is assumed that the company is subjected to tax rate of 50%.
(b) Cost of equity shares is calculated on E/P basis as under: Average EPS ----------------------
Average EPS ----------------------
x 100
Average Market Price
----------------------
Rs. 6.00
i.e. x 100 ----------------------
Rs. 40.00
= 15% ----------------------
3. A company needs Rs. 5,00,000 for the construction of a new plant. ----------------------
Following alternative capital structures are under consideration:
----------------------
a. The company may issue 50,000 Equity Shares of Rs. 10 per share at
par. ----------------------
b. The company may issue 2,500 debentures of Rs. 100 per debenture
----------------------
carrying the rate of interest of 12% p.a. and balance by way of Equity
Shares of Rs. 10 per share issued at par. ----------------------

Notes c. The company may issue 2,500 Preference Shares of Rs. 100 per share
at par carrying the rate of dividend of 10% and balance by way of
---------------------- Equity Shares of Rs. 10 per share issued at par.
---------------------- If the company’s Profit Before Interest and Tax is Rs. 60,000 or Rs. 80,000 or
Rs. 1,00,000 what will be the Earning Per Share under each of the above capital
---------------------- structures? If the objective of the company is to maximise the EPS, which of the
capital structures will be recommended? Assume 50% as the corporate tax rate.
----------------------
Solution:
----------------------
It is assumed that the following three plans are possible for the company:
---------------------- Plan 1 - Only Equity Shares
---------------------- Plan 2 - Equity Shares and Debentures
---------------------- Plan 3 - Equity Shares and Preference Shares
a. When Profit Before Interest and Tax is Rs. 60,000
----------------------
Plan 1 Plan 2 Plan 3
---------------------- Profit Before Interest and Tax 60,000 60,000 60,000
Interest – 30,000 –
----------------------
Profit Before Tax 60,000 30,000 60,000
---------------------- Tax 30,000 15,000 30,000
Profit After Tax 30,000 15,000 30,000
---------------------- Preference Dividend – – 25,000
Distributable Profit 30,000 15,000 5,000
---------------------- No. of Equity Shares 50,000 25,000 25,000
---------------------- Earnings Per Share Re. 0.60 Re. 0.60 Rs. 0.20
b. When Profit Before Interest and Tax is Rs. 80,000
----------------------
---------------------- Profit Before Interest and Tax 80,000 80,000 80,000
Interest – 30,000 –
---------------------- Profit Before Tax 80,000 50,000 80,000
---------------------- Tax 40,000 25,000 40,000
Profit After Tax 40,000 25,000 40,000
---------------------- Preference Dividend – – 25,000
Distributable Profit 40,000 25,000 15,000
---------------------- No. of Equity Shares 50,000 25,000 25,000
Earning Per Share Re. 0.80 Rs. 1.00 Re. 0.60
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

c. When Profit Before Interest and Tax is Rs. 1,00,000 Notes
----------------------
Profit Before Interest and Tax 100,000 100,000 100,000
Interest – 30,000 – ----------------------
Profit Before Tax 100,000 70,000 100,000
Tax 50,000 35,000 50,000 ----------------------
Profit After Tax 50,000 35,000 50,000
Preference Dividend – – 25,000 ----------------------
Distributable Profit 50,000 35,000 25,000 ----------------------
No. of Equity Shares 50,000 25,000 25,000
Earning Per Share Re. 1.00 Rs. 1.40 Re. 1.00 ----------------------
Summary ----------------------
----------------------
• Capital Structure refers to the mix of sources from where the long-term
funds required in a business may be raised. ----------------------
• The principles of capital structure management should consider i) Cost
principle i.e. it should minimise the cost of capital ii) Risk principle i.e. ----------------------
it should not accept unduly high risk. iii) Control principle, i.e. it should ----------------------
keep controlling position of owners intact. iv) Flexibility principle, i.e.
it should be able to cater to additional requirements of funds in future. ----------------------
v) Timing principle, i.e. it should be able to seize market opportunities,
should minimise cost of raising funds and obtain substantial savings. ----------------------
• The cost of capital may be defined as, “the rate at which an organisation ----------------------
must pay to the suppliers of capital for the use of their funds”.
----------------------
• There are various methods for measuring the cost of capital: a) Cost of debt:
the cost of capital in the form debt is the interest, which the company has ----------------------
to pay. But this is not the real cost attached with debt capital. To ascertain
the real cost of debt, adjustments are required to be made for it tax impact. ----------------------
b) Cost of preference shares: The fixed dividend rate is the cost of capital
----------------------
in case of preference share. c) Cost of equity shares: The cost of equity
shares basically depends upon the expectations of equity shareholders. d) ----------------------
Cost of retained earnings: The cost of retained earnings is in the form of
the opportunity cost in terms of dividend foregone by or withheld from the ----------------------
equity shareholders.
----------------------
Keywords ----------------------
• Cost Principle: According to this principle, ideal capital structure should ----------------------
minimise cost of financing and maximise earnings per share.
----------------------
• The cost of capital: The rate at which an organisation must pay to the
suppliers of capital for the use of their funds. ----------------------
• E/P Approach: According to this approach, the cost of equity shares is
----------------------
based upon the stream of unchanged earnings earned by a company.
----------------------

Notes
----------------------
1. Define the term ‘Capital Structure’ and give principles of capital structure
---------------------- management.
2. Explain the factors that influence the capital structure of a company.
----------------------
3. What do you mean by ‘Cost of Capital’ and what is the importance of cost
---------------------- of capital for a company?
---------------------- 4. Write short notes on:
---------------------- a. D/P approach for computation of cost of equity shares
b. E/P approach for computation of cost of equity shares
----------------------
c. Realised yield approach for computation of cost of equity shares.
---------------------- 5. How do you compute the composite cost of capital?
---------------------- 6. How is the cost of capital calculated?
---------------------- a. Equity Shares

b. Preference Shares
----------------------
c. Debentures
----------------------
d. Retained Earnings
----------------------
----------------------
----------------------
Fill in the blanks.
----------------------
1. Capitalisation refers to sources of procurement of long-term finance and
---------------------- capital structure refers to the mix, in which the various sources long-term
finance should be used.
----------------------
2. Capital structure means deciding mix of sources from which the funds
---------------------- required by a business are raised.
---------------------- 3. Funds can be procured from external sources and internal sources.
4. Debt capital involves contractual obligation as to the payment of interest
---------------------- and repayment of capital sum.
---------------------- 5. Interest must be paid irrespective of profits.
---------------------- 1. False
2. False
----------------------
3. True
----------------------
4. True
---------------------- 5. False

Match the following. Notes
i. b
----------------------
ii. d
iii. e ----------------------
iv. a ----------------------
v. c
----------------------
----------------------
1. True ----------------------
2. False ----------------------
3. True
----------------------
4. False
5. False ----------------------
1. While assigning weights to various sources of funds, weights may be in the
form of book value of funds or market value of funds. ----------------------
2. For calculation of composite cost of capital, cost of funds and weights are ----------------------
required to be multiplied.
----------------------
3. The composite cost is calculated by dividing total weighted cost by the
total weights. ----------------------
4. If total of weighted cost is Rs.50,000 and total of weights is Rs.5,00,000,
then the composite cost is 10%. ----------------------

1. True ----------------------
2. False
----------------------
3. True
4. False ----------------------
5. True ----------------------
----------------------
Suggested Reading
----------------------
1. Prasanna Chandra, Prasanna. Financial Management
----------------------
2. Eugene Brigham, Joel Houston. Fundamentals of Financial Management,
Concise Edition ----------------------
----------------------
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Leverages and Theories of Capital Structure
UNIT
9
Structure:
9.1 Introduction
9.2 Concept of Leverages
9.3 Leverages
9.4 Theories of Capital Structure
Summary
Key Words
Suggested Reading
Leverages and Theories of Capital Structure 171

Notes
Objectives
----------------------
----------------------
• Explain the concept of leverages and theories of capital structure
----------------------
• Recognize the different types of leverages
---------------------- • Elaborate on the significance of operating, financial and combined
leverage
----------------------
• Analyse various theories of capital structure
----------------------
---------------------- 9.1 INTRODUCTION

---------------------- A finance manager has to estimate the requirement of funds for meeting the
laid down objectives of the concern. He procures the estimated funds. Before
---------------------- procuring these funds, he determines the best mix of such funds or decides about
---------------------- the capital structure of the concern. The desired structure of funds influences
the shareholder’s return and risk. Leverages analysis is the technique used by
---------------------- business firms to quantify risk-return relationship of different alternative capital
structures.
----------------------
---------------------- 9.2 CONCEPT OF LEVERAGES

---------------------- Before we go ahead with discussing the concept of Leverages, consider the
following example–Let us assume that there are two companies A and B, which
---------------------- are exactly similar to each other in terms of nature of business, size, extent of
---------------------- turnover etc. As such, the amount of capitalisation is also the same for both the
companies, which is assumed to be Rs. 10,000. However, strategies for raising
---------------------- the capital are different from each other. Assuming that the required capital can
be raised by way of equity or debt, following particulars are available:
----------------------
Company A Company B
---------------------- Equity Share capital
(Each Share of Rs. 10 each) 1,000 9,000
---------------------- 10% Debentures 9,000 1,000
---------------------- 10,000 10,000
Profitability statements of both the companies when the sales are Rs. 20,000
---------------------- and Rs. 18,000 are as below:
---------------------- Company A Company B
a) Sales 20,000 18,000 20,000 18,000
---------------------- b) Less : Variable Cost 10,000 9,000 10,000 9,000
c) Contribution (c = a-b) 10,000 9,000 10,000 9,000
----------------------
d) Less : Fixed Cost 5,000 5,000 5,000 5,000
---------------------- e) PBIT : (e = c-d) 5,000 4,000 5,000 4,000
f) Less : Interest 900 900 100 100
---------------------- g) PBT (g = e-f) 4,100 3,100 4,900 3,900

Company A Company B Notes
h) Less : Income Tax @50% 2,050 1,550 2,450 1,950
i) PAT (i = g-h) 2,050 1,550 2,450 1,950 ----------------------
j) Number of Equity Shares 100 100 900 900
----------------------
k) Earnings per share (k = i ) 20.50 15.50 2.72 2.16
It can be noted from the above example that A Ltd. is able to earn more ----------------------
amount per equity share because in its capital structure, the amount of debentures
----------------------
is more and also because the interest paid on debentures is tax-deductible
expenditure and amount of tax is less in case of A Ltd. ----------------------
It can also be noted from the above example that a 10% reduction in sales
----------------------
in case of A Ltd. reduces the earnings per share by around 24% while the same
percentage of reduction in sales in case of B Ltd. reduces the earnings per share ----------------------
by around 20%. It happens so because the risk of reduction in sales and earnings
gets distributed among less number of equity shares in case of company A Ltd., ----------------------
while the said risk gets distributed among more number of equity shares in case
----------------------
of company B Ltd.
Explanations: ----------------------
Operating costs incurred by a company can be classified into three categories: ----------------------
a. Variable Cost ----------------------
b. Fixed Cost
----------------------
c. Semi-variable Cost
----------------------
Fixed Cost is the cost, which remains constant irrespective of changes in
the sales revenue, at least over a shorter span of time. ----------------------
Variable Cost is the cost, which varies, in direct proportion to the sales ----------------------
revenue.
Semi-variable Cost lies in between the two extremes of fixed cost and ----------------------
variable cost. Such costs remain constant up to a certain sales revenue and ----------------------
increase if the sales revenue increases beyond a certain point. There may be some
statistical or mathematical techniques available whereby the semi-variable cost ----------------------
can be segregated into the fixed cost component and variable cost component.
Hence, let us assume that the costs can be either fixed costs or variable costs. ----------------------
Difference between the sales revenue and variable cost is referred to as ----------------------
contribution or marginal contribution. Significance of the term contribution is
that it is equated with the term profits over a shorter period, as the fixed cost ----------------------
remains the same at all levels of activities. As such, sales revenue generated by ----------------------
the company after deducting the variable cost incurred for the same contributes
towards the profit, which is technically referred to as contribution. The operating ----------------------
profit earned by the company is in the form of contribution duly reduced by the
fixed operating cost. ----------------------
As such, using the above-referred terms, the operating statement of a ----------------------

company can be presented as below
----------------------

Notes Sales Revenue
Less : Variable Operating Cost
----------------------
Contribution
----------------------
Less : Fixed Operating Cost
----------------------
Operating Profit
----------------------
Breakeven point is that level of sales revenue at which there is no profit or
---------------------- no loss. Till the sales revenue reaches the breakeven point, the company incurs
the losses. It is only after crossing the breakeven point that the profit generating
---------------------- capacity of the company starts. As such, it is the intention of every company to
reach the breakeven point as early as possible.
----------------------
The essential implication of high fixed cost in the cost structure is that
---------------------- the breakeven point is high which indicates that the amount of sales revenue a
---------------------- company is required to generate to be in a no profit no loss situation is very high
which makes the company a very risky proposition.
---------------------- The operating profit earned by a company is also referred to as Profit
---------------------- Before Interest and Taxes (PBIT) in financial terms. After the level of operating
profit, the company is contractually required to pay the interest on the long-term
---------------------- borrowed capital like debentures, term loans etc. The amount of profit earned
after recovering the interest on long-term sources of capital is referred to as
---------------------- Profit Before Taxes (PBT). The company is required to pay the taxes as per
---------------------- the provision of Income Tax Act, 1961 after the amount of profit before taxes
is arrived at. Profit remaining after the payment of income tax is referred to as
---------------------- Profit After Taxes (PAT). This profit can be distributed among the owners of the
company by way of dividend.
----------------------
We have already seen that before the company can pay the dividend on
---------------------- Equity Shares, it is bound to pay the dividend on Preference Shares. After
paying the dividend on preference shares, remaining profits can be distributed
----------------------
among the equity shareholders by way of dividend and hence are referred to as
---------------------- distributable profits.
In financial terms, Profit Before Interest and Taxes (PBIT) can be referred
----------------------
as Earnings Before Interest and Taxes (EBIT) and Profit After Tax (PAT) can be
---------------------- referred to as Earnings After Tax (EAT).
Using the above terms, the profitability statement of a company takes the
----------------------
following form:
---------------------- Profit before Interest and Taxes (PBIT)
---------------------- Less : Interest on long term borrowings
Profit before Taxes (PBT)
----------------------
Less : Taxes
---------------------- Profit after Taxes (PAT)
Less : Preference Dividend
----------------------
Distributable Profits for Equity
If both the calculations are merged, the following relationship emerges. Notes
Sales Revenue
----------------------
Less : Variable Operating Cost
Contribution ----------------------
Less : Fixed Operating Cost
----------------------
Profit before Interest and Taxes (PBIT)
Less : Interest on Long term borrowings ----------------------
Profit before Taxes (PBT) ----------------------
Less : Taxes
----------------------
Profit after Taxes (PAT)
Less : Preference Dividend ----------------------
Distributable Profits for Equity ----------------------
In continuation of these calculations, the following two calculations are made ----------------------
very frequently in practical situations
----------------------
Earnings Per Share (EPS)
Earnings Per Share is a very widely used ratio to measure the profits available ----------------------
to the equity shareholders on a per share basis. ----------------------
EPS is calculated as:
----------------------
Profit after Tax - Preference Dividend
----------------------
No. of Equity Shares
----------------------
EPS is calculated on the basis of current profits and not on the basis of retained
profits. EPS does not indicate the amount of profits distributed among the owners ----------------------
by way of dividend and also the amount of profits retained in the business.
----------------------
This calculation is very significant for an investor in equity shares as higher
EPS indicates higher amount of profits available to him. ----------------------
Price Earning Ratio (P/E Ratio) ----------------------
Price Earning Ratio indicates the price currently being paid in the stock market
----------------------
for every one rupee of EPS.
P/E Ratio is calculated as: ----------------------
Market Price Per Share ----------------------
Earnings Per Share ----------------------
P/E Ratio is of great significance to an operator on the stock exchange ----------------------
buying and selling the shares. An ideal investor makes a comparison between
the current market price and future EPS as the market value of shares depends ----------------------
upon the future EPS also.
----------------------
----------------------

Notes
----------------------

1. The operating profit earned by a company is also referred to as _______
----------------------
in financial terms.
---------------------- 2. The Price Earning Ratio indicates the price _______ being paid in the
stock market for every one rupee of EPOS.
----------------------
----------------------
Activity 1
----------------------
---------------------- Study the contents of profitability statement of a company and draw a

standard statement.
----------------------
---------------------- 9.3 LEVERAGES
---------------------- In very simple words, the term leverage measures relationship between two
---------------------- variables. In financial analysis, the term leverage represents the influence of
one financial variable over some other financial variable. In financial analysis,
---------------------- generally three types of leverages may be computed:
---------------------- 1. Operating Leverage

2. Financial Leverage
----------------------
3. Combined Leverage
----------------------
1. Operating Leverage
---------------------- It measures the effect of change in sales quantity on Earnings Before
---------------------- Interest and Taxes (EBIT). It is computed as:
Sales - Variable Cost (i.e. Contribution)
----------------------
Earnings before interest and tax
----------------------
Indications:
---------------------- A high degree of operating leverage means that the component of fixed
---------------------- cost is too high in the overall cost structure. A low degree of operating average
means that the component of fixed cost is less in the overall cost structure. In
---------------------- other words, operating leverage measures the impact of percentage increase or
decrease in sales on earnings before interest and taxes.
----------------------
E.g. In the example cited above, when sales are Rs. 20,000 contribution
---------------------- is Rs. 10,000 and earnings before interest and taxes are Rs. 5,000. As such
operating leverage can be calculated as:
----------------------
----------------------

Operating Leverage = Contribution Notes
EBIT
= Rs. 10,000 ----------------------
Rs. 5,000 ----------------------
= 2
----------------------
It means that every 1% increase in contribution will increase the EBIT
by 2% and vice versa. As such, when contribution is Rs. 9,000 instead of Rs. ----------------------
10,000 i.e. the contribution is reduced by 10%, the EBIT is reduced by 20% i.e. ----------------------
the EBIT has become Rs. 4,000 instead of Rs. 5,000.
2. Financial Leverage: ----------------------
It indicates the firm’s ability to use fixed financial charges to magnify the ----------------------
effects of changes in EBIT on the firm’s EPS. It indicates the extent to
----------------------
which the Earnings Per Share (EPS) will be affected with the change in
Earnings Before Interest and Tax (EBIT). It is computed as: ----------------------
EBIT EBIT
= ----------------------
EBIT - Interest EBT
Indications: ----------------------
A high degree of financial leverage indicates high use of fixed income
bearings securities in the capital structure of the company. A low degree of ----------------------
financial leverage indicates less use of fixed income bearing securities in the ----------------------
capital structure of the company.
----------------------
E.g. In the example cited above, in case of A Ltd., the EBIT is Rs. 5,000
and interest on debentures is Rs. 900, when sales are Rs. 20,000 whereas in case ----------------------
of B Ltd., the EBIT is Rs. 5,000 and interest on debentures is Rs. 100 when
sales are Rs. 20,000. As such, the degree of financial leverage can be computed ----------------------
as:
----------------------
EBIT
EBIT- Interest ----------------------
A Ltd. B Ltd. ----------------------

Rs. 5,000 Rs. 5,000 ----------------------
Financial leverage = =
Rs. 5,000 - Rs. 900 Rs. 5,000 - Rs. 100
----------------------
Rs. 5,000 Rs. 5,000
= = ----------------------
Rs. 4,100 Rs. 4,900
= 1.22 = 1.02 ----------------------
----------------------
High degree of financial leverage is supported by the knowledge of the
fact that in the capital structure of A Ltd, 90% is the debt capital component, ----------------------
whereas in case of B Ltd., 10% is the debt capital component.
----------------------
It means that in case of A Ltd. every 1% increase in EBIT will increase
EPS by 1.22% and vice versa. ----------------------

Notes As such, when EBIT is reduced from Rs. 5,000 to Rs. 4,000 (i.e. 20%
reduction), EPS of A Ltd. is reduced from Rs. 20.50 to Rs. 15.50 (i.e. 24.40%
---------------------- reduction) and EPS of B Ltd. is reduced from Rs. 2.72 to Rs. 2.16 (i.e. 20.40%
reduction).
----------------------
Uses of Financial Leverage:
----------------------
The degree of financial leverage gives an indication regarding the extent
---------------------- to which EPS may be affected due to every change in EBIT.As the use of debt
capital in the capital structure increases the EPS, the company may like to
---------------------- use more and more debt capital in its capital structure by using the financial
leverage.
----------------------
As explained in the example cited above, EPS in case of A Ltd. is Rs. 20.50
---------------------- when sales are Rs. 20,000, as 90% of its capital is debt capital. But in case of
B Ltd. EPS is only Rs. 2.72 when sales are Rs. 20,000, as only 10% of its total
----------------------
capital is debt capital. As such, the phrase is often used that financial leverage
---------------------- magnifies both profits and losses’.
---------------------- However, though financial leverage magnifies the profits as well as EPS, the
use of debt capital beyond a certain limit will not necessarily give a favourable
---------------------- impact. Use of financial leverage is useful as long as debt capital costs less than
what it earns. It reduces profits or EPS if it costs more than what it earns. As
---------------------- such, financial leverage also acts as a guideline in setting maximum limit up to
---------------------- which the company should use the debt capital.
However, the technique of financial leverage suffers from some limitations.
----------------------
Limitations:
----------------------
i. It ignores implicit cost of debt. It assumes that the use of debt capital may
---------------------- be useful so long as the company is able to earn more than the cost of debt,
i.e. interest. But it is not always correct. Increasing use of debt capital
---------------------- makes the investment in the company a risky proposition, as such the
market price of the shares may decline, which may not be maximising the
----------------------
shareholders’ wealth. Before considering the capital structure, the implicit
---------------------- cost of debt should be considered.
ii. It assumes that cost of debt remains constant regardless of degree of
----------------------
leverage, which is not true. With every increase in debt capital, the interest
---------------------- rate goes on increasing due to the increased risk involved with the same.
---------------------- 3. Combined Leverage:

The combined effect of operating leverage and financial leverage measures
---------------------- the impact of charge in contribution on EPS.
---------------------- It is computed as:
---------------------- Operating Leverage X Financial Leverage
---------------------- Sales - Variable Cost EBIT

= X
EBIT EBIT - Interest
----------------------

Sales - Variable Cost Notes
=
EBIT - Interest
----------------------
In the example cited above, in case of both A Ltd. and B Ltd., when sales are
Rs. 20,000, contribution is Rs. 10,000 but earnings after interest and before tax ----------------------
are Rs. 4,100 and Rs. 4,900 respectively. As such, combined leverage can be
computed as: ----------------------
Sales - Variable Cost (i.e. contribution) ----------------------
EBIT - Interest
----------------------
A Ltd. B Ltd.
Rs. 10,000 ----------------------
Rs. 10,000
= =
Rs. 4,100 Rs. 4,900 ----------------------
= 2.44 = 2.04 ----------------------
It means that in case of A Ltd. every 1% increase in contribution will ----------------------
increase EPS by 2.44% and vice versa, while in case of B Ltd. every 1% increase
in contribution, will increase EPS by 2.04%. As such when contribution gets ----------------------
reduced from Rs. 10,000 to Rs. 9,000 i.e. 10% reduction, EPS of A Ltd. gets
reduced from Rs. 20.50 to Rs. 15.50 (i.e. 24.4% reduction) and EPS of B Ltd. ----------------------
gets reduced from Rs. 2.72 to Rs. 2.16 (i.e. 20.4 reduction). ----------------------
Indications:
----------------------
The indications given by the combined effect of operating and financial
leverages may be studied under the following possible situations: ----------------------
1. High Operating Leverage, High Financial Leverage: ----------------------
It indicates a very risky situation as a slight decrease in sales and/or ----------------------
contribution may affect the EPS to a very great extent. As far as possible,
this situation should be avoided. ----------------------
2. High Operating Leverage, Low Financial Leverage: ----------------------
It indicates that a slight decrease in sales and/or contribution may affect
EBIT largely due to existence of high fixed cost but this possibility is ----------------------
already taken care of by low proportion of debt capital in the overall capital ----------------------
structure.
----------------------
3. Low Operating Leverage, High Financial Leverage:
It indicates that the decrease in sales/contribution will not affect EBIT ----------------------
greatly as the component of fixed cost is negligible in the overall cost
----------------------
structure. As such, the company has accepted the risk of borrowing more
debt capital in order to increase EPS to the maximum possible extent. This ----------------------
may be considered to be an ideal situation.
----------------------
4. Low Operating Leverage, Low Financial Leverage:
It indicates that the decrease in sales/contribution will not affect EBIT ----------------------
largely as the component of fixed cost is negligible in the overall cost ----------------------
structure. But still, the company has not accepted the risk of having a large

Notes component of debt capital in its capital structure. It may indicate a very
cautious policy followed (unnecessarily) by the management, as it will not
---------------------- maximise the shareholders’ wealth. At the same time, it may also indicate
that the company is not utilising its borrowing capacity properly and fully.
----------------------

----------------------
---------------------- 1. The term leverage measures relationship between two variables.
---------------------- 2. Operating leverage is calculated by dividing Fixed Costs by Earnings
Before Interest and Tax.
----------------------
3. Use of financial leverage is useful as long as equity capital costs less
---------------------- than what it earns.
----------------------
Activity 2
----------------------
---------------------- Study the level of Financial Leverage from the Balance Sheet of a Company
and note down the limitations of the same.
----------------------
----------------------
9.4 THEORIES OF CAPITAL STRUCTURE
----------------------
In the previous pages, we have seen that the introduction of debt capital
---------------------- in the capital structure increases the earning per share of equity shareholders.
We have also seen that the introduction of debt capital increases the risk also
----------------------
which is the risk of insolvency due to non-availability of cash and variability
---------------------- of earnings available to equity shareholders. As such, increasing the debt
component beyond a certain limit will not increase the earnings per share. If
---------------------- debt component crosses a particular limit, the expectations of the lenders of
money also increase due to the risk factor involved. Similarly, the shareholders
----------------------
also will demand a higher rate of return on their investment to compensate for
---------------------- the risk arising out of additional amount of debt capital in the capital structure.
As such, introduction of a heavy amount of debt capital in the capital structure
---------------------- will not only reduce the valuation of the firm but will also increase the cost of
capital.
----------------------
However, this view is not universally accepted. It is not an accepted
---------------------- principle that the valuation of a firm and its cost of capital may be affected
by the change in financing mix. Different views have been expressed in this
----------------------
context. We will classify these views in the form of the following four theories
---------------------- of capital structure.
---------------------- (a) Net Income Approach

(b) Net Operating Income Approach
----------------------

(c) Traditional Approach Notes
(d) Modigliani - Miller Approach
----------------------
For this purpose, following assumptions have been made:
----------------------
1. Firms use only long-term debt capital or equity share capital to raise funds.
2. Corporate Income Tax does not exist. ----------------------
3. Firms follow policy of paying 100% of its earnings by way of dividend. ----------------------
4. Operating earnings are not expected to grow. ----------------------
Following definitions and symbols are also used:
----------------------
Following definitions and symbols are also used.
----------------------
S = Market Value of equity shares
B = Market Value of debt ----------------------
V = Total Market Value of firm ----------------------

NOI = Net Operating Income i.e. EBIT ----------------------
I = Total Interest Payments
----------------------
NI = Net Income available to equity shareholders.
----------------------
i.e. EBIT - I = EBT
----------------------
EBIT
Overall cost of capital =
V ----------------------
a) Net Income Approach:
----------------------
According to this approach as proposed by Durand, there exists a direct
relationship between the capital structure and valuation of the firm and ----------------------
cost of capital. By the introduction of additional debt capital in the capital ----------------------
structure, the valuation of the firm can be increased and cost of capital can
be reduced and vice versa. ----------------------
To explain the approach more precisely, we will consider the following example: ----------------------
Present 50% 50%
----------------------
Position Increase in Decrease in
Debt Capital Debt Capital ----------------------
Rs. Rs. Rs.
8% Debentures 6,00,000 9,00,000 3,00,000 ----------------------
NOI i.e. EBIT 1,50,000 1,50,000 1,50,000
----------------------
Interest 48,000 72,000 24,000
NI i.e. EBT 1,02,000 78,000 1,26,000 ----------------------
Equity Capitalisation Rate 10% 10% 10%
Market value of Equity Shares (S) 10,20,000 7,80,000 12,60,000 ----------------------
Market value of Debentures (B) 6,00,000 9,00,000 3,00,000 ----------------------
Total value of firm V = S + B 16,20,000 16,80,000 15,60,000
Overall cost of capital 9.26% 8.93% 9.62% ----------------------

Notes It can be seen from above, that by the increase in debentures, the total value
of the firm increases and cost of capital reduces and vice versa. However, this
---------------------- will hold good only if the cost of debentures i.e. rate of interest is less than the
equity capitalisation rate.
----------------------
b) Net Operating Income Approach:
----------------------
According to this approach, also proposed by Durand, the valuation of the
---------------------- firm and its cost of capital are independent of its capital structure. Any change
in the capital structure does not affect the value of the firm or cost of capital,
---------------------- though the further introduction of debt capital may increase equity capitalisation
rate and vice versa.
----------------------
To explain the approach, more precisely, we will consider the following example.
----------------------
Present 50% 50%
---------------------- Position Increase in Decrease in
Debt Capital Debt Capital
---------------------- Rs. Rs. Rs.
---------------------- 8% Debentures 6,00,000 9,00,000 3,00,000
Overall Capitalisation Rate 10% 10% 10%
---------------------- EBIT 1,50,000 1,50,000 1,50,000
Total value of firm (V) 15,00,000 15,00,000 15,00,000
---------------------- Overall cost of capital 1,50,000 1,50,000 1,50,000
15,00,000 15,00,000 15,00,000
----------------------
EBIT/V 10% 10% 10%
---------------------- Market value of Debentures (B) 6,00,000 9,00,000 3,00,000
Market value of Equity shares (S)
---------------------- i.e.V-B 9,00,000 6,00,000 12,00,000
Interest 48,000 72,000 24,000
---------------------- Equity Capitalisation Rate
---------------------- EBIT-I 1,02,000 78,000 1,26,000
V-B 9,00,000 6,00,000 12,00,000
----------------------
11.3% 13% 10.5%
----------------------
It can be seen from the above that the market value of the firm remains
---------------------- unaffected by change in the capital structure. However, the introduction of
additional debentures increases the equity capitalisation rate and vice versa.
----------------------
c) Traditional Approach:
---------------------- This is the mean between two extreme approaches of net income approach
---------------------- on one hand and net operating income on another. It believes the existence
of what may be called ‘Optimal Capital Structure’. It believes that up to a
---------------------- certain point, additional introduction of debt capital, in spite of increase in
cost of debt capital and equity capitalisation rate individually, the overall
---------------------- cost of capital will reduce and total value of the firm will increase. Beyond
---------------------- the point, the overall cost of capital will tend to rise and total value of the
firm will tend to reduce. Thus, for the judicious mix of debt and equity
---------------------- capital, it is possible for the firm to minimise overall cost of capital and

maximise total value of the firm. Such a capital structure where overall Notes
cost of capital is minimum and total value of the firm is maximum is called
‘Optimal Capital Structure’. ----------------------
To explain this approach, more precisely, we will consider the following ----------------------
example:
----------------------
No Debt 5%n 8% Debentures
Debentures Rs. Rs. 6,00,000 ----------------------
3,00,000
EBIT 1,50,000 1,50,000 1,50,000 ----------------------
Less :
Interest on debentures – 15,000 48,000 ----------------------
NI i.e. EBT 1,50,000 1,35,000 1,02,000
Cost of Equity Capital 10% 11% 12% ----------------------
Market value of Equity Shares (S) 15,00,000 12,27,273 8,50,000
----------------------
Market value of Debentures (B) 0 3,00,000 6,00,000
Total value of firm i.e. V = S + B 15,00,000 15,27,273 14,50,000 ----------------------
EBIT 1,50,000 x 100 1,50,000 x 100 1,50,000 x 100
Overall capital cost = ----------------------
V 15,00,000 15,27,273 14,50,000
= 10% = 9.82% = 10.34% ----------------------
It can be seen from the above neither the no-debentures position nor the
----------------------
position where debentures are issued to the extent of Rs. 6,00,000 minimise
the overall cost of capital or maximise the total value of the firm. It is when ----------------------
debentures are issued to the extent of Rs. 3,00,000 that the overall cost of capital
is minimum and total value of the firm is maximum, hence that is the Optimal ----------------------
Capital Structure.
----------------------
d) Modigliani - Miller (MM) Approach:
----------------------
This approach closely resembles net operating income approach.
According to this approach, value of the firm and its cost of capital are ----------------------
independent of its capital structure. It argues, that overall cost of capital
is the weighted average of cost of debt capital and cost of equity capital. ----------------------
Cost of equity capital depends upon shareholders’ expectations. Now, if ----------------------
shareholders expect 10% from a certain company, they already take into
consideration debt capital in the capital structure. For every increase in debt ----------------------
capital the expectations of the shareholders also increase as in the eyes of
shareholders, risk in the company also increases. Thus, each change in the ----------------------
mix of debt capital and equity capital is automatically offset by change in ----------------------
the expectations of the shareholders, which in turn is attributable to change
in risk element. As such, they argue that, leverage i.e. mix in debt capital ----------------------
and equity capital, has nothing to do with overall cost of capital and overall
cost of capital is equal to the capitalisation rate of pure equity stream of a ----------------------
risk class. Hence, leverage has no impact on share market prices or cost of ----------------------
capital.
----------------------
----------------------

Notes
----------------------

1. High Operating Leverage, High Financial Leverage indicates
----------------------
i. A very risky situation as slight decrease in sales/contribution may
---------------------- affect EPS to a great extent
---------------------- ii. A very comfortable position of finance
---------------------- iii. A position of high returns and rewards

iv. A position of very low returns and rewards
----------------------
2. In the context of theories of capital structure, NOI means:
----------------------
i. Net Operating Income, i.e. EBIT
---------------------- ii. Non-Operating Income
---------------------- iii. New Obligatory Income
---------------------- iv. Non Objectionable Income
----------------------
Activity 3
----------------------
---------------------- Through a diagram, explain the components of Net Income Approach.
----------------------
----------------------
1. Assuming no taxes and given the earnings before interest and taxes (EBIT),
----------------------
interest (I), at 10% and equity capitalisation rate (K), below, calculate the
---------------------- total market value of each firm:
---------------------- Firms EBIT I K

Rs. Rs.
----------------------
X 2,00,000 20,000 12.0%
---------------------- Y 3,00,000 60,000 16.0%
---------------------- Z 5,00,000 2,00,000 15.0%
W 6,00,000 2,40,000 18.0%
----------------------
----------------------
----------------------
----------------------
----------------------

Also determine the weighted average cost of capital for each firm. Notes
Firm X Firm Y Firm Z Firm W
EBIT Rs. 2,00,000 3,00,000 5,00,000 6,00,000 ----------------------
Interest Rs. 20,000 60,000 2,00,000 2,40,000
----------------------
NI (Net Income available to
the shareholders) Rs. 1,80,000 2,40,000 3,00,000 3,60,000 ----------------------
Equity Capitalisation Rate 12% 16% 15% 18%
Market value of Equity Shares* (S) Rs. 15,00,000 15,00,000 20,00,000 20,00,000 ----------------------
Market value of debt (B)* Rs. 2,00,000 6,00,000 20,00,000 24,00,000
----------------------
Total value of the firm V = S + B Rs. 17,00,000 21,00,000 40,00,000 44,00,000
Overall cost of capital ----------------------
i.e. EBIT/V 10.59% 11.43% 7.50% 8.18%
----------------------
*Note : As the rate of interest i.e. 10% and the amount of interest is known, the
amount of debt capital can be calculated as : ----------------------
100
Amount of interest x ----------------------
10
NI x 100 ----------------------
*Market value of Equity Shares =
Equity Capitalisation Rate ----------------------
2. Operating Leverage and Combined Leverage of a company is 2 and
3 respectively at the present level of sales of 10,000 units. The selling ----------------------
price per unit is Rs. 12 while its variable cost is Rs. 6. The company has
----------------------
no preference share capital. Applicable corporate income tax rate can be
assumed to be 50%. The rate of interest on company’s debt is 16% p.a. ----------------------
What is the amount of debt in the capital structure of the company?
----------------------
Solution:
As Sales are Rs. 1,20,000 and Variable Cost is Rs. 60,000, Contribution is ----------------------
known to be Rs. 60,000. ----------------------
As Operating Leverage is 2, Contribution / PBIT = 2
----------------------
Hence, PBIT = Contribution / 2, i.e. Rs. 30,000
As Combined Leverage is 3, Contribution / PBT = 3 ----------------------
Hence, PBT = Contribution / 3, i.e. Rs. 20,000. ----------------------
As PBIT is Rs. 30,000 and PBT is Rs. 20,000, Interest will be Rs. 10,000. ----------------------
Rate of Interest is known to be 16%. Hence, the amount of debt capital in the
capital structures will be ----------------------
10,000 ----------------------
x 100 = 62,500
16
----------------------
3. The Capital Structure of a company is as below:
----------------------
Equity Share Capital
(Each Share of Rs. 10) Rs. 60,000 ----------------------
10% Debentures Rs. 80,000 ----------------------
Retained Earnings Rs. 20,000
Notes Sales of the company are Rs. 6,00,000. Its variable operating cost is 40% of
sales and fixed operating cost is Rs. 1,00,000. Assuming the income tax rate of
---------------------- 50%,
---------------------- i. Calculate different types of leverages.
ii. Determine the likely level of PBIT if EPS is (a) Re.1 (b) Rs. 3 and (c) Re. 0.
----------------------
Profitability structure of the company will be as below:
----------------------
Sales Rs. 6,00,000
---------------------- – Variable Cost Rs. 2,40,000
---------------------- Contribution Rs. 3,60,000
---------------------- – Fixed Cost Rs. 1,00,000
EBIT Rs. 2,60,000
----------------------
– Interest Rs. 8,000
----------------------
EBT Rs. 2,52,000
---------------------- – Taxes Rs. 1,26,000
---------------------- Profit After Tax Rs. 1,26,000
---------------------- Calculation of leverage
(a) Operating Leverage:
----------------------
Contribution 3,60,000
---------------------- = = 1.38
EBIT 2,60,000
----------------------
(b) Financial Leverage:
---------------------- EBIT 2,60,000
= = 1.03
---------------------- EBT 2,52,000
(c) Combined Leverage:
----------------------
Contribution 3,60,000
---------------------- = = 1.43
EBT 2,52,000
---------------------- Calculation of EBIT
---------------------- We know that,
---------------------- 50% of (EBIT - Interest) = EPS

No. of Equity Shares
----------------------
We further know that
----------------------
Interest = Rs. 8,000
----------------------
No. of Equity shares = 6000
----------------------
----------------------

(a) 50% (EBIT - 8000) = 1 Notes
6000
----------------------
50% (EBIT - 8000) = 6000
1/2 EBIT - 4000 = 6000 ----------------------
1/2 EBIT = 10,000 ----------------------
EBIT = 20,000 ----------------------
(b) 50% (EBIT - 8000) = 3 ----------------------
6000
----------------------
... 50% (EBIT - 8000) = 18000
----------------------
... 1/2 EBIT - 4000 = 18000
... 1/2 EBIT = 22000 ----------------------
... EBIT = 44000 ----------------------
(c) 50% (EBIT - 8000) = 0 ----------------------

6000
----------------------
... 50% (EBIT - 8000) = 0
----------------------
... 1/2 EBIT - 4000 = 0
... 1/2 EBIT = 4000 ----------------------
... EBIT = 8000 ----------------------
----------------------
Summary
----------------------
• In financial analysis, leverage represents the influence of one financial
----------------------
variable over some other related financial variable. These financial
variables may be costs, output, sales revenue, Earning Before Interest and ----------------------
Tax (EBIT), Earning Per Share (EPS) etc.
----------------------
• There are three commonly used measures of leverage in financial analysis:
o Operating Leverage ----------------------
o Financial leverage ----------------------

o Combined Leverage ----------------------
• Capital structure is the combination of different financial sources for the
----------------------
capital of the business in the most economical and efficient manner. There
are four theories, which are useful for determination of capital structure: ----------------------
o Net Income approach ----------------------
o Net Operating Income approach
----------------------
o Traditional approach
----------------------
o Modigliani -Miller approach

Notes Keywords
----------------------
• Leverage: Leverage represents the influence of one financial variable over
---------------------- some other related financial variable.
• Financial Leverage: The ability of a firm to use fixed financial charges to
----------------------
magnify the effect of changes in EBIT/Operating Profits.
---------------------- • Combined Leverage: Measures the effect of a percentage change in Sales
on percentage change in EPS.
----------------------

----------------------
1. What do you mean by the term ‘Leverages’? Explain it with an example.
---------------------- 2. What are the different types of leverages? Explain the indication of each
type of leverages.
----------------------
3. Discuss the combined effect of the operating leverage and financial
---------------------- leverage.
---------------------- 4. What do you mean by the term ‘Optimal Capital Structure’? What is its
link with cost of capital?
----------------------
5. Explain Net income approach of capital structure.
---------------------- 6. Write short notes on the following:
---------------------- a. Operating and Financial Leverage
---------------------- b. Traditional Approach
---------------------- c. Modigliani-Miller Approach
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Answers to Check your Progress Notes
1. The operating profit earned by a company is also referred to as Profit
Before Interest and Taxes (PBIT) in financial terms. ----------------------
2. The Price Earning Ratio indicates the price currently being paid in the ----------------------
stock market for every one rupee of EPOS.
----------------------
----------------------
1. True ----------------------
2. False ----------------------
3. False ----------------------
----------------------
----------------------
1. High Operating Leverage, High Financial Leverage indicates
i. A very risky situation as slight decrease in sales/contribution may ----------------------
affect EPS to a great extent ----------------------
2. In the context of theories of capital structure, NOI means:
----------------------
i. Net Operating Income, i.e. EBIT
----------------------
1. Prasanna Chandra, Prasanna. Financial Management ----------------------
2. Eugene Brigham, Joel Houston. Fundamentals of Financial Management, ----------------------
Concise Edition
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
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----------------------
----------------------
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----------------------
----------------------

Capital Market
UNIT
10
Structure:
10.1 Introduction
10.2 SEBI Guidelines for Public Issue and Rights Issue
10.3 SEBI Guidelines for the Issue of Debt Instruments
10.4 Intermediaries in Capital Market
10.5 Recent Trends in Capital Market
10.6 Credit Rating
10.7 Buyback of Shares
10.8 Venture Capital
Summary
Key Words
Suggested Reading
Capital Market 191

Notes
Objectives
----------------------
----------------------
• Define the concept of capital market
----------------------
• Analyse SEBI guidelines for public issue, rights issue and debt
---------------------- instruments.
• Analyse the functions of different intermediaries in capital market.
----------------------
• Define credit rating and explain the methodology of credit rating
----------------------
• Evaluate the Buyback and Initial public offering
----------------------
10.1 INTRODUCTION
----------------------
In simple words, Capital Market refers to the market available to the
----------------------
company for raising the long-term requirement of funds. Last decade of the
---------------------- twentieth century has witnessed various liberalisation measures and reforms
taking place in various sectors of the economy. Capital Market is no exception
---------------------- to the rule. The changes, which have taken place in the capital market, are
basically in two forms-
----------------------
a. Repeal of Capital Issues (Control) Act, 1947 and abolition of the office of
---------------------- Controller of Capital Issues. This came into effect from 29th May, 1992.
---------------------- b. Enactment of the Securities and Exchange Board of India Act, 1992 and
formation of Securities and Exchange Board of India (SEBI).
----------------------
As a result of this, the market for the long-term securities of the companies
---------------------- has become freer and companies are now able to raise the funds in the market in
a free manner. However, in order to protect the interests of investors, SEBI has
---------------------- been empowered to issue the directions from time to time. As such, at present,
---------------------- the only regulatory framework applicable to the companies trying to raise the
funds by issuing their securities in the market is in the form of guidelines issued
---------------------- by SEBI from time to time for disclosure and investors’ protection. The extract
of these SEBI guidelines are discussed in the following paragraphs.
----------------------
In the Capital Market (in technical words it is referred to as ‘Primary
---------------------- Market’), a company can raise the funds in following three manners:
---------------------- a. Public Issue
b. Rights Issue
----------------------
c. Private Placement of Securities
----------------------
Public Issue indicates the sale of securities to the members of general public.
---------------------- According to the provisions of the Companies Act, 2013, if a Public
---------------------- Limited Company wants to raise further capital by way of issuing additional
shares, they are required to be offered to the existing equity shareholders first
---------------------- in the similar proportion. This is technically called as ‘Rights Issue’ of shares.

However, the existing shareholders are not compelled to buy those shares. The Notes
existing shareholder can buy those shares himself or he can renounce the right
in favour of any other person. ----------------------
Private placement of Securities, as the name indicates, is the private ----------------------
placement made by the company to a selected few investors.
----------------------
10.2 SEBI GUIDELINES FOR PUBLIC ISSUE AND RIGHTS ISSUE ----------------------
If the company wishes to collect the funds by making Public Issue or Rights ----------------------
Issue of the Securities, following requirements of SEBI guidelines are required
to be complied with by the company. ----------------------
Filing of Prospects or Letters of Offer ----------------------
A company cannot make the public issue of Equity Shares unless a draft
----------------------
prospects is filed with SEBI, through an eligible Merchant Banker, at least 21
days before it is filed with the Registrar of Companies (ROC). Contents of the ----------------------
prospectus are also prescribed in the guidelines.
----------------------
A listed company cannot make the rights issue of Equity Shares where
aggregate value exceeds Rs. 50 Lakh, unless the letter of offer is filed with SEBI, ----------------------
through an eligible Merchant Banker, at least 21 days before it is filed with the
Regional Stock Exchange. Contents of the offer letter are also prescribed in the ----------------------
guidelines.
----------------------
Listing on Stock Exchange
----------------------
A company cannot make the public issue of Equity Shares, unless it has
made an application for listing of these equity shares in the stock exchange(s). ----------------------
Eligibility for an unlisted company for making public issue ----------------------
An unlisted company cannot make the public issue of equity shares unless
----------------------
the company has:
a. A track record of distributable profits for at least three years out of ----------------------
immediately preceding five years.
----------------------
b. A pre-issue net worth of more than Rs. 1 Crore in three out of preceding
five years, with the minimum net worth to be met during immediately ----------------------
preceding two years. ----------------------
c. The issue size not exceeding 5 times its net-worth.
----------------------
If the unlisted company does not satisfy any of the above conditions,
it can make the public issue only through the Book Building process. In the ----------------------
Book Building process, the company has to compulsorily allot at least 60%
of the issue size to the Qualified Institutional Buyers, failing which the full ----------------------
subscription amount will have to be refunded. ----------------------
Eligibility for a listed company for making public issue
----------------------
A listed company can make the public issue if the issue size is less than 5
times its pre-issue net worth. ----------------------
Capital Market 193

Notes If the issue size is more than or equal to 5 times of pre-issue net worth, the
company has to take the route of Book Building and has to allot at least 50%
---------------------- of the issue size to the Qualified Institutional Buyers, 15% to High Net Worth
Individuals and 35% to Retail Investors.
----------------------
Partly paid shares
----------------------
No company can make the public issue of Equity Shares unless all the
---------------------- partly paid shares have been fully paid up.
Pricing of the issue
----------------------
A listed company can freely price its equity shares offered through the
---------------------- public issue or rights issue. An unlisted company making the Public Issue of
---------------------- Equity Shares and desirous of getting the shares listed on the stock exchange
can freely price its equity shares. However, the company is required to give the
---------------------- justification of the price in the offer document.
---------------------- Any unlisted company or a listed company making issue of equity shares
can issue them to applicants in the firm allotment category at a price different
---------------------- from the price at which offer is made to the public provided that the price at
which the security is offered to the applicants in firm allotment category is
---------------------- higher than the price at which the security is offered to the public.
---------------------- Denomination of the shares
---------------------- Denomination of the equity shares in the public issue or rights issue can be
freely decided by the company.
----------------------
Promoters’ Contribution
---------------------- In a public issue by an unlisted company, the promoters shall contribute not
---------------------- less than 20% of the post-issue capital. In a public issue by a listed company, the
promoters shall participate to the extent of 20% of the proposed issue or ensure
---------------------- post-issue holding to the extent of 20% of the post-issue capital. Promoters
shall bring the full amount of the promoter contribution at least one day before
---------------------- the issue opens for public.
---------------------- Lock-in period
---------------------- The lock-in period for the promoter contribution shall be three years from
the date of commercial production or the date of allotment of shares whichever
---------------------- is later.
---------------------- If an unlisted company making the public issue of equity shares and
desirous of getting the shares listed on the stock exchange has issued the shares
---------------------- to any person within six months prior to the opening of issue for the public
at a price lower than the price at which shares are offered to the public, the
----------------------
entire share capital (except the shares of venture capitalist and employees of the
---------------------- company) shall have lock-in period of six months from the date of trading of
shares on the stock exchange.
----------------------
----------------------

Minimum application Notes
If the equity shares are being issued at par, the minimum number of shares
----------------------
for which an application is to be made is 200 shares of the face value of Rs.
10 per share. In other words, the minimum application money payable by the ----------------------
applicant shall not be less than Rs. 2,000. Minimum application money payable
by the applicant along with the application shall not be less than 25% of the ----------------------
issue price.
----------------------
Subscription List
----------------------
A public issue of shares shall be kept open for minimum three working
days and not more than ten working days. ----------------------
Rights issue shall be kept open for at least 30 days and not more than 60 ----------------------
days.
Underwriting ----------------------
Underwriting of the public issue of shares is compulsory for the company ----------------------
making the issue.
----------------------
Minimum Subscription
----------------------
If the company receives less than 90% of the issued amount from the public
plus the shares taken over by the underwriters, the company must refund the ----------------------
subscription amount in full within 60 days from the date of closure of the issue.
----------------------
Utilisation of funds
The company can utilise the funds collected by way of rights issue after ----------------------
satisfying the stock exchange that minimum 90% subscription has been received. ----------------------
Retention of oversubscription
----------------------
The quantum of issue shall not exceed the amount specified in the prospectus
or the letter of offer. However, an oversubscription to the extent of 10% is ----------------------
permissible for rounding off to the nearer multiple of 100 while finalising the
----------------------
allotment.
----------------------
----------------------
1. Eligibility for an unlisted company for making public issue is ----------------------
i. A track record of distributable profits for at least three years out of
immediately preceeding five years. ----------------------
ii. A pre-issue net worth of more than Rs. 1 crore in three out of ----------------------
preceeding five years
----------------------
iii. Issue size not exceeding 5 times its net-worth
----------------------
iv. Having firm financial commitment from 100 subscribers
v. Acceptance of issue by the public at large ----------------------
Capital Market 195

Notes 2. The lock-in-period for the promoter contribution shall be:
---------------------- i. Three years
---------------------- ii. Three years from the date of commercial production
iii. Three years from the date of allotment of shares
----------------------
iv. Five years
----------------------
v. NIL
----------------------
---------------------- Activity 1
----------------------
Denomination of the equity shares in public or rights issue can be freely
---------------------- decided. In view of this, analyse and find out various denominations
available in BSE Sensex list.
----------------------
----------------------
10.3 SEBI GUIDELINES FOR THE ISSUE OF DEBT INSTRUMENTS
----------------------
Basic
----------------------
The company cannot issue FCDs having a conversion period of more than
---------------------- 36 months unless conversion is made optional with ‘put’ and ‘call’ option.
If the conversions take place after 18 months but before 36 months from
----------------------
the date of allotment of debentures, any conversion in part or in whole shall be
---------------------- optional at the hands of debenture-holders.
Rate of Interest, premium and period of conversion
----------------------
The rate of interest for the debentures can be freely decided by the company.
---------------------- The amount of premium on redemption and the period of conversion can be
---------------------- decided by the company and disclosed in the offer document.
Credit Rating
----------------------
The company cannot make the public issue of the FCDs/PCDs/NCDs
---------------------- unless credit rating is obtained from a credit rating agency and disclosed in the
offer document. If the size of the issue is greater than Rs. 100 crore, two ratings
---------------------- from two different credit rating agencies are required to be obtained. When the
---------------------- rating is obtained from more than one credit rating agency, all the credit ratings,
including the unacceptable ratings, shall be disclosed by the company. All the
---------------------- credit ratings obtained during the three preceding years for any listed securities
of the company are required to be disclosed.
----------------------
Debenture Trustees
----------------------
If the issue of debentures is having the maturity period of more than 18
---------------------- months, the company shall appoint a Debenture Trustee. The name of the
Debenture Trustee shall be disclosed in the offer document. A Trust Deed
---------------------- shall be executed by the company in favour of the Debenture Trustees within

six months from the date of closure of the issue. The Debenture Trustee shall Notes
have the requisite powers for protecting the interests of the debenture holders
including the right to appoint a nominee director. ----------------------
Debenture Redemption Reserve (DRR) ----------------------
If the company issues the debentures with the maturity of more than 18 months,
----------------------
it has to create DRR. DRR should be created out of the post-tax profits earned
by the company. The company shall create the DRR to the extent of at least 50% ----------------------
of the amount of debenture issue before debenture redemption commences.
Drawl from DRR is permissible only after 10% of the debenture liability has ----------------------
actually been redeemed by the company. DRR will be treated as free reserve
----------------------
while issuing the bonus shares.
Security ----------------------
The company shall create the security within six months from the date of issue ----------------------
of debentures. If the company fails to create the charge within 12 months of the
issue, the company is liable to pay interest @ 2% penal interest over and above ----------------------
the coupon rate of interest till the charge is registered. ----------------------
----------------------
Fill in the blanks.
----------------------
1. If the size of the issue is greater than _______, two ratings from two
different credit rating agencies are required to be obtained. ----------------------
2. If the company issues the debentures with the maturity of more than 18
----------------------
months, it has to create _________________.
----------------------
Activity 2 ----------------------
----------------------
Study the ratings symbols given by the Credit Rating Agencies and prepare
a comparative statement of any two rating agency symbols. ----------------------
----------------------
10.4 INTERMEDIARIES IN CAPITAL MARKET ----------------------
If a company wants to raise the funds from various sources, services given ----------------------
by various intermediaries become essential in the process. Among all these
intermediaries, probably the most important and significant intermediary is the ----------------------
Merchant Banker. In the area of Capital Markets, it is the basic responsibility of
the Merchant Banker to ensure that the issue is a success. To be more particular, ----------------------
the Merchant Banker performs the following functions: ----------------------
a. Advise the company about the structuring of the issue after taking into
----------------------
consideration the overall economic conditions, expectations of the investors
etc. ----------------------
Capital Market 197

Notes b. Assist in getting the various statutory approvals.
c. Drafting of the Prospectus and the Offer Document in consultation with
----------------------
the solicitors and others.
---------------------- d. Assist the company in the appointment of other intermediaries like
underwriters, brokers, bankers, registrars, advertising agencies, printers
----------------------
etc.
---------------------- e. Develop the strategies for marketing the issue properly through the various
techniques like advertisements, mailers, press conferences, investors’
----------------------
conferences, broker conferences etc.
---------------------- f. Coordinate the efforts of all the intermediaries for the success of the issue.
---------------------- g. Monitor the issue during the period of subscription.
---------------------- h. Assist in finalising the basis of allotment.
i. Assist in securing the stock exchange listing
----------------------
In addition to the Merchant Bankers, following intermediaries play a
---------------------- significant role in the process of raising the funds in Capital Market.
---------------------- Underwriters
---------------------- Underwriters provide a protection to the company in the situation of

investors not fully subscribing to the issue of the securities. Thus, underwriting
---------------------- is a contract where the underwriter agrees to subscribe directly or to procure
subscription for that portion of the issue, which is not taken up by the public.
---------------------- As a result, when the issue is underwritten, the company making the issue is
---------------------- assured of getting the total requirement of funds, either from the investors or
from the underwriters. The return received by the underwriters is in the form of
---------------------- underwriting commission, which is based upon the amount underwritten by the
underwriter.
----------------------
It has already been stated, that as per the SEBI regulations, underwriting is
---------------------- not obligatory. However, in case of every underwritten issue, the Lead Merchant
Banker shall accept the minimum underwriting obligation of 5% of the total
---------------------- underwriting commitment or Rs. 25 Lakh whichever is less.
---------------------- Bankers to the Issue
---------------------- Bankers to the issue collect the application money on behalf of the
company. Bankers to the issue are the banks who provide the term finance or
---------------------- working capital finance to the company and who underwrite the issue.
---------------------- Registrars to the Issue
---------------------- – Registrars to the Issue typically perform the following tasks

– Collection of applications from the banks after the issue is closed.
----------------------
– Scrutiny of the application forms.
----------------------
– Classification and tabulation of information for allotment.
----------------------

– Finalisation of basis of allotment. Notes
– Preparation and dispatch of allotment letters, share certificates, debentures
----------------------
certificates and refund orders.
----------------------
10.5 RECENT TRENDS IN CAPITAL MARKET
----------------------
We will study the recent trends in Capital Market mainly under the following
headings: ----------------------
a. Equity Warrants ----------------------

b. Floating Rate Bonds ----------------------
c. Zero Coupon Bonds
----------------------
d Deep Discount Bonds
----------------------
e. Secured Premium Notes
Innovative instruments in Capital Market ----------------------
During the last few years, the companies have entered the capital market with ----------------------
various innovative instruments to raise the funds from the public. We will
----------------------
discuss the following innovative instruments used by the companies.
a. Equity Warrants ----------------------
b. Floating Rate Bonds ----------------------
c. Zero Coupon Bonds ----------------------
d. Deep Discount Bonds
----------------------
a. Equity Warrants
----------------------
The holders of the warrants are entitled to purchase the equity shares
at a specific price during the specified period (technically referred to as ----------------------
‘exercise period’). However, the holder of the equity warrants has a right
but not the obligations to purchase the equity shares. Naturally, the holder ----------------------
of the equity warrant will exercise the option to buy the equity shares if the
----------------------
prevailing market price of the equity shares is more than the specified price
during the exercise period. The equity warrants are generally issued along ----------------------
with some other instrument with the intention to make the issue of that
other instrument more attractive. Equity Warrants can be either detachable ----------------------
or non-detachable. Detachable Equity Warrants can be detached from the
----------------------
underlying instruments and can be traded independently. Non-detachable
Equity Warrants cannot be detached from the underlying instrument. ----------------------
Advantages of Equity Warrants
----------------------
The issuing company gets benefited with the help of Equity Warrants
particularly when the requirement of funds of the company is staggered ----------------------
over a period of time. The company can decide the exercise period taking ----------------------
into consideration its requirement of funds.
----------------------
Capital Market 199

Notes Risks associated with Equity Warrants
If the market price of the equity shares is less than the exercise price during
----------------------
the exercise period, the company may not get the subscription for the
---------------------- shares. Once the exercise period is over, equity warrants are of no use to
the company.
----------------------
b. Floating Rate Bonds
---------------------- In case of floating rate bonds, the rate of interest paid by the company is
not fixed. The rate of interest is tied up with some base rate say bank rate
----------------------
and the variations in base rate decide the actual rate of interest payable by
---------------------- the company on the bonds. E.g. State Bank of India issued the Floating
Rate Bonds of the Face Value of Rs. 1,000 carrying the rate of interest of
---------------------- 3% over the maximum interest payable by the bank on the term deposits.
If the rate of interest payable on the term deposits increases, the rate of
----------------------
interests on the floating rate bonds will increase and vice versa.
---------------------- At the same time, the company may prescribe some rate as the ‘Floor Rate’
---------------------- (indicating the minimum rate of interest payable by the company on the
bonds even if the base rate falls below a certain limit) and as the ‘Cap Rate’
---------------------- (which indicates the maximum rate of interest payable by the company
even if the base rate increases beyond a certain limit).
----------------------
Advantages of Floating Rate Bonds
---------------------- The Floating Rate Bonds avoid the risk of interest rate fluctuations in the
---------------------- economy both for the issuing company as well as for the investors.
c. Zero Coupon Bonds (ZCB)
----------------------
Zero Coupon Bonds do not have any explicit or coupon rate of interest
---------------------- payable by the company. E.g., ZCB can be issued on the following terms:
---------------------- Face value Rs. 100 per ZCB
---------------------- Redemption Value Rs. 125 per ZCB
---------------------- Redemption Period 3 years
---------------------- Difference between the redemption value and the face value is the gain to
the investor.
----------------------
Advantages of ZCB
---------------------- The company does not require any periodical outflow of funds to service
the borrowing during the currency of the borrowing.
----------------------
d. Deep Discount Bonds (DDB)
----------------------
Deep Discount Bonds were issued by Industrial Development Bank of
---------------------- India (IDBI) in 1992 for the first time. The terms on which IDBI issued the
DDB were as below:
----------------------
----------------------

Face Value Rs. 1,00,000 Notes
Issue Price Rs. 2,700 ----------------------
Maturity Period 25 years
----------------------
The investors were given the option to quit investment at the end of every
5 years period. E.g., the investors will be paid Rs. 5,700 after the end of 5 ----------------------
years and Rs. 50,000 at the end of 20 years etc. ----------------------
Advantages of DDB
----------------------
The company does not require any periodical outflow of funds to service
the borrowing during the currency of the borrowing. ----------------------
Risks associated with DDB ----------------------
The redemption period is usually very long and hence, the investors accept
----------------------
the risk of non-payment at the time of maturity.
----------------------
10.6 CREDIT RATING
----------------------
After 1990, Indian capital market saw a lot of companies entering the
----------------------
capital market with the intention of raising the funds by issuing the shares and /
or debentures. It is expected that before an investor makes the investment in the ----------------------
instruments issued by the company, he should satisfy himself about the financial
credentials of the company. While investing in the equity shares of a company, ----------------------
the investor is assumed to know about the risk involved with the investment.
----------------------
However, in case of the debt instruments, the investors are expected to make
the investment in these instruments after making the study of the various factors ----------------------
relating to the investment. However, a small investor is not sufficiently equipped
to make such a study. As such, the financial service in the form of credit rating ----------------------
has emerged as a tool to help the investor evaluate his investment portfolio.
----------------------
What is credit rating?
----------------------
Credit Rating is the expression of opinion, with the help of symbols, given
by an independent credit rating agency, about the ability of the issuer of a debt ----------------------
instrument to make timely payments of principal and interest at the specified
dates. ----------------------
The above description of credit rating reveals the following features of credit ----------------------
rating.
----------------------
a. Credit rating is with respect to a particular instrument issued by the
company. In other words, credit rating indicates the safety associated with ----------------------
the particular instrument issued by the company. It does not indicate the
financial health of the company as a whole. ----------------------
b. Credit rating is not a recommendation for buying, selling or holding a ----------------------

security. Actual investment made by the investor depends upon the other
----------------------
important factors like expectation of returns, risk-taking capacity of the
investor etc. ----------------------
Capital Market 201

Notes c. For the purpose of deciding the rating about the particular instrument, the
rating agency may use the various types of information. This information
---------------------- may be made available to the rating agency either by the company itself
or it may be available to the agency from any other source. However, the
---------------------- rating agency does not perform the audit function. In the sense, the rating
---------------------- agency does not certify that the information available to it is true and
correct.
----------------------
d. Credit Rating does not create any legal relationship between the rating
---------------------- agency and the investor. If an investor invests in a particular security on the
basis of high credit rating given by rating agency and the said investment
---------------------- turns out to be bad investment subsequently, the investor cannot hold rating
agency responsible for the bad investment.
----------------------
e. The Credit rating once given is not a one-time phenomenon applicable
---------------------- during the entire tenure of the security. With the changing risk characteristics
of the company, the credit rating should be reviewed and upgraded or
----------------------
downgraded accordingly.
---------------------- Is credit rating obligatory?
---------------------- In the Indian circumstances, credit rating is not obligatory in case of equity
shares. It is obligatory only in case of the debt instruments. To be more precise,
---------------------- credit rating is obligatory in case of the following debt instruments.
---------------------- a. Convertible or Non-convertible Debentures/ Bonds irrespective of the
period of maturity or redemption.
----------------------
b. Fixed Deposits issued by non-banking financial companies.
----------------------
c. Commercial Paper.
---------------------- Recently amended SEBI guidelines provide that if the size of issue is more
than Rs. 100 crore, the issue is required to be rated by at least two credit rating
----------------------
agencies.
---------------------- It should be noted that the requirement of credit rating in respect of the
---------------------- above instruments is not a part of any particular law or statute. It is included in
the various guidelines applicable for the issue of above instruments.
---------------------- Who can do the credit rating?
---------------------- Presently there are four approved credit rating agencies that can do the credit
rating of the various instruments. These agencies are:
----------------------
a. Credit Rating and Information Services of India Ltd. (CRISIL)
----------------------
b. Investment Information and Credit Rating Agency (IICRA)
---------------------- c. Credit Analysis and Research Limited (CARE)
---------------------- d. FITCH Rating India Private Limited.
----------------------
----------------------

Advantages of credit rating Notes
a. In the developing capital market conditions, credit rating provides the
----------------------
investor with the reliable and superior information from an independent
and professional source, about the company at no cost. This facilitates the ----------------------
investment on the part of investors on conscious basis instead of on some
ad-hoc basis. ----------------------
b. With a satisfactory credit rating, it is comparatively easy for a company ----------------------
to market the instrument at less cost. Similarly, with a satisfactory credit
rating, it is possible for the company to approach a wide audience of the ----------------------
investors.
----------------------
c. Credit rating provides a motivation to the companies to improve their
performance. A company with a low credit rating with respect to a particular ----------------------
instrument, always strives to improve its performance.
----------------------
d. With the help of credit rating, the investible funds of the investors are
directed towards more productive investment portfolios. The possibility of ----------------------
investment failing is comparatively less. ----------------------
Methodology of Credit Rating
----------------------
For this purpose, we will take into consideration the rating methodology
followed by CRISIL. ----------------------
The rating procedure followed by CRISIL may be based upon the ----------------------
information available to it either directly from the company or from any other
source. During this process, CRISIL considers the following aspects about the ----------------------
company.
----------------------
a. Business Analysis
----------------------
i) Industry Risk – This indicates the overall demand/supply position in
the industry as a whole, the existing as well as the potential competitors ----------------------
in the industry, various government policies affecting the industry etc.
----------------------
ii) Market Position – This indicates the market position of the company
vis-à-vis that of the competitors in the industry in terms of the ----------------------
market share, competitive advantages and disadvantages, selling and
distribution arrangements etc. ----------------------
iii) Operating Efficiency – This involves the consideration of manufacturing ----------------------

process and operating efficiency of the company in relation to those
of the competitors, availability of various infrastructural facilities, ----------------------
modernisation/expansion/ diversification plans etc. ----------------------
b. Financial Analysis
----------------------
This involves the consideration of the various factors like ‘accounting
policies followed by the company, analysis of the financial statements, ----------------------
adequacy of cash flows for fixed capital and working capital needs, ability
----------------------
to raise funds from the market, etc.
----------------------
Capital Market 203

Notes c. Management Evaluation
This involves the consideration of the various factors like track record of
----------------------
the management, capacity to overcome the adverse business conditions,
---------------------- management targets/ objectives/strategies etc.
Credit Rating Symbols
----------------------
CRISIL IICRA CARE
----------------------
Long Term (Debentures/Bonds)
---------------------- Highest Safety AAA LAAA CARE AAA
---------------------- High Safety AA LAA CARE AA
Adequate Safety A LA CARE A
----------------------
Moderate Safety BBB LBBB CARE BBB
---------------------- Inadequate Safety BB LBB CARE BB
---------------------- High Risk B LB CARE B
---------------------- Substantial Risk C LC Care C

Default D LD Care D
----------------------
Medium Term (Fixed Deposits)
---------------------- Highest Safety FAAA MAAA CAREAAA(FD)
---------------------- High Safety FAA MAA CARE AA (FD)
Adequate Safety FA MA CARE A (FD)
----------------------
Inadequate Safety FB MB CARE B (FD)
----------------------
High Risk FC MC CARE C (FD)
---------------------- Default FD MD CARE D (FD)
---------------------- Short Term (Commercial Paper)
Highest Safety P1 A1 PR1
----------------------
High Safety P2 A2 PR2
---------------------- Adequate Safety P3 A3 PR3
---------------------- Inadequate Safety P4 A4 PR4
---------------------- Default P5 A5 PR5

a. The above table indicates the comparison between the symbols used by the
----------------------
various rating agencies. The basic description for the use of symbols is as
---------------------- used by CRISIL. The exact description used by the remaining two rating
agencies varies slightly from the description used by CRISIL.
----------------------
b. The rating agencies may add + or - signs to indicate the degree of variation.
---------------------- The Credit Rating Symbols used by Fitch Rating India Pvt. Ltd. are as
---------------------- below:
----------------------

For Long Term (12 months and more) Notes
AAA (ind) Highest Credit Quality
----------------------
AA + (ind), AA (ind), AA-(ind) High Credit Quality
----------------------
A+ (ind), A(ind), A- (Ind) Adequate Credit Quality
BBB+(ind), BBB (ind), BBB- (ind) Moderate Credit Quality ----------------------
BB+ (ind), BB(ind), BB-(ind) Speculative ----------------------
B+(ind), B(ind), B-(ind) Highly Speculative ----------------------
C(ind) High Default Risk
----------------------
D(ind) Default
----------------------
Public Deposits
----------------------
AAA (ind) Highest Credit Quality
AA+(Ind), AA(ind), A-(ind) High Credit Quality ----------------------
A_(ind), A(ind), A-(ind) Adequate Credit Quality ----------------------

BBB+(ind), BBB(ind), BBB-(ind) Moderate Credit Quality ----------------------
BB+(ind), BB(ind), BB-((ind) Speculative ----------------------
B+(ind), B(ind), B-(ind) Highly Speculative
----------------------
C (ind) High Default Risk
----------------------
D(ind) Default
----------------------
For Short Term (Less than 12 months)
F1+(ind), F1(ind) Highest Credit Quality ----------------------
F2+(ind), F2(ind) Good Credit Quality ----------------------

F3(ind) Fair Credit Quality ----------------------
F4(ind) Speculative
----------------------
F5(ind) Default
----------------------
Limitations of Credit Rating
----------------------
a. Credit Rating is based upon the evaluation made by the agencies which
is essentially a subjective evaluation which may vary depending upon ----------------------
the experience, knowledge and the individual opinion of the rators which
maybe biased in some cases. ----------------------
b. The various guidelines issued for regulating the various types of instruments ----------------------
for which credit rating is required, require the companies to get the credit
----------------------
rating done. However, these guidelines do not require the companies to
publish these ratings. As such, in certain cases the companies may not ----------------------
publish the ratings, particularly when the ratings are not favourable to the
companies. This defeats the basic purpose of credit rating. ----------------------
Capital Market 205

Notes c. The approved credit rating agencies prevailing in the country are promoted
by the government controlled organisations. This may involve its own
---------------------- consequences.
---------------------- d. It is usually observed that the ratings given by the credit rating agencies is
primarily based upon the past performance of the companies, whereas the
---------------------- future prospects of the companies should be given more importance while
deciding the credit rating. Moreover, if a particular company or a particular
----------------------
industry is passing through the temporary adverse conditions, it may get a
---------------------- low credit rating if judged on temporary basis.
e. Multiplicity of the rating agencies can be considered to be the limitation of
----------------------
the credit rating. If a company is not satisfied with the rating given by one
---------------------- agency, the company can approach another rating agency with the hope
to get better rating from that agency. The recently introduced guidelines
---------------------- issued by SEBI provide that if the company has approached more than
one rating agency, it is required that the ratings given by all the agencies
----------------------
are made known to the investors. If there is a vast difference between the
---------------------- ratings awarded by the different agencies, it may be a point of concern for
the investor.
----------------------
f. In the recent past, some cases were observed that the ratings given by the
---------------------- agencies were either upgraded or downgraded within comparatively a
very short span of time. The question arises what went wrong to such an
---------------------- extent that the ratings were required to be upgraded or downgraded to such
an extent. In the whole process, the basic rating given by the agencies is
----------------------
challenged. Effectively, the credibility of the agency is at stake.
----------------------
----------------------

---------------------- 1. CRISIL stands for:
i. Credit Rating & Information Services of India Ltd.
----------------------
ii. Credit Report and Information Services of India Ltd.
----------------------
iii. Credit Risk and Intimation Services of India Ltd.
---------------------- iv. Credit Revision and Implementation Services of India Ltd.
---------------------- 2. IICRA is the abbreviation of :
---------------------- i. Investment Information and Credit Rating Agency
ii. Investor Information and Credit Reporting Agency
----------------------
iii. Internet Information and Credit Reporting Agency
----------------------
iv. Internal Information and Credit Risk Agency
----------------------
----------------------

Notes
Activity 3
----------------------
Identify the Credit Rating Symbols given by CRISIL, IICRA & Care for ----------------------
Highest Safety & High Safety and Moderate Safety.
----------------------
10.7 BUYBACK OF SHARES ----------------------
As per the provisions of Companies (Amendment) Act, the company is ----------------------

authorised to buy back its own shares. This is one of the exceptions to the rule ----------------------
that no company can reduce the amount of its share capital during its lifetime.
The provisions in respect of buy back of own shares are as below: ----------------------
a. Articles of Association of the company should authorise the company ----------------------
to buy back its own shares. If there is no authorisation in the Articles of
Association, they need to be amended first. ----------------------
b. The buy back of the shares should be approved by passing a special ----------------------
resolution in the general meeting of the Company. The explanatory
statement enclosed to such notice should contain the details like disclosure ----------------------
of all material facts, necessity for buy back, the class of shares proposed
----------------------
to be bought back, amount required for such buy back of shares and time
required for completion of buy back. After the special resolution is passed ----------------------
but before the buyback of shares, the company shall file with the Registrar of
Companies of the respective state and with SEBI, if shares of the Company ----------------------
are listed on a recognised stock exchange, a declaration that the company
----------------------
is capable of meeting its liabilities and will not be insolvent within a period
of one year from such declaration. Such declaration shall be signed by at ----------------------
least two directors, one of whom should be the managing director. This
special resolution should be filed with the Registrar of Companies of the ----------------------
respective state in Form No. 23. The procedure of buy back should be
----------------------
completed within 12 months from passing such a special resolution. If the
company buys back the shares with the intention to get delisted in the ----------------------
stock exchange, the company has to follow the procedure of reverse book
building. ----------------------
c. The shares can be bought back out of the following amounts: ----------------------
i) Free Reserves of the company. ----------------------
ii) Share Premium Account of the company.
----------------------
iii) Proceeds of issue of any shares or other specified securities.
----------------------
However, proceeds of earlier issue of shares or other specified securities
cannot be used for buy back of shares. ----------------------
----------------------
----------------------
Capital Market 207

Notes Similarly, the shares can be bought back
i) From the open market.
----------------------
ii) From the existing shareholders on a proportionate basis.
----------------------
iii) By purchasing the shares issued to the employees under the employees
---------------------- stock option scheme or issued to them as sweat equity.
---------------------- d. The amount of shares bought back should not be more than 25% of the
total paid-up capital of the company and its free reserves. A company may
---------------------- be able to buy back its own shares every year, however, the amount of
shares bought back in any financial year shall not be more than 25% of its
---------------------- paid up equity capital in that financial year.
---------------------- e. The debt equity ratio of the company after such buy back of shares should
not be more than 2:1 except where the Central Government allows a higher
---------------------- ratio in case of certain companies.
---------------------- f. The shares, which are proposed to be bought back, should be fully paid up
shares. Securities so bought back within a period of 7 days from the last
---------------------- date of completion of buy back.
---------------------- h. If the company buys back its own shares, it shall not make further issue of
same kind of shares (including rights shares) within a period of 24 months.
----------------------
However, this provision shall not apply to
---------------------- i) Issue of bonus shares.
---------------------- ii) Conversion of preference shares/debentures into the equity shares.
---------------------- iii) Fulfillment of obligations in respect of conversion of equity warrants,

employees stock options or sweat equity.
----------------------
10.8 VENTURE CAPITAL
----------------------
---------------------- In the recent past, Ventures Capital has become one of the best possible
sources for raising the funds for the companies involving more business risks
---------------------- and for whom the normal avenues for raising the funds are unavailable as the
common investors are unwilling to invest their funds into such ventures. Venture
---------------------- capital as a source of funds has become a necessity for the organisations that have
---------------------- good growth opportunities. Venture Capitalist or Venture Capital Fund (VCF) is
interested in investing in these projects (i.e. Venture Capital Undertaking) as his
---------------------- investment is likely to generate huge amount of returns. These returns may not
be in the form of recurring returns like dividend, but also in the form of capital
---------------------- gains over a longer span of time.
---------------------- A venture capitalist investing in the project is aware of the fact that the
project is in the untested area, involving more amount of risk. He is also aware
---------------------- that the projects are likely to involve larger gestation period. As such, a venture
---------------------- capitalist is not worried about the failure of the project in which he invests his
funds. This is because he knows that the project, which succeeds, will give huge
---------------------- returns, which will compensate for the losses incurred by other projects. This

is the reason why the venture capitalist is not only the investor of funds or the Notes
lender of the funds. A conventional lender of funds is not directly involved in
the operations and management of the company. He keeps away from managing ----------------------
the company and is bothered about the safety of the funds lent by him. A
conventional investor only trades in the shares of the company without any ----------------------
relationship with the management of the company. ----------------------
As against this, before investing in the project, Venture Capital Company
----------------------
or Venture Capital Fund scrutinises the project carefully and studies the merits
of the project. He takes active participation in the management of the project ----------------------
providing the benefit of his expertise and experience to the Venture Capital
Undertaking. ----------------------
Before investing in the project, the Venture Capitalist is interested in ensuring ----------------------
that:
----------------------
a. The project is technically feasible.
b. The project is commercially viable. ----------------------
c. The entrepreneurs are technically competent. ----------------------

d. The project has a competitive advantage over a longer span of time. ----------------------
Types of Venture Capital Financing
----------------------
The venture capital funding can be either in the form of equity financing or
debt financing. However, equity financing is a more preferred route for venture ----------------------
capital funding. This is due to the following facts –
----------------------
a. Projects for venture capital financing are more risky in nature and involve
larger gestation period. Hence, the project will require the long-term funds ----------------------
on which it may not be able to pay the returns during the initial period. At the ----------------------
same time, venture capitalist is not interested in interfering in the project.
Hence, the investment of the venture capitalist does not exceed 49% so that ----------------------
the effective control of the project remains with the entrepreneur.
----------------------
b. Venture capitalist is not interested in keeping his investment in the project
on a permanent basis. He wishes to quit his investment as early as possible. ----------------------
He can do so when the project becomes successful and profitable and he is
able to sell off his equity shares. ----------------------
Exit Routes available to VCF ----------------------

As stated earlier, the VCF is not interested in remaining associated with the ----------------------
Venture Capital Undertaking on a permanent basis. He is interested in quitting
his investment at a suitable point of time. In the Indian circumstances, following ----------------------
two options may be available to VCF for quitting his investment:
----------------------
a. Purchase of VCF stake by the promoters.
----------------------
b. Initial Public Offering (IPO).
----------------------
----------------------
Capital Market 209

Notes Purchase of VCF stake by the promoters
This exit route is very popular in the Indian circumstances where the
----------------------
promoters of the Venture Capital Undertaking, purchase the equity stake
---------------------- of VCF within the agreed period at a pre decided price. This enables the
promoters to maintain their stake in the Venture Capital Undertaking intact.
---------------------- The limitation of this exit route lies in the fixation of the price, which the
promoters will be required to pay to the VCF for buying the equity stake of
----------------------
the VCF.
---------------------- Initial Public Offering (IPO)
---------------------- The first public offering of equity shares of a company to be followed
by listing of the shares on the stock exchange is known as Initial Public
---------------------- Offering (IPO). Once the Venture Capital Undertaking becomes profitable,
it can make the public issue of its shares. After the abolition of the office of
----------------------
Controller of Capital Issues, it is possible for the companies to decide the
---------------------- premium on the issue of its shares. After the shares of the company are listed
on the stock exchange, the VCF can sell its stake on the stock exchange
---------------------- earning the capital appreciation in return. The limitation of this exit route
is the restricted scope of IPO for the Venture Capital Undertaking as the
----------------------
venture promoted by comparatively unknown promoters may be viewed
---------------------- as an unattractive proposition by the investors. Further, complexities in
getting the securities listed on the stock exchange and the efficiency of the
---------------------- secondary markets in India restrict the scope of this exit route available to
the VCFs.
----------------------
Ventures Capital in India
----------------------
The history of venture capital in India can be traced back to the establishment
---------------------- of Technology Development Fund (TDF) in the year 1987-88, through the levy
of cess on all technology import payments. TDF was for providing financial
---------------------- assistance to innovative and high-risk projects through Industrial Development
---------------------- Bank of India (IDBI). In 1988, Industrial Credit and Investment Corporation of
India (ICICI) promoted Technology Development and Information Company
---------------------- of India (TDICI) as the first venture capital company under the Companies Act,
1956.
----------------------
In 1996, Securities and Exchange Board of India issued the guidelines for
---------------------- the operations of Venture Capitalists to carry out their operations in India. This
has made the entry of foreign venture capital funds easier in Indian situations.
----------------------
At present, the venture capital funds (VCFs) operating in India can be
---------------------- classified in the following categories:
---------------------- a. VCFs promoted by All India Development Financial Institutions like IDBI,
ICICI and IFCI, e.g. TDICI promoted by ICICI.
----------------------
b. VCFs promoted by State level Financial Institutions, e.g. Gujarat Venture
---------------------- Finance Company Limited or Andhra Pradesh Venture Capital Limited.
----------------------

c. VCFs promoted by the Commercial Banks, e.g. Can Bank Venture Capital Notes
Fund or State Bank Venture Capital Fund etc.
----------------------
d. Private Sector Venture Capital Funds, e.g. Indus Venture Fund, 20th
Century Venture Capital Company, Infrastructure Leasing and Financial ----------------------
Services Limited etc.
----------------------
In order to promote the venture capital, Section 10 (23FB) was inserted in
Income Tax Act, 1961 that provides that any income earned by a VCF will ----------------------
be exempt from tax. To get this exemption, following two conditions are
required to be satisfied. ----------------------
a. Venture Capital Company or Venture Capital Fund should have been given ----------------------
the certificate of registration by SEBI and such Venture Capital Company
or Venture Capital Fund should have fulfilled all the conditions as specified ----------------------
by SEBI.
----------------------
b. Venture Capital Company or Venture Capital Fund is set up to raise the
funds for investment in a Venture Capital Undertaking which essentially ----------------------
means a company whose shares are not listed in a recognised stock ----------------------
exchange.
If the above conditions are satisfied, any income of such Venture Capital ----------------------
Company or Venture Capital Fund will be exempt from income tax even ----------------------
if the shares of such company are subsequently listed in recognised stock
exchange. ----------------------
----------------------
----------------------
----------------------
1. Venture Capital Fund is promoted by
----------------------
i. All India Development Financial Institutions-IDBI
ii. State Level Financial Institutions-Gunjarat Venture Finance Co. Ltd. ----------------------
iii. Commercial Banks-Can Bank Venture Capital Fund ----------------------

iv. Private Sector Venture Capital Fund: Indus Venture Fund ----------------------
2. In order to promote the Venture Capital this Act was Amended
----------------------
i. Income Tax Act
----------------------
ii. Sales Tax Act
iii. Property Tax Act ----------------------
iv. Estate Duty Act ----------------------
----------------------
----------------------
----------------------
Capital Market 211

Notes Summary
---------------------- • The Capital Market refers to the market available to the company for
raising the long-term requirement of funds. The company can raise funds
----------------------
in the following three manners: 1. Public issue, 2. Rights issue, 3. Private
---------------------- placement of securities.
---------------------- • If the company wishes to collect the funds by making Public Issue or Rights
issue of the Securities, it has to follow the SEBI Guidelines such as filling
---------------------- of prospectus or letter of offer with the Registrar of Companies, listing on
stock exchange, denomination of shares, etc.
----------------------
• If a company wants to raise funds from various sources, services provided
---------------------- by various intermediaries become essential in the process. The most
important and significant intermediary is the merchant banker. Equity
---------------------- warrants, floating rate bonds, zero coupon bonds, deep discount bonds and
---------------------- secured premium notes are some examples of innovative instruments used
by companies to raise funds from the public.
---------------------- • Credit rating is the expression of opinion, with the help of symbols, given
---------------------- by an independent credit rating agency, about the ability of the issuer of
a debt instrument to make timely payments of principal and interest at
---------------------- specified dates. In Indian circumstances, credit rating is not obligatory in
case of equity shares. It is obligatory only is case of the debt instruments.
----------------------
• V
enture Capital has become one of the best possible sources for raising
---------------------- the funds for the companies involving more business risks and for whom
the normal avenues for raising the funds are unavailable as the common
----------------------
investors are unwilling to invest their funds into such ventures.
----------------------
Keywords
----------------------
• Public Issue: Public Issue indicates the sale of securities to the members
----------------------
of general public
---------------------- • Private Placement: It is the privately placing the securities to a selected
---------------------- few investors
• Underwriting: Assurance given by an agency as regards subscription to
---------------------- an initial public issue. The agency is called Underwriter and the amount
---------------------- assured is Underwriting
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
1. State the guidelines for the public issue and rights issue of shares.
2. Explain in brief SEBI guidelines for issue of Debt Instruments. ----------------------
3. Write a short note on various intermediaries in the capital market. ----------------------
4. Write a short note on various innovative instruments used by the companies ----------------------
for raising the funds in the capital market.
5. Explain credit rating with its advantages. ----------------------
6. What are the limitations of credit rating? ----------------------

7. What are the types of venture capital financing? Explain each in brief. ----------------------
8. Write short notes. ----------------------
a. Methodology of credit rating
----------------------
b. Venture Capital
----------------------
c. Buyback of shares
----------------------
----------------------
----------------------
----------------------
1. Eligibility for an unlisted company for making public issue is
i. A track record of distributable profits for at least three years out of ----------------------
immediately preceeding five years.
----------------------
ii. A pre-issue net worth of more than Rs. 1 crore in three out of preceeding
five years ----------------------
iii. Issue size not exceeding 5 times its net-worth ----------------------

2. The lock-in-period for the promoter contribution shall be: ----------------------
i. Three years
----------------------
ii. Three years from the date of commercial production
----------------------
iii. Three years from the date of allotment of shares

1. If the size of the issue is greater than Rs. 100 crore, two ratings from two ----------------------
different credit rating agencies are required to be obtained.
----------------------
2. If the company issues the debentures with the maturity of more than 18
months, it has to create Debenture Redemption Reserve (DRR). ----------------------
----------------------
Capital Market 213

----------------------
1. CRISIL stands for:
----------------------
i. Credit Rating & Information Services of India Ltd.
---------------------- 2. IICRA is the abbreviation of :
---------------------- i. Investment Information and Credit Rating Agency

----------------------
1. Venture Capital Fund is promoted by
----------------------
i. All India Development Financial Institutions-IDBI
---------------------- 2. In order to promote the Venture Capital this Act was Amended
---------------------- i. Income Tax Act
----------------------
Suggested Reading
----------------------
1. Khan & Jain. Financial Management
----------------------
2. Christine Robertson. Financial Management: Review of Education’s Grant
---------------------- Back Account
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Capital Budgeting
UNIT
11
Structure:
11.1 Introduction
11.2 The Process of Capital Budgeting
11.3 How to Compute Cash Flows
11.4 Time Value of Money
11.5 Techniques for Evaluation of Capital Expenditure Proposals
11.6 Limitations of Capital Budgeting
11.7 Evaluation Criteria in Certain Typical Situations
11.8 Planning, Organisation and Control of Capital Expenditure
11.9 Capital Rationing
11.10 Capital Budgeting and Risk
Summary
Key Words
Suggested Reading
Capital Budgeting 215

Notes
Objectives
----------------------
----------------------
• Define the steps involved in the process
----------------------
• Explain the concept of time value of money
---------------------- • Evaluate various techniques of capital expenditure proposals
---------------------- • Describe the concept of capital rationing
----------------------
---------------------- 11.1 INTRODUCTION

---------------------- As discussed in the earlier units, the finance function has to deal with one of the
most important decisions regarding the amount to be invested in fixed assets
----------------------
and the decision is technically in the form of ‘Capital Budgeting’. Thus, the
---------------------- capital budgeting decisions are decisions as to whether or not money should
be invested in long-term projects. It includes analysis of various proposals
---------------------- regarding capital expenditure to evaluate their impact on the financial situation
of the company and to choose the best out of the various alternatives. The
----------------------
function of finance in this area is to enable the management to take a proper
---------------------- capital budgeting decision.
Capital budgeting decisions are the most crucial and critical decisions for a
----------------------
business to take. This is the fact due to the various reasons.
---------------------- 1. Capital budgeting decisions have long-term implications on the operations
---------------------- of the business. A wrong decision may affect the long-term survival of the
Company. The investment in fixed assets more than required, may increase
---------------------- the operating costs of the Company. The inadequate investment in fixed
assets may make it difficult for the Company to compete and may affect its
---------------------- market share.
---------------------- 2. Capital budgeting decisions involve large amount of the funds. As such, it
is necessary to take the decision very carefully and to make the arrangement
---------------------- of the funds for the procurement of these assets.
---------------------- 3. The capital budgeting decisions are irreversible due to the fact that it is
difficult to find the market for such capital goods. The only alternative is to
---------------------- scrap these assets, which involves huge losses.
---------------------- 4. Capital budgeting decisions are difficult to make because it involves the
assessment of future events that are difficult to ascertain. The investments
----------------------
are required to be made immediately but the returns are expected over a
---------------------- number of years.
----------------------
----------------------

11.2 THE PROCESS OF CAPITAL BUDGETING Notes
The process of capital budgeting involves generally the following steps: ----------------------
1. Project Generation: The generation of the proposals may fall under any ----------------------
of the following categories:
(a) Additions to the present product line. ----------------------
(b) Expansion of the capacity of the existing product line. ----------------------
(c) Proposals to reduce costs of the existing product line without affecting
----------------------
the scale of operations.
The generation of the projects may take place at the levels of top ----------------------
management or at the level of workers also, e.g. Proposal to replace on
old machine or to improve the production techniques may originate at the ----------------------
worker’s level also. ----------------------
2. Project Evaluation: As in case of any types of decision-making, the
capital budgeting decisions also have two faces. Firstly, estimation of the ----------------------
benefits and costs measured in terms of cash flows. Secondly, selection ----------------------
of an appropriate criterion to judge the desirability of the projects. It
is necessary that the evaluation of the projects is done by an impartial ----------------------
group and experts in the field. Care must be taken to choose the criteria to
judge the desirability of the projects and it should be consistent with the ----------------------
company’s basic objective to maximise the wealth. ----------------------
3. Project Selection: There is no fixed and laid down procedure to select
the final criteria among the various available alternatives. Generally, the ----------------------
selection of the final project is done by the top management though it ----------------------
may be scrutinised at various levels. In many cases, top management may
delegate the authority to approve certain projects to lower management ----------------------
also.
----------------------
4. Project Execution: After the final selection of the project is made, the
funds are appropriated and the execution of the project is carried on. ----------------------
However, there has to be a proper system to check that the execution of the
----------------------
project is being made as per the predecided plans and schedules.
Evaluation of the Projects ----------------------
As discussed earlier, the process of evaluation of the projects necessarily ----------------------
involves the cost benefit analysis. This cost benefit analysis will generally be
made in financial terms, though in some cases non-financial considerations ----------------------
may also come into play. E.g., sometimes a project may be undertaken to get ----------------------
established in the market or to satisfy certain legal requirements or for some
social welfare benefits or just for some emotional reasons. However, financial ----------------------
cost benefit analysis will be the basic evaluation criteria.
----------------------
There are many techniques and tools to evaluate the various investment
proposals. But before going into the details of these various techniques, one ----------------------
most important aspect of the evaluation has to be studied and that is ‘how to
compute the cash flows?’ ----------------------

Notes
----------------------

1. The process of capital budgeting involves proposal to reduce _________
----------------------
without affecting _____________.
---------------------- 2. The process of evaluation of the projects necessarily involves
__________________.
----------------------
----------------------
---------------------- Activity 1
---------------------- Study a project and note down the important areas it needs evaluation.
----------------------
---------------------- 11.3 HOW TO COMPUTE CASH FLOWS
---------------------- As the estimation of cash flows – both outflows as well as inflows – is the
crux for evaluating the projects, this estimation should be made as carefully as
----------------------
possible. The following stages should be considered for this purpose.
---------------------- 1. Following items constitute the cash outflow.
---------------------- i. Cost of new equipment.
---------------------- ii. Cost for demolition of old equipment (similarly, if there is some scrap
value receivable from the disposal of the old equipment, the outflow
---------------------- on account of the new equipment should be suitably adjusted.)
---------------------- iii. Cost of preparing site and installation charges incurred with respect to
the new equipment.
----------------------
Following factors should also be taken into consideration.
---------------------- i. If the cost of the new equipment is not to be incurred in one single
installment, but is to be paid over a period of years, it will involve the
----------------------
cash outflow not only in the first year but in the subsequent years also.
---------------------- Similarly, if the cost of the equipment/project is met by raising the
term borrowing, the cash outflow will come into consideration as and
---------------------- when the installment of term borrowings and interest on the same are
paid.
----------------------
ii. If the new equipment/project brings certain scrap value after the
---------------------- useful life is over, the amount realised as scrap value will constitute
---------------------- the cash inflow, but in relation to the year in which the amount is
actually received.
---------------------- iii. In some cases, implementation of the project may involve investment
---------------------- in the form of additional working capital due to increased inventory,

increased debtors etc. This additional investment in working capital Notes
constitutes cash outflow. Similarly, after the useful life of the project
is over, this investment in the working capital is released and hence ----------------------
should be considered as inflow but only with respect to the year in
which it is so released. Further, if the company resorts to some outside ----------------------
source of funds for financing working capital requirements, the cash ----------------------
outflow on account of investment in working capital will be the
amount invested by the company itself. The amount received from the ----------------------
outside source of working capital finance constitutes the cash inflow.
----------------------
iv. If a new asset is intended to be purchased in order to replace an
existing asset, the sale proceeds of the old asset should be considered ----------------------
as the cash inflow and the cash outflow required to purchase the new
----------------------
asset should be adjusted accordingly.
2. Following factors should be considered while computing cash inflows: ----------------------
i. Computation of cash inflows highly depends upon correct estimation ----------------------
of production and sales. On the basis of the additional production units
which can be sold and the price at which they can be sold, the gross ----------------------
revenue from the project can be worked out. However, while doing so,
----------------------
the possibility of reduction in selling price, introduction of a cheaper
product by competitors, etc. should also be considered. ----------------------
ii. Second stage in deciding the cash inflows is to estimate the costs ----------------------
attached to the project. These costs may be in the form of fixed costs
or variable costs or depreciation. ----------------------
iii. The difference between the gross revenue and the costs give the result ----------------------
of the net revenue, which should be adjusted for the taxation factor
for computation of cash inflows as it involves the actual payment of ----------------------
cash. However, the amount of depreciation, if it is already included
in the cost to consider the taxation factor should be added back while ----------------------
computing the cash inflow as depreciation does not involve the cash ----------------------
outflow. In simple words, the cash inflows should be computed in the
following stages. ----------------------
Sales Revenue Less: Costs (including depreciation) Net Revenue ----------------------
Less: Tax Liability Revenue after taxes Add: Depreciation Net cash
inflow ----------------------
iv. Care should be taken not to include the cost of interest and dividends ----------------------
while considering the costs attached to the project. This is due to the
fact that for evaluating the proposals if cost of capital is considered ----------------------
as the discounting factor (as discussed in details later), the amounts
----------------------
of interest and dividend are already given due consideration while
computing the cost of capital. ----------------------
v. Sometimes, the cash inflows may be considered in terms of net savings
----------------------
in costs rather than in terms of excess of sales over the additional cost.
Thus, for computing the cash inflows, these savings in costs will be ----------------------

Notes the starting point, which will have to be adjusted further for taxation
and depreciation factor. The cash inflows will be computed as below.
----------------------
Saving in costs
---------------------- (Other than Depreciation)
---------------------- Less : Depreciation
---------------------- Net Saving in costs

Less : Taxliability
----------------------
Saving after tax
----------------------
Add : Depreciation
---------------------- Net Cash inflows
----------------------
11.4 TIME VALUE OF MONEY
----------------------
It has already been discussed that the evaluation of capital expenditure
---------------------- proposals involves the comparison between cash outflows and cash inflows.
The peculiarity of evaluation of capital expenditure proposals is that it involves
----------------------
the decisions to be taken today whereas the flow of funds- either outflow or
---------------------- inflow- may be spread over a number of years. It goes without saying that for a
meaningful comparison between the cash outflows and cash inflows, both the
---------------------- variables should be on a comparable basis. As such, the question that arises is
that “is the value of flows arising in future the same in terms of today?” E.g. If
----------------------
a proposal involves the cash inflow of Rs. 10,000 after one year, is the value
---------------------- of this cash inflow really Rs. 10,000 as on today when the capital expenditure
proposal is to be evaluated? The ideal reply to this question is ‘no’. The value
---------------------- of Rs. 10,000 received after one year is less than Rs. 10,000 if received today.
The reasons for this can be stated as below:
----------------------
(1) There is always an element of uncertainty attached with the future cash
---------------------- flows.
---------------------- (2) The purchasing power of cash inflows received after the year may be less
than that of equivalent sum if received today.
----------------------
(3) There may be investment opportunities available if the amount is received
---------------------- today, which cannot be exploited if the equivalent sum is received after
one year.
----------------------
E.g., if Mr. X is given the option that he can receive an amount of Rs. 10,000
---------------------- either today or after one year, he will most obviously select the first option.
Why? Because, if he receives Rs. 10,000 today he can always invest the same,
---------------------- say in the fixed deposits with a bank carrying the interest of 10% p.a. As such, if
---------------------- the choice is given to him, he will like to receive Rs. 10,000 today or Rs. 11,000
(i.e. Rs. 10,000 plus interest @ 10% p.a. on Rs. 10,000) after one year. If he has
---------------------- to receive Rs. 10,000 only after one year, the real value of the same in terms of
today is not Rs. 10,000 but something less than that. This concept is called time
---------------------- value of money.

In the capital budgeting decisions, if there has to be a meaningful comparison Notes
between the cash outflows and cash inflows which may arise in future at different
points of time whereas the evaluation is required to be done as on today, both ----------------------
the future cash outflows and cash inflows are required to be expressed in terms
of today. ----------------------
There are two techniques available for this: ----------------------

(a) Compounding: ----------------------
In this technique, the interest is compounded and becomes a part of the initial
----------------------
principal at the end of the compounding period.
E.g. If Mr. X invests Rs. 10,000 in fixed deposit carrying interest @ 10% p.a. ----------------------
compounded annually, at the end of first year, Rs. 10,000 will be worth Rs. ----------------------
11,000 (i.e. Rs. 10,000 + interest on Rs. 10,000 @ 10% p.a.). If Rs. 11,000
are reinvested in the same fixed deposit, at the end of second year Rs. 11,000 ----------------------
will be worth Rs. 12,100 (i.e. Rs. 11,000 + interest on Rs. 11,000 @ 10% p.a.).
In other words, the value of today’s Rs. 10,000, if received after two years, ----------------------
becomes Rs. 12,100. ----------------------
The compounding of interest can be calculated with the help of following
equation: ----------------------
A = P(1+i)n where, ----------------------

A = Amount at the end of the period ----------------------
P = Amount of principal at the beginning of the priod
----------------------
i = Rate of interest
----------------------
n = Number of years
In the above example, after two years, the value of today’s Rs. 10,000 if invested ----------------------
in the investment carrying the interest of 10% p.a. can be computed as follows: ----------------------
A = 10,000 x (1 + 0.10) 2
----------------------

= 10,000 x 1.21
----------------------
= Rs. 12,100
(b) Discounting: ----------------------
These techniques involve the process, which is exactly opposite to that involved ----------------------
in the technique of compounding. This technique tries to find out the present
value of Re. 1, if received or spent after n years, provided that the interest rate ----------------------
of i can be earned on investment. The present value is calculated with the help ----------------------
of the following equation.
P = A ----------------------
(1 + i)n ----------------------
where, ----------------------
P = Present value of sum received or spent
----------------------

Notes A = Sum received or spent in fulure
i = Rate of interest
----------------------
n = Number of years
----------------------
E.g., If Mr. X is given the opportunity to receive Rs. 10,000 after two years,
---------------------- when he can earn interest of 10% p.a. on his investment, what amount should
he invest today so that he may be able to receive Rs. 10,000 after two years?
----------------------
It can be computed as:
---------------------- P = A
---------------------- (1 + i)n
=
---------------------- 10,000
(1+0.10)2
----------------------
= Rs. 8,264.46
---------------------- In other words, if Mr. X invests Rs. 8,264.46 today in the investment carrying
interest rate of 10% p.a. he may be able to receive Rs. 10,000 after two years or
---------------------- the present value or Rs. 10,000 if received after two years is only Rs. 8,264.46
---------------------- as on today if investment opportunities are available to earn the interest of 10%
p.a.
----------------------
Present Value Tables
---------------------- To simplify the computation of present value, use can be made of the present
value of rupee one for the various interest rates (i) and years (n) for computing
----------------------
the present value of a future lump sum, the said sum can be multiplied by
---------------------- choosing the interest factor/discounting factor/present value factor for the
relevant combination of i and n.
----------------------
E.g. To find out the present value of Rs. 4,000 received after 7 years, assuming
---------------------- interest rate to be 15%, we ascertain the present value factor to be 0.513. We
ascertain the present value to be
----------------------
Rs. 4000 x 0.513
---------------------- = Rs. 2,052
---------------------- Present value of series of cash flows
---------------------- In capital budgeting decisions, the cash flows, either cash outflow or cash
inflow, may occur at various points of time. For finding out the present value
---------------------- of this series of cash flows, it is necessary to find out the present value of each
future cash flow and then aggregate them.
----------------------
----------------------
----------------------
----------------------
----------------------

Illustration I Notes
A project involves cash inflows as below.
----------------------
Year Cash Inflows Rs.
----------------------
1 10,000
2 12,000 ----------------------
3 15,000
----------------------
4 20,000
Assuming interest rate to be 15%, find out the present value of cash inflows. ----------------------
Solution: Calculation of present value of cash inflows.
----------------------
Year Cash inflows Present Value Total Present value
Rs. Factor 15% Rs. ----------------------
1 10,000 0.870 8,700 ----------------------
2 12,000 0.756 9,072
3 15,000 0.658 9,870 ----------------------
4 20,000 0.572 11,440 ----------------------
39,082
----------------------
Illustration II
A machine costing Rs. 1,00,000 is to be purchased as below: ----------------------
Rs. 20,000 - Down payment out of own contribution. ----------------------

Rs. 80,000 - Borrowing by way of tearn loan. To be paid in 4 equal annual ----------------------
instalment along with the interest @ 15% p.a. The interest
being computed on openng outstanding balance. ----------------------
Calculate present value of the cash outflow. ----------------------
Solution:
----------------------
Calculation of present value of cash outflows
----------------------
Year Principal sum/ Intestest Total outflow PV. Factor Total PV
Own Contribution Rs. Rs. 15% Rs. ----------------------
Rs.
----------------------
0 20,000 - 20,000 1,000 20,000
1 20,000 12,000 32,000 0.870 27,840 ----------------------
2 20,000 9,000 29,000 0.756 21.924
----------------------
3 20,000 6,000 26,000 0.658 17,108
4 20,000 3,000 23,000 0.572 13,156 ----------------------
1,00,028 ----------------------
If a project involves uniform cash flows, the present value of the cash flows can
be calculated by a short cut method. Instead of calculating present value for ----------------------
each cash flow and then summing up the present values, the discounting factors ----------------------
(interest factor or present value factors) themselves can be summed up to find
out the Accumulated Discounting Factor for the various interest rates (i) and ----------------------

Notes years (n) and the multiplication of Accumulated Discounting Factor and cash
flow will give present value of cash flow.
----------------------
Illustration III
---------------------- A project involves the cash inflow of Rs. 20,000 per year for 4 years. Assuming
the interest rate of 15%, find out the present value of cash inflows.
----------------------
Accumulated Discounting factor at 15% for 4 years is 2.855.
----------------------
Present value of cash inflows Rs. 20,000 x 2.855
---------------------- = Rs. 57,100.
---------------------- Relevance in Capital Budgeting Decisions
---------------------- As discussed earlier, to make the value of cash outflows and cash inflows
comparable, it is necessary to reduce future cash outflows or cash inflows to
---------------------- their present value by discounting them by proper discounting factor or interest
factor or present value factor. Usually, weighted average cost of capital is
----------------------
considered as the discounting factor in capital budgeting decisions.
----------------------
----------------------
---------------------- 1. Discounting is one of the technique to calculate Time Value of Money.

2. Compounding in time valuation of money usually refers to Interest.
----------------------
----------------------
11.5 TECHNIQUES FOR EVALUATION OF CAPITAL
----------------------
EXPENDITURE PROPOSALS
----------------------
Various techniques are available for evaluation of capital expenditure proposals.
---------------------- They can be broadly categorised under two heads:
---------------------- (a) Techniques not considering time value of money:

1. Payback period:
----------------------
Payback period indicates the period within which the cost of the project will be
---------------------- completely recovered. In other words, it indicates the period within which the
total cash inflows equal to the total cash outflows. Thus,
----------------------
Cash outlay
Payback period = Annual cash inflow
----------------------
----------------------
----------------------
----------------------
----------------------

Illustration I: Notes
A project requires an outlay of Rs. 5,00,000 and earns, an annual cash inflow of
Rs. 1,00,000 for 8 years. Calculate payback period. ----------------------
Payback period for the project is ----------------------
Rs. 5,00,000
= 5 years ----------------------
Rs. 1,00,000
----------------------
If the project involves unequal cash inflows, the payback period can be computed
by adding up the cash inflow till the total is equal to cash outlay. ----------------------
Illustration II ----------------------
A project requires an outlay of Rs. 1,00,000 and earns, the annual cash inflow or
Rs. 25,000, Rs. 30,000, Rs. 20,000 and Rs. 50,000. Calculate payback period. ----------------------
If we add up cash inflows, we find that in the first 3 years, an amount of Rs. ----------------------
75,000 of the cash outlay is recovered. Fourth year generates the cash inflow
----------------------
of Rs. 50,000, whereas the amount of Rs. 25,000 only remains to be recovered.
Assuming that the cash inflows occur evenly during the year, the time required ----------------------
to recover Rs. 25,000 will be
----------------------
Rs. 25,000
x 12 months = 6 months.
Rs. 50,000 ----------------------
Thus, the payback period is 3 years and 6 months. ----------------------
Acceptance Rule: ----------------------
Payback period method can be used as an accept or reject criteria or as a method
----------------------
of ranking the project. If the payback period computed for a project is more than
maximum payback period estimated by the management it would be rejected ----------------------
or vice versa. As a ranking method, the projects having shortest payback period
will be ranked highest. ----------------------
Advantages: ----------------------
1. It is quite simple to calculate and easy to understand. It makes it quite clear
----------------------
that there are no profits on a project unless payback period is over.
2. It costs less. ----------------------
3. It may be a suitable technique where risk of obsolescence is high. In ----------------------
such cases, projects with shorter payback period may be preferred as the
changes in technology may make other projects obsolete before their costs ----------------------
are recovered. ----------------------
Disadvantages:
----------------------
1. It does not consider the returns from a project after its payback period
is over. Thus, one project A may have a payback period of 5 years while ----------------------
another project B may have a payback period of 3 years, thus making project
----------------------
B more preferable. But it is quite possible that project A may generate good
cash inflows after 5 years till the end of 10 years, while project B may stop ----------------------

Notes generating cash inflows after 3 years only. In such cases, project A may
prove to be more advantageous.
----------------------
2. It may not be a suitable method to evaluate the projects if they involve
---------------------- uneven cash inflows.
3. It ignores time value of money.
----------------------
4. To decide the acceptable payback period is a difficult task. There is no
---------------------- rational basis for deciding the maximum payback period. It is a subjective
decision.
----------------------
2. Accounting Rate of Return:
----------------------
Accounting rate of return (ARR) computes the average annual yield on the
---------------------- net investment in the project. ARR is computed by dividing the average
profits after depreciation and taxes by net investments in the project. Thus,
---------------------- ARR can be computed as:
---------------------- Total Profits
x 100
Net investment in project x No. of years of profits
----------------------
---------------------- Illustration:
A project involves the investment of Rs. 5,00,000, which yields profits after
---------------------- depreciation and tax as stated below:
---------------------- Years Profits after depreciation and tax
---------------------- 1 Rs. 25,000
2 Rs. 37,500
---------------------- 3 Rs. 62,500
---------------------- 4 Rs. 65,000
5 Rs. 40,000
---------------------- Rs. 2,30,000
---------------------- At the end of 5 years, the machineries in the project can be sold for Rs. 40,000.
Find the ARR.
----------------------
The total profits after depreciation and taxes are Rs. 2,30,000.
----------------------
The net investment in the project will be Original cost Less salvage value i.e.
---------------------- Rs. 5,00,000 – Rs. 40,000 = Rs. 4,60,000
---------------------- ARR will be

Rs. 2,30,000 x 100 = 10%
---------------------- Rs. 4,60,000 X 5 years
---------------------- Acceptance Rule:
---------------------- As payback period method, ARR also can be used as accept or reject criteria
or as a method for ranking the projects. As accept or reject criteria, the projects
---------------------- having the ARR more than minimum rate prescribed by the management will
---------------------- be accepted and vice versa. As a ranking method, the projects having maximum
ARR will be ranked highest.
Advantages: Notes
1. It is simple to calculate and easy to understand.
----------------------
2. It considers the profits from the project throughout its life.
----------------------
3. It can be calculated from the accounting data.
Disadvantages: ----------------------
1. It uses profits after depreciation and taxes and not the cash inflows for ----------------------
evaluating the projects.
----------------------
2. It ignores time value of money.
----------------------
(b) Techniques considering time value of money
1. Discounted Payback period: ----------------------
This is an improvement over the payback period method in the sense that it ----------------------
considers time value of money. Thus, discounted payback period indicates that
period within which the discounted cash inflows equal the discounted cash ----------------------
outflows involved in a project.
----------------------
Illustration:
----------------------
A project requires an outlay of Rs. 1,00,000 and earns the annual cash inflows
of Rs. 35,000, Rs. 40,000, Rs. 30,000 and Rs, 50,000. Calculate discounted pay ----------------------
back assuming the discounting rate of 15%.
----------------------
Years Cash inflows Discounting Discounted Cumulative
Discounted ----------------------
Rs. Factor Cash Inflow Cash Inflows ----------------------
@15% Rs. Rs.
1 35,000 0.870 30,450 30,450 ----------------------
2 40,000 0.756 30,240 60,690 ----------------------
3 30,000 0.658 19,740 80,430
4 50,000 0.572 28,600 1,09,030 ----------------------
Thus, payback period is after 3 years but before 4 years. Assuming that cash ----------------------
inflows accrue evenly during the year, Pay Back Period will be 3 years and 250
----------------------
days.
1,00,000 - 80,430 ----------------------
x 365 = 250 days
28,600
----------------------
Acceptance rule, advantages and disadvantages
----------------------
They are the same as in case of payback period method except the fact that it
considers time value of money. ----------------------
----------------------
----------------------
----------------------

Notes 2. Net Present Value:
Net Present Value (NPV) is a method of calculating present value of cash
----------------------
inflows and cash outflows in an investment project, by using cost of capital as
---------------------- the discounting rate, and finding out net present value by subtracting present
value of cash outflows from present value of cash inflows. Thus,
----------------------
NPV = { Σ Discounted cash}
Less
{
Σ Discounted Cash }
---------------------- Inflows Outflows
Illustration:
----------------------
Calculate net present value of a project involving initial cash outflow Rs.1,00,000
---------------------- and generating annual cash inflows of Rs. 35,000, Rs. 40,000, Rs. 30,000 and
Rs. 50,000 Discounting rate is 15%.
----------------------
Years Cash inflows Discounting factor Present Value of cash
----------------------
Rs. 15% inflows Rs.
---------------------- 1 35,000 0.870 30,450
2. 40,000 0.756 30,240
----------------------
3. 30,000 0.658 19,740
---------------------- 4. 50,000 0.572 28,600
1,09,030
----------------------
Less : Investment outlay 1,00,000
---------------------- Net Present Value (NPV) 9,030
---------------------- Acceptance Rule:
---------------------- As accept or reject criteria, all the projects which involve positive NPV i.e.
NPV > 0 will be accepted and vice versa.
---------------------- As a ranking method, the projects having maximum positive NPV, will be
---------------------- ranked highest.
Advantages:
----------------------
1. It considers time value of money.
----------------------
2. It considers cash inflows from the project throughout its life.
---------------------- Disadvantages:
---------------------- 1. It is difficult to use, calculate and understand.
---------------------- 2. It presupposes that the discounting rate, i.e. cost of capital is known. But
cost of capital is difficult to measure in practice.
----------------------
3. It may give dissatisfactory results, if the alternative projects involve
---------------------- varying investment outlay. A project involving maximum positive NPV
may not be desirable if it involves huge investment.
----------------------
4. It presupposes that the cash inflows can be reinvested immediately to yield
---------------------- the return equivalent to the discounting rate, which may not be possible
always.
----------------------

3. Internal Rate of Return: Notes
Internal Rate of Return (IRR) is that rate at which the discounted cash inflows
----------------------
match with discounted cash outflows. The indication given by IRR is that this is
the maximum rate at which the company will be able to pay towards the interest ----------------------
on amounts borrowed for investing in the projects, without losing anything.
Thus, IRR may be called as the ‘break even rate’ of borrowing for the company. ----------------------
In simple words, IRR indicates that discounting rate at which NPV is zero. If ----------------------
by applying 10% as the discounting rate, the resultant NPV is positive, while
by applying 12% discounting rate, the resultant NPV is negative, it means that ----------------------
IRR, i.e. the discounting rate at which NPV is zero, falls between 10% and 12%.
----------------------
Thus, by applying the trial and error method, one can find out the discounting
rate at which NPV is zero. The process to compute IRR will be to select any ----------------------
discounting rate and compute NPV. If NPV is negative, a lower discounting rate
should be tried and the process should be repeated till the NPV becomes zero. ----------------------
The following illustration explains the process to calculate IRR.
----------------------
Illustration:
----------------------
A project cost Rs. 1,00,000 and generates annual cash flows of Rs 35,000, Rs.
40,000, Rs. 30,000 and Rs. 50,000 over its life of 4 years. Calculate the Internal ----------------------
Rate of Return.
----------------------
Using 15% as a discounting rate, the present value of cash inflows can be
calculated as below: ----------------------
Year Cash inflows Rs. PV factor 15% Total PV Rs. ----------------------
1 35,000 0.870 30,450
----------------------
2 40,000 0.756 30,240
3 30,000 0.658 19,740 ----------------------
4 50,000 0.572 28,600
----------------------
1,09,030
Using 18% as discounting rate, the present value of cash inflows can be ----------------------
calculated as below: ----------------------
Year Cash inflows Rs. PV factor 18% Total PV Rs.
----------------------
1 35,000 0.847 29,645
2 40,000 0.718 28,720 ----------------------
3 30,000 0.609 18,270 ----------------------
4 50,000 0.516 25,800
1,02,435 ----------------------
NPV 2,435 ----------------------
Using 20% as discounting rate, the present value of cash inflows can be
----------------------
calculated as below:
----------------------
----------------------

Notes Year Cash inflows Rs. PV factor 20% Total PV Rs.
1 35,000 0.833 29,155
----------------------
2 40,000 0.694 27,760
---------------------- 3 30,000 0.579 17,370
4 50,000 0.482 24,100
----------------------
98,385
---------------------- NPV -1,615
---------------------- Thus, at 18% discounting rate, NPV, is Rs. 2,435 and at 20% discounting rate,
NPV is (-) Rs. 1,615. Hence, IRR is between 18% and 20%, i.e. more than 18%
---------------------- but less than 20%. Difference between PV at 18% and 20% is Rs. 4,050 (i.e. Rs.
---------------------- 1,02,435 – Rs. 98,385 and the negative NPV of Rs. 1,615 has to be covered by
this amount to arrive as IRR.
---------------------- IRR = Lower Rate +
---------------------- NPV at Lower Rate
x Difference between Rates
Difference between PV at two rates
----------------------
2435 X 2
---------------------- Thus, IRR will be = 18 + 4,050
----------------------
= 18 + 1.2
---------------------- = 19.2% (Appr.)
---------------------- Acceptance Rule:
---------------------- The computed IRR will be compared with the cost of capital. If the IRR is more
than or at least equal to the cost of capital the project may be accepted (IRR >
---------------------- Cost of Capital – Accept). If the IRR is less than cost of capital, the project may
---------------------- be rejected. (IRR < Cost of Capital – Reject)
Advantages:
----------------------
1. It considers time value of money.
----------------------
2. It considers cash inflows from the project throughout its life.
---------------------- 3. It can be computed even in the absence of the knowledge about the firm’s
cost of capital. But in order to draw the final conclusion, the comparison
----------------------
with the cost of capital is a must.
---------------------- Disadvantages:
---------------------- 1. It is difficult to use, calculate and understand.
---------------------- 2. It presupposes that the cash inflows can be reinvested immediately to

yield the return equivalent to the IRR. NPV method, on the other hand,
---------------------- presupposes that the cash inflows can be reinvested to yield the return
equivalent to the cost of capital, which is more realistic.
----------------------
----------------------

4. Profitability Index (PI)/Benefit Cost Ratio (B/C Ratio) Notes
It is the ratio between total discounted cash inflows and total discounted cash
----------------------
outflows. Thus, the Profitability Index can be computed as:
Σ Discounted cash inflows ----------------------
PI =
Σ Discounted cash outflows
----------------------
PI can be computed as gross one, as stated above, or as net one, which means
gross minus one. ----------------------
Illustration ----------------------
A project requires an outlay of Rs. 1,00,000 and earns the annual cash inflows ----------------------
of Rs. 35,000, Rs. 40,000, Rs. 30,000 and Rs. 50,000. Calculate, Profitability
Index assuming the discounting rate of 15%. ----------------------
Year Cash flows Discounting factor Discounted Cash Inflows ----------------------
Rs. @15% Rs.
----------------------
1 35,000 0.870 30,450
2 40,000 0.756 30,420 ----------------------
3 30,000 0.658 19,740
----------------------
4 50,000 0.572 28,600
1,09,030 ----------------------
Profitability Index can be calculated as: ----------------------
= Σ Discounted cash inflows
----------------------
Σ Discounted cash outflows
----------------------
Rs. 1,09,030
Thus, PI (Gross) = 1.09 ----------------------
Rs. 1,00,000
----------------------
PI (Net) 1.09 – 1.00 = 0.09
----------------------
As accept or reject criteria, the projects having the Profitability Index of more
than one will be accepted and vice versa. As a ranking method, the projects ----------------------
having highest profitability index will be ranked highest.
----------------------
Final choice of evaluation method:
Between the basic two types of techniques as described above, the techniques ----------------------
considering time value of money are generally preferred for the obvious reasons.
----------------------
However, the choice of the evaluation technique depends upon the objective
of the management in the investment decisions. The objective is naturally in ----------------------
the form of maximisation of wealth of the shareholders. As such, only those
projects will be in the interest of the shareholders, which can earn more rate of ----------------------
return than other alternative investment opportunities.
----------------------
----------------------
----------------------

Notes
----------------------

1. Payback Period Method can be used as an accept or _______ criteria
----------------------
or as a method of ranking the project.
---------------------- 2. Accounting rate of return (ARR) computes the _______________ on
the net investment in the project.
----------------------
----------------------
---------------------- Activity 2
---------------------- A project requires an outlay of Rs. 10 lacs and earns an annual cash inflow
---------------------- of Rs. 2 lacs for 8 years. Calculate the payback period.
----------------------
11.6 LIMITATIONS OF CAPITAL BUDGETING
----------------------
The basic limitation of the capital budgeting process lies in this fact that it
---------------------- involves various estimations. These estimations are specifically in respect of
---------------------- (a) Cash outflow
---------------------- (b) Revenues / Saving and costs attached with projects

(c) Life of the projects
----------------------
Whereas the cash outflows can be estimated with a reasonable accuracy, the
---------------------- cash inflows and life of the projects cannot be estimated accurately. Further, the
changes in fiscal and taxation policies of the Government also have the impact
----------------------
on determination of cash inflows. If the techniques use the discounted flows to
---------------------- evaluate the projects, the cost of capital is used as discounting rate. Difficulties
in deciding the cost of capital prove to be the limitation of capital budgeting
---------------------- process.
----------------------
11.7 EVALUATION CRITERIA IN CERTAIN TYPICAL
---------------------- SITUATIONS
---------------------- (a) In certain cases, the capital expenditure may not involve any specific
---------------------- inflow of funds, but only outflow of funds. E.g. If a machine manufactures
such products which themselves cannot be marketed, there may not be
---------------------- any specific inflow of funds associated with such machines. Under such
situations, if the company is required to make the choice between two
---------------------- machines, the company should choose that machine which involves less
---------------------- amount of present value of outflow of funds.
----------------------

Illustration: Notes
A company has to make a choice between buying of two machines. Machine
----------------------
A would cost Rs. 1,00,000 and require cash running expenses of Rs. 32,000
p.a. Machine B would cost Rs. 1,50,000 and its cash running expenses would ----------------------
amount to Rs. 20,000 p.a. Both the machines have a life of 10 years with zero
salvage value. The company follows a straight-line depreciation and is subject ----------------------
to 50% tax on its income. The company’s required rate of return is 10%. Which
----------------------
machine should it buy?
Note: Present value of Re. 1 p.a. for 10% discount rate is Rs. 61,446. ----------------------
Solution: ----------------------
Machine A ----------------------
Particulars Pre-tax Post-tax Years PV factor Total PV
----------------------
Amt. Amt. @10%
Cost of Machine 1,00,000 1,00,000 0 1.0000 1,00,000 ----------------------
Running Expenses 32,000 16,000 1-10 6.1446 98,314
----------------------
Depreciation (-)10,000 (-) 5,000 1-10 6.1446 (-) 30,723
Net Cash Outflow 1,67,591 ----------------------
Machine B ----------------------
Particulars Pre-tax Post tax Years PV factor Total PV ----------------------
Amt. Rs. Amt. Rs. @10% Rs.
----------------------
Cost of Machine 1,50,000 1,50,000 0 1.0000 1,50,000
Running Expenses 20,000 10,000 1-10 6.1446 61,446 ----------------------
Depreciation (-) 15,000 (-) 7,500 1-10 6.1446 (-) 46,085
----------------------
Net Cash Outflow 1,65,361
As the PV of net outflow of funds is less in case of Machine B, investment in ----------------------
Machine B will be accepted. ----------------------
(b) In certain cases, the capital expenditure may involve replacement of an
existing machinery or equipment, which is likely to result into the savings ----------------------
of costs. Under such situations, the inflow of funds is in the form of savings ----------------------
arising from the investment which should be considered in the light of
costs and benefits associated with a new proposal vis-à-vis the costs and ----------------------
benefits associated with an existing proposal which will not be available in
future. ----------------------
----------------------
11.8 PLANNING, ORGANISATION AND CONTROL OF
CAPITAL EXPENDITURE ----------------------
----------------------
It has already been discussed that the various proposals for incurring capital
expenditure may be generated either at top management level or even at lower ----------------------
management level though the latter is the rare possibility. The various proposals
generated are evaluated with the help of various techniques as discussed above. ----------------------

Notes The ultimate selection for proposals depends upon the evaluation made by these
techniques; however, the factors like urgency or availability of funds may also
---------------------- play an important role.
---------------------- The ultimate power to reject or accept various capital expenditure proposals
rests with the top management, which may be in the form of Board of Directors
---------------------- or Executive Committee or Management Committee. In some cases, the power
may rest with the Chairman or Managing Director. The proposals involving
----------------------
the outlay to a certain extent may fall within the powers of the chief executive
---------------------- also and the proposals involving the outlay beyond that extent will have to be
referred to top management as described above. If the actual implementation
---------------------- of the selected proposals involves the arrangement of funds from the financial
institutions or requires certain Government approvals, it is the responsibility of
----------------------
middle management to arrange for the same.
---------------------- If it is intended to exercise proper control on the capital budgeting process, an
organisation may be required to take the following steps.
----------------------
1. Planning: The capital expenditure has to be planned properly taking into
---------------------- consideration the present and future needs of the business. It should be
planned in such a way as to ensure the balanced development of all the
----------------------
sections of the organisation individually as well as of the organisation as a
---------------------- whole. Usually, the plans in respect of capital expenditure are prepared in
the form of capital expenditure budget. Care should be taken to select the
---------------------- period for which capital expenditure budget should be prepared. Too long
a period may not be useful.
----------------------
2. Evaluation: Utmost care should be taken while evaluating the capital
---------------------- expenditure proposals. As the capital expenditure proposals involve long-
---------------------- term and irreversible decisions, a wrong decision may disturb the entire
financial structure of the organisation. The evaluation of various proposals
---------------------- should be done as rationally as possible. Proper weightage should be given
to the elements of risk and uncertainly.
----------------------
3. Control over progress: Usually, the implementation of capital expenditure
---------------------- proposals are spread over more than one year. As such proper control
is required to be exercised over issue of work orders/purchase orders,
---------------------- acquisition of material, labour force and other assets, supply of funds etc.
---------------------- 4. Periodic and post completion audit: These are required to be conducted
in order to confirm whether the proposal has been implemented as per
---------------------- the original plan or not. If some faults are pointed out regarding planning
---------------------- process, they may be corrected while considering future projects. If some
faults are pointed out during mid-term review of the projects, corrective
---------------------- actions may be taken during the remaining period of implementation.
---------------------- 5. Forms and procedures: In order to ensure proper control over capital
expenditure, certain forms and procedures may be prescribed. Care should
---------------------- be taken that the said forms are used and procedures are followed at each
and every stage of implementation of the capital expenditure proposals.
----------------------

11.9 CAPITAL RATIONING Notes
The various techniques available with the company for evaluating the capital ----------------------
expenditure proposals facilitate the company to decide which of the projects may
be accepted. If the company has sufficient funds to invest in all the acceptable ----------------------
projects, the problem is very simple. However, it may not be the situation in
----------------------
practice. The company may not have enough funds to invest in all the acceptable
projects. Or the company may not be willing to acquire necessary funds to invest ----------------------
in all acceptable projects due to the external or internal reasons (E.g. Fixed
budget for capital expenditure). Thus, capital rationing refers to a situation ----------------------
where the company has more acceptable proposals requiring a greater amount
----------------------
of funds than is available with the company. As such, under capital rationing, it
is not only necessary to decide profitable investments, but it is also necessary ----------------------
to rank the acceptable proposals according to their relative profitabilities. With
limited funds, the company must obtain the optimum combination of acceptable ----------------------
investment proposals.
----------------------
The normal process that may be followed under the capital rationing situations
may be: ----------------------
(1) To rank the projects according to some measure of profitability. ----------------------

(2) To select projects in the descending order of profitability till the available ----------------------
funds are exhausted.
----------------------
However, the situation of capital rationing may involve the consideration of
other problems also. ----------------------
1. Project Indivisibility: Some projects may not be divided during execution.
----------------------
They can be either accepted or rejected in its entirety. These projects cannot
be undertaken partially or in pieces. ----------------------
Consider the following situation: ----------------------
The company has the following four acceptable proposals ranked according to
Profitability Index Method with the ultimate capital expenditure budget ceiling ----------------------
of Rs. 10,00,000. ----------------------
Project Project Cost Rs. Profitability Index Ranking
----------------------
A 5,00,000 1.25 1
B 3,50,000 1.20 2 ----------------------
C 2,50,000 1.18 3
D 1,00,000 1.15 4 ----------------------
According to capital rationing process, projects A and B can be executed ----------------------
completely. Project C is costing Rs. 2,50,000 whereas funds available after the
execution of projects A and B is only Rs. 1,50,000. If project C can be either ----------------------
accepted or rejected completely, the problem is how to face such a situation?
----------------------
2. Avoidance of smaller projects: If the process of capital rationing is strictly
followed, it may result into the exclusion of various smaller projects by ----------------------
larger projects though the smaller projects may be competitively profitable
----------------------
when compared with the larger projects. Consider the following situation.

Notes The company has the following four acceptable proposals ranked according to
Profitability Index Method with the ultimate capital expenditure budget ceiling
---------------------- of Rs. 10,00,000
---------------------- Project Project Cost Rs. Profitability Index Ranking
A 6,50,000 1.26 1
----------------------
B 3,50,000 1.25 2
---------------------- C 50,000 1.24 3
D 40,000 1.23 4
----------------------
If capital rationing process is to be applied strictly, projects A and B will be
---------------------- selected for execution, whereas projects C and D will be rejected though they
are equally profitable like projects A and B.
----------------------
3. Mutually Dependent Project: The projects available before the company
---------------------- may be basically of two types. Firstly, projects may be mutually exclusive
---------------------- i.e. the execution of one project rules out the possibility of execution of other
projects e.g. Five different machines are available for a company to carry
---------------------- out a job. If the company decides to purchase one machine, the possibility
of purchasing other four machines is ruled out. Secondly, projects may
---------------------- be mutually dependent i.e. the execution of one project depends upon the
---------------------- execution of another project.
Now under the capital rationing situation, if sufficient funds are available to
---------------------- invest only in machine A but not in B when investment in both the machines is
---------------------- mutually dependent, then the problem is how to face such a situation?
4. Multi Period Projects: There may some projects the execution of which
---------------------- cannot be completed in one accounting period, but their execution is spread
---------------------- over in various accounting periods. In such situations, the constraints of
capital rationing are required to be considered over all the subsequent
---------------------- periods also, which are required for the execution of the project.
----------------------
----------------------
----------------------
1. Under capital rationing situations, projects are ranked on the basis of
---------------------- profitability.
---------------------- 2. Capital rationing refers to a situation where company has more
acceptable proposals requiring equal amount of funds than is available.
----------------------
----------------------
Activity 3
----------------------
---------------------- If a company has four acceptable proposals ranked according to profitability

Index Method, which one will you select first? Justify your response.
----------------------

11.10 CAPITAL BUDGETING AND RISK Notes
The various techniques, as discussed above, for evaluating the capital ----------------------
expenditure proposals may be ideally applied in a riskless situation, which is
a rare possibility. As stated above, the capital budgeting process involves the ----------------------
estimation of various future aspects regarding future cash inflows, life of the
----------------------
project etc. The accuracy of these estimates and hence reliability of investment
decisions mainly depends upon the precision in the forecasting of these aspects. ----------------------
Howsoever carefully these aspects are forecast, there is always the possibility
that the actual situations may not correspond with these estimates. As such, the ----------------------
term risk with reference to investment decisions may be defined as the variability
----------------------
in the actual returns emanating from a project in future over its working life
in relation to the estimated return as forecast at the time of the initial capital ----------------------
budgeting decision.
----------------------
Several mathematical and non-mathematical methods have been developed to
consider the risk in capital budgeting decisions. We will consider mainly three ----------------------
methods that are commonly used.
----------------------
1. Informal Method:
----------------------
This method does not follow any mathematical or statistical model to consider
the risk factor. This is surely an informal or subjective method, which depends ----------------------
on the knowledge and experience of the evaluator. The standard fixed to consider
a project risky is strictly internal and is not specified. ----------------------
Illustration: ----------------------
A company has under consideration two mutually exclusive projects for
----------------------
increasing its plant capacity, the management has developed pessimistic, most
likely and optimistic estimates of the annual cash flows associated with each ----------------------
project. The estimates are as follows:
----------------------
Project A Project B
(Rs.) (Rs.) ----------------------
Net Investment 30,000 30,000 ----------------------
Cash flow estimates :
Pessimistic 1,200 3,700 ----------------------
Most likely 4,000 4,000 ----------------------
Optimistic 7,000 4,500
----------------------
(a) Determine the NPV associated with each estimate given for both the
projects. The projects have 20 years life each and the company’s cost of ----------------------
capital is 10%.
----------------------
(b) Which project do you consider should be selected by the company and
why? ----------------------
P.V. Factor is 8.514 ----------------------
----------------------

Notes Solution:
Calculation of NPV
----------------------
Pessimistic Most Optimistic
----------------------
Likely
---------------------- Project A :
Annual cash inflows 1,200 4,000 7,000
----------------------
Present value of Annual cash flows
---------------------- (At PV factor for 20 years) 10,217 34,056 59,598
Outflow 30,000 30,000 30,000
----------------------
NPV (-)19,783 4,056 29,598
---------------------- Project B :
Annual cash inflows 3,700 4,000 4,500
----------------------
Present value of Annual cash inflows
---------------------- (At PV factor for 20 years) 31,502 34,056 38,313
Outflow 30,000 30,000 30,000
----------------------
NPV 1,502 4,056 8,313
---------------------- Conclusion:
---------------------- It can be seen from the above calculations that in case of most likely cash
inflows, both the projects are equally profitable.
----------------------
However, Project A involves more risk as the variation of NPV in pessimistic
---------------------- conditions and optimistic conditions is more in case of Project A.
---------------------- As such, if risk involved with the projects is considered as the criteria, Project
B will be selected.
---------------------- 2. Risk adjusted discounting rate:
---------------------- According to this method, the discounting rate is used not only to consider the
futurity of the returns from the project but also to consider the risk involved with
---------------------- the project. As such, in this method, the discounting rate is increased in case of
---------------------- projects involving greater risk whereas it is reduced in case of projects involving
lesser risk. This can be explained with the help of the following illustration.
----------------------
Suppose that following two projects involving outflow of cash of Rs. 1200
---------------------- generate the cash inflows as below:
---------------------- Year Project A (Rs.) Project B (Rs.)

1 800 500
---------------------- 2 700 500
---------------------- 3 300 500
4 150 500
----------------------
Obviously, Project A is more risky than Project B. As such, the discounting
---------------------- rate of 14% is applied in case of Project A whereas the discounting rate of 10%
is applied in case of Project B, the difference of 4% being to take care of risk
---------------------- involved in case of Project A.

Thus, the computations of net present value are made as below: Notes
|Project A :
----------------------
Year Cash inflows Rs. PV factor 14% Total PV Rs.
1 800 0.877 701.60 ----------------------
2 700 0.769 538.30
----------------------
3 300 0.675 202.50
4. 150 0.592 88.80 ----------------------
1531.20
Less: Outflow 1200.00 ----------------------
NPV 331.20
Project B : ----------------------
Years Cash Inflow PV factor 10% Total PV Rs. ----------------------
1 to 4 500 per year 3.169 1,584.50
Less : Outflow 1,200.00 ----------------------
NPV 384.50
----------------------
As project B involves greater NPV, it will be accepted.
This method is advantageous in the sense that it is simple to understand ----------------------
and incorporates the risks attached with the future returns in case of capital ----------------------
expenditure proposals. However, this method certainly suffers from some
limitations. ----------------------
1. Additional discounting rate is considered to compensate for the risk ----------------------
attached to a project as compared to any other riskless project. How much
additional discounting rate will be sufficient to take care of this risk cannot ----------------------
be decided accurately, say with the help of any statistical or mathematical
formula. Charging additional discounting rate is a subjective concept to be ----------------------
decided by the evaluator of the proposals. ----------------------
2. This method takes into consideration the risk factor by considering
----------------------
additional discounting rate, however the cash inflows forecasted for the
future period are considered without taking into consideration the risk ----------------------
factor. E.g. if the cash inflows of Rs. 50,000 are estimated to be received
in a riskless situation, this method assumes that the amount of cash inflows ----------------------
will be the same even in a risky situation. As such, only the discounting
----------------------
rate is increased to take care of the risk factor.
3. This method presupposes that the investors are not willing to take the risk ----------------------
and may demand the compensation for assuming the risk. However, it
----------------------
ignores the possibility of existence of risk-seekers who may be willing to
pay premium for taking the risk. ----------------------
3. Certainty-Equivalent Approach:
----------------------
According to this method, rather than adjusting the discounting rate to take
care of the risk factor, the future cash inflows themselves are adjusted by ----------------------
using the certainty equivalent co-efficient which can be calculated as: ----------------------
Certainty Cash Inflows
Risky Cash Inflows ----------------------


Notes E.g., cash inflows from a project are expected to be Rs. 25,000, however
generation of cash inflow of Rs. 20,000 is most certain. As such, the certainty
---------------------- equivalent co-efficient can be computed as:
Rs. 20,000
----------------------
= 0.80
---------------------- Rs. 25,000
---------------------- Accordingly, depending upon the degree of risk, the certainty equivalent co-
efficient is decided. Higher the risk, lower the certainty equivalent co-efficient
---------------------- and vice versa.
---------------------- To explain this approach, the following illustration may be considered.
---------------------- Year Cash Certainty Adjusted Cash PV factor Total PV
Inflows Equivalent Inflows @10% Rs.
----------------------
Rs. Co-efficient Rs.
---------------------- 1 6,000 0.90 5,400 0.909 4,908.60
2 4,000 0.80 3,200 0.826 2,643.20
----------------------
3 2,000 0.70 1,400 0.751 1,051.40
---------------------- 4 4,000 0.60 2,400 0.683 1,639.20
10,242.40
----------------------
Less : Outflow 10,000.00
---------------------- NPV 242.40
----------------------
----------------------
1. A company is considering an investment proposal to install new milling
---------------------- controls. The project will cost Rs. 50,000. The facility has a life expectancy
of 5 years and no salvage value. The company’s tax rate is 55%. The firm
---------------------- uses straight-line depreciation, which is allowed for income tax purposes.
---------------------- The estimated cash flows before tax (CFBT) from the proposed investment
proposals are as follows:
----------------------
Year CFBT
---------------------- Rs
1 10,000
----------------------
2 11,000
---------------------- 3 14,000
4 15,000
----------------------
5 25,000
---------------------- Compute the following.
---------------------- i. Payback period
---------------------- ii. Average rate of return
----------------------

Solution: Notes
The Cash inflows in respect of the project can be computed as below:
----------------------
Cash flows = CFBT – Taxes
----------------------
= PAT + Depreciation
----------------------
Year CFBT Depreciation Taxable Taxes Profits Cash
income after taxes inflows ----------------------
(1.5)
(2-3) (4-5) or (6+3) ----------------------
1 2 3 4 5 6 7 ----------------------
1 10,000 10,000 0 0 0 10,000
----------------------
2 11,000 10,000 1,000 550 450 10,450
3 14,000 10,000 4,000 2,200 1,800 11,800 ----------------------
4 15,000 10,000 5,000 2,750 2,250 12,250
----------------------
5 25,000 10,000 15,000 8,250 6,750 16,750
11,250 61,250 ----------------------
Thus, the pay back period is after 4 years before 5 years. Pay back period – 4 ----------------------
years 4 months (Approx.)
50,000 - 44,500 ----------------------
X 365 = 120 days
----------------------
16,750
i. Pay Back Period ----------------------
Assuming that cash inflows accrue evenly during the year, the payback ----------------------
period i.e. the period within which the cost of the machine will be recovered
----------------------
by cash inflows can be computed as below:
Year Cash inflows Rs. Cumulative Cash inflows Rs. ----------------------
1 10,000 10,000 ----------------------
2 10,450 20,450
3 11,800 32,250 ----------------------
4 12,250 44,500 ----------------------
5 16,750 61,250
----------------------
Thus, the payback period is after 4 years before 5 years. Payback period approx.
4 years 4 months. ----------------------
50,000 - 44,500 ----------------------
X 365 = 120 days
16,750 ----------------------
----------------------
----------------------
----------------------

Notes ii. Average Rate of Return
It can be computed as –
----------------------
Total profits (after depreciation and taxes)
---------------------- = X 100
Net Investment in machine X No. of years of profits
----------------------
Rs. 11,250
---------------------- = X 100
Rs. 50,000 X 5
----------------------
= 4.5%
----------------------
2. A company has an investment opportunity costing Rs. 40,000 with the
---------------------- following expected net cash flow (i.e. after taxes and before depreciation).
---------------------- Year Net cash flows Rs.
1 7,000
----------------------
2 7,000
---------------------- 3 7,000
4 7,000
----------------------
5 7,000
---------------------- 6 8,000
7 10,000
----------------------
8 15,000
---------------------- 9 10,000
---------------------- 10 4,000
Using 10% as the cost of capital (rate of discount) determine the following:
----------------------
(a) Payback period.
----------------------
(b) Net Present Value of 10% discounting factor.
---------------------- (c) Profitability index at 10% discounting factor.
---------------------- (d) Internal rate of return with the help of 10% discounting factor and 15%
discounting factor.
----------------------
Solution:
---------------------- (a) Pay Back Period
---------------------- Year Cash inflows Cumulative cash inflow Rs.
---------------------- 1 7,000 7,000
2 7,000 14,000
----------------------
3 7,000 21,000
---------------------- 4 7,000 28,000
---------------------- 5 7,000 35,000
6 8,000 43,000
----------------------

7 10,000 53,000 Notes
8 15,000 68,000 ----------------------
9 10,000 78,000
----------------------
10 4,000 82,000
Thus, the pay back is more than 5 years and less than 6 years. The fraction can ----------------------
be computed as:
----------------------
Rs. 5000 X 12
= 7.5 months ----------------------
Rs. 8,000 ----------------------
Thus, payback period is 5 years and 7 and 1/2 months.
----------------------
(b) NPV Method
----------------------
Year Cash inflows PV Factor Total PV
Rs. 10% 15% 10% 15% ----------------------
1 7,000 0.909 0.870 6,363 6,090
----------------------
2 7,000 0.826 0.756 5,782 5,292
3 7,000 0.751 0.658 5,257 4,606 ----------------------
4 7,000 0.683 0.572 4,781 4,004 ----------------------
5 7,000 0.621 0.497 4,347 3,479
6 8,000 0.564 0.432 4,512 3,456 ----------------------
7 10,000 0.513 0.376 5,130 3,760 ----------------------
8. 15,000 0.467 0.327 7,005 4,905
9 10,000 0.424 0.284 4,240 2,840 ----------------------
10 4,000 0.386 0.247 1,544 988 ----------------------
48,961 39,420
Less : Outflow 40,000 40,000 ----------------------
NPV 8,961 (-) 580 ----------------------
Hence, NPV at 10% Rs. 8,961
at 15% (-) Rs. 580 ----------------------
(c) Profitability Index ----------------------
It can be calculated as : ----------------------
∑ Discounted cash inflows ----------------------
∑ Discounted cash outflows
----------------------
At 10% Discounting rate ----------------------
48,961
PI = = 1.224 ----------------------
40,000
----------------------
----------------------

Notes At 15% Discounting rate
39,420
---------------------- PI = = 0.9855
40,000
----------------------
(d) Internal Rate of Return
----------------------
At 10% discounting rate, NPV is Rs. 48,961 and at 15%, discounting rate NPV
---------------------- is Rs. 39,420. Hence, IRR is between 10% and 15% i.e. more than 10% but
less than 15%. Difference between NPV at 10% and 15% is Rs. 9,541 (i.e. Rs.
----------------------
48,961 – Rs. 39,420) and the negative NPV of Rs. 580 has to be covered by this
---------------------- amount to arrive at IRR.
---------------------- 580 X 5
Thus, IRR will be = 15% –
9541
----------------------
= 15% – 0.30 %
---------------------- = 14.70% [ Two decimal]
----------------------
Summary
----------------------
• This chapter introduces the important concept of Capital Budgeting and its
---------------------- process. Capital Budgeting includes analysis of various proposals regarding
---------------------- capital expenditure to evaluate their impact on the financial situation of
the company and to choose the best out of the various alternatives. The
---------------------- process of capital budgeting generally involves project generation, project
evaluation, project selection, project execution.
----------------------
• There are two broad categories of techniques of evaluation of capital
---------------------- expenditure proposals.
---------------------- • Techniques not considering time value of money: It includes a) Payback
period- payback period indicates the period within which the cost of the
---------------------- project will be completely recovered. b) Accounting Rate of Return – it
computes the average annual yield on the net investment in the project.
----------------------
• Techniques considering time value of money: It includes a) Discounted
---------------------- Payback period – it indicates that period within which the discounted cash
inflows equal to the discounted cash outflows involved in the project. b)
----------------------
Net Present Value – it is a method of calculating present value of cash
---------------------- inflows and cash outflows in an investment project. c) Internal Rate of
Return – it is that rate at which the discounted cash inflows match with
---------------------- discounted cash outflows. d) Profitability index / Benefit Cost Ratio – it is
the ratio between total discounted cash inflows and total discounted cash
----------------------
outflows.
---------------------- • Capital rationing refers to a situation where the company has more
---------------------- acceptable proposals requiring a greater amount of funds than is available
with the company.
----------------------

Keywords Notes
----------------------
• Capital: The amount invested in fixed assets for undertaking a project
• Budgeting: Is taking a decision as to whether money should be invested in ----------------------
long-term projects
----------------------
• Evaluation: Considering a project from its various angles to know the
pros and cons ----------------------
----------------------
----------------------
1. What are the advantages of risk adjusted discounting rates? What is the
----------------------
major problem in using this approach to handle risk in capital budgeting?
2. What is meant by capital rationing? State and explain the problems involved ----------------------
in it.
----------------------
3. Write a detailed note on organisation for planning and controlling capital
expenditure. ----------------------
4. “Payback period, as a method of evaluating investment proposals, suffers ----------------------
from a number of serious limitations.” Discuss.
----------------------
5. Enumerate the major criteria of selecting investment projects under
uncertain conditions. ----------------------
a. Net present value method
----------------------
b. Capital Rationing
----------------------
c. Internal Rate of Return method
----------------------
----------------------
----------------------
Fill in the blanks.
----------------------
1. The process of capital budgeting involves proposal to reduce cost without
affecting scale of operation. ----------------------
2. The process of evaluation of the projects necessarily involves Cost Benefit ----------------------
Analysis.
----------------------
----------------------
----------------------
----------------------

Notes 1. True
2. True
----------------------
----------------------
Fill in the blanks.
---------------------- 1. Payback Period Method can be used as an accept or reject criteria or as a
---------------------- method of ranking the project.
2. Accounting rate of return (ARR) computes the average annual yield on the
---------------------- net investment in the project.
1. True
----------------------
2. False
----------------------
---------------------- 1. Khan & Jain. Financial Management
---------------------- 2. Christine Robertson. Financial Management: Review of Education’s Grant
Back Account
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Working Capital Management
UNIT
12
Structure:
12.1 Introduction
12.2 Working Capital – The Term
12.3 Principles of Working Capital Management
12.4 Factors affecting Working Capital Requirement
12.5 Financing of Working Capital Requirement
12.6 Control over Working Capital
Summary
Key Words
Suggested Reading
Working Capital Management 247

Notes
Objectives
----------------------
----------------------
• Explain the concept of working capital and its management
----------------------
• Identify the factors affecting working capital requirement
---------------------- • Specify various sources of finance for working capital
---------------------- • Appreciate the recommendations of different committees appointed by
RBI for control over working capital finance
----------------------
----------------------
12.1 INTRODUCTION
----------------------
In the previous units, we have seen that whatever funds are raised by a company
----------------------
can be applied for two purposes:
---------------------- a. To acquire fixed assets, the technical terminology used being Capital
Budgeting.
----------------------
b. To invest in the current assets, technical terminology used being Working
---------------------- Capital Management.
---------------------- Working capital management is considered one of the most important functions
of finance, as a very large amount of funds is blocked in current assets in
---------------------- practical circumstances. Unless working capital is managed properly, it may
---------------------- lead to the failure of business.
---------------------- 12.2 WORKING CAPITAL – THE TERM

---------------------- The term ‘Working Capital’ may mean Gross Working Capital or Net Working
Capital. Gross Working Capital means Current Assets. Net Working Capital
----------------------
means Current Assets less Current Liabilities. Unless otherwise specified,
---------------------- Working Capital means Net Working Capital. As such, Working Capital
Management refers to proper management of Current Assets and Current
---------------------- Liabilities.
---------------------- The term current assets refers to those assets held by a business which can be
converted in the form of cash or used during the course of normal operations
---------------------- within a short span of time say one year, without any reduction in value. Current
---------------------- assets change the shape very frequently. The current assets ensure smooth and
fluent business operations and are considered the life-blood of the business. In
---------------------- case of a manufacturing organisation, current assets may be found in the form
of stocks, receivables, cash and bank balances and sundry loans and advances.
----------------------
The term current liabilities refers to those liabilities, which are to be paid off
---------------------- during the course of business, within a short span of time say one year. They
are expected to be paid out of current assets or the earnings of the business.
----------------------

Current liabilities consist of sundry creditors, bills payable, bank overdraft or Notes
cash credit, outstanding expenses etc.
----------------------

1. Unless otherwise specified, Working Capital always means Net ----------------------
Working Capital.
----------------------
2. The basic objective of Working Capital Management is to avoid
investment in Current Assets. ----------------------
----------------------
Activity 1 ----------------------
----------------------
Observe any manufacturing process and list out the factors, which comprise
part of the working capital needs of that manufacturing process. ----------------------
----------------------
12.3 PRINCIPLES OF WORKING CAPITAL MANAGEMENT
----------------------
The basic objective of Working Capital Management is to avoid over investment
----------------------
or under investment in Current Assets, as both the extremes involve adverse
consequences. Over investment in Current Assets may lead to the reduced ----------------------
profitability due to cost of funds blocked, extra storing space required, extra
efforts for follow up and recovery required, possibility of malpractice etc. The ----------------------
objective of Working Capital Management is to ensure Optimum Investment in
----------------------
Current Assets. In other words, Working Capital Management intends to ensure
that the investment in Current Assets is reduced to the minimum possible extent. ----------------------
However, the normal operations of the organisation should not be affected
adversely. If the normal operations of the organisation are affected adversely, ----------------------
reducing the investment in Current Assets is fruitless.
----------------------
Why does the need for Working Capital arise?
----------------------
Generally, it will not be possible for any organisation to operate without the
working capital. Let us assume that a manufacturing organisation commences ----------------------
its business with a certain amount of cash. This cash will be invested to buy
the raw material. The raw material purchased will be processed with the help ----------------------
of various infrastructural facilities like labour, machinery etc. to convert the
----------------------
same in the form of finished products. These finished products will be sold
in the market on credit basis whereby the receivables get created. And when ----------------------
receivables make the payment to the organisation, cash is generated again. As
such, there is a cycle in which cash available to the organisation is converted ----------------------
back in the form of cash. This cycle is referred to as Working Capital Cycle.
----------------------
----------------------

Notes Cash
----------------------
Debtors Raw Material
----------------------
----------------------
Finished Goods
----------------------
In between each of these stages, there is some time gap involved. The entire
---------------------- requirement of working capital arises due to this time gap. As this time gap
---------------------- is unavoidable, requirement of working capital is unavoidable. The finance
professional is interested in reducing this time gap to the minimum possible
---------------------- extent in order to manage the working capital properly.
----------------------
12.4 FACTORS AFFECTING WORKING CAPITAL REQUIREMENT
----------------------
a. Nature of business
---------------------- Some businesses are such that due to their very nature, their requirement
---------------------- of fixed capital is more rather than working capital. These businesses may
sell services and not the commodities and that too on cash basis. As such,
---------------------- no funds are blocked in piling the inventories and no funds are blocked in
receivables. E.g. Public utility services like railways, electricity boards,
---------------------- infrastructure oriented projects etc. Their requirement of working capital is
---------------------- less. Whereas if the organisation is a trading organisation, the requirement
of working capital will be on the higher side, as huge amount of funds get
---------------------- blocked in mainly two types of current assets, stock and receivables.
---------------------- b. Size of the organisation
In small-scale organisations, requirement of working capital is quite high
----------------------
due to high amount of overheads, high buying costs and high selling costs.
---------------------- As such, medium sized organisations have an edge over the small-scale
organisations. However, if the business grows beyond a certain limit, the
---------------------- requirement of working capital may be adversely affected by the increasing
size.
----------------------
c. Phase of trade cycles
----------------------
During the inflationary conditions, the working capital requirement will
---------------------- be on the higher side as the company may like to buy more raw material,
may increase the production to take the advantage of favourable market
---------------------- conditions and due to increased sales more funds are blocked in stocks and
---------------------- receivables. During the depression, the requirement of working capital will
be on the lower side due to reduced operations but more working capital
---------------------- may be required due to piling up of inventories and due to non-payment of
dues by customers in time. As such, in both the extreme situations of trade
---------------------- cycles, requirement of working capital may be high.
----------------------

d. Trading terms Notes
The terms on which the organisation makes the purchases and sales affect
----------------------
the requirement of working capital in a big way. If the purchases are
required to be made on cash basis and sales are to be made on credit basis ----------------------
to cope with competition existing in the market, it will result into high
requirement of working capital. Whereas, if the purchases can be made ----------------------
on credit basis and sales can be made on cash basis, it will reduce the
----------------------
requirement of working capital, as a part of working capital requirement
can be financed out of credit offered by the suppliers. ----------------------
e. Length of production cycle
----------------------
The term production cycle refers to the time duration from the stage raw
material is acquired till the stage the finished product is manufactured. ----------------------
The principle will be “longer the duration of production cycle, higher the
----------------------
requirement of working capital”. In some businesses like machine tool
industry, the time gap between the acquisition of raw material till the ----------------------
completion of production is quite high. As such, more amount is blocked in
raw materials or work in progress or finished goods and even in receivables. ----------------------
Requirement of working capital is always very high in this case, whereas in
----------------------
case of the industries like paper industry or sugar industry, the production
cycle is very short. As such, the requirement of working capital, at least for ----------------------
stocks, may be very less.
----------------------
f. Profitability
High profitability reduces the strain on working capital as the profit to the ----------------------
extent they are earned in cash can be used for financing the requirement ----------------------
of working capital. However, the profit that reduces the strain on working
capital is the post-tax profit (i.e. the profit earned after paying off the tax ----------------------
liability) and post-dividend profit (i.e. the profit remaining in the business
after paying the dividend on the shares.) ----------------------
----------------------
----------------------
Fill in the blanks.
1. The working capital requirement in respect of Public Utility Services ----------------------
such as railways, electricity is ________ than that required in a
----------------------
production unit.
2. If purchases are on Cash basis and sales are made on credit basis, it ----------------------
will result into __________ working capital requirement. ----------------------
3. _______ profitability reduces the strain on working capital.
----------------------
----------------------
----------------------

Notes 12.5 FINANCING OF WORKING CAPITAL REQUIREMENT
---------------------- Before we go ahead with the discussions on the various methods available for
financing the working capital requirement, the term working capital needs to be
---------------------- viewed from one more angle.
---------------------- a. Fixed or Permanent Working Capital
---------------------- b. Variable or Temporary Working Capital

Fixed Working Capital is the minimum working capital required to be maintained
----------------------
in the business on permanent or uninterrupted basis. The requirement for this
---------------------- type of working capital is unaffected due to the changes in the level of activity.
Variable working capital is the working capital required over and above the
----------------------
fixed or permanent working capital and changes with the fluctuations in the
---------------------- level of activity as a result of changes in production and sales. The relationship
between fixed and variable working capital can be shown with the help of the
---------------------- following diagram.
----------------------
Amount of
----------------------
Working
Capital
Temporary
----------------------
----------------------
Permanent
----------------------
---------------------- The basic principle of finance states that the permanent requirement of working
capital should be financed out of long-term or permanent sources viz. own
---------------------- generation of funds, cash profits, shares or debentures etc.
---------------------- For financing temporary requirement of working capital, the organisation can
go for various sources, which can be discussed as below:
----------------------
a. Spontaneous Sources
----------------------
b. Inter-Corporate Deposits
---------------------- c. Commercial Papers
---------------------- d. Banks
---------------------- a. Spontaneous Sources

Spontaneous Sources for financing the working capital requirement arise
---------------------- during the course of normal business operations. During the course of
---------------------- business operations, the company may be able to buy certain goods or
services for which the payment is to be made after a certain time gap.
---------------------- As such, the company is able to buy goods or services without making
payment for the same. These spontaneous sources are unsecured in nature
---------------------- and vary with the level of sales. These spontaneous sources do not have any
---------------------- explicit cost attached to the same. They are generally known as ‘Current
Liabilities.’
Following forms of current liabilities may be used as spontaneous sources Notes
for financing the working capital requirement.
----------------------
1. Trade Credit:
If the company buys the raw material from the suppliers on credit basis, ----------------------
it gets the raw material for utilisation immediately with the facility
----------------------
to make the payment at a delayed time. By accepting the delayed
payment, the suppliers of raw material finance the requirement of ----------------------
working capital. For using this source, certain factors may play an
important role – ----------------------
• Trends in the industry ----------------------
• Liquidity position of the company ----------------------
• Earnings of the company over a period of time
----------------------
• Record of payment by the company to the suppliers over a period
of time ----------------------
• Relationship of the company with the suppliers. ----------------------
2. Outstanding Expenses
----------------------
All the services enjoyed by the company are not required to be paid
for immediately. They are paid for after a certain time gap. As such, ----------------------
the company is able to get the benefit of these services without paying ----------------------
for the same immediately, thus getting the finance for working capital
purposes. These are called ‘outstanding expenses’. This may apply ----------------------
to salaries, wages, telephone expenses, electricity expenses, water
charges etc. ----------------------
b. Inter-Corporate Deposits (ICD) ----------------------
Intercorporate Deposits indicate the amount of funds borrowed by one ----------------------
company from another company, usually both the companies being under
the same management but not necessarily so. Point to be noted here is that ----------------------
ICDs are not considered deposits as per the provisions of Section 58-A of
the Companies Act, 1956 and as such, the regulations applicable to the ----------------------
public deposits do not apply to ICDs. ----------------------
Intercorporate Deposits as a source for financing the working capital
----------------------
requirement has the following characteristic features.
1. ICDs are for a very short period of time, viz. three months or six ----------------------
months.
----------------------
2. ICDs is an unsecured source for raising the funds required for working
capital purposes. ----------------------
3. ICDs, as a source, is not regulated by any law. As such, the rate of ----------------------
interest, period of ICD etc. can be decided by the company on its own.
----------------------
4. ICDs is a relationship based borrowing made by the company.
----------------------

Notes c. Commercial Papers
In the recent past, Commercial Papers (CPs) have become one of the best
----------------------
methods for financing the working capital requirements of the companies.
---------------------- The companies trying to raise the funds by issuing the CP are regulated
by Guidelines for issue of Commercial Papers (CPs), 2000 issued by
----------------------
Reserve Bank of India on October 10, 2000. These guidelines apply to
---------------------- the companies trying to raise the funds by issuing the CPs. As per these
guidelines, a company means a company as defined in Section 45-I (aa)
---------------------- of Reserve Bank of India Act, 1934. Section 45-I (aa) of Reserve Bank
Act, 1934 defines a company as the company as defined in section 3 of the
----------------------
Companies Act, 1956.
---------------------- What is a CP:
---------------------- Commercial Paper is an unsecured promissory note issued at a discount. The
rate of discount is required to be decided by the issuer and is not regulated. E.g.,
---------------------- ACP of Rs. 100 may be issued at Rs. 98, indicating that the investor has to pay
---------------------- Rs. 98 while at the time of maturity, he will get Rs. 100. It means that difference
between Rs. 98 and Rs. 100 i.e. Rs.2 is in the form of interest on investment
---------------------- made by the investor.
---------------------- Who can issue the CP:
A company will be eligible to issue the CP provided:
----------------------
a. The tangible net worth of the company as per latest audited balance sheet
---------------------- is not less than Rs. 4 Crore.
---------------------- Note: Tangible net worth means share capital plus free reserves duly
reduced by intangible assets like accumulated losses, deferred revenue
---------------------- expenditure etc. Free Reserves include share premium and debenture
---------------------- redemption reserve but do not include revaluation reserve.
b. Company has been sanctioned working capital limits by banks.
----------------------
c. Borrowed amount of the company is classified as a standard asset by the
---------------------- bank.
---------------------- Before the company issues the CPs, it is required to obtain satisfactory credit
rating from an approved credit rating agency. Presently, following credit rating
---------------------- agencies have been approved by RBI for this purpose.
---------------------- a. Credit Rating Information Services of India Ltd. (CRISIL)
b. Investment Information and Credit Rating Agency of India Ltd. (ICRA)
----------------------
c. Credit Analysis and Research Ltd. (CARE)
----------------------
d. FITCH Rating India (P) Ltd.
---------------------- The minimum credit rating required is P-2 of CRISIL. If the rating is given by
---------------------- any other agency, equivalent minimum rating will be required. The rating so
obtained by the company should be current and should not have fallen due for
---------------------- review.

Who can invest in CP: Notes
Following persons can invest in the CP
----------------------
a. Individuals
----------------------
b. Banks
c. Corporate Bodies incorporated in India ----------------------
d. Unincorporated Bodies ----------------------
e. Non-resident Indians ----------------------
f. Foreign Institutional Investors
----------------------
Nature of a CP:
----------------------
a. A CP can be issued for the maturity period of 7 days to one year.
b. A CP has the denomination of Rs. 5 Lakh and every single investor should ----------------------
invest minimum Rs. 5 Lakh in the CP. ----------------------
c. Every issue of CP, including the renewal, will be considered to be the fresh
issue. ----------------------
d. The amount of CP shall be within the overall limit sanctioned by the Board ----------------------
of Directors. It can be issued as a ‘stand alone’ product. Banks will be free
----------------------
to adjust the working capital limits after considering the CPs issued by the
company. ----------------------
It will not be out of place to mention here that CP is not treated as a deposit as
----------------------
per the provisions of Section 58-A of the Companies Act, 1956.
Procedure for issuing the CPs: ----------------------
Every company issuing the CP should appoint a scheduled bank as the Issuing ----------------------
and Paying Agent (IPA). IPA will satisfy itself that the company has obtained
satisfactory credit rating. It shall also verify the documents submitted by the ----------------------
issuing company and issue a certificate that the documents are in order. IPA ----------------------
should also certify that it has a valid agreement with the issuing company.
The issuing company shall arrange to place the CPs on private placement basis ----------------------
with the investors. The issuing company shall disclose to the potential investor ----------------------
its financial position. After the deal is confirmed, the issuing company shall
issue physical certificates to the investor. Investors shall be given a copy of IPA ----------------------
certificate to the effect that the issuing company has a valid agreement with the
IPA and documents are in order. ----------------------
Every issue of CP should be reported to RBI through the IPA within three days ----------------------
from the date of completion of the issue.
----------------------
Advantages of Commercial Papers:
----------------------
a. As CPs are required to be rated, good rating reduces the cost of capital for
the company. ----------------------
b. CP is one of the best possible ways available to the company to take the
----------------------
advantage of short-term interest fluctuations in the market.

Notes c. CP being the negotiable instrument, it provides the exit option to the
investor to quit the investment.
----------------------
d. As CPs are unsecured, no charge is required to be created on the assets of
---------------------- the issuing company.
Disadvantages of Commercial Papers:
----------------------
a. CP is a source for short-term financing available only to a few selected blue
---------------------- chip and profitable companies.
---------------------- b. By issuing CP, the credit available from the banks may get reduced.
---------------------- c. Issue of CP is very closely regulated by the RBI guidelines.

d. Banks
----------------------
In the Indian circumstances, banks play a very major role in financing the
---------------------- working capital requirement of the organisations. We will consider the bank
as a source for financing the working capital requirement of the organisations
----------------------
under the following heads:
---------------------- a. What should be the amount of assistance?
---------------------- b. What should be the form in which working capital assistance is extended?
---------------------- c. What security should be obtained for working capital assistance?

d. What are the various applicable regulations to be considered by the banks
---------------------- while extending the working capital assistance?
---------------------- 1. Amount of Assistance
---------------------- To obtain the bank credit for financing the working capital requirements, the
company is required to estimate the working capital requirement properly.
---------------------- To estimate the requirement of working capital requirement properly, the
company will be required to estimate its level of current assets and current
----------------------
liabilities properly, as working capital is the difference between current
---------------------- assets and current liabilities. For this, the techniques like ratio analysis,
trend analysis etc. can be used by the company. More accurate the estimation
---------------------- of the level of current assets and current liabilities, more accurate will be
estimation of the requirement of working capital. Then, the company will
----------------------
have to approach the bank along with the necessary supporting data. On the
---------------------- basis of the estimates submitted by the company, the bank may decide the
amount of assistance that can be extended. While extending the working
---------------------- capital assistance, the bank may prescribe the margin money requirement.
The margin money stipulation is made by the banks in order to ensure the
----------------------
borrowing company’s own stake in the business and also to provide the
---------------------- cushion against the possible reduction in the value of security offered to
the bank. The percentage of margin money stipulation may depend upon
---------------------- the credit standing of the borrowing company, fluctuations in the price
of the security and the directives of RBI from time to time. The general
----------------------
principle applicable will be, “the dicier the nature of security, the higher
---------------------- will be the margin money stipulations.”

2. Form of Assistance: Notes
After deciding the amount of overall assistance to be extended to the
----------------------
company, the bank can disburse the amount in any of the following forms:
Non-Fund Based Lending ----------------------
In case of Non-Fund Based Lending, the lending bank does not commit any ----------------------
physical outflow of funds. As such, the funds position of the lending bank
remains intact. The Non-Fund Based Lending can be made by the banks in two ----------------------
forms:
----------------------
a. Bank Guarantees:
----------------------
The mechanism of bank guarantees is described below:
Suppose Company A is the selling company and Company B is the purchasing ----------------------
company. Company A does not know Company B and as such is concerned ----------------------
whether Company B will make the payment or not. In such circumstances,
D who is the Bank of Company B, opens the Bank Guarantee in favour of ----------------------
Company A in which it undertakes to make the payment to Company A, if
Company B fails to honour its commitment to make the payment in future. As ----------------------
such, interests of Company A are protected as it is assured to get the payment, ----------------------
either from Company B or from its Bank D. As such, Bank Guarantee is the
mode, which will be found typically in the seller’s market. As far as Bank D ----------------------
is concerned, while issuing the guarantee in favour of Company A, it does not
commit any outflow of funds. As such, it is a Non-Fund Based Lending for Bank ----------------------
D. If on due date, Bank D is required to make the payment to Company A due ----------------------
to failure on account of Company B to make the payment, this Non-Fund Based
Lending becomes the Fund based Lending for Bank D which can be recovered ----------------------
by Bank D from Company B. For issuing the Bank Guarantee, Bank D charges
the Bank Guarantee Commission to Company B, which is decided on the basis ----------------------
of two factors, viz. the amount of Bank Guarantee and the period of validity ----------------------
of Bank Guarantee. In case of this conventional form of Bank Guarantee, both
Company A as well as Company B is benefited. Company A is benefited as it ----------------------
is assured to get the payment. Company B is benefited, as it is able to make the
credit purchases from Company A without knowing Company A.As such, Bank ----------------------
Guarantee transactions will be applicable in case of credit transactions. ----------------------
In some cases, interests of purchasing company are also to be protected. Suppose
----------------------
that Company A which manufactures capital goods takes some advance from
the purchasing Company B. If Company A fails to fulfill its part of the contract ----------------------
to supply the capital goods to Company B, there needs to be some protection
available to Company B. In such circumstances, Bank C, which is the banker ----------------------
of Company A, opens a Bank Guarantee in favour of Company B in which
----------------------
it undertakes that if Company A fails to fulfill its part of the contract, it will
reimburse any losses incurred by Company B due to this non-fulfillment of ----------------------
contractual obligations. Such Bank Guarantee is technically referred to as
Performance Bank Guarantee and is ideally found in the buyer’s market. ----------------------
----------------------

Notes b. Letter of Credit:
The non-fund based lending in the form of Letter of Credit (LC) is very
----------------------
regularly found in the international trade. In this case, the exporter and importer
---------------------- are unknown to each other. Under these circumstances, the exporter is worried
about getting the payment from importer and the importer is worried as to
---------------------- whether he will get the goods or not. In this case, the importer applies to his
bank in his country to open a letter of credit in favour of the exporter whereby
----------------------
the importer’s bank undertakes to pay the exporter or accept the bills or drafts
---------------------- drawn by the exporter on the exporter fulfilling the terms and conditions
specified in the letter of credit. Thus, there are essentially three parties in the
---------------------- case of a letter of credit:
---------------------- a. The Importer
b. The Issuer who is the bank of the importer
----------------------
c. The Exporter who is the beneficiary in case of Letter of Credit
----------------------
In practical circumstances, there may be some other parties involved in case of
---------------------- Letter of Credit.
---------------------- a. Advising Bank – This bank is in the exporter’s country, which notifies the
exporter about opening of Letter of Credit.
----------------------
b. Confirming Bank – If the exporter is not satisfied about the security offered
---------------------- by the importer, he may insist that the letter of credit be confirmed by any
other bank, other than the issuing bank. In this case, both the banks are
---------------------- liable to honour the bills of exchanges.
---------------------- The letter of credit may be of different varieties.
a. Revocable or Irrevocable – In case of revocable letter of credit, the issuing
----------------------
bank can cancel or change the obligation to make the payment or honour
---------------------- the bills or drafts drawn upon it. In case of irrevocable letter of credit, the
issuing bank agrees not to cancel or modify the terms of Letter of Credit.
----------------------
b. Confirmed or Unconfirmed – If the exporter is not satisfied with the security
---------------------- offered by the importer, he insists upon the confirmation of a bank, other
than the issuing bank which guarantees the payment and/or acceptance of
---------------------- the drafts or bills drawn by the exporter. In case of unconfirmed letter of
---------------------- credit, there is no such confirmation.
The combination of irrevocable and confirmed letter of credit can be considered
---------------------- to be a guaranteed payment on the part of the exporter.
---------------------- The mechanism of letter of credit proves to be beneficial for the exporter as well
as the importer.
----------------------
Advantages to the Exporter:
----------------------
a. Exporter is assured to get the payment for the goods exported by him, if
---------------------- he satisfies all the terms and conditions specified in the letter of credit.
This eliminates the risk of dealing with an unknown importer in a different
---------------------- country.

b. If the exporter has fulfilled all the terms and conditions of the letter of Notes
credit, he can approach his local bank and get the advance pending against
export proceeds receivable from the importer. ----------------------
Advantages to the Importer: ----------------------
a. The issuing bank specifies various terms and conditions in the letter of
----------------------
credit, which are required to be fulfilled by the exporter, compliance of
which is carefully examined by the issuing bank. As such, the importer is ----------------------
assured to get a proper supply of the goods.
----------------------
b. As the letter of credit assures the payment to the exporter, the importer can
bargain for better trading terms with the exporter. ----------------------
It should be noted here that the mechanism of letter of credit could be equally ----------------------
applicable in case of domestic trade also.
Fund based lending ----------------------
In case of Fund Based Lending, the lending bank commits the physical outflow ----------------------
of funds. As such, the funds position of the lending bank does get affected. The
Fund Based Lending can be made by the banks in the following forms: ----------------------
1. Loan: In this case, the entire amount of assistance is disbursed at one ----------------------
time only, either in cash or by transfer to the company’s account. It is a
----------------------
single advance. The loan may be repaid in installments, the interest will be
charged on outstanding balance. ----------------------
2. Overdraft: In this case, the company is allowed to withdraw in excess
----------------------
of the balance standing in its Bank account. However, a fixed limit is
stipulated by the Bank beyond which the company will not be able to ----------------------
overdraw the account. Granting of the assistance in the form of overdraft
presupposes the opening of a formal current account. Legally, overdraft is ----------------------
a demand assistance given by the bank i.e. bank can ask for the repayment
----------------------
at any point of time. Overdraft is given by the bank for a very short period,
at the end of which the company is supposed to repay the same. Interest ----------------------
is payable on the actual amount drawn and is calculated on daily product
basis. ----------------------
3. Cash Credit: In practice, the operations in cash credit facility are similar ----------------------
to those of overdraft facility except the fact that the company need not have
a formal current account. Here also a fixed limit is stipulated beyond which ----------------------
the company is not able to withdraw the amount. Legally, cash credit also ----------------------
is a demand facility, but in practice, it is on continuous basis. Here also,
the interest is payable on actual amount drawn and is calculated on daily ----------------------
product basis.
----------------------
4. Bills Purchased / Discounted: This form of assistance is comparatively
of recent origin. This facility enables the company to get the immediate ----------------------
payment against the credit bills/invoices raised by the company. The bank
holds the bills as a security till the payment is made by the customer. The ----------------------
entire amount of bill is not paid to the company. The company gets only ----------------------

Notes the present worth of the amount of the bill, the difference between the
face value of the bill and the amount of assistance being in the form of
---------------------- discount charges. However, on maturity, the bank collects the full amount
of bill from the customer. While granting this facility to the company, the
---------------------- bank inevitably satisfies itself about the credit worthiness of the customer
---------------------- and the genuineness of the bill. A fixed limit is stipulated in case of the
company, beyond which the bills are not purchased or discounted by the
---------------------- bank.
---------------------- 5. Working Capital Term Loans: To meet the working capital needs of the
company, banks may grant the working capital term loans for a period of 3
---------------------- to 7 years, payable in yearly or half yearly installments.
---------------------- 6. Packing Credit: This type of assistance may be considered by the bank to
take care of specific needs of the company when it receives some export
---------------------- order. Packing credit is a facility given by the bank to enable the company
to buy/manufacture the goods to be exported. If the company holds a
----------------------
confirmed export order placed by the overseas buyer or an irrevocable
---------------------- letter of credit in its favour, it can approach the bank for packing credit
facility. Basically, packing credit facility may take two forms:
----------------------
i) Pre-shipment Packing Credit: To take care of needs of the company
---------------------- before the goods are shipped to the overseas buyer.
---------------------- ii) Post-shipment Packing Credit: To take care of needs of the company
from the shipment of goods to the overseas buyer till the date of
---------------------- collection of dues from him.
---------------------- Necessarily, both these facilities are short-term facilities. The company may
be required to repay the same within a predecided span or out of the export
---------------------- proceeds of the goods exported.
---------------------- 3. Security for Assistance:
The bank may provide the assistance in any of the modes as stated above.
----------------------
But normally no assistance will be available unless the company offers
---------------------- some security in any of the following forms.
1) Hypothecation :
----------------------
Under this mode of security, the bank extends the assistance to the
---------------------- company against the security of movable property, usually inventories.
---------------------- Under this mode of security neither the property not the possession of
the goods hypothecated is transferred to the bank. But the bank has the
---------------------- right to sell the goods hypothecated to realise the outstanding amount
of assistance granted by it to the company.
----------------------
2) Pledge :
---------------------- Under this mode of security, the bank extends the assistance to the
---------------------- company against the security of movable property, usually inventories.
But unlike in case of hypothecation, possession of the goods is with the
---------------------- Bank and the goods pledged are in the custody of the bank. As such, it

is the duty of the bank to take care of the goods in its custody. In case Notes
of default on the part of company to repay the amount of assistance,
the bank has the right to sell the goods to realise the outstanding ----------------------
amount of assistance.
----------------------
3) Lien :
----------------------
Under this mode of security, the bank has a right to retain the goods
belonging to the company until the debt due to the bank is paid. ----------------------
Lien can be of two types. i) Particular Lien : It is valid till the claims
pertaining to specific goods are fully paid. ii) General Lien : It is valid ----------------------
till all the dues payable to the bank are paid. Normally, banks enjoy
----------------------
general Lien.
4) Mortgage : ----------------------
This mode of security pertains to immovable properties like land and ----------------------
buildings. It indicates transfer of legal interest in a specific immovable
property as security for the payment of debt. Under this mode, the ----------------------
possession of the property remains with the borrower while the bank ----------------------
gets full legal title there, subject to borrower’s right, to repay the
debt. The party who transfers the interest (i.e. the company) is called ----------------------
mortgager and the party in whose favour the interest is so transferred
(i.e. the bank) is called mortgagee. ----------------------
----------------------
----------------------
1. For financing temporary requirement of working capital, various
----------------------
sources available are:
i. Spontaneous Sources ----------------------
ii. Inter-Corporate Deposits
----------------------
iii. Commercial Papers
iv. Banks ----------------------
v. Term Lending Institutions ----------------------
vi. Refinancing Institutions
----------------------
2. Usually, Trade Credit is required to be extended because of
i. Trends in the industry ----------------------
ii. Liquidity position of the company ----------------------
iii. Earnings of the company over a period of time
----------------------
iv. Relationship of the company with the suppliers
v. Defective quality of the products ----------------------
vi. Manufacturer wants to dump the products in the market ----------------------
----------------------

Notes
Activity 2
----------------------
---------------------- In view of the fact that Commercial Papers (CPs) have become best methods
for financing the working capital requirements of the companies, study
---------------------- some CPs and list down special features of CPs.
----------------------
---------------------- 12.6 CONTROL OVER WORKING CAPITAL

---------------------- It can be seen from the preceding discussions that the commercial banks play a
very significant role in financing working capital needs. These working capital
---------------------- needs used to be met mainly in the form of cash credit facilities and these
advances used to be totally security oriented rather than end-use oriented. As
----------------------
such, the units which were able to provide securities to the banks were able to get
---------------------- main chunk of the finances provided by the banks whereas others experienced
shortage of inputs, lower capacity utilisation, high cost of production and
---------------------- ultimately threat of closure. Reserve Bank of India has attempted to identify
major weakness in the system of financing of working capital needs by Banks
----------------------
in order to control the same properly. These attempts were mainly in the form
---------------------- of appointment of following committees:
---------------------- (a) Dahejia Committee

(b) Tandon Committee
----------------------
(c) Chhore Committee
----------------------
(d) Marathe Committee
---------------------- (e) Nayak Committee and Vaz Committee
---------------------- (a) Dahejia Committee:
---------------------- This committee was appointed in October 1968 to examine the extent to which
credit needs of industry and trade are likely to be inflated and how such trends
---------------------- could be checked.
---------------------- Findings: The committee found out that there was a tendency of industry to
avail of short-term credit from Banks in excess of growth rate in production for
---------------------- inventories in value terms. Secondly, it found out that there was a diversion of
short-term bank credit for the acquisition of long-term assets. The reason for
---------------------- this is that generally banks granted working capital finance in the form of cash
---------------------- credit, as it was easy to operate. Banks took into consideration security offered
by the client rather than assessing financial position of the borrowers. As such,
---------------------- cash credit facilities granted by the banks was not utilised necessarily for short-
term purposes.
----------------------
Recommendations: The committee, firstly, recommended that the banks
---------------------- should not only be security oriented, but they should take into consideration
total financial position of the client. Secondly, it recommended that all cash
---------------------- credit accounts with banks should be bifurcated in two categories.

i. Hard core which would represent the minimum level of raw materials, Notes
finished goods and stores which any industrial concern is required to hold
for maintaining certain level of production. ----------------------
ii. Short-term component, which would represent of funds for temporary ----------------------
purposes i.e. Short-term increase in inventories, tax, dividend and bonus
payments etc. ----------------------
It also suggested that hard-core part in case of financially sound companies ----------------------
should be put on a term loan basis subject to repayment schedule. In other
cases, borrowers should be asked to arrange for long-term funds to replace bank ----------------------
borrowings.
----------------------
In practice, recommendations of the committee had only a marginal effect on
the pattern and form of banking. ----------------------
(b) Tandon Committee: ----------------------

In August 1975, Reserve Bank of India appointed a study group under the ----------------------
Chairmanship of Mr. P. L. Tandon, to make the study and recommendations on
the following issues: ----------------------
i. Can the norms be evolved for current assets and for debt equity ratio to ----------------------
ensure minimum dependence on bank finance?
----------------------
ii. How the quantum of bank advances may be determined?
iii. Can the present manner and style of lending be improved? ----------------------
iv. Can an adequate planning, assessment and information system be evolved ----------------------
to ensure a disciplined flow of credit to meet genuine production needs and
its proper supervision? The observations and recommendations made by ----------------------
the committee can be considered as below: ----------------------
1. Norms: The committee suggested the norms for inventory and accounts
receivables for as many as 15 industries excluding heavy engineering ----------------------
industry. These norms suggested, represent maximum level of inventory ----------------------
and accounts receivables in each industry. However if the actual levels are
less than the suggested norms, it should be continued. ----------------------
The norms were suggested in the following forms: ----------------------
• For Raw Materials: Consumption in months.
----------------------
• For Work in Progress: Cost of production in months.
----------------------
• For Finished Goods: Cost of Sales in months.
• For Receivables: Sales in months. ----------------------
It was clarified that the norms suggested cannot be absolute or rigid and the ----------------------
deviations from the norms may be allowed under certain circumstances.
----------------------
Further, it suggested that the norms should be reviewed constantly.
----------------------
It was suggested that the industrial borrowers having an aggregate limits
of more than Rs. 10/- Lakh from the Banks should be subjected to these ----------------------
norms initially and later it can be extended even to the small borrowers.
Notes 2. Methods of Borrowings: The committee recommended that the amount of
bank credit should not be decided by the capacity of the borrower to offer
---------------------- security to the banks but it should be decided in such a way to supplement
the borrower’s resources in carrying a reasonable level of current assets
---------------------- in relation to his production requirement. For this purpose, it introduced
---------------------- the concept of working capital gap i.e. the excess of current assets over
current liabilities other than bank borrowings. It further suggested three
---------------------- progressive methods to decide the maximum limits according to which
banks should provide the finance.
----------------------
Method I: Under this method, the committee suggested that the Banks should
---------------------- finance maximum to the extent of 75% of working capital gap, remaining 25%
should come from long-term funds i.e. own funds and term borrowings.
----------------------
Method II: Under this method, the committee suggested, that the borrower
---------------------- should finance 25% of current assets out of long-term funds and the banks
provide the remaining finance.
----------------------
Method III: Under this method, the committee introduced the concept of core
---------------------- current assets to indicate permanent portion of current assets and suggested that
the borrower should finance the entire amount of core current assets and 25%
----------------------
of the balance current assets out of long-term funds and the banks may provide
---------------------- the remaining finance.
---------------------- To explain these methods in further details, let us consider the following data:
Current Assets Rs. 400
----------------------
Core Current Assets Rs. 100
----------------------
Current Liabilities Rs. 80
---------------------- (Except bank borrowings)
---------------------- The maximum amount of bank finance can be decided as below:
---------------------- Method I
Current Assets 400
----------------------
Less : Current Liabilities (except bank borrowings) 80
---------------------- Working Capital Gap 320
25% of above from Own Sources 80
----------------------
Maximum Permissible Bank Finance (MPBF) 240
---------------------- Current Ratio = 400 1.25
---------------------- 320
----------------------
----------------------
----------------------
----------------------

Method II Notes
Current Assets 400 ----------------------
300 ----------------------
Less : Current Liabilities (except bank borrowings) 80 ----------------------
Working Capital Gap 220
Maximum Permissible Bank Finance (MPBF) 220 ----------------------
Current Ratio = 400 1.33 ----------------------
300
----------------------
Method III
Current Assets 400 ----------------------
Less : Core Current Assets from Own Sources 100 ----------------------
Other Current Assets 300
----------------------
225 ----------------------
Less : Current Liabilities (except bank borrowings) 80
----------------------
Maximum Permissible Bank Finance (MPBF) 145
Current Ratio = 400 1.78 ----------------------
225
----------------------
It can be observed from above that the gradual implementation of these methods
will reduce the dependence of borrowers on bank finance and improve their ----------------------
current ratio. The committee suggested that the borrowers should be gradually
subjected to these methods of borrowings from first to third. ----------------------
However, if the borrower is already in second or third method of lending, ----------------------

he should not be allowed to slip back to first or second method of lending
----------------------
respectively.
It was further suggested that if the actual bank borrowings are more than the ----------------------
maximum permissible bank borrowings, the excess should be converted into
----------------------
a term loan to be amortized over a suitable period depending upon the cash
generating capacity. ----------------------
3. Style of Lending: The committee suggested changes in the manner of
----------------------
financing the borrower. It suggested that the cash credit limit should be
bifurcated into two components i.e. Minimum level of borrowing required ----------------------
throughout the year should be financed by way of a term loan and the
demand cash credit to take care for fluctuating requirements. It was ----------------------
suggested that both these limits should be reviewed annually and that the
----------------------
term loan component should bear a slightly lower rate of interest so that the
borrower will be motivated to use the least amount of demand cash credit. ----------------------
The committee also suggested that within overall eligibilities, a part of the
limits may be in the form of bill limits (to finance the receivables) rather ----------------------
than in the form of cash credit.
----------------------

Notes 4. Credit Information Systems: In order to ensure the receipt of operational
data from the borrowers to exercise control over their operations properly,
---------------------- the committee recommended the submission of a quarterly reporting
system, based on actual as well as estimations, so that the requirements
---------------------- of working capital may be estimated on the basis of production needs. As
---------------------- such, borrowers enjoying total credit limits aggregating Rs. 1 Crore and
above were required to submit certain statements in addition to monthly
---------------------- stock statements and projected balance sheet and profit and loss account at
the end of the financial year. The working capital limits sanctioned were
---------------------- to be reviewed on annual basis. Within the overall permissible level of
---------------------- borrowing, the day-to-day operations were to be regulated on the basis of
drawing power.
----------------------
5. Follow up, Supervision and Control: In order to assure that the assumptions
---------------------- made while estimating the working capital needs still hold good and that
the funds are being utilised for the intended purpose only, it was suggested
---------------------- that there should be a proper system of supervision and control. Variations
between the projected figures and actuals may be permitted to the extent of
----------------------
10%, but variations beyond that level will require prior approval. After the
---------------------- end of the year, credit analysis should be done in respect of new advances
when the banks should re-examine terms and conditions and should make
---------------------- necessary changes. For the purpose of proper control, it suggested the
system of borrower classification in each bank within a credit rating scale.
----------------------
6. Norms for Capital Structure: As regards the capital structure or debt
---------------------- equity ratio, the committee did not suggest any specific norms. It opined
that debt equity relationship is a relative concept and depends on several
----------------------
factors. Instead of suggesting any rigid norms for debt equity ratio, the
---------------------- committee opined that if the trend of debt equity ratio is worse than the
medians, the banker should persuade the borrowers to strengthen the equity
---------------------- base as early as possible.
---------------------- Action taken by RBI
---------------------- According to the notification of RBI dated 21st August, 1975, RBI accepted
some of the main recommendations of the committee.
---------------------- 1. Norms for Inventories and Receivables: Norms suggested by the
---------------------- committee were accepted and banks were instructed to apply them in case
of existing and new borrowers. If the levels of inventories and receivables
---------------------- are found to be excessive than the suggested norms, the matters should
be discussed with the borrower. If excessive levels continue without
---------------------- justification, after giving reasonable notice to the borrowers, banks may
---------------------- charge excess interest on that portion which is considered as excessive.
2. Coverage: Initially, all the industrial borrowers (including small-scale
----------------------
industries) having aggregate banking limits of more than Rs. 10/- Lakh
---------------------- should be covered, but it should be extended to all borrowers progressively.
3. Methods of Borrowing: RBI instructed the banks that all the covered
----------------------
borrowers should be placed in method I as recommended by the committee.

However, all those borrowers who are already complying with requirements Notes
of Method II should not slip back to Method I. As far as Method III is
concerned, RBI has not taken any view. However, in case of the borrowers ----------------------
already in Method II, matter of application of Method III may be decided
on case-to-case basis. ----------------------
4. Style of Credit: As suggested by the committee, instead of granting entire ----------------------

facility by way of cash credit, banks may bifurcate the limit in two: i. Term
----------------------
loan to take care of permanent requirement and ii. fluctuating cash credit.
Within the overall limits, bill limits may also be considered. ----------------------
5. Information system: Suggestions made by the committee regarding the
----------------------
information system were accepted by RBI and were made applicable to all
the borrowers having the overall banking limits of more than Rs. 1 crore. ----------------------
(c) Chhore Committee:
----------------------
In April 1979, Reserve Bank of India appointed a study group under the
chairmanship of Mr. K.B. Chhore to review mainly the system of cash credit ----------------------
management policy by banks. ----------------------
The observations and recommendations made by the committee can be discussed
as below: ----------------------
1. The committee has recommended increasing role of short-term loans and ----------------------
bill finance and curbing the role of cash credit limits.
----------------------
2. The committee has suggested that the borrowers should be required to
enhance their own contribution in working capital. As such, they should be ----------------------
placed in Second Method of lending as suggested by Tandon Committee.
If the actual borrowings are in excess of maximum permissible borrowings ----------------------
as permitted by Method II, the excess portion should be transferred to ----------------------
Working Capital Term Loan (WCTL) to be repaid by the borrower by half
yearly installments maximum within a period of 5 years. Interest on WCTL ----------------------
should normally be more than interest on cash credit facility.
----------------------
3. The committee has suggested that there should be the attempts to inculcate
more discipline and planning consciousness among the borrowers, their ----------------------
needs should be met on the basis of quarterly projections submitted by
them. Excess or under utilisation beyond tolerance limit 10% should be ----------------------
treated as irregularity and corrective action should be taken. ----------------------
4. The committee has suggested that the banks should appraise and fix
separate limits for normal non-peak levels and also peak levels. It should ----------------------
be done in respect of all borrowers enjoying the banking credit limits of ----------------------
more than Rs. 10 Lakh.
5. The committee suggested that the borrowers should be discouraged from ----------------------
approaching the banks frequently for ad hoc and temporary limits in ----------------------
excess of limits to meet unforeseen contingencies. Requests for such limits
should be considered very carefully and should be sanctioned in the form ----------------------
of demand loans or non-operating cash credit limits. Additional interest of
1% p.a. should be charged for such limits. ----------------------

Notes (d) Marathe Committee
In 1982, Reserve Bank of India appointed a study group known as Marathe
----------------------
Committee to review the Credit Authorisation Scheme (CAS), which was in
---------------------- existence since 1965. Under CAS, the banks were required to take the prior
approval of RBI for sanctioning the working capital limits to the borrowers. As
---------------------- per Marathe Committee recommendations, in the year 1988, CAS was replaced
by Credit Monitoring Arrangement (CMA) according to which the banks were
----------------------
supposed to report to RBI, sanctions or renewals of the credit limits beyond the
---------------------- prescribed amounts for the post-sanction scrutiny.
(e) Nayak Committee and Vaz Committee:
----------------------
Recently, RBI has accepted the recommendations made by Nayak Committee.
---------------------- This was with the intention to recognise the contribution made by the SSI Sector
---------------------- to the economy.
According to Nayak Committee recommendations, for evaluating working
---------------------- capital requirements of village industries, tiny industries and other SSI units
---------------------- having the total fund based working capital limits up to Rs. 50 Lakh, the norms
for inventory and receivables as suggested by Tandon Committee will not
---------------------- apply. The working capital requirement of these units will be considered to be
25% of their projected turnover (for both new as well as existing units), out of
---------------------- which 20% is supposed to be introduced by the units as their margin money
---------------------- requirements and remaining 80% can be financed by the bank. In other words,
there are four working capital cycles assumed in every year.
----------------------
Vaz Committee has extended the recommendations of Nayak Committee to all
---------------------- the business organisations. This has also been accepted by RBI.
As a result of Nayak Committee and Vaz Committee recommendations,
----------------------
projected turnover of the borrowers is the basis for evaluating the working
---------------------- capital requirement. Out of the projected turnover, 5% is supposed to be
introduced by the borrower in the form of own contribution and remaining 20%
---------------------- can be financed by the bank. The requirement of working capital has nothing to
do with the level of current assets and current liabilities, which was the basis of
----------------------
Tandon Committee and Chhore Committee recommendations.
---------------------- Evaluation of working capital requirements by the banks relaxed with the
intention to give greater autonomy to the banks while evaluating working capital
----------------------
requirement, RBI has officially withdrawn the concept of MBPF with effect
---------------------- from 15th April, 1997. As a result of this, now the banks are free to have their
own methods for evaluating the working capital requirement of the borrowers.
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
i. Daheja Committee a. 4 working capital cycles assumed in every ----------------------
year
ii. Tandon Committee b. To review the system of Cash Credit ----------------------
management policy by banks
----------------------
iii. Chhore Committee c. To see how the quantum of bank advances
may be determined ----------------------
iv. Nayak Committee d. To examine the extent to which credit
needs of industry and trade are likely to ----------------------
be inflated and how such trends could be ----------------------
checked
----------------------
----------------------
Activity 3
----------------------
Study the manufacturing activity of a Small Scale Unit and identify the
----------------------
cycle of its working capital requirement.
----------------------
12.7 ILLUSTRATIVE PROBLEMS ----------------------
1. A proforma cost sheet of a company provides the following particulars: ----------------------
Elements of cost Amount per unit ----------------------

Raw material 80
----------------------
Direct Labour 30
Overheads 60 ----------------------
Total Cost 170
----------------------
Profit 30
Selling Price 200 ----------------------
The following further particulars are available: ----------------------
Raw materials are in stock for one month.
----------------------
Credit allowed by suppliers is one month.
Credit allowed to customers is two months. ----------------------
Lag in payment of wages 1.5 weeks. ----------------------
Lag in payment of overheads one month. ----------------------
Materials are in process for an average of half month.
----------------------
Finished Goods are in stock for an average of one month.
¼ output is sold against cash. ----------------------

Notes Cash in hand and at bank is expected to be Rs. 25,000. You are requested to
prepare a statement showing the working capital needed to finance a level of
---------------------- activity of 1,04,000 units of product.
---------------------- You may assume that production is carried on evenly throughout the year.
Wages and overheads accrue similarly and a period of 4 weeks is equivalent to
---------------------- a month.
---------------------- Solution:
---------------------- (A) Current Assets

1) Raw Material 2000 units X Rs. 80 X 4 weeks 6,40,000
---------------------- 2) Work in Process* 2000 units X Rs. 125 X 2 weeks 5,00,000
---------------------- 3) Finished Goods 2000 units X Rs. 170 X 4 weeks 13,60,000
4) Debtors 1500 units X Rs. 170 X 8 weeks 20,40,000
---------------------- (Cost Equivalent)
5) Cash Balance 25,000
----------------------
* For WIP, cost is taken at 50% in respect of labour and 45,65,000
---------------------- overheads
(B) Current Liabilities
----------------------
1) Creditors 2000 units X Rs. 80 X 4 weeks 6,40,000
---------------------- 2) Outstanding wages 2000 units X Rs. 30 X 1.5 weeks 90,000
3) Outstanding 2000 units X Rs. 60 X 4 weeks 4,80,000
---------------------- Overheads
---------------------- 12,10,000
(C) Net Working Capital Required (A-B) 33,55,000
---------------------- Working Notes:
---------------------- 1. It is assumed that the total units during the year are distributed over total
number 52 weeks. As total units sold during the year are 1,04,000, weekly
---------------------- sales work out to 2,000 units.
---------------------- 2. Calculation of Debtors: 1/4th of total units are sold in cash. As such, out of
weekly sales of 2,000 units, only 1500 units are sold on credit, each unit
---------------------- having the cost of Rs. 170 and the balance is outstanding for 2 months i.e.
---------------------- 8 weeks. As such, amount blocked in debtors works out to
1500 Units X Rs. 170 X 8 weeks i.e. Rs. 20,40,000.
----------------------
---------------------- 2. The management of Royal Industries has called for a statement showing
the working capital needs to finance a level of activity of 1,80,000 units of
----------------------
output for the year. The cost structure for the company’s product for the
---------------------- above mentioned activity level is detailed below.
----------------------
----------------------
----------------------

Cost per Unit (Rs.) Notes
Raw Materials 20
----------------------
Direct Labour 5
Overheads (including depreciation of Rs. 5 per unit) 15 ----------------------
40
----------------------
Profit 10
Selling Price 50 ----------------------
Additional Information: ----------------------
(a) Minimum desired cash balance is Rs. 20,000.
----------------------
(b) Raw materials are held in stock on an average for two months.
----------------------
(c) Work in progress (assume 50% completion stage in respect of labour and
overheads) will approximate to half a month’s production. ----------------------
(d) Finished goods remain in warehouse on an average for a month. ----------------------
(e) Suppliers of materials extend a month’s credit and debtors are provided
two month’s credit. Cash sales are 25% of total sales. ----------------------
(f) There is a time lag in payment of wages of a month and half and a month ----------------------
in case of overheads.
----------------------
From the above facts, you are required to:
----------------------
(i) Prepare a statement showing working capital needs.
(ii) Determine the maximum working capital finance available under first two ----------------------
methods suggested by Tandon Committee :
----------------------
Solution:
----------------------
Estimated Requirement of Working Capital
Estimated Requirement of Working Capital ----------------------
Rs. ----------------------
(A) Current Assets ----------------------
Raw Materials 15000 units x Rs. 20 x 2 months 6,00,000
Work-in-Progress 15000 units x Rs. 27.50 x 1/2 2,06,250 ----------------------
month ----------------------
Finished Goods 15000 units x Rs. 35 x 1 month 5,25,000
Sundry Debtors 15000 units x Rs. 35 x 2 months 7,87,500 ----------------------
x 75% ----------------------
Cash Balance 20,000
21,38,750 ----------------------
----------------------
----------------------
----------------------

Notes (B) Current Liabilities :
Sundry Creditors 15000 units x Rs. 20 x 1 month 3,00,000
----------------------
Outstanding Wages 15000 units x Rs. 5 x 1 month 75,000
---------------------- Outstanding Overheads 15000 units x Rs. 10 x 1/2 month 75,000
4,50,000
----------------------
(C) Working Capital (A - B) 16,88,750
---------------------- Calculation of Maximum Permissible Bank Borrowing
---------------------- (A) Method I :
---------------------- Current Assets 21,38,750
Less : Current Liabilities 4,50,000
---------------------- Working Capital Gap 16,88,750
---------------------- Own contribution (i.e. 25% of Working Capital Gap) 4,22,187.50
Maximum Permissible Bank Finance 12,66,562.50
---------------------- (B) Method II :
---------------------- Current Assets 21,38,750
Less : Own Contribution 5,34,687.50
----------------------
(i.e. 25% of Current Assets)
---------------------- Working Capital Gap 16,04,062.50
Less : Current Liabilities 4,50,000.00
----------------------
Maximum Permissible Bank Finance 11,54,062.50
---------------------- Working Notes:
---------------------- It is assumed that the year consists of 360 days and that sales are evenly
distributed throughout the year. As such, monthly sales will be 15000 units.
----------------------
---------------------- Summary
---------------------- • Working capital refers to the funds invested in current assets, i.e. investment
in stocks, sundry debtors, cash and other current asset. The objective of
---------------------- working capital management is to ensure Optimum Investment in current
---------------------- assets.
• There are certain factors affecting working capital requirement such as
---------------------- nature of business, size of organisation, trading terms, length of production
---------------------- cycle, profitability, etc.
• Reserve Bank of India has attempted to identify major weakness in the
----------------------
system of financing of working capital needs by Banks in order to control
---------------------- the same properly. These attempts were mainly in the form of appointment
of various committees namely Dahejia committee, Tandon committee,
---------------------- Chhore Committee, Marathe Committee, Nayak Committee and Vaz
Committee. These committees have suggested various norms for Working
----------------------
Capital Finance.
----------------------

Keywords Notes
----------------------
• Working Capital: The Gross Working Capital or Net Working Capital
• Trade Credit: If the company buys raw material on credit from supplier, ----------------------
supplier gives trade Credit
----------------------
• Commercial Paper: Commercial paper is an unsecured promissory note
issued at a discount. ----------------------
• Fund Based Lending: When the lending organisation commits the ----------------------
physical outflow of funds, it is fund based lending.
----------------------
1. What do you mean by working capital? Why does the need for working ----------------------
capital arise for a manufacturing company?
----------------------
2. State the various factors affecting the requirement of working capital.
----------------------
3. How do you calculate the amount of working capital needed by a company?
Enumerate the various sources for financing these working capital needs. ----------------------
4. Explain the main recommendations of various committees appointed by ----------------------
Reserve Bank of India to regulate the banks financing working capital
needs of a company. ----------------------
a. Trade Credit and Outstanding Expenses
----------------------
b. Intercorporate Deposits
----------------------
c. Commercial Papers
d. Bank Guarantees ----------------------
e. Letter of Credit ----------------------

f. Cash Credit ----------------------
g. Packing Credit
----------------------
Answers to Check your Progress ----------------------

1. True
----------------------
2. False
----------------------
----------------------
----------------------

Fill in the blanks.
----------------------
1. The working capital requirement in respect of Public Utility Services such
---------------------- as railways, electricity is less than that required in a production unit.
---------------------- 2. If purchases are on Cash basis and sales are made on credit basis, it will
result into high working capital requirement.
----------------------
3. High profitability reduces the strain on working capital.
---------------------- Multiple Choice Multiple Response
---------------------- 1. For financing temporary requirement of working capital, various sources
available are:
----------------------
i. Spontaneous Sources
---------------------- ii. Inter-Corporate Deposits
---------------------- iii. Commercial Papers
---------------------- iv. Banks

2. Usually, Trade Credit is required to be extended because of
----------------------
i. Trends in the industry
----------------------
ii. Liquidity position of the company
---------------------- iii. Earnings of the company over a period of time
---------------------- iv. Relationship of the company with the suppliers

----------------------
i. d
----------------------
ii. c
---------------------- iii. b
---------------------- iv. a
----------------------
Suggested Reading
----------------------
1. John P. Quinn, Joseph A. Bailey (Jr.), David E. Gaulin. Law Firm
---------------------- Accounting and Financial Management.
---------------------- 2. George H. Stalcup. Financial Management.
----------------------
----------------------
----------------------

Management of Cash
UNIT
13
Structure:
13.1 Introduction
13.2 Motives of Holding Cash
13.3 Estimating the Cash Requirements
13.4 Principles of Cash Management
13.5 Concept of Float
Summary
Key Words
Suggested Reading
Management of Cash 275

Notes
Objectives
----------------------
----------------------
• Define the motives of holding cash
---------------------- • Assess the method for estimation of cash requirements
---------------------- • State the principles of cash management
---------------------- • Judge the concept of float

• Evaluate the techniques employed for cash management
----------------------
----------------------
13.1 INTRODUCTION
----------------------
Management of cash is one of the most important areas of overall working
---------------------- capital management. This is due to the fact that cash is the most liquid type of
current assets. As such, it is the responsibility of the finance function to see that
---------------------- the various functional areas of the business have sufficient cash whenever they
---------------------- require the same. At the same time, it has also to be ensured that the funds are
not blocked in the form of idle cash, as the cash remaining idle also involves
---------------------- cost in the form of interest cost and opportunity cost. As such, the management
of cash has to find a mean between these two extremes of shortage of cash as
---------------------- well as idle cash.
----------------------
13.2 MOTIVES OF HOLDING CASH
----------------------
A company may hold the cash with the various motives as stated below:
----------------------
1. Transaction Motive: The company may be required to make various
---------------------- regular payments like purchases, wages/salaries, various expenses, interest,
taxes, dividends etc. for which the company may hold the cash. Similarly,
---------------------- the company may receive the cash from its sales operations. However,
---------------------- receipts of the cash and the payments by cash may not always match with
each other. In such situations, the company will like to hold the cash to
---------------------- honour the commitments whenever they become due. This requirement of
cash balances to meet routine needs is known as transaction motive.
----------------------
2. Precautionary Motive: In addition to the requirement of cash for routine
---------------------- transactions, the company may also require the cash for such purposes,
which cannot be estimated or foreseen. E.g., there may be a sudden decline
---------------------- in the collection from the customers, there may be a sharp increase in the
---------------------- prices of the raw materials etc. The company may like to hold the cash
balance to take care of such contingencies and unforeseen circumstances.
---------------------- This need of cash is known as precautionary motive.
---------------------- 3. Speculative Motive: The company may like to hold some reserve kind of
cash balance to take the benefit of favourable market conditions of some
---------------------- specific nature. E.g. Purchases of raw material available at low prices on

the immediate payment of cash, purchase of securities if interest rates are Notes
expected to increase, etc. This need to hold the cash for such purposes is
known as speculative motive. ----------------------
----------------------
----------------------
----------------------
1. People and organisations usually hold cash with various motives, one
of which is: ----------------------
i. To show their wealth ----------------------

ii. To meet emergency ----------------------
iii. Because it is safe to hold cash than deposit in bank account
----------------------
iv. Transaction motive
----------------------
2. The standard item, which may not appear as Non-Operating cash
Outflow in the budget is: ----------------------
i. Redemption of shares/debentures ----------------------
ii. Loan installments
----------------------
iii. Purchase of fixed assets
----------------------
iv. Payment to creditors
----------------------
Activity 1 ----------------------
----------------------
Examine the cash budget of a firm and jot down Operating and Non-
Operating Cash Inflow and Cash Outflow items. ----------------------
----------------------
13.3 ESTIMATING THE CASH REQUIREMENTS ----------------------
As has been discussed in the preceding paragraphs, the company should hold ----------------------
adequate cash balance but should necessarily avoid the excessive balances.
For this purpose, basically the company is required to assess its need for cash ----------------------
properly. For this purposes, one of the best tools available with the company is
----------------------
to prepare the cash budget. A cash budget is the statement showing the various
estimated sources of cash receipts on one hand and the various applications of ----------------------
cash on another hand. Thus, by preparing the cash budget, the company may
predict whether at any point of time there is likely to be excess or shortage of ----------------------
cash. If the shortage of cash is estimated, the company has to arrange the cash
----------------------
from some other source. If the excess of cash is estimated, the company may
explore the possibility of investing the cash balance profitably. ----------------------
----------------------

Notes Before preparing the cash budget, following principles must be kept in mind:
1. The period for which the cash budget is to be prepared should be selected
----------------------
very carefully. There is no fixed rule as to the period to be covered by the
---------------------- cash budget. It depends on company and individual circumstances. As a
rule, the period to be covered by the cash budget should be neither too
---------------------- long nor too short. If it is too long, it is possible that the estimates will
be inaccurate. If it is short, the areas which are beyond the control of the
----------------------
company will not be given due consideration.
---------------------- 2. The items, which should appear in the cash budget, should be carefully
decided. Naturally, all those items, which do not have bearing on the cash
----------------------
flows, will not be considered while preparing the cash budget. E.g. As the
---------------------- cost in the form of depreciation does not involve any cash outflow, it does
not affect the cash budget, though the amount of depreciation affects the
---------------------- determination of the tax liability, which involves cash outflow.
---------------------- While preparing the cash budget, the various items appearing the same maybe
classified under the following two categories:
----------------------
i. Operating cash flows: These are the items of cash flow that arise as the
---------------------- result of regular operations of the business.
---------------------- ii. Non-Operating cash flows: These are the items of cash flow, which arise
as the result of other operations of the business.
---------------------- The standard items, which may appear on a standard cash budget may be stated
---------------------- as below:
---------------------- Cash Inflow Cash Outflow

Operating Operating
---------------------- Cash Sales Payment to creditors
---------------------- Collection from debtors Purchases of raw material
Interest/Dividend Received Wages/Salaries
---------------------- Various kinds of overheads
---------------------- Non-Operating Non-Operating
Issue of shares/debentures Redemption of shares/debentures
---------------------- Receipt of loans/borrowings Loan Instalments
---------------------- Sale of Fixed Assets Purchase of Fixed Assets
Interest
---------------------- Taxes
---------------------- Dividends
---------------------- 13.4 PRINCIPLES OF CASH MANAGEMENT

----------------------
The basic objective of cash management is to reduce the operating cash
---------------------- requirement to the minimum possible extent without affecting the routine
transactions. In particular, the objectives of cash management can be stated as
---------------------- below:

(a) Accelerate the cash collections. Notes
(b) Delay the cash payments.
----------------------
(c) Maintenance of optimum cash balance.
----------------------
(d) Investment of excess cash available.
----------------------
13.5 CONCEPT OF FLOAT
----------------------
In non-technical language, Float indicates the difference between the bank
----------------------
balances as per the bankbook and as per the bank pass book/bank statement.
This float arises mainly due to the fact that there is always a time gap between ----------------------
the time a cheque is written by the company and the time when it is presented
to the bank for payment or there is a time gap between the time when a cheque ----------------------
is deposited by the company in the bank and the time when the credit is actually
----------------------
given by the bank to the company. This time gap may arise due to various
reasons. ----------------------
(a) Time required for receiving the cheque from the customer through the post
----------------------
office. This is called postal float.
(b) Time required by the company to process the received cheque and deposit ----------------------
the same in the bank. This is called deposit float. ----------------------
(c) Time required by the banker of the company to collect the payment from
the customers’ bank. This is called bank float. ----------------------
This concept of float can be illustrated with the help of the following example. ----------------------
Suppose that company A of Calcutta has to make a payment to company B ----------------------
of Pune for Rs. 10,000 towards certain purchases made by company A from
company B. Accordingly, company A draws a cheque in favour of company ----------------------
B on 1st June, 1993. This cheque is sent by company A by Registered A.D.
----------------------
and it is physically received by company B on 8th June, 1993. After company
B receives the cheque, it completes the various administrative formalities and ----------------------
deposits the cheque in its bank account on 12th June, 1993. Company B’s bank
sends the cheque to company A’s bank for collection and after getting the advice ----------------------
from company A’s bank, finally credits company B’s account with Rs. 10,000
----------------------
on 20th June, 1993. Now, the various concepts of float can be stated as below.
1st June, 93 to 8th June, 93 – Postal Float ----------------------
8th June, 93 to 12th June, 93 – Deposit float ----------------------
12th June, 93 to 20th June, 93 – Bank Float ----------------------
From the paying company’s point of view, attempts should be made to increase
these various types of floats as much as possible. From the receiving company’s ----------------------
point of view, attempts should be made to decrease these various types of floats ----------------------
as much as possible. Now, in the light of discussions regarding the concept of
float, we will discuss the principles of cash management. ----------------------
----------------------

Notes (a) Accelerate Cash Collections:
This can be done with the help of following techniques:
----------------------
1. As far as possible insist upon the payment from the customer in the
---------------------- safe modes like demand drafts, letters of credit, pre-accepted hundies/
bills of exchange etc. This may reduce the bank float.
----------------------
2. In order to ensure the prompt payment from customers, a self-addressed
---------------------- envelope can be sent along with the bill/invoice itself. Allowing the
cash discounts is the best possible way to induce the customer to make
----------------------
prompt payments.
---------------------- 3. In case of the outstation customers, faster means of communications
---------------------- can be used to reduce the postal float to the minimum possible extent.
E.g. Courier Services, Speed Post etc.
---------------------- 4. Decentralised Collection: In case of the company that has the branches
---------------------- at different places, the company can establish the decentralised
collection centres. The customers in a certain area are required to make
---------------------- the payment at the local collection centre and the cheques collected by
the local collection centre are deposited in the local bank account. The
---------------------- balance in the local bank account beyond a predetermined level may
---------------------- be transferred to the central or head office bank account at periodic
intervals. The decentralised collections may be useful for reducing the
---------------------- postal float as well as bank float.
---------------------- 5. Lock Box System: Under this arrangement, the company hires a
post office box at important collection centres. The customers are
---------------------- instructed to make the payment directly to the lock box. The local
bankers of the company are authorised to pick up the cheques from
---------------------- the lock box. After crediting the cheques to the company’s account,
---------------------- the bank informs the company about the details of cheques credited.
The lock box system reduces the postal float as well as bank float. The
---------------------- clerical work of handling the cheques before deposits is performed
by the banker and the process of collection of cheques can be started
---------------------- immediately on the receipt of cheque from the customer.
---------------------- It should be noted in this connection that both the above systems of
decentralised collections as well as lock box system help to reduce deposit
----------------------
float but at the same time, it involves cost. Before taking any decision in
---------------------- this connection, it is necessary to carry out a cost-benefit analysis to ensure
that the funds released due to speedy collections justify the additional
---------------------- costs.
---------------------- (b) Delay cash payments:
This can be done with the help of the following techniques:
----------------------
1. Payments can be made from a bank, which is distant from the bank of
---------------------- the company to which payment is to be made. This may increase the
---------------------- postal float and bank float.

2. Attempts should be made by the company to get the maximum credit Notes
for the goods or service supplied to it. E.g. In case of wages payable
to the workers, the company gets the services in advance, which are ----------------------
to be paid for later. Thus, they provide the credit to the company for
the period after which they are paid, say a week or a month. As such, ----------------------
if the company can make monthly payment of wages rather than ----------------------
weekly payment of wages, it can enjoy extended credit, slow down
the payments and reduce the requirement of operating cash balance. ----------------------
3. Avoid Early Payments: If according to the terms of credit available to ----------------------
the company, it is required to make the payment within the stipulated
period, it should not make the payment before the specified date ----------------------
unless the company is entitled to cash discounts. The delay in making
----------------------
the payment beyond the stipulated time may affect the credit standing
of the company. ----------------------
4. Centralised Disbursements: Under this method, the payments are
----------------------
made by the Head Office of the company from its central bank account.
This involves the benefits mainly in three respects as compared to ----------------------
decentralised payments. Firstly, it increases the transit time. E.g. If
the creditor at Madras is to be paid out of the Central bank account ----------------------
of the company in Delhi, it increases the postal float as well as the
----------------------
bank float, which is ultimately beneficial for the company. Secondly if
the company decides to make decentralised payments by maintaining ----------------------
various bank accounts at various branches, it will be necessary for it to
maintain minimum cash balance at all these bank accounts, whereas in ----------------------
case of centralised disbursement system, the problem of maintaining
----------------------
minimum cash balance will be only in case of central bank account.
Thirdly, to maintain the bank accounts at different branches may prove ----------------------
to be administratively difficult.
----------------------
5. In case of a company operating on decentralised basis, the arrangements
can be made in such a way that the local branches are authorised to ----------------------
deposit the cheques in the local bank accounts but are not authorised to
withdraw the amounts from there. This facilitates speedy collections ----------------------
as well as ensures proper control over the disbursements from the
----------------------
bank accounts.
6. It may not be necessary for the company to arrange for the funds ----------------------
immediately after it issues the cheque. If it is possible to analyse the ----------------------
time lag in the issue of cheque and their presentation for payment,
which is possible on the basis of past experience, the company may ----------------------
make arrangements for funds only on the expected date of presentation
of cheque for payment. ----------------------
(c) Maintenance of optimum cash balance: ----------------------
As stated earlier, maintenance of more than or less than requirement cash ----------------------
balance involves the consequences. As such, one of the basic objectives
of cash management is to maintain the optimum cash balance. One of the ----------------------

Notes tools available to the company to ensure the maintenance of optimum cash
balance is to prepare the cash budget. By preparing the cash budget in a
---------------------- proper way, the company can have an idea in advance of the timing and
quantum of excess availability of cash or shortage of cash. Accordingly,
---------------------- the company can take the decision of investment of excess cash on short-
---------------------- term basis (in case of excess cash available) or to meet the shortfall (in case
of shortage of cash).
----------------------
(d) Investment of excess cash balance:
---------------------- As stated earlier, one of the basic objectives of cash management is to
optimise the investment in cash. The company cannot afford to keep the
----------------------
excess cash balance idle as it involves the opportunity cost. As such, one
---------------------- of the basic objectives of cash management requires the company to think
about the possibility of investing the excess cash balance on short-term
---------------------- basis.
---------------------- The avenues available to the company to invest the excess cash balance
on short-term basis may be in various forms. E.g. Inter-corporate loans/
---------------------- deposits, inter-corporate bills discounting, stock market operations,
commercial paper, bank deposits etc. However, the final selection of the
----------------------
avenue for investing the cash balance may depend upon various factors.
---------------------- 1. Return – The basic factor affecting any investment decision is
---------------------- essentially in the form of return on investment. The higher the return,
the better the investment.
---------------------- 2. Risk – Risk and return always go hand in hand. High return investments
---------------------- may involve high risk. While selecting the investment yielding high
return, the company should take into consideration the risk involved
---------------------- with the proposition.
---------------------- 3. Liquidity – In some cases, due to unexpected cash needs, it may
be necessary to sell the investment before maturity. Under these
---------------------- circumstances, liquidity associated with the investment becomes an
important criterion to formulate the investment policy.
----------------------
4. Legal requirements – Some organisations may be subjected to certain
---------------------- legal requirements before they can select their investment portfolio.
E.g. Public charitable trusts, co-operative societies etc. These
----------------------
organisations are required to invest their funds in certain specified
---------------------- forms.
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
1. In non-technical language, Float indicates the difference between
----------------------
___________ balances as per bankbook and bank statement.
2. The system under which the company hires a post office box at ----------------------
important collection centres is called _________ System.
----------------------
----------------------
Activity 2
----------------------
Obtain the following information from the Finance Manager of the company, ----------------------
the turnover of which is more than Rs. 10 crore.
----------------------
a. What is the average daily cash balance and how is it maintained?
----------------------
b. What is cash budget and on what basis is it prepared?
c. How does the company arrange for cash in any emergency? ----------------------
d. Prepare a cash budget for the above company. ----------------------
----------------------
----------------------
1. A Private Limited Company is formed to take over a running business. It ----------------------
has decided to raise Rs. 55 lakh by issue of Equity Shares and the balance
of the capital required in the first six months is to be financed by a financial ----------------------
institution against an issue for Rs. 5 lakh, 8% Debentures (Interest payable
annually) in its favour. ----------------------
Initial outlay consists of ----------------------
Initial outlay consists of : ----------------------
Freehold premises Rs. 25 Lakhs
----------------------
Plant and Machinery Rs. 10 Lakhs
Stock Rs. 6 Lakhs ----------------------
Vehicle and Other items Rs. 5 Lakhs
----------------------
Payments on the above items are to be made in the month of incorporation. ----------------------
Sales during the first 6 months ending on 30th June are estimated as under:
January Rs. 14 Lakhs April Rs. 25 Lakhs ----------------------
February Rs. 15 Lakhs May Rs. 26.50 Lakhs ----------------------
March Rs. 18.50 Lakhs June Rs. 28 Lakhs
----------------------
Lag in payment – Debtors 2 Months
– Creditors 1 Month ----------------------

Notes Other information:
1. Preliminary expenses Rs. 50,000 (Payable in February)
----------------------
2. General Expenses Rs. 50,000 p.m. (Payable at the end of each month)
---------------------- 3. Monthly wages (Payable on 1st day of next month) Rs.80,000 p.m. for first
3 months and Rs. 95,000 p.m. thereafter.
----------------------
4. Gross profit rate is expected to be 20% on sales.
---------------------- 5. The shares and debentures are to be issued on 1st January.
---------------------- 6. The stock levels throughout is to be the same as the outlay. Prepare cash
budget for the 6 months ended 30th June.
----------------------
Solution:
---------------------- Cash Budget (For 6 months ending 30th June) Rs. In Lakh
---------------------- Jan. Feb. Mar. Apr. May June
(A) Cash Inflow
---------------------- Issue of shares 55.00 – – – – –
Issue of Debentures 5.00 – – – – –
----------------------
Collection from Debtors – – 14.00 15.00 18.50 25.00
---------------------- 60.00 – 14.00 15.00 18.50 25.00
(B) Cash Outflow
---------------------- Fixed Assets 40.00 – – – – –
Stock (Initial) 6.00 – – – – –
---------------------- Preliminary Expenses – 0.50 – – – –
---------------------- Sundry Creditors – 10.40 11.20 14.00 19.05 20.25
General Expenses 0.50 0.50 0.50 0.50 0.50 0.50
---------------------- Wages – 0.80 0.80 0.80 0.95 0.95
46.50 12.20 12.50 15.30 20.50 21.70
---------------------- (C) Net Cash Inflows
i.e. (A – B) 13.50 (12.20) 1.50 (0.30) (2.00) 3.30
----------------------
Opening Balance – 13.50 1.30 2.80 2.50 0.50
---------------------- + Surplus for the month 13.50 (12.20) 1.50 (0.30) (2.00) 3.30
Closing Balance 13.50 1.30 2.80 2.50 0.50 3.80
----------------------
Working Notes:
---------------------- (1) It is assumed that the company is incorporated in January.
---------------------- (2) Assuming that the company is carrying on manufacturing operations, the
purchases, say for the month of January, are computed as below:
----------------------
Sales of January 14.00
---------------------- Less Gross Profit @ 20% 2.80
---------------------- Cost of goods sold 11.20
Less wages for January 0.80
---------------------- Purchases 10.40
----------------------
----------------------

2. Prepare a cash budget for the quarter ended 30th September, 2008 based on Notes
the following information.
----------------------
Cash at bank on 1st July, 2008 Rs. 25,000
Salaries and Wages estimated monthly Rs. 10,000 ----------------------
Interest Payable – August 2008 Rs. 5,000 ----------------------
June July August September ----------------------
Rs. Rs. Rs. Rs.
Estimated cash sales – 1,40,000 1,52,000 1,21,000 ----------------------
Credit Sales 1,00,000 80,000 1,40,000 1,20,000
Purchases 1,60,000 1,70,000 2,40,000 1,80,000 ----------------------
Other expenses – 20,000 22,000 21,000 ----------------------
(Payable in same month)
Credit sales are collected 50% in the month of sales made and 50% in the month ----------------------
following. Collection from credit sales are subject to 5% discount if payment is ----------------------
received in the month of sales and 2.5% if payment is received in the following month.
Creditors are paid on either a prompt or 30 days basis. It is estimated that 10% ----------------------
of the creditors are in the prompt category. ----------------------
Solution:
----------------------
Cash Budget (For Quarter ending September 2008.
Cash Budget ----------------------
(For Quarter ending September 2008)
----------------------
July August September
Rs. Rs. Rs. ----------------------
(A) Cash Inflows
Cash Sales 1,40,000 1,52,000 1,21,000 ----------------------
Collection from Debtors
Last Month 48,750 39,000 68,250 ----------------------
Current Month 38,000 66,500 57,000 ----------------------
2,26,750 2,57,500 2,46,250
July August September ----------------------
Rs. Rs. Rs.
(B) Cash Outflows ----------------------
Sundry Creditors
Prompt Basis 17,000 24,000 18,000 ----------------------
Credit Basis 1,44,000 1,53,000 2,16,000
Salaries and Wages 10,000 10,000 10,000 ----------------------
Other Expenses 20,000 22,000 21,000
Interest – 5,000 – ----------------------
1,91,000 2,14,000 2,65,000
(C) Net Cash Inflows (A-B) 35,750 43,500 (18,750) ----------------------
Opening Balance 25,000 60,750 1,04,250
----------------------
+ Surplus for the month 35,750 43,500 (18,750)
Closing Balance 60,750 1,04,250 85,500 ----------------------
Working Notes:
It is assumed that salaries and wages are paid in the same month. ----------------------

Notes Summary
---------------------- • This unit introduces you to the techniques of cash management.
---------------------- • The motives of holding cash may be the transaction motive, precautionary
motive or speculative motive.
----------------------
• By preparing the cash budget, the company may predict any likely excess
---------------------- or shortage of cash and thereby the company may take appropriate action.
---------------------- • The basic objective of cash management is to reduce the operating cash
requirement to the minimum possible extent without affecting the routine
---------------------- transactions.
---------------------- • Float indicates the difference between the bank balances as per bankbook
and as per the bank pass book/bank statement.
----------------------
---------------------- Keywords
---------------------- • Float: In non-technical language, float indicates the difference between
the bank balances as per the bankbook and as per the bank passbook.
----------------------
• Cash Budget: One of the best tools available with the company to access
---------------------- its need for cash.
---------------------- • Operating cash flow: Cash flow which arise as the result of regular
operations of the business
----------------------
• Non-Operating cash flow: Cash flow, which arises as the result of other
---------------------- operations of the business.
----------------------
----------------------
1 Explain the various motives for holding the cash.
---------------------- 2 Explain the various principles to be followed for managing the cash in a
---------------------- very big size organisation having the branches all over the country.
3 Define the concept of float and illustrate this concept with an example.
----------------------
4 Write short notes.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

a. Estimation of cash requirements Notes
b. Cash management
----------------------
5 What are the various techniques used by companies to accelerate cash
collections? ----------------------
6 What techniques are used by companies to delay cash payments? ----------------------
7 Why is it necessary for companies to maintain optimum cash balance at all ----------------------
times?
----------------------
----------------------
----------------------
----------------------
1. People and organisations usually hold cash with various motives, one of
which is: ----------------------
iv. Transaction motive ----------------------
2. The standard item, which may not appear as Non-Operating cash Outflow
----------------------
in the budget is:
iv. Payment to creditors ----------------------
1. In non-technical language, Float indicates the difference between bank
balances as per bankbook and bank statement. ----------------------
2. The system under which the company hires a post office box at important ----------------------
collection centres is called Lock Box System.
----------------------
1. Eugene Brigham, Michael Ehrhardt. Financial Management: Theory & ----------------------

Practice ----------------------
2. I.M. Pandey. Financial Management
----------------------
3. Prasanna Chandra, Prasanna. Financial Management
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
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----------------------
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----------------------
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Management of Receivables
UNIT
14
Structure:
14.1 Introduction
14.2 Objectives of Management of Receivables
14.3 Float in Receivables Management
14.4 Areas Covered by Receivables Management
14.5 Factoring
Summary
Key Words
Suggested Reading
Management of Receivables 289

Notes
Objectives
----------------------
----------------------
• Identify the importance of management of receivables
----------------------
• Select the basis on which credit policy of a firm is decided
---------------------- • Explain the use of float in receivables management
---------------------- • Justify various aspects of credit policy
---------------------- • Assess the technique of factoring
---------------------- 14.1 INTRODUCTION

---------------------- Receivables or Debtors as Current Assets are created because of the credit
sales made by the company, i.e. the company makes the sales to the customers
----------------------
but the customers do not make the payment immediately. Even if the customers
---------------------- do not pay the cash immediately, the company has to make credit sales to the
customers in order to face the competition and also to attract the new and
---------------------- potential customers to buy the goods or services from the company.
----------------------
14.2 OBJECTIVES OF MANAGEMENT OF RECEIVABLES
----------------------
As in case of general objective of working capital management, the
---------------------- receivables management is also to achieve a tradeoff between the risk and
profitability. The aim of receivables management is to ensure optimum
----------------------
investment in receivables i.e. the investment in receivables should be neither
---------------------- less nor more. If the objective of the company is to reduce the investment in
receivables to the minimum extent, the company will not make any credit sales
---------------------- at all, as receivables is the result of credit sales made by the company. This
will reduce the investment in receivables, but the company will suffer in terms
----------------------
of profitability as the customers will not buy from the company, particularly
---------------------- if the competitors offer the credit to the customers. On the other hand, if the
company makes credit sales to the customers in order to increase the sales
---------------------- and profitability, the company may be accepting the risk of bad debts, more
collection efforts etc. As such, the objective of receivables management is to
----------------------
increase the credit sales to such an extent that the risk of non-recoverable dues
---------------------- is reasonable and within control. As in case of any other financial decisions,
decisions regarding the receivables management also involve the cost benefit
---------------------- analysis. Costs associated with the receivables management maybe in the form
of credit administration costs, cost of bad debts and opportunity cost of funds
----------------------
blocked in receivables. Benefits associated with the receivable management are
---------------------- naturally in the form of profits from the sales made on credit basis. An effective
receivables management policy tries to increase the credit sales to such an
---------------------- extent that the profits arising therefrom are more than the costs attached to it.
----------------------

Notes
----------------------
Multiple Choice Single Response. ----------------------
1. Receivables management is to achieve a tradeoff between:
----------------------
i. Risk and profitability
----------------------
ii. Receipt and payment
iii. Income and expenditure ----------------------
iv. Sources and outgo ----------------------

2. Decisions regarding the receivables management also involve ----------------------
i. Cost Benefit Analysis
----------------------
ii. Income Expenditure Analysis
----------------------
iii. Input output analysis
iv. BEP Analysis ----------------------
----------------------
14.3 FLOAT IN RECEIVABLES MANAGEMENT ----------------------
The concept of float can be extended to the receivables management as well. ----------------------
The time gaps in the receivables management can be in the following forms:
----------------------
a) Frequency of period of service at which invoices or bills are raised in
favour of the customers. ----------------------
b) Administrative delay for raising the invoices or bills in favour of the
----------------------
customers.
c) Period of credit offered to the customers. ----------------------
An effective receivables management will target at reducing these time gaps to ----------------------
the maximum possible extent. From this angle, following propositions should
be remembered: ----------------------
a. If the bills or invoices are raised in favour of the customers at periodic ----------------------
intervals, attempts should be made to reduce this time interval. E.g. If the
----------------------
bills are raised in favour of the customers on monthly basis, raising the bills
on customers on fortnightly basis may be an effective way of managing the ----------------------
receivables. This will reduce the first time gap.
----------------------
b. Bills or invoices should be raised in favour of the customers immediately
after the dispatch of material or rendering the services. Documentation for ----------------------
this purpose should be completed as early as possible. This will reduce the
second category of time gap. ----------------------
c. Period of credit offered to the customers gets affected due to many other ----------------------
factors which are discussed later on.
----------------------

Notes 14.4 AREAS COVERED BY RECEIVABLES MANAGEMENT
---------------------- Receivables Management may be concerned with the following aspects:
---------------------- a. Credit Analysis

b. Credit Terms
----------------------
c. Financing of Receivables
----------------------
d. Credit Collection
---------------------- e. Monitoring of Receivables
---------------------- (a) Credit Analysis: Even though the intention of the company will be to
increase the profits by increasing the sales, the company will not like to
---------------------- sell its products to any customer who comes its way. For this purpose, the
---------------------- company has to decide the customers to whom it should sell its products
on credit. The credit should be extended only to those customers whose
---------------------- creditworthiness is established. For deciding the credit worthiness of the
customers, the company may consider various factors viz. analysis of
---------------------- the financial status of the customer, reputation of the customer, record of
---------------------- previous dealing of the customer with the company, quality and character
of the management running the business of the customer etc. For deciding
---------------------- the credit worthiness of the customer, the company may need information
that may be available from the following sources.
----------------------
1. Trade References:
---------------------- The company can ask the prospective customer to give trade references.
---------------------- The company may insist that the references should be given of those names
who are currently dealing with the company. The company in turn can
---------------------- obtain the information from these references, either by personal interview
or by sending short questionnaires. While doing this, honesty, seriousness
---------------------- and integrity of the references should be examined.
---------------------- 2. Bank Reference:
---------------------- The company can ask the prospective customer to instruct its banker to
give the relevant information to the company. In this case, there may be
---------------------- two problems. Firstly, the banker of the prospective customer may not
give clear answers to the enquiries made by the company. Secondly, even
----------------------
though the Bank of the prospective customer certifies the proper conduct
---------------------- of the account, it may not mean that he will settle his dues of the company
in time. As such, along with Bank reference, other ways of obtaining the
---------------------- information should also be used.
---------------------- 3. Credit Bureau Reports:
---------------------- The sources of trade references and bank references maybe biased in some
cases. In such cases, the credit bureau reports may be considered. In some
---------------------- cases, the associations for some specific industries maintain a credit bureau
that may give useful and authentic information about their members.
----------------------

4. Financial Statements: Notes
This is one of the easiest ways to obtain the information about the
----------------------
creditworthiness of the prospective customer. If the prospective customer
is a public limited company, there may not be any difficulty in getting the ----------------------
financial statements in the form of Profit and Loss Account and Balance
Sheet. However, getting the financial statements, may be difficult in case ----------------------
of private limited companies or partnership firms.
----------------------
5. Past Experience:
----------------------
This can be considered the most reliable source of getting the information
about the creditworthiness of the customer who is dealing with the company ----------------------
presently. If there is the question of extending further credit to the existing
customer, the company should inevitably consider the past experience ----------------------
while dealing with that customer.
----------------------
6. Salesmen’s Interviews and Reports:
----------------------
Many a times, companies may depend upon the reports given by the sales
personnel for evaluating the creditworthiness of the customers. ----------------------
After the creditworthiness of the customer is ascertained, the next question ----------------------
is to decide the limit on the credit to be allowed to them, both in terms of
amount and duration. The decision depends upon the amount of anticipated ----------------------
sales, increased cost of monitoring and servicing the receivables and the
financial strength of the customer. If the customer is a frequent buyer of the ----------------------
goods of the company, a line of credit for selling may be established which ----------------------
means the maximum amount of credit which the company may extend. In
such case, the company need not investigate every order of the customer so ----------------------
long as it is within the limit of line of credit. The line of credit granted for
the customer should be reviewed periodically in the light of the collection ----------------------
of the previous dues, specific requirements of the customer for the future ----------------------
and so on.
----------------------
(b) Credit Terms:
Credit terms indicate the terms on which the company should extend the ----------------------
credit to the customer. This involves the consideration of the following
----------------------
aspects:
• Credit Period ----------------------
• Discount Policy ----------------------
Credit Period: ----------------------
Credit period is the time allowed by the company to the customers to pay their
----------------------
dues. The duration of this credit period may depend upon various factors. One,
in case of the products having inelastic demand, the credit period may be small, ----------------------
however if the demand is elastic, small credit period may affect quantum of
sales. Two, credit period may depend upon the nature of industry. In the buyer’s ----------------------
market, the company may be required to offer more credit period. In the seller’s
----------------------

Notes market, the company may afford to offer smaller credit period. Further, it
also depends upon the policies followed by the competitors. Three, decisions
---------------------- regarding the credit period may be affected by the management attitudes. If the
management attitude is aggressive, it may offer more credit period to increase
---------------------- sales and profits. However, if management attitude is conservative, it will like
---------------------- to restrict the credit period. Lastly, the credit period may depend upon the
amount of funds available and also upon possible bad debts losses. Naturally,
---------------------- the company will like to have a credit period as short as possible, whereas the
customers will like to have a longer credit period. As such, by liberalising its
---------------------- credit period, the company can attract new customers. However, the proposition
---------------------- of liberalising the credit period may involve the consequences in the form of
more investment in receivables, possibility of bad debts losses, increased cost
---------------------- of monitoring and servicing the receivables etc. As such, policy to liberalise the
credit period should be viewed from this angle.
----------------------
Illustration:
----------------------
A company is currently selling 12000 units at Rs. 50 per unit. Variable cost
---------------------- per unit is Rs. 40. At present, the company gives credit of one month, which is
proposed to be extended to two months, whereby it will be able to increase sales
---------------------- by 25%. If the required rate of return is 18% and average cost per unit is Rs. 45,
should the new credit policy be implemented?
----------------------
Solution:
----------------------
Calculation of incremental profits
---------------------- Present Costs Proposed Differences
---------------------- Structure Costs
Structure
---------------------- Rs. Rs. Rs.
Sales 6,00,000 7,50,000 1,50,000
---------------------- Variable cost 4,80,000 6,00,000 1,20,000
---------------------- Contribution 1,20,000 1,50,000 30,000
Fixed Costs 60,000 60,000 __
---------------------- Profit 60,000 90,000 30,000
Thus, the new credit policy will result into increased profits of Rs. 30,000.
----------------------
The costs involved with the new credit policy will be as below:
----------------------
Present Policy New Policy
---------------------- Rs. Rs.
Variable cost 4,80,000 6,00,000
---------------------- Fixed Cost 60,000 60,000
---------------------- Total Cost 5,40,000 6,60,000
Average Debtors Period (1 month) (2 months)
---------------------- Total cost 45,000 1,10,000
Investment in Debtors
---------------------- Average Debtors Period
----------------------

As such, incremental investment in debtors is Rs. 65,000 i.e. 1,10,000 Notes
– Rs. 45,000. As the required rate of return is 18% p.a., costs attached with
incremental debtors will be Rs. 11,700 i.e. 18% of Rs. 65,000. ----------------------
As the increased profits of Rs. 30,000 are more than increased costs of Rs. ----------------------
11,700, the new credit policy will be desirable.
----------------------
However, before liberalising the credit period, the following factors should
also be considered. ----------------------
i. Liberalising the credit period is likely to increase the demand. It should
----------------------
be verified whether the company has the capacity to meet this additional
demand. If the company is operating at its full capacity and it is necessary ----------------------
to increase the capacity to meet the additional demand, the effect of this
possibility on the cost structure of the company is required to be considered. ----------------------
ii. Liberalising the credit period may increase the demand, which in turn may ----------------------
call for the additional investment in working capital say inventory. While
evaluating the proposal to liberalise the credit period, cost associated ----------------------
with the additional investment in working capital is also required to be ----------------------
considered.
Discount Policy: ----------------------
Discounts are usually allowed to speed up the collection process, and ----------------------
to induce the customers to pay the dues early. The decisions regarding the
rate of discount and period of discount depends upon the usual cost benefit ----------------------
considerations i.e. The cost of carrying the debts on one hand and on another ----------------------
hand, the benefits received from getting the amount released from the debtors
immediately, which may be available for some different and beneficial use. ----------------------
Proposal to liberalise the discount policy should be evaluated in terms of ----------------------
loss of revenue on one hand and the benefits arising out of released investment
in receivables on another hand. ----------------------
Illustration: ----------------------
A Ltd. is considering to introduce cash discount policy of “3/10 net 30” ----------------------
i.e. if the customer pays his dues within 10 days, he will be entitled to a cash
discount of 3%, otherwise he has to pay the dues within 30 days. The company ----------------------
expects that 60% of the sales will opt for this facility, which will improve the
Average Collection Period from 30 days to 18 days. If sales of the company ----------------------
amount to Rs. 50 lakh and if required rate of return is 15%, should the proposal ----------------------
be accepted?
Solution: ----------------------
(a) Loss of Revenue ----------------------

60% of Rs. 50,00,000 X 3% Rs. 90,000 ----------------------
(b) Receivables before discount
----------------------
50,00,000
X 30 ----------------------
360 Rs. 4,16,666

Notes (c) Receivables after discount
50,00,000
---------------------- X 18
360 Rs. 2,50,000
----------------------
(d) Investment in receivables released
----------------------
i.e. b – c Rs. 1,66,666
----------------------
(e) Return on investment released
---------------------- 15% on Rs. 1,66,666 Rs. 25,000
----------------------
As the return on investment released is likely to be less than loss of revenue, the
---------------------- proposal of cash discount should not be accepted.
(c) Financing the Receivables:
----------------------
Whichever sources are available to the company for financing the
---------------------- working capital requirement, are equally the sources available for financing the
receivables. This is because receivables are a part of working capital. However,
----------------------
following sources may be identified as the sources available for financing the
---------------------- receivables particularly.
---------------------- a) Bills Discounting

b) Cash Credit against hypothecation of book debts as the security.
----------------------
c) In the recent past, factoring has become one of the sources available for
---------------------- financing the receivables. The mechanism of factoring is discussed in the
following paragraphs.
----------------------
(d) Credit Collection:
----------------------
This indicates the steps taken by the company to collect the dues from the
---------------------- customer. For this purpose, the company may follow the standard practices of
reminding the customer just before the due date. This can be done by sending
---------------------- the reminder letters, or making telephone calls or by paying the personal visits.
---------------------- The customers who are slow paying ones should be handled properly. If
they are permanent customers, they may object to harsh collection procedure
---------------------- and the company may lose them ultimately. If the slow paying customer is facing
---------------------- some temporary funds problem, the company should understand the same. If
there are some defaulting customers, the company should decide as to how
---------------------- many reminders should be sent and how each of them should be drafted. If these
measures fail, the next step taken may be the personal call to these customers or
---------------------- the personal visit by the company’s representative. If all these above courses of
---------------------- action fail, the company may decide to take legal action against the defaulting
customer as a last resort.
---------------------- It is a very regular practice to offer cash discounts to the customers in order
---------------------- to speed up the credit collection process.
While designing the credit collection policy, following propositions should
---------------------- be remembered.

(a) Before deciding collection policies and procedures, it is essential to make a Notes
cost benefit analysis. The costs are the administrative expenses associated
with the collection policies and the benefits are the reduced bad debts losses ----------------------
and interest on released investment in debtors. As a financial management
proposition, it is necessary that the cost should be justified by the benefits. ----------------------
(b) Before deciding collection policies and procedures, provisions of the ----------------------
Indian Limitation Act should be kept in mind. In spite of the repeated
----------------------
reminders, if the customer fails to pay the amount due from him, the legal
action should be initiated against the customer before the limitation period ----------------------
is over.
----------------------
(e) Monitoring the Receivables:
It may be necessary to ensure that the outstanding receivables are within ----------------------
the framework of the credit policy decided by the company. For this, the
----------------------
company may be required to apply regular checks and have a regular system to
monitor the receivables properly. For this, the company may use the following ----------------------
techniques.
----------------------
Techniques available on Macro Basis:
One of the most common methods to monitor the receivables on macro ----------------------
basis is to calculate the Average Collection Period (ACP), which effectively ----------------------
indicates the period taken by the customers to make payment to the company or
the average period of credit allowed by the company to the customers. ----------------------
Average Collection Period may be calculated in two stages described below: ----------------------
a. Calculation of daily or monthly sales –
----------------------
Credit Sales during the year
----------------------
No. of days / No. of months

b. Calculation of Average Collection Period – ----------------------
Sundry Debtors in Balance Sheet ----------------------

Daily/Monthly Sales ----------------------

For the purpose of proper interpretation of ACP, it needs to be compared ----------------------
with the NCP, the Normal Credit Period offered by the company to customers
for making the payment. If ACP works out to be more than the NCP, it indicates ----------------------
inefficiency on the part of marketing department or sales department or
collection department of the company in collecting the dues from the customers. ----------------------
If ACP works out to be less than the NCP, it indicates efficiency on the part of ----------------------
the marketing department or sales department or collection department of the
company in collecting the dues from the customers. However, calculation of ----------------------
ACP as a tool to monitor the receivables involves some limitations:
----------------------
• Calculation of ACP assumes that the credit sales are evenly spread
throughout the year. In practical circumstances, credit sales are not evenly ----------------------
spread throughout the year. In such situations, ACP may give wrong
indications. ----------------------

Notes • Calculation and interpretation of ACP as a tool to judge the efficiency or
inefficiency of the company in collecting the dues from the customers is
---------------------- not possible based upon the published financial statements of the company
due to non-availability of sufficient data for the same. E.g., the amount of
---------------------- credit sales made by the company or the normal credit period offered by
---------------------- the company is not available in the published financial statements.
Techniques available on Micro Basis:
----------------------
Considering the limitations associated with the calculation of ACP, it may
---------------------- not be a tool available to monitor the receivables on micro basis. For this, the
calculation of age-wise analysis of receivables maybe made. Age-wise analysis
----------------------
of the receivables involves the classification of outstanding receivables at any
---------------------- given point of time (say at the end of every month) into the different age groups
(age of the receivables indicating the number of days since the date receivables
---------------------- become outstanding). Percentage of receivables falling under each age group
may also be calculated. For example,
----------------------
Age Group Amount %
----------------------
(No. of days) Rs.
---------------------- Less than 30 days
---------------------- 31-60 days
60-90 days
---------------------- More than 90 days
---------------------- Now, if the normal credit period offered by the company to the customers
is 30 days, any amount, which is outstanding for more than 30 days, is
----------------------
definitely indicating the inefficiency on the part of the collection department
---------------------- of the company in collecting the receivables. Thus, age-wise analysis of the
receivables may provide superior information about the quality of receivables
---------------------- and the company can concentrate its collection efforts on those receivables,
which are outstanding for a longer period.
----------------------

----------------------
Fill in the blanks.
---------------------- 1. The sources of trade references and bank references may be biased;
---------------------- therefore, ________ reports may be considered.
2. The time allowed by the company to the customers to pay their dues is
----------------------
called ___________.
----------------------
---------------------- 14.5 FACTORING

---------------------- In the recent past, factoring has emerged as one of the major financial
service in the Receivables Management area.
----------------------

What is Factoring? Notes
Factoring indicates the relationship between a financial institution (called
----------------------
as the ‘factor’) and a business organisation (called as the ‘client’) who in turn
sells the goods/services to its customers (called as the ‘customer’), whereby ----------------------
the factor purchases book debts of the client, either with recourse or without
recourse, and in relation thereto controls the credit extended to the customers ----------------------
and administers the sales ledger of the client. In non-technical language, the
----------------------
financial service in the form of factoring tries to provide the services, which
the marketing department of an organisation will be undertaking, e.g. the factor ----------------------
may provide the following services to the client:
----------------------
a. Factor may undertake the credit analysis of the customers of the client.
Factor may also help the client in deciding the credit limit upon each ----------------------
customer and the other credit terms like period of credit, discount to be
allowed etc. It should be noted that the factor need not factor all the debts ----------------------
of the client. He may have his own assessment of the customers of the
----------------------
client and accordingly, he will factor the debts of the client.
b. Factor will undertake the various bookkeeping and accounting activities in ----------------------
relation to the receivables management. This will consist of maintenance
----------------------
of debtors’ ledger and generation of the various periodical reports on behalf
of the client (like outstanding from the customers, age wise analysis of the ----------------------
outstandings etc.)
----------------------
c. The factor undertakes the responsibility of following up with the customers
for making the collection from the customers. For this, it will be necessary ----------------------
that the client inform its customers about the fact that the debts have been
factored by the factor and that the customers should make the payments to ----------------------
the factor directly. ----------------------
d. Factor can purchase the debts of the client making the immediate payment
of these debts to the client after maintaining about 20% to 30% margin. ----------------------
This reduces the strain on the working capital requirements of the client ----------------------
and the client can concentrate on the manufacturing and other activities.
After the customer makes the payment to the factor on the due date, the ----------------------
factor passes on the funds to the client after adjusting the funds advanced
by him to the client. If the factor purchases the debt of the client, it will be ----------------------
involving the cost and the cost is slightly higher than the interest, which the ----------------------
client would have paid had he borrowed the funds from the bank. If some
of the debts are not purchased by the factor, the client can borrow from the ----------------------
bank against these debts.
----------------------
e. Factor can assume the risk of non-payment by the customers if the
factoring is without recourse factoring and in such cases, the factor is not ----------------------
able to recover the money from the client. If the factoring is with recourse
factoring, the risk of non-payment by the customers is assumed by the ----------------------
client and not by the factor. As such, the factor is entitled to recover the ----------------------
funds advanced by him to the client.
----------------------

Notes Factoring VS. Bills Discounting
Factoring is different from the bills discounting in two ways. One, Bills
----------------------
Discounting is essentially a financial function whereby the client gets the
---------------------- finance against the book debts, whereas the factoring is a financial as well as an
administrative function. The factor is engaged not only in financing the book
---------------------- debts of the client, but he is engaged in the various administrative activities
as well like the maintenance of sales ledger, generation of the various reports,
----------------------
follow up with the customers, collection of dues from the customers etc.
---------------------- Secondly, in case of Bills Discounting, the risk of non-payment of dues by the
customers is essentially assumed by the client, whereas in the case of factoring
---------------------- the risk of nonpayment by the customers may be assumed by the factor if the
factoring is without recourse factoring.
----------------------
Procedure of Factoring:
----------------------
a. After the careful evaluation of customers and setting the credit limits upon
---------------------- the customers, the factoring firm enters into the agreement with the selling
company.
----------------------
b. Sales invoices raised by the selling company in favour of its customers
---------------------- consists of an indication to the customer that the amount is being factored
with the factor and on the due date, the customer should make the payment
---------------------- to the factor directly.
---------------------- c. The factor makes the prepayment of the invoice to the selling company
after keeping the margin as stipulated.
----------------------
d. On the due date, when the customer makes the payment, the factoring
---------------------- firm recovers its fees/charged as agreed upon and also the amount already
advanced to the selling company and passes on the balance amount to the
---------------------- selling company.
---------------------- The various steps involved in the factoring operations may be explained with
the help of the following figure.
----------------------
MECHANICS OF FACTORING
---------------------- 1
CLIENT CUSTOMER
---------------------- (SELLER)
3 (BUYER)
----------------------
----------------------
----------------------
----------------------
6
---------------------- 8
5 7
---------------------- 4 FACTOR
2
----------------------
Fig 14.1: Steps in the Factoring Operation
Description of Numbers in above figure Notes
1. Places the order.
----------------------
2. Fixes the limit.
----------------------
3. Delivers the goods and instructs the customer to make payment to the
factor. ----------------------
4. Sends the invoice copy. ----------------------
5. Makes the prepayment of invoice.
----------------------
6. Follows up.
----------------------
7. Makes the payment.
8. Pays the balance amount. ----------------------
Types of Factoring: ----------------------
On the basis of above features of factoring, factoring can be classified in the ----------------------
following ways:
a. Without Recourses Factoring: In case of this type of factoring, the risk ----------------------
on account of non-payment by the customer is assumed by the factor. The ----------------------
factor is not entitled to recover the amount from the selling company. Thus,
without Recourse Factoring results into the outright buying of selling ----------------------
company’s receivables by the factor. This type of factoring is also referred
to as full factoring. ----------------------
b. With Recourse Factoring: In case of this type of factoring, the risk on ----------------------
account of non-payment by the customer is assumed by the selling company
----------------------
and the factor is entitled to recover the funds advanced by him from the
selling company. ----------------------
Advantages of Factoring:
----------------------
a. Factoring is the way in which the company can finance its requirement of
working capital in respect of receivables. Immediate availability of cash ----------------------
reduces the strain on the working capital of the company. As the financing
----------------------
in the form of factoring moves with the level of receivables directly, the
company need not worry about financing the additional requirement of ----------------------
working capital due to the increased amount of sales.
----------------------
b. Factoring orgainsation is a professional specialising in the various fields.
The company can take the advantage of the expertise of the factor in the ----------------------
areas of credit evaluation, credit analysis, deciding the credit limits upon
the customers etc. ----------------------
c. With the help of factoring as a financial service, the company can be ----------------------
relieved of the administrative responsibilities of maintaining the debtors’
ledger, periodical report generations and following up with the customers ----------------------
for collecting the dues etc. This not only results in the cost saving for the ----------------------
company, but the company is also able to concentrate its efforts on business
development. ----------------------

Notes Disadvantages of Factoring:
a. As the amount charged by the factoring organisation, consists of the
----------------------
components towards the administrative services rendered by the factor as
---------------------- well as the cost of finance provided by the factor, the effective financial
burden on the company increases.
----------------------
b. In Indian circumstances, Factoring is mainly with-recourse factoring. This
---------------------- means that the risk of non-payment on the part of customer is not borne by
the factor. It is borne by the selling firm. This has restricted the popularity
---------------------- of factoring services in Indian circumstances.
---------------------- c. While making the credit evaluation, if the factor adopts a very conservative
approach with the intention to minimise the risk of delay and default, it
---------------------- may restrict the sales growth of the selling company.
---------------------- d. Factoring may be considered to be a symptom of financial weakness on the
part of the selling company. It may indicate that the selling company is not
---------------------- able to manage its receivables effectively on its own and is required to take
---------------------- the help of an outside agency in the form of factor.
Factoring in Indian situations:
----------------------
Factoring services in Indian circumstances started on the basis of the
---------------------- recommendations of Kalyanasundaram Committee, which was appointed in the
year 1989 with the intention of studying the scope of starting factoring services
---------------------- in India. The committee recommended the factoring in India. Reserve Bank of
---------------------- India demarcated the zones for the banks who wished to get involved in the
factoring business. The distribution of zones bank wise was as below:
----------------------
Western Zone – State Bank of India
---------------------- Southern Zone – Canara Bank
---------------------- Northern Zone – Punjab National Bank
---------------------- Eastern Zone – Allahabad Bank

Recently, Export Credit Guarantee Commission (ECGC) has been
---------------------- authorised to start the Export Factoring business.
---------------------- Out of the above banks, State Bank of India started its factoring services in
1991 by forming a separate subsidiary viz. SBI Factors Limited.
----------------------
Generally, the factoring in India is with recourse factoring i.e. the risk of
---------------------- non-payment by the customer is not accepted by the factor but by the client.
That may be the reason that the experience of factoring in India is not very
----------------------
encouraging.
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
1. If the factoring is with recourse factoring, the risk of non-payment by
the customers is assumed by Factor. ----------------------
2. Factoring is a financial function like Bills Discounting, whereby the ----------------------
client gets the finance against book debts.
----------------------
Activity 1 ----------------------
----------------------
Visit the website www.financialservices.gov.in and Study the Rules
and Regulations for factoring. ----------------------
----------------------
Summary
----------------------
• The basic objective of management of receivables is to optimise the return
----------------------
on investment in receivables. And it also has to achieve a tradeoff between
the risk and profitability. ----------------------
• Receivables management has the following aspects; credit analysis, setting
----------------------
of credit terms, financing of receivables, credit collection and monitoring
of receivables. ----------------------
• Factoring indicates the relationship between a financial institution (called ----------------------
as factor) and a business organisation (called as client) who in turns sells
the goods/services to its customers, whereby the factor purchases book ----------------------
debts of the client, either with recourse or without recourse, and in relation
thereto controls the credit extended to the customers and administers the ----------------------
sales ledger of the client. ----------------------
Keywords ----------------------
• Float in receivables management: The time gap arising in the receivables ----------------------
management due to various reasons such as frequency of bills drawn, ----------------------
administrative delay etc.
----------------------
• Credit Bureau Report: An independent agency giving useful and authentic
information about their members. ----------------------
• Factoring: The services given by a Factor. Factor is engaged in financing
----------------------
the book debts of the client and also giving various administrative activities
like maintenance of sales ledger etc. ----------------------
----------------------
----------------------

Notes
----------------------
1 How would you manage the credit policy in a company where the amount
---------------------- locked up in receivables (debtors) is equal to six month’s sales?
2 What is meant by a firm’s credit terms? What are the expected effects of (a)
----------------------
A decrease in the firm’s cash discounts and (b) A decrease in credit period?
---------------------- 3 “The credit policy of a company is criticised because bad debt losses have
---------------------- increased considerably and collection period has also increased”. Discuss
under what conditions the criticism may not be justified.
---------------------- 4 What are the important dimensions of a firm’s credit policy? Discuss the
---------------------- consequences of a liberal credit policy.
5 Write a detailed essay on ‘factoring’.
----------------------
6 Give the advantages and disadvantages of factoring.
----------------------
7 Write short notes.
---------------------- a. Credit Analysis
---------------------- b. Credit Collection
---------------------- c. Monitoring of Receivables

---------------------- 1. Receivables management is to achieve a tradeoff between:
i. Risk and profitability
----------------------
2. Decisions regarding the receivables management also involve
----------------------
i. Cost Benefit Analysis
---------------------- 1. The sources of trade references and bank references may be biased;
therefore, credit bureau reports may be considered.
----------------------
The time allowed by the company to the customers to pay their dues is
---------------------- called credit period.

----------------------
1. False
----------------------
2. False
----------------------

Notes
Suggested Reading
----------------------
Accounting and Financial Management ----------------------
2. George H. Stalcup. Financial Management.
----------------------
----------------------
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----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
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Management of Inventory
UNIT
15
Structure:
15.1 Introduction
15.2 Motives of Holding Inventory
15.3 Objectives of Inventory Management
15.4 Techniques of Inventory Management
15.5 Calculation of Various Levels
Summary
Key Words
Suggested Reading
Management of Inventory 307

Notes
Objectives
----------------------
----------------------
• Classify the different motives of holding inventory
----------------------
• Recognise the significance of inventory management
---------------------- • State the objectives of inventory management
---------------------- • Demonstrate the application of various techniques of inventory
management
----------------------
---------------------- 15.1 INTRODUCTION

---------------------- Management of inventory assumes importance due to the fact that
investment in inventory constitutes one of the major investments in current
---------------------- assets. The various forms in which a manufacturing concern may carry inventory
are:
----------------------
1. Raw Material: These represent inputs purchased and stored to be converted
---------------------- into finished products in future by making certain manufacturing process
on the same.
----------------------
2. Work in Progress: These represent semi-manufactured products which
---------------------- need further processing before they can be treated as finished products.
---------------------- 3. Finished Goods: These represent the finished products ready for sale in
the market.
----------------------
4. Stores and Supplies: These represent that part of the inventory, which does
---------------------- not become a part of the final product but are required for the production
process. They may be in the form of cotton waste, oil and lubricants, soaps,
----------------------
brooms, light bulbs, etc. Normally, they form a very minor part of total
---------------------- inventory and do not involve significant investment.
---------------------- 15.2 MOTIVES FOR HOLDING INVENTORY

---------------------- A company may hold the inventory with the various motives as stated
---------------------- below:
1. Transaction Motive: The company may be required to hold the
----------------------
inventories in order to facilitate the smooth and uninterrupted production
---------------------- and sales operations. It may not be possible for the company to procure
raw material whenever necessary. There may be a time lag between the
---------------------- demand for the material and its supply. Hence, it is needed to hold the raw
material inventory. Similarly, it may not be possible to produce the goods
----------------------
immediately after they are demanded by the customers. Hence, it is needed
---------------------- to hold the finished goods inventory. The need to hold work in progress
may arise due to the production cycle.
----------------------

2. Precautionary Motive: In addition to the requirement to hold the Notes
inventories for routine transactions, the company may like to hold them
to guard against the risk of unpredictable changes in demand and supply ----------------------
forces. E.g., the supply of raw material may get delayed due to the factors
like strike, transport, disruption, short supply, lengthy processes involved ----------------------
in import of the raw materials etc. Hence, the company should maintain ----------------------
sufficient level of inventories to take care of such situations. Similarly, the
demand for finished goods may suddenly increase (especially in case of ----------------------
seasonal types of products) and if the company is unable to supply them,
it may mean gain of the competitions. Hence, the company will like to ----------------------
maintain sufficient stock of finished goods. ----------------------
3. Speculative Motive: The company may like to purchase and stock the
----------------------
inventory in the quantity, which is more than needed for production and
sales purpose. This may be with the intention to get the advantages in terms ----------------------
of quantity discounts connected with bulk purchasing or anticipated price
rise. ----------------------
----------------------
15.3 OBJECTIVES OF INVENTORY MANAGEMENT
----------------------
Usually, the company is faced with the following conflicting objectives in
the area of inventory management: ----------------------
(1) To carry maximum inventory in order to facilitate efficient and smooth ----------------------
production and sales operations.
----------------------
(2) To minimise investment in inventory to maximise profitability.
Both over-investment and under-investment in inventories is undesirable as ----------------------
both involve the consequences. The over-investment involves the consequences
----------------------
like:
i. Unnecessary blocking of funds in inventory and hence loss of profit. ----------------------
ii. Excessive storage and insurance cost. ----------------------
iii. Risk of liquidity: The inventories once purchased and stored are normally ----------------------
difficult to dispose off at the same value. In other words, the value of
inventory reduces with the increasing holding period. ----------------------
The under-investment involves the consequences like: ----------------------
i. If sufficient stock of raw material and work in process is not available, it
----------------------
may result into frequent interruptions in production.
ii. If sufficient stock of finished goods is not available, it may not be possible ----------------------
for the company to serve the customers properly and they may shift to the
----------------------
competitors.
Thus, the objective of inventory management is to avoid the situation ----------------------
of over-investment as well as under-investment. The inventories should be ----------------------
maintained at the optimum level.
To conclude, it can be said that the objective of inventory management is to ----------------------

Notes minimise the investment in inventory without affecting the production or sales
operations.
----------------------
----------------------

---------------------- 1. One of the motives for holding the inventory is:
---------------------- i. Increase production

ii. Earn Profit
----------------------
iii. Plan for the scarcity
----------------------
iv. Transaction motive
---------------------- 2. The objective of inventory management is to avoid the situation of:
---------------------- i. Over-investment as well as under-investment
---------------------- ii. Stock out position

iii. Excess stock position
----------------------
iv. Excess procurement cost
----------------------
----------------------
Activity 1
----------------------
Check the Bin card/Stores ledger in our organisation and find out the
----------------------
position for a period of six months and reasons thereof.
----------------------
---------------------- 15.4 TECHNIQUES OF INVENTORY MANAGEMENT

---------------------- A. Economic Order Quantity
---------------------- It indicates that quantity which is fixed in such a way that the total variable
cost of managing the inventory can be minimised. Such cost consists of two
---------------------- parts. First, Ordering Cost (which in turn consists of the costs associated with
the administrative efforts connected with preparation of purchase requisitions,
----------------------
purchase enquiries, comparative statements and handling of more number of
---------------------- bills and receipts). Second, Carrying Cost, i.e. the cost of carrying or holding
the inventory, (which in turn consists of the cost such as godown rent, handling
---------------------- and upkeep expenses, insurance, opportunity cost of capital blocked, i.e. interest
etc.) There is a reverse relationship between these two types of costs i.e. if the
----------------------
purchase quantity increases, ordering cost may get reduced but the carrying cost
---------------------- increases and vice versa. A balance is to be struck between these two factors and
it is possible at Economic Quantity where the total variable cost of managing
---------------------- the inventory is minimum.
---------------------- It is possible to fix the Economic Order Quantity with the help of mathematical

formula. The following assumptions may be made for this purpose. Notes
Let Q be Economic Order Quantity
----------------------
A be Annual Requirement of material in units O be the cost of placing an
order (which is assumed to remain constant irrespective of size of order) C be ----------------------
the cost of carrying one unit per year
----------------------
Now, if A is the annual requirement and Q is the size of one order, the total
number of orders will be A/Q and the total ordering cost will be: A/Q x O. ----------------------
Similarly, if the size of one order is Q and if it is assumed that the inventory is ----------------------
reduced at a constant rate from order quantity to zero when it is repurchased, the
average inventory will be Q/2 and the cost of carrying one unit per year being ----------------------
C, the total carrying cost will be Q/ 2 x C. ----------------------
Thus,
----------------------
Total cost = Ordering Cost + Carrying Cost
A Q ----------------------
= xO+ xC
Q 2
----------------------
The intention is that the value of Q should be such that the total cost should
----------------------
be minimum. Hence, taking the first derivative of the equation with respect to
Q and setting the result to zero. ----------------------
do (– 1) C
= AO Q2 + 2
dq ----------------------
=0 ----------------------
2 x A x O ----------------------
or Q =
C
----------------------
Where Q = Order Quantity
A = Annual Requirement in Units ----------------------
O = Cost of Placing an Order ----------------------
C = Cost of Carrying One Unit Per Year ----------------------
Illustration: ----------------------
A manufacturer uses 200 units of a component every month and he buys them
----------------------
entirely from the outside supplier. The order placing cost is Rs. 100 per order
and annual carrying cost per unit is Rs. 12. From this set of data, calculate the ----------------------
Economic Order Quantity.
----------------------
Solution:
2 x A x O ----------------------
EOQ =
C
----------------------
2 x 2400 x 100
= ----------------------
12
= 200 units ----------------------

Notes In some cases, the carrying cost may be expressed as an annual percentage of
the unit cost of purchases. In which case, the calculation of Economic Order
---------------------- Quantity takes the following form.
---------------------- 2 x A x O
EOQ =
Cxi
----------------------
where A =Annual requirement in units
---------------------- O = Cost of placing an order
---------------------- C = Unit purchase price
---------------------- i = Carrying cost expressed as a percentage of unit purchase price.
Illustration:
----------------------
From the following data, work out the EOQ of a particular component.
----------------------
Annual Demand : 5000 Units
---------------------- Ordering Cost : Rs. 60 per Order
---------------------- Price per Unit : Rs. 100
---------------------- Inventory Carrying Cost : 15% on average inventory.
Solution:
----------------------
2 x 5000 x 60
---------------------- EOQ =
15% of 100
---------------------- = 200 units
----------------------
The total cost of managing inventory will be
----------------------
500
---------------------- Ordering Cost = x 60 i.e. 25 x 60 = Rs . 1,500
200
200
---------------------- + Carrying Cost = x 15% of 100 = Rs. 1,500
2
---------------------- Total cost = Rs. 3,000
---------------------- (Based on average inventory)

Now, the next question is whether the purchases in Economic Order Quantity
----------------------
really reduce the total cost of managing inventory to the minimum. We can
---------------------- verify this, by trial and error method, by considering the above results.
----------------------
----------------------
----------------------
----------------------
----------------------

Order No. of Ordering Cost Carrying Cost Total Notes
Quantity Orders Nx0xO Q/2 x Ci Cost
Q N=A/Q Rs. Rs. Rs. ----------------------
1 2 3 4 5 = 3+4
----------------------
50 100 6,000 375 6,375
100 50 3,000 750 3,750 ----------------------
200 25 1,500 1,500 3,000
250 20 1,200 1,875 3,075 ----------------------
1,000 5 300 7,500 7,800
1,250 4 240 9,375 9,615 ----------------------
2,500 2 120 18,750 18,870 ----------------------
It can be observed from the above, that the order size of 200 units proves to
----------------------
be the most economic one in terms of minimum total cost. If the purchases are
made in any other way, the same may not necessarily result into minimum total ----------------------
cost.
----------------------
Illustration:
Kapil Motors purchased 9,000 motor spare parts for its annual requirements, ----------------------
ordering one-month usage at a time. Each spare part costs Rs. 20. The ordering ----------------------
cost per order is Rs. 15 and the carrying charges are 15% of the average inventory
per year. You have been asked to suggest a more economical purchasing policy ----------------------
for the company. What advice would you offer and how much would it save the
company per year? ----------------------
Solution: ----------------------
Present Policy : ----------------------
Annual Requirement
Number of Orders = ----------------------
Order size
9000 ----------------------
= = 12
750 ----------------------
Ordering Cost = 12 x 15
= 180 …(1) ----------------------
Order Size x Cost Price x Carrying cost in % ----------------------
Carrying Cost =
2
750 x 15% of Rs. 20 ----------------------
=
2
----------------------
= 375 x 3
----------------------
= 1,125 …(2)
Total cost i.e. 1 + 2 = 180 + 1125 ----------------------
= 1,305 …(3) ----------------------
Proposed Policy : ----------------------
To purchase in Economic Order Quantity ----------------------

Notes 2xAxO
EOQ =
Cxi
----------------------
2 x 9000 x 15
---------------------- = 15% of 20

---------------------- = 300 units
Now, the revised total cost will be
----------------------
9000
---------------------- Number of Orders =
300
---------------------- = 30
---------------------- Ordering Cost = 30 x 15

= 450 …(4)
----------------------
300 x 15% of 20
---------------------- Carrying
2 Cost =
---------------------- = 150 x 3
---------------------- = 450 …(5)

Total Cost i.e. 4 + 5 = 450 + 450
----------------------
= 900 …(6)
----------------------
Thus, purchases in Economic Order Quantity will result into the yearly saving
---------------------- of Rs. 405 (i.e. Rs. 1305 - Rs. 900)
---------------------- B. Fixation of Inventory Levels:
---------------------- Fixation of various inventory levels facilitates initiating of proper action in

respect of the movement of various materials in time so that the various materials
---------------------- may be controlled in a proper way. However, the following propositions should
be remembered:
----------------------
i. Only the fixation of inventory levels does not facilitate the inventory
---------------------- control. There has to be a constant watch on the actual stock level of
various kinds of materials so that proper action can be taken in time.
----------------------
ii. The various levels fixed are not fixed on a permanent basis and are subject
---------------------- to revision regularly.
---------------------- Various levels that can be fixed are as below:
1. Maximum Level:
----------------------
It indicates the level above which the actual stock should not exceed. If it
---------------------- exceeds, it may involve unnecessary blocking of funds in inventory. While
---------------------- fixing this level, following factors are considered:
i. Maximum usage
----------------------
ii. Lead time
----------------------

iii. Storage facilities available, cost of storage and insurance etc. Notes
iv. Prices for material
----------------------
v. Availability of funds
----------------------
vi. Nature of material, e.g. If a certain type of material is subject to Government
regulations in respect of import of goods etc. maximum level may be fixed ----------------------
at a higher level.
----------------------
vii. Economic Order Quantity.
2. Minimum Level: ----------------------
It indicates the level below which the actual stock should not reduce. If it ----------------------
reduces, it may involve the risk of non-availability of material whenever it is
required. While fixing this level, following factors are considered: ----------------------
i. Lead time ----------------------

ii. Rate of consumption ----------------------
3. Re-order Level: ----------------------
It indicates that the level of material stock at which it is necessary to take the
steps for procurement of further lots of material. This is the level falling in ----------------------
between the two existences of maximum level and minimum level and is fixed ----------------------
in such a way that the requirements of production are met properly till the new
lot of material is received. ----------------------
4. Danger Level: ----------------------
This is the level fixed below minimum level. If the stock reaches this level,
----------------------
it indicates the need to take urgent action in respect of getting the supply. At
this stage, the company may not be able to make the purchases in a systematic ----------------------
manner but may have to make rush purchases which may involve higher
purchases cost. ----------------------
----------------------
----------------------
1. Quantity fixed in such a way that the total variable cost of managing
the inventory can be minimized is called _________________. ----------------------
2. Inventory levels fixed are not fixed on a _______________basis and ----------------------

are subject to revision regularly.
----------------------
15.5 CALCULATION OF VARIOUS LEVELS ----------------------
----------------------
The various levels can be decided by using the following mathematical
expressions: ----------------------
1. Re-order Level:
----------------------

Notes Maximum Lead Time x Maximum Usage
2. Maximum Level:
----------------------
Re-order Level + Re-order Quantity - (Minimum Usage x Minimum Lead
---------------------- Time)
---------------------- 3. Minimum Level:
---------------------- Reorder Level - (Normal Usage + Normal Lead Time)

4. Average Level:
----------------------
Minimum Level + Minimum Level
---------------------- 2
---------------------- 5. Danger Level:
---------------------- Normal Usage x Lead time for emergency purchases

Note: It should be noted that the expression of the Re-order Quantity in the
----------------------
calculation of Maximum Level indicates Economic Order quantity.
---------------------- Illustration:
---------------------- Two components X and Y used are as follows:
---------------------- Normal usage – 50 units per week each

Minimum usage – 20units per week each
----------------------
Maximum usage – 75units per week each
----------------------
Re-order quantity – X -400 units
---------------------- Y - 600 units
---------------------- Re-order period – X - 4 to 6 weeks
---------------------- Y - 2 to 4 weeks
Calculate for each component:
----------------------
(a) Reorder level
----------------------
(b) Minimum level
---------------------- (c) Maximum level
---------------------- (d) Average stock level
---------------------- Solution:
1. Re-order Level:
----------------------
Maximum Lead Time x Maximum Usage
----------------------
X = 6 weeks x 75 units
---------------------- = 450 units
---------------------- Y = 4 weeks x 75 units
---------------------- = 300 units

2. Minimum Level: Notes
Re-order Level - (Normal Usage x Normal Lead Time)
----------------------
X = 450 units - (50 units x 5 weeks)
----------------------
= 200 units
Y = 300 units - (50 units x 3 weeks) ----------------------
= 150 units ----------------------
3. Maximum Level: ----------------------
Re-order Level + Re-order Quantity - (Minimum Usage x Minimum Lead
----------------------
time)
X = 450 units + 400 units - (25 units x 4 weeks) ----------------------
= 750 units ----------------------
Y = 300 units + 600 units - (25 units x 2 weeks) ----------------------
= 850 units
----------------------
4. Average Stock Level:
----------------------
Maximum Level + Minimum Level
2 ----------------------
200 units + 750 units ----------------------
X =
2
----------------------
= 475 units
150 units + 850 units ----------------------
Y =
2 ----------------------
= 500 units
----------------------
As stated above, the expression of the Re-order Quantity in the calculation of
----------------------
Maximum level indicates Economic Order Quantity. Hence, in some cases, it
may be necessary to decide the Economic Order Quantity before fixing the ----------------------
inventory levels.
----------------------
Illustration:
Shriram Enterprises manufactures a special product ‘ZED’. ----------------------
The following particulars are collected for the year 1986: ----------------------
(a) Monthly demand of ZED – 1000 units ----------------------
(b) Cost of placing an order – Rs. 100
----------------------
(c) Annual carrying cost per unit – Rs. 15
----------------------
(d) Normal Usage – 50 units per week
(e) Minimum Usage – 25 units per week ----------------------
(f) Maximum Usage – 75 units per week ----------------------

Notes (g) Re-order period – 4 to 6 weeks.
Compute from the above:
----------------------
(1) Re-order Quantity.
----------------------
(2) Re-order Level.
---------------------- (3) Minimum Level.
---------------------- (4) Maximum Level.
---------------------- (5) Average Stock Level.
Solution:
----------------------
1. Re-order Quantity:
----------------------
2xAxO
---------------------- C
---------------------- Where, A = Annual Requirement

O = Ordering cost per order
----------------------
C = Carrying cost per unit per year
----------------------
2 x 12000 x 100 16000
---------------------- EOQ = =
15
---------------------- = 400 units
---------------------- 2. Reorder Level:
---------------------- Maximum Lead Time x Maximum Usage
---------------------- ∴ 6 weeks x 75 units = 450 units

3. Minimum Level:
----------------------
Re-order Level - (Normal Usage x Normal Lead Time)
----------------------
∴ 450 units - (50 units x 5 weeks)
---------------------- = 200 units
---------------------- 4. Maximum Level:
---------------------- Re-order Level + Re-order Quantity/- (Minimum usage x Minimum Lead

time)
---------------------- ∴ 450 units + 400 units - (25 units x 4 weeks)
---------------------- = 750 units
---------------------- 5. Average Stock Level:
Minimum Level + Minimum Level
----------------------
2
----------------------
200 units + 750 units
---------------------- = 475 units
2

There may be one more way in which the various inventory levels may be fixed Notes
and for this, determination of the safety stock (also called as minimum stock
or buffer stock) is essential. Safety stock is that level of stock below which the ----------------------
actual should not be allowed to fall. The safety stock may be calculated as:
----------------------
(Maximum Usage x Maximum Lead time) less
----------------------
(Normal Usage x Normal Lead time)
According to this method, the various inventory levels as discussed above may ----------------------
be fixed as below:
----------------------
1. Minimum Level:
----------------------
It is equal to safety stock.
2. Maximum Level: ----------------------
It can be calculated as Safety Stock + EOQ ----------------------

3. Re-order Level: ----------------------
It can be calculated as Safety Stock + (Normal Usage x Normal Lead time) ----------------------
4. Average Stock Level:
----------------------
It can be calculated as
----------------------
Minimum Level + Maximum Level
2 ----------------------
Safety Stock + Safety Stock + EOQ
= ----------------------
2
----------------------
EOQ
Safety Stock +
2 ----------------------
Illustration: ----------------------
You have been asked to calculate the following levels for Part No. 007 from the ----------------------
information given thereunder:
----------------------
(a) Re-ordering level
----------------------
(b) Maximum level
(c) Minimum level ----------------------
(d) Danger level ----------------------
(e) Average level ----------------------
There, the ordering quantity is to be calculated from the following data:
----------------------
i. Total cost relating to one order: Rs. 20
----------------------
ii. Number of units to be purchased during the year: 5,000
iii. Purchase price per unit: Rs. 50 ----------------------
iv. Annual cost of storage of one unit: Rs. 5 ----------------------

Notes Lead Times:
Average …10 days
----------------------
Maximum …15 days
---------------------- Minimum …6 days
---------------------- Maximum for emergency purchases … 4 days
---------------------- Rate of consumption: Average … 15 units per day

Maximum … 20 units per day
----------------------
Solution:
----------------------
Working Notes:
---------------------- (a) Calculation of Safety Stock:
---------------------- (Maximum Usage x Maximum Lead Time) – (Normal Usage x Normal
Lead time)
----------------------
= (20 units x 15 days) - (15 days x 10 days)
---------------------- = 300 units - 150 units
---------------------- = 150 units
---------------------- (b) Calculation of EOQ:
2xAxO
----------------------
C
---------------------- Where A = Annual requirement
---------------------- O = Ordering cost per order
---------------------- C = Carrying cost per unit per year

Hence,
----------------------
2 x 500 x 20
---------------------- EOQ =
5
---------------------- = 200 units
---------------------- 1. Re-ordering Level:

---------------------- It can be calculated as Safety Stock + (Normal Usage x Normal Lead time)
= 150 units + (15 units x 10 days)
----------------------
= 150 units + 150 units
----------------------
= 300 units
---------------------- 2. Maximum Level:
---------------------- It can be calculated as Safety Stock + EOQ
---------------------- = 150 units + 200 units
---------------------- = 350 units

3. Minimum Level: Notes
It is equal to Safety Stock = 150 units.
----------------------
4. Danger Level:
----------------------
Normal Usage x Lead time for emergency purchases
= 15 units x 4 days ----------------------
= 60 units ----------------------
5. Average Stock Level: ----------------------
It can be calculated as
----------------------
Safety Stock + EOQ ----------------------
2
200 units ----------------------
=
150 units + 2
----------------------
= 250 units
----------------------
C. Inventory Turnover:
----------------------
Inventory turnover indicates the ratio of materials consumed to the average
inventory held. It is calculated as below: ----------------------
Value of material consumed
----------------------
Average inventory held
----------------------
where value of material consumed can be calculated as:
Opening Stock + Purchases – Closing Stock ----------------------
Average inventory held can be calculated as: ----------------------

Opening Stock + Closing Stock ----------------------
2
----------------------
Inventory turnover can be indicated in terms of number of days in which
average inventory is consumed. It can be done by dividing 365 days (a year) by ----------------------
inventory turnover ratio. ----------------------
Illustration:
----------------------
From the following data for the year ended 31st December, 1986, calculate the
inventory turnover ratio of the two items and put forward your comments on ----------------------
them.
----------------------
Material A Material B
----------------------
Rs. Rs.
Opening Stock 1.1.86 10,000 9,000 ----------------------
Purchases during the year 52,000 27,000
----------------------
Closing Stock 31.12.86 6,000 11,000
----------------------

Notes Solution:
Value of material consumed
---------------------- Inventory turnover ratio =
Average Inventory held
----------------------
Material A Material B
---------------------- Inventory turnover ratio = 56,000 25,000
---------------------- 8,000 10,000
---------------------- = 7 2.5
Inventory Turnover Period = 365 365
----------------------
7 2.5
----------------------
= 52 days 146 days
---------------------- Material consumed = opening stock + purchases - closing stock
---------------------- opening stock + closing stock
Average inventory =
2
----------------------
A high inventory turnover ratio or low inventory turnover period indicates that
---------------------- maximum material can be consumed by holding minimum amount of inventory
of the same, thus indicating fast moving items. Thus, high inventory turnover
---------------------- ratio or lower inventory turnover period will always be preferred.
---------------------- Thus, knowledge of inventory turnover ratio or inventory turnover period in
case of various types of material will enable to reduce the blocked up capital in
---------------------- undesirable types of stocks and will enable the organisation to exercise proper
---------------------- inventory control.
D. ABC Analysis:
----------------------
This technique assumes the basic principle of ‘Vital Few Trivial Many’ while
---------------------- considering the inventory structure of any organisation and is popularly known
as ‘Always Better Control’. It is an analytical method of inventory control,
----------------------
which aims at concentrating efforts in those areas where attention is required
---------------------- most. It is usually observed that, in practice, only a few numbers of items of
inventory prove to be more important in terms of amount of investment in
---------------------- inventory or value of consumption, while a very large number of items of
inventory account for a very meagre amount of investment in inventory or value
----------------------
of consumption. This technique classifies the various inventory items according
---------------------- to their importance. E.g. A class consists of only a small percentage of total
number of items handled but is most important in nature. B class items include
---------------------- relatively less important items. C class items consist of a very large number
of items that are less important. The importance of the various items may be
----------------------
decided on the basis of following factors.
---------------------- i. Amount of investment in inventory.
---------------------- ii. Value of material consumption.
---------------------- iii. Critical nature of inventory items.

An example of ABC Analysis can be given as below: Notes
Class No. of % of total Value/Consumption % of total Value ----------------------
items no. of items Rs. Consumption
A 300 6 5,60,000 70 ----------------------
B 1,500 30 1,60,000 20
----------------------
C 3,200 64 80,000 10
Total 5,000 100 8,00,000 100 ----------------------
In order to exercise proper inventory control, A class items are watched very ----------------------
closely and control is exercised right from initial stages of estimating the
requirements, fixing minimum level/lead times, following proper purchase/ ----------------------
storage procedures etc. Whereas in case of C class of items, only those inventory
----------------------
control measures may be implemented which are comparatively simple,
elaborate and inexpensive in nature. ----------------------
Advantages of ABC Analysis: ----------------------
(a) A close and strict control is facilitated on the most important items, which
constitute a major portion of overall inventory valuation or overall material ----------------------
consumption and due to this, costs associated with inventories may be ----------------------
reduced.
(b) The investment in inventory can be regulated in proper manner and ----------------------
optimum utilisation of the available funds can be assured. ----------------------
(c) A strict control on inventory items in this manner helps in maintaining a
----------------------
high inventory turnover ratio.
However, it should be noted that the success of ABC analysis depends mainly ----------------------
upon correct categorisation of inventory items and hence should be handled by
----------------------
only experienced and trained personnel.
E. Bill of Materials: ----------------------
In order to ensure proper inventory control, the basic principle to be kept in ----------------------
mind is that proper material is available for production purpose whenever it is
required. This aim can be achieved by preparing what is normally called as ‘Bill ----------------------
of Materials’. ----------------------
A bill of material is the list of all the materials required for a job, process
or production order. It gives the details of the necessary materials as well as ----------------------
the quantity of each item. As soon as the order for the job is received, bill of ----------------------
materials is prepared by the Production Department or Production Planning
Department. ----------------------
----------------------
----------------------
----------------------
----------------------

Notes The form in which the bill of material is usually prepared is as below:
BILL OF MATERIALS
---------------------- No. Date of Issue Production/Job Order No.
Department authorised
---------------------- S.No. Description Code Qty. For Department Use only Remarks
of Material No. Material Date Quantity
---------------------- Requisition Demanded
No.
----------------------
----------------------
----------------------
The functions of bill of materials are as below:
----------------------
1. Bill of materials gives an indication about the orders to be executed to all
---------------------- the persons concerned.
---------------------- 2. Bill of materials gives an indication about the materials to be purchased by

the Purchase Department if the same is not available with the stores.
---------------------- 3. Bill of material may serve as a base for the Production Department for
---------------------- placing the material requisition slips.
4. Costing/Accounts Department may be able to compute the material cost
----------------------
in respect of a job or a production order. A bill of material prepared and
---------------------- valued in advance may serve as a base for quoting the price for the job or
production order.
----------------------
F. Perpetual Inventory System:
---------------------- As discussed earlier, in order to exercise proper inventory control, a perpetual
inventory system may be implemented. It aims at two facts.
----------------------
1. Maintenance of Bin Cards and Stores Ledger in order to know about the
---------------------- stock in quantity and value at any point of time.
---------------------- 2. Continuous verification of physical stock to ensure that the physical
balance and the book balance tallies.
----------------------
The continuous stocktaking may be advantageous from the following angles:
----------------------
1. Physical balances and book balance can be compared and adjusted without
---------------------- waiting for the entire stock taking to be done at the year-end. Further, it is
not necessary to close down the factory for Annual stocktaking.
----------------------
2. The figures of stock can be readily available for the purpose of periodic
---------------------- Profit and Loss Account.
---------------------- 3. Discrepancies can be located and adjusted in time.

4. Fixation of various levels and bin cards enables the action to be taken for
---------------------- placing the order for acquisition of material.
---------------------- 5. A systematic maintenance of perpetual inventory system enables to locate
slow and non-moving items and to take remedial action for the same.
----------------------
6. Stock details are available correctly for getting the insurance of stock.
Notes
----------------------
i. Re-Order Level a. Re-order level+Re-order Quantity-Minimum
----------------------
UsagexMinimum
ii. Maximum Level b. Maximum Lead Time xMaximum UsageLead ----------------------
Time
iii. Minimum Level c. Minimum Level+Minimum Level / 2 ----------------------
iv. Average Level d. Reorder Level-(Normal Usage+Minimum
----------------------
Level)
----------------------
15.6 ILLUSTRATIVE PROBLEMS ----------------------
1. A company uses annually 50,000 units of an item each costing Rs. 1.20. ----------------------
Each order costs Rs. 45 and inventory carrying costs 15% of the annual
average inventory value. ----------------------
(a) Find EOQ. ----------------------

(b) If the company operates 250 days a year, the procurement time is ----------------------
10 days and safety stock is 500 units, find reorder level, maximum,
minimum and average inventory. ----------------------
Solution: ----------------------
(a) Economic Order Quantity ----------------------
2xAxO
Cxi ----------------------
2 x 50,000 x 45 ----------------------
15% of 1.20
----------------------
= 5,000 units
----------------------
(b) 1. Reorder Level:
----------------------
Safety Stock + (Normal Usage x Normal Lead time)
= 500 units + (200 units x 10 days) ----------------------
= 2,500 units ----------------------
2. Maximum Level: ----------------------
Safety stock + EOQ
----------------------
= 500 units + 5,000 units
----------------------
= 5,500 units
----------------------
----------------------

Notes 3. Minimum Level
It is equal to safety stock, i.e. 500 units
----------------------
4. Average Level
----------------------
EOQ
Safety Stock +
---------------------- 2
---------------------- = 5,000 units
500 units +
---------------------- 2
---------------------- = 3,000 units
---------------------- 2. M/s. Kailas Pumps Ltd. uses about 75,000 valves per year and the usage is
fairly constant at 6,250 per month. The value costs Rs. 1.50 per unit when
---------------------- purchased in quantities and inventory carrying cost is 20% of the average
---------------------- inventory investment on annual basis. The cost to place an order and to
process the delivery is Rs. 18. It takes 45 days to receive from the date of
---------------------- an order and minimum stock of 3,250 valves is desired. You are required
to determine:
----------------------
(a) The most economical order quantity and the number of orders in a
---------------------- year.
---------------------- (b) The reorder level.
(c) The most economic order quantity, if value costs Rs. 4.50 each instead
----------------------
of Rs. 1.50 each.
---------------------- Solution:
---------------------- (a) Economic Order Quantity:
---------------------- 2xAxO
EOQ = Cxi
---------------------- 2 x 50,000 x 45
= 20% of 1.50
----------------------
---------------------- = 3,000 units
---------------------- EOQ = Number of Orders:

Annual Consumption
----------------------
EOQ
----------------------
= 75,000 units
---------------------- 3,000 units
----------------------
= 25
----------------------
----------------------

(b) Reorder Level: Notes
Safety stock + (Normal Usage x Normal Lead time)
----------------------
= 3,250 units + (6,250 units x 1.5 months)
----------------------
= 12,625 units
(c) Revised EOQ ----------------------
(If unit cost is Rs. 4.50 instead of Rs. 1.50) ----------------------
2xAxO ----------------------
EOQ = Cxi
2 x 75,000 x 18 ----------------------
= 20% of 4.50
----------------------
= 1,732 units ----------------------
----------------------
Summary
----------------------
• Inventory includes raw material, stores and supplies, work in progress and
finished goods. ----------------------
• The basic objective of inventory management is to optimise the returns of ----------------------
investment in inventory by stocking enough inventory to ensure smooth
uninterrupted production and at the same time avoiding unnecessary ----------------------
blocking of funds.
----------------------
• The various techniques of inventory management include: i) Economic
Order Quantity ii) Fixation of Inventory levels iii) Computation of ----------------------
Inventory turnover iv) ABC analysis v) Preparation of Bill of Materials vi)
----------------------
Perpetual Inventory System.
----------------------
Keywords
----------------------
• Inventory Management: Managing investment in inventory so as to
----------------------
derive maximum benefit by incurring minimum cost
• Economic Order Quantity: That quantity which is fixed in such a way ----------------------
that the total variable cost of managing the inventory can be minimised ----------------------
• ABC Analysis: Known as Always Better Control, is an analytical method
of inventory control ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
1. State various motives for holding inventory.
---------------------- 2. What are the objects of inventory management?
---------------------- 3. How do you explain various levels of inventory?
---------------------- 4. Write short notes on the following techniques of inventory management.

a. ABC Analysis
----------------------
b. Perpetual Inventory System
----------------------
c. Economic Order Quantity
----------------------
----------------------
----------------------
----------------------
1. One of the motives for holding the inventory is:
---------------------- iv. Transaction motive
---------------------- 2. The objective of inventory management is to avoid the situation of:
---------------------- i. Over-investment as well as under-investment
----------------------
Fill in the blanks.
----------------------
1. Quantity fixed in such a way that the total variable cost of managing the
---------------------- inventory can be minimized is called Economic Order Quantity.
---------------------- Inventory levels fixed are not fixed on a permanent basis and are subject to
revision regularly.
---------------------- i. b
---------------------- ii. c
iii. d
----------------------
iv. a
----------------------

Practice.
----------------------
2. I.M. Pandey. Financial Management
---------------------- 3. Prasanna Chandra, Prasanna. Financial Management
----------------------

Dividend Policy
UNIT
16
Structure:
16.1 Introduction
16.2 Importance of Dividend Policy
16.3 Approaches to Dividend Policy
16.4 Factors Determining Dividend Policy
16.5 Choosing the Dividend Policy
16.6 Forms of Dividend Payment
Summary
Key Words
Suggested Reading
Dividend Policy 329

Notes
Objectives
----------------------
----------------------
• Show the impact of dividend policy on the valuation of the firm
----------------------
• State the different factors determining dividend policy
---------------------- • Evaluate the concept of bonus shares with its advantages and
disadvantages
----------------------
• List the guidelines for issue of bonus shares
----------------------
---------------------- 16.1 INTRODUCTION

---------------------- The Finance Manager has to decide the dividend policy very carefully.
A wrong dividend policy may put the company into financial troubles and the
---------------------- capital structure of the company may get unbalanced. The growth of the company
may get hampered if sufficient resources are not available to implement growth
----------------------
programmes. The Finance Manager has to formulate the dividend policy in
---------------------- such a way that it coincides with the ultimate object of the finance function of
maximising the wealth of shareholders and value of the firm.
----------------------
---------------------- 16.2 IMPORTANCE OF DIVIDEND POLICY
---------------------- Profits earned by a company may be handled by it basically in two ways:

1. To distribute the profits among the shareholders by way of dividend.
----------------------
2. To retain the profits in the business to be used in future.
----------------------
There are no strict rules and guidelines available to decide as to what
---------------------- portion of the profits should be distributed by way of dividend and what portion
should be retained in the business. As such, to decide the dividend policy may
---------------------- be one of the trickiest and most delicate decisions that the management of the
---------------------- company may be required to take.
If the management decides to retain a large portion of the profits in the
---------------------- business, funds required for future expansion and modernisation needs of the
---------------------- company may be available to it on long-term basis, without any obligations to
repay the same. The expansion or modernisation programmes may improve the
---------------------- earning capacity of the company in future, which may carry forward the growth
of the company. The company may be able to absorb the shocks of business
---------------------- fluctuations and adverse situations boldly. A strong and stable company may
---------------------- earn the confidence of the investors and creditors and funds may be available to
it at reasonable rates conveniently. As a result, the share prices and the value of
---------------------- the company will increase. Thus, though the shareholders are required to forego
the dividends in the short run, they get benefit in the long run.
----------------------
On the other hand, if the management decides to distribute a large portion
---------------------- of profits by way of dividend, the company may be able to earn the confidence

of the shareholders and may be able to attract the prospective investors to invest Notes
in the securities of the company. Shareholders are necessarily interested in
getting larger dividends immediately due to the time value of money and also ----------------------
due to uncertainty regarding the future. Shareholders are thus attracted to the
----------------------
companies paying high dividends, due to which prices of the shares and value
of the company increases. ----------------------
Thus, it can be seen that both high retentions and high dividends may
----------------------
be desirable, but there is necessarily a reciprocal relationship between the
retentions and dividends – Higher the retentions, lower the dividends; Lower ----------------------
the retentions, higher the dividends. The skill of the Finance Manager lies in
striking the balance between these two extremes. ----------------------
----------------------
----------------------
1. To distribute the profits among the shareholders by way of _______ is
a way of rewarding them. ----------------------
2. If the dividend is not declared by the company, shareholders are ----------------------

required to forgo the benefit in the short run, but they get the benefit in
----------------------
the ___________.
----------------------
Activity 1 ----------------------
----------------------
Look for the Dividend track record of a company and state how it relates
with business cycle. ----------------------
----------------------
16.3 APPROACHES TO DIVIDEND POLICY ----------------------
However, there are conflicting opinions regarding the impact of dividend ----------------------
policy on the valuation of the firm. According to one school of thought, dividends
are irrelevant, so the dividends have no impact on value of the firm. According ----------------------
to the second school of thought, dividends are relevant to the value of the firm
measured in terms of market prices of the shares. ----------------------
(A) Irrelevance Approach: ----------------------

This approach is suggested mainly by Modigliani and Miller. According to ----------------------
this approach, the value of the company remains unaffected by the dividend
policy of the company. It is the earnings potential and the investment ----------------------
opportunities available to the company that affect its value and not the
----------------------
dividend policy.
Suppose, that a company wants to invest in a project, it has two options ----------------------
open before it.
----------------------
Dividend Policy 331

Notes i. Pay the earnings and raise the funds from market.
ii. Retain the earnings to be used to finance the project.
----------------------
If the company pays the dividend, it will have to go to the market for
---------------------- raising the funds. Acquisition of the funds from the market will dilute the
shareholding, which results in reduced share values. As such, whatever
----------------------
the shareholders receive by way of cash dividends, they lose in terms of
---------------------- reduced share values. As such, they are not concerned with the fact whether
the earnings are retained or are distributed by way of dividend. The market
---------------------- price of the shares and as such value of the company remains the same in
both the situations.
----------------------
It is worth recollecting here the Modigliani Miller approach in relation
---------------------- to capital structure, which suggests that the value of firm and its cost of
capital are independent of its capital structure. As such, in relation to
----------------------
dividend policy also, the source from which the funds required to finance
---------------------- the investment programme are raised does not affect the value of the
company.
----------------------
(B) Relevance Approach:
---------------------- This approach is suggested mainly by Walter and Gordon. They hold that
---------------------- there is a direct relationship between the dividend policy of the company
and its value in terms of market price of its shares.
---------------------- The propositions of the above approach can be stated, in most simple words
---------------------- as below.
The investors prefer current dividend income to future dividend income
----------------------
as it does not involve any risk. As such, increasing payout ratio increases
---------------------- the share prices under normal circumstances. However, if the company has
the investment opportunities open before it where expected rate of return
---------------------- is more than cost of capital, the share prices may increase even with the
declining payout ratio, which is due to the anticipated and future dividend
----------------------
income.
----------------------
----------------------
---------------------- Multiple Choice Multiple Response.
---------------------- 1. Broadly, there are two important factors determining dividend policy:
i. External factors
----------------------
ii. Internal factors
----------------------
iii. Economic factors
---------------------- iv. Financial factors
----------------------
----------------------

2. External factors affecting the decision regarding declaring dividend are: Notes
i. Phase of trade cycles ----------------------

ii. Legal restrictions ----------------------
iii. Tax policy
----------------------
iv. Inflation level
----------------------
v. Competition level
----------------------
Activity 2 ----------------------
----------------------
Jot down important guidelines issued by SEBI regarding declaration of
dividend by the company. ----------------------
----------------------
16.4 FACTORS DETERMINING DIVIDEND POLICY ----------------------
Before formulating the dividend policy of the company, the Finance Manager ----------------------
is required to take into consideration various factors, which may be classified
as below: ----------------------
a. External Factors ----------------------
b. Internal Factors ----------------------
External Factors
----------------------
1. Phase of Trade Cycles: The company’s dividend policy depends upon
the phase of trade cycles through which the company may be moving. ----------------------
During the phase of boom and prosperity, the company may not like to
----------------------
distribute huge amount of profits by way of dividends though the earning
capacity of the company may permit it to do so. The company will like ----------------------
to retain more profits that can be used during the depression, which is
likely to follow. Further, the company will like to take the benefits of ----------------------
investment opportunities prevailing during the period of boom. Similarly,
----------------------
during the period of depression, the company will like to withhold the
dividend payments to retain the profits in the business in order to preserve ----------------------
its liquidity position. At all the times, though it may be necessary to declare
higher dividends to increase marketability of its shares. ----------------------
2. Legal Restrictions: The Company can formulate its dividend policy ----------------------
within the overall legal framework. If the company wants to pay the
dividend in cash, relevant provisions of Companies Act, 1956 are required ----------------------
to be followed by the company. If the company wants to issue the bonus
----------------------
shares with the intention to capitalise its reserves, relevant SEBI guidelines
are required to be followed by the company. The relevant provisions of ----------------------
Companies Act, 1956 and SEBI guidelines are discussed later.
----------------------
Dividend Policy 333

Notes 3. Tax Policy: Tax policy as a factor affecting the dividend policy of the
company needs to be considered from the point of view of company
---------------------- as well as from the shareholders. As far as the company is considered,
dividend can be paid out of profit after tax. As such, the company does not
---------------------- get any tax advantage by paying the dividend. On the other hand, as per the
---------------------- provisions to Section 115-O of the Income Tax Act, 1961, it increases the
tax burden for the company as the company paying the dividend is required
---------------------- to pay ‘tax on distributable profits’ which in common language is referred
to as ‘dividend tax’. The rate at which the company is required to pay the
---------------------- dividend tax is 12.5% of the amount of dividend paid and the said basic
---------------------- rate is further increased by the surcharge of 10% and the education cess of
2%. As such, the effective rate of dividend tax works out as 14.025%. As
---------------------- far as shareholders are concerned, as per the provisions of Section 10(34)
of the Income Tax Act, 1961, dividend received, whether interim or final, is
---------------------- a tax-free income. As such, they are not required to pay the tax on dividend
---------------------- received by them.
4. Investment Opportunities: Formulation of dividend policy of the
----------------------
company depends upon the investment opportunities available to the
---------------------- company. If the investment opportunities involve a higher rate of return
than the cost of capital of the company, the company will like to retain the
---------------------- profits to be invested in these projects.
---------------------- 5. Restrictions imposed by the lending institutions: In practical
circumstances, the lending banks or financial institutions impose certain
---------------------- restrictions on the company preventing the payment of dividend entirely or
limiting the amount of dividend or disallowing the payment of dividend if
----------------------
certain conditions are not fulfilled. This is due to the fact that the payment
---------------------- of dividend amounts to the withdrawal of profits from the business and
company paying the dividend may be against the interest of the lending
---------------------- banks or financial institutions so long as the loans are still unpaid to them.
---------------------- Internal Factors
---------------------- 1. Attitude of the Management: If the attitude of the management is

aggressive, it may decide to pay more dividend as the management is
---------------------- interested in increasing the recurring income of the shareholders. Whereas
if the attitude of the management is conservative, the company will like to
---------------------- retain more profits in the business to take care of the contingencies.
---------------------- 2. Composition of Shareholding: The composition of the shareholding may
play an important role in the dividend policy formulation of the company.
---------------------- If the company is a private limited company having less number of
---------------------- shareholders, the company will like to retain more profits and restrict the
payment of dividend in order to reduce the tax liability of the individual
---------------------- shareholders, as the dividend received by the shareholders is a taxable
income in their hands. If the company is a public limited company, tax
---------------------- brackets of the individual shareholders may not have a significant impact
---------------------- on the dividend policy of the company.

3. Age of the Company: A young and growing concern will like to retain Notes
maximum profits in the business in order to finance its growth and
expansion needs as it may be difficult for it to raise the funds from the open ----------------------
market whenever the need arises. On the other hand, an old or established
company having reached the saturation point, may follow a high dividend ----------------------
policy. ----------------------
4. Nature of Business / Earnings: The nature of business of the company
----------------------
inevitably affects its dividend policy. A company having stability of
earnings may be able to formulate long-term dividend policy and may even ----------------------
follow a high dividend policy if the earnings so permit. On the other hand,
a company having unstable income may like to retain its profits during ----------------------
boom to ensure that dividend policy is not affected by cyclical variations.
----------------------
5. Growth Rate of Company: The growth rate of the company closely
affects its dividend policies. A rapidly growing company may like to retain ----------------------
majority of its profits in order to take care of its expansion needs. However,
----------------------
care should be taken by the management to invest only in those projects
that yield more returns than its cost of capital. ----------------------
6. Liquidity Position: Profitability and Liquidity are separated from each
----------------------
other. In spite of existence of high profitability or huge reserves, the
company may not have sufficient funds to pay cash dividends. As such, ----------------------
before formulating the dividend policy, due considerations should be
given to the liquidity positions of the company. At the same time, future ----------------------
commitments affecting the liquidity should also be considered. E.g. At
----------------------
present, company’s cash position may be comfortable, but it may need cash
within a short time to pay installments of term loans or to pay creditors for ----------------------
materials. In such case, the Finance Manager may not like to impair its
liquidity for making dividend payment. ----------------------
7. Customs and Traditions: In some cases, the customs and traditions built ----------------------
by the company may affect its dividend policy. E.g. If the company is
following the stable dividend policy for 20 years, it may like to maintain ----------------------
the trend in the 21st year also, in spite of adverse profitability or liquidity ----------------------
situations.
----------------------
16.5 CHOOSING THE DIVIDEND POLICY
----------------------
As discussed above, a host of factors is required to be considered by the
----------------------
company before formulating its dividend policy. The selection of ultimate
dividend policy varies from industry to industry. There may be various patterns ----------------------
in which a company may pay dividends.
----------------------
1. Stable Dividend Policy:
According to this policy, the company pays a fixed amount of dividend ----------------------
irrespective of the fluctuations in income. During the periods of prosperity, ----------------------
the company withholds extra income to be used for paying dividends in
lean years. Stable dividend policy does not indicate stagnation in dividend ----------------------
Dividend Policy 335

Notes payout. If the company is assured about permanent increase in earnings,
amount of dividend per share may be increased.
----------------------
Stable dividend policy helps the company in following respects:
---------------------- i. The credit standing of the company in market increases. The investors
are assured of a stable income and the company can raise as much
----------------------
funds as required in the market.
---------------------- ii. The share prices of the company increase. The marketability of the
shares increase and the investors are ready to pay high premium for
----------------------
these shares.
---------------------- iii. The management of the company enjoys confidence of the shareholders.
---------------------- This may enable the company to raise the funds whenever required,
also improving the morale of management.
---------------------- iv. The company following a stable dividend policy can formulate
---------------------- financial plan on long-term basis as future demand and supply of
capital can be correctly estimated.
---------------------- While formulating stable dividend policy, care should be taken not to fix
---------------------- the dividend payout ratio at a very high level, which cannot be maintained
in the lean period. For this purpose, correct estimations of earnings capacity
---------------------- and future earnings of the company should be made.
---------------------- 2. No Immediate Dividend Policy:
According to this policy, the company does not pay any dividend despite
----------------------
the huge earnings. The company retains the earnings to be used in future
---------------------- for its growth and expansion programmes if it is feared that the access to
capital market will be difficult or costly in future. The main drawback with
---------------------- this policy is that the shareholders do not get immediate cash income by
way of dividend and hence shareholders who invest in the shares with the
----------------------
view to get regular income may not be in favour of this policy. However,
---------------------- this policy may attract the shareholders who are willing to devote short-
term dividend income for long-term capital gains and share in the increased
---------------------- prosperity of the company.
---------------------- 3. Regular and Extra Dividend Policy:
---------------------- This policy may be used as a supplement to stable dividend policy. In case
of a stable dividend policy, the dividend payout is maintained at a constant
---------------------- rate. However, if in a particular year, the earnings of the company increase
abnormally, the additional earnings may be distributed by way of extra
---------------------- dividends rather than increasing the dividend payout rate itself.
---------------------- The advantage attached with the policy is that the shareholders are aware
of the fact that the extra dividends are solely due to the abnormal earnings,
---------------------- which may be dropped if there is no abnormal earning in a particular year.
---------------------- However, if a company follows a policy of regular and extra dividends
for years together, a wrong impression may be created in the minds of
---------------------- shareholders who may treat the extra dividends as a part of regular

dividends and the omission to pay extra dividend in some year may result Notes
into loss of confidence of the shareholders with the adverse effect on share
prices and credit standing of the company. ----------------------
4. Regular Stock Dividend Policy: ----------------------
According to this policy, the company may decide to pay dividends in
----------------------
the form of stock rather than in the form of cash i.e. by issuing bonus
shares. This policy may be useful to the company as it does not involve the ----------------------
effect on liquidity position of the company. However, following its policy
on a regular basis may prove to be disadvantageous due to two reasons. ----------------------
Firstly, if the company is not in the position to increase future earnings
----------------------
on a permanent basis, issue of Bonus shares may reduce the earnings per
share, which may adversely affect the share prices and credit standing of ----------------------
the company. Secondly, the shareholders who are interested in getting cash
income on regular basis may not approve of this policy on a permanent ----------------------
basis and may demand cash dividends.
----------------------
5. Irregular Dividend Policy:
----------------------
According to this policy, the dividend payout rate is not fixed by the
company. The dividend per share varies according to the level of earnings. ----------------------
As such, high earnings may result into high dividends, whereas less
earnings may result into less or no dividends. ----------------------
As such, this policy believes that the shareholders are entitled to dividends ----------------------
only when the earnings and liquidity position of the company justify the
payment of dividends. This policy may be followed by the companies ----------------------
having unstable income. ----------------------
This policy may be advantageous for the company as it does not commit
itself to any fixed and regular payment of dividend. However, it may not ----------------------
be approved by the shareholders, as it does not assure any fixed or regular ----------------------
dividend income.
----------------------
16.6 FORMS OF DIVIDEND PAYMENT ----------------------
If a company wants to distribute the profits among the shareholders by way ----------------------
of dividend, it can do so in two forms:
a. Payment of dividend in cash ----------------------
b. Issue of Bonus Shares ----------------------

Cash Dividend ----------------------
If the company wants to distribute the dividend by way of cash i.e. by issuing ----------------------
the dividend warrants, the company is required to fulfill various procedural and
legal formalities. ----------------------
a. The rate of dividend to be paid needs to be decided by the Board of ----------------------
Directors. However, the capacity of the Board of Directors is only the
recommendatory capacity. The dividend is declared by the shareholders ----------------------
Dividend Policy 337

Notes in their meeting i.e. Annual General Meeting. However, the shareholders
cannot increase the rate of dividend recommended by Board of Directors.
----------------------
According to the provisions of Section 205-1(B) of the Companies Act,
---------------------- 1956, the Board of Directors can declare the interim dividend. The term
interim dividend refers to the dividend declared in between two Annual
---------------------- General Meetings.
---------------------- b. The dividend is payable out of the current year’s profit after providing for
sufficient amount of depreciation as per the provisions of Schedule XIV of
---------------------- the Companies Act, 1956.
---------------------- c. Before any dividend is paid in cash, the company is required to transfer a
certain minimum amount to reserves from the profits earned in the current
---------------------- year. This provision is made to ensure that the company does not withdraw
the entire amount of profits from the business. The rates at which the profits
----------------------
need to be transferred to reserves, are stated below:
---------------------- Rate of dividend % of current profits to be
---------------------- To be paid transferred to reserves
More than 10% but less than 12.5% 2.5%
---------------------- More than 12.5% but less than 15% 5%
---------------------- More than 15% but less than 20% 7.5%
More than 20% 10%
----------------------
d. Generally, the company will not be able to pay the dividend unless the
---------------------- company has the profits in the current year. However, in some cases, the
company can pay the dividend out of the profits earned by the company
---------------------- in the past and retained as reserves. If the company pays the dividends out
---------------------- of the retained profits, the company needs to comply with the following
conditions:
---------------------- i. The rate of dividend declared shall not exceed the average rate at
---------------------- which the dividend was declared during 5 immediately preceding
years or 10% of its paid up capital.
----------------------
ii. The total amount to be drawn from the reserves shall not exceed an
---------------------- amount equal to 10% of its paid up capital and free reserves.
e. Any amount of dividend declared including interim dividend shall be
----------------------
deposited in a separate bank account within five days from the date of
---------------------- declaration of such dividend and the amount so deposited shall be used for
the payment of interim dividend.
----------------------
If the dividend has been declared but has not been paid or the dividend
---------------------- warrants are not posted within 30 days from the declaration of dividend to
any shareholder entitled to the payment of dividend, every director of the
---------------------- company who is knowingly a party to the default, shall be punishable with
simple imprisonment up to three years and also to a fine of Rs. 1000 for
----------------------
every day during which the default continues. Further, the company shall
---------------------- be liable to pay simple interest @18% p.a. during the period for which the
default continues.
f. Any dividend which has been declared by the company but which remains Notes
to be paid or claimed within 30 days from its declaration, the company
shall, within 7 days from the expiry of such 30 days, transfer this amount ----------------------
of unpaid or unclaimed dividend to a separate account opened with
a scheduled bank. If any amount remains pending in this account for a ----------------------
period of 7 years, such amount will be transferred by the company to a ----------------------
fund established by the Central Government as ‘Investor Education and
Protection Fund’ which is supposed to be used for promotion of investors’ ----------------------
awareness and protection of the interests of the investors.
----------------------
Bonus Shares:
----------------------
Bonus Shares indicate the payment of dividend in the form of shares of
the same company in proportion to their existing shareholding. This form of ----------------------
paying the dividend does not involve any outflow of cash, but involves only
transfer of retained earnings to share capital. Profits earned by a company in ----------------------
the previous years effectively belong to the equity shareholders as they are the
----------------------
ultimate owners of the company. However, so long as the reserves appear on the
balance sheet of the company, the legal ownership of the reserves remains with ----------------------
the company. By issuing the bonus shares, the company transfers ownership of
reserves to the shareholders legally. As such, issue of bonus shares is technically ----------------------
referred to as the capitalisation of reserves. When a company issues bonus
----------------------
shares, reserves of the company get reduced and share capital of the company
increases. ----------------------
Advantages:
----------------------
To the Company:
----------------------
i. Conservation of Cash: The company can satisfy the desire of
shareholders for dividend without affecting its cash position. Thus, ----------------------
issuing of bonus shares may be a best remedy for a company having
deficiency of the funds in spite of the huge earnings. ----------------------
ii. Remedy for Undercapitalisation: As discussed earlier, the conditions ----------------------

of undercapitalisation indicate huge amount of earnings per share. By
issuing bonus shares, the company increases number of shares thereby ----------------------
reducing the amount of earnings per share and the amount of dividends ----------------------
per share. Thus, bonus shares can be a best remedy for overcoming the
situation of undercapitalisation. ----------------------
iii. Transferring Ownership of Reserves: Existence of huge reserves ----------------------
may tempt a company to indulge itself in the speculative activities
and manipulation of market value of shares. Issuing the bonus shares ----------------------
prevents the company from doing so.
----------------------
iv. Increased Marketability: Bonus shares may increase the
marketability of the shares. Increased number of shares and reduced ----------------------
earnings per share may keep the market price of the shares within the
----------------------
reach of an ordinary investor. Thus, the market for the shares of the
company may become wide. ----------------------
Dividend Policy 339

Notes v. Increased Prestige: Issuance of bonus shares increases the credit
standing of the company in the eyes of the lending financial institutions
---------------------- and it can arrange for the funds at a reasonable cost.
---------------------- vi. Proper Presentation of Earning Capacity: Issuance of bonus shares
results into proper presentation of earning capacity of the company. If
---------------------- bonus shares are not issued, the accumulated reserves go on increasing
with no change in shares capital, which may create a false idea about
----------------------
the profitability, and earning capacity of the company.
---------------------- To Shareholders:
---------------------- Due to bonus shares, shareholders are benefited from two angles. First, their
equity holding in the company increases. Though they may get dividend per
---------------------- share at a reduced rate, their total income is not affected. Second, the increased
prestige of the company in the eyes of probable investors creates a ready market
----------------------
for their shareholding.
---------------------- To Creditors:
---------------------- Creditors react favourably as company’s liquidity position is not affected
and the margin of safety available for the creditors increases. But if the company
---------------------- continues to pay dividend at old rates on increased capital, it increases the strain
---------------------- on the liquidity position of the company.
Disadvantages:
----------------------
1. Issue of bonus shares presupposes that the earnings of the company will
---------------------- increase proportionately, otherwise the increased capital may not be
justified. If the earnings per share are not increased with respect to the
----------------------
increased capital, it may suggest low profitability of the company and its
---------------------- poor management. This may prove to be fatal to the company.
2. The stock dividends are more expensive to administer as compared to cash
----------------------
dividends.
---------------------- Guidelines for the issue of Bonus Shares:
---------------------- Earlier, the companies issuing bonus shares were governed by the
guidelines issued by Controller of Capital Issues (CCI). After the abolition of
---------------------- office of CCI, these guidelines were replaced by SEBI guidelines. Whereas the
---------------------- guidelines issued by CCI were restrictive in nature, the guidelines issued by
SEBI are more administrative in nature. Even though the guidelines issued by
---------------------- SEBI are more particularly applicable to the companies listed on the recognised
stock exchanges, they equally apply to non-listed companies as well. The SEBI
---------------------- guidelines in respect of issue of bonus shares are as below:
---------------------- a. Articles of Association of the company should permit the issue of bonus
shares. If there is no provision in the Articles of Association, they need to
---------------------- be amended first.
---------------------- b. The authorised share capital of the company should be sufficient to absorb
the share capital of the company after the issue of bonus shares. If the
----------------------

authorised share capital is not sufficient, the same needs to be increased Notes
first.
----------------------
c. The bonus shares cannot be issued in respect of partly paid shares.
d. The issue of bonus shares needs to be approved by the board of directors ----------------------
and the company should issue the bonus shares within a period of six
----------------------
months from the date of approval given by the board of directors. Approval
given by the board of directors cannot be reversed. ----------------------
e. Bonus shares can be issued out of the free reserves appearing on the
----------------------
balance sheet and the share premium amount collected in cash. It is made
very clear in the SEBI guidelines that revaluation reserve cannot be used ----------------------
for issue of bonus shares.
----------------------
f. The company cannot issue the bonus shares if it has defaulted -
i) in respect of payment of interest or repayment of principal amount, ----------------------
either in case of debentures or in case of public deposits. This provision ----------------------
is to protect the interests of debenture holders or depositors.
ii) in respect of payment of employee dues, like provident fund, gratuity, ----------------------
bonus etc. This provision is to protect the interests of employees. ----------------------
g. Pending the conversion of Fully Convertible Debentures (FCDs) or
----------------------
partly Convertible Debentures (PCDs) into the shares of the company, no
company can issue the bonus shares unless the same benefit is extended to ----------------------
holders of these FCDs or PCDs by reserving a part of shares for them. Such
shares can be actually issued when the conversion into shares takes place. ----------------------
h. A company which is a listed company shall forward certificates duly signed ----------------------
by the company and countersigned by its statutory auditor or a company
secretary in practice, certifying that the company has compiled with all the ----------------------
terms and conditions in respect of issue of bonus shares.
----------------------
When CCI guidelines were applicable, no company could issue the bonus shares
in the proportion of more than 1:1, i.e. for every one share held in the company, ----------------------
maximum one bonus share could be issued by the company. This restriction ----------------------
was removed by SEBI guidelines. First company to take the advantage of these
revised SEBI guidelines was Cipla Ltd., which issued the bonus shares in the ----------------------
proportion of 5:1, i.e. for every one share held in the company, the shareholders
got five bonus shares. ----------------------
----------------------
Summary
----------------------
• This chapter introduces you with the factors determining Dividend Policy
and its impact on the valuation of firm. The factors may be classified as ----------------------
External and Internal.
----------------------
• The external factor generally includes legal restrictions, tax policy and
investment opportunities. ----------------------
----------------------
Dividend Policy 341

Notes • The internal factors may include attitude of management, nature of
business, growth rate of company and liquidity position of the company.
----------------------
• Dividend can be paid in cash or by issue of bonus shares to the shareholders.
---------------------- • There are various procedures and legal formalities, which are required to
be complied with by the company for the payment of dividend.
----------------------
• In case of Bonus Shares, company issues shares to the shareholders as
---------------------- dividend in proportion of their existing shareholding in the same company.
----------------------
Keywords
----------------------
• Dividend: The reward given to the shareholders by the company
----------------------
• Dividend Policy: Document stating the decision of the company to handle
---------------------- the profits earned by the company
---------------------- • Cash Dividend: If the company distributes the dividend by way of cash,
i.e. by issuing the dividend warrants, it is cash dividend.
----------------------

---------------------- 1 Discuss the significance of dividend policy decisions. Which factors affect
dividend policy decisions of a company?
----------------------
2 Explain the approaches of dividend policy.
----------------------
3 What are the different dividend policies a company can follow?
---------------------- 4 Discuss various legal and procedural formalities to be complied with by a
company while paying the dividend in cash.
----------------------
5 What do you mean by Bonus shares? What are the advantages of Bonus
---------------------- shares?
---------------------- 6 Explain SEBI guidelines for the issue of Bonus shares.
----------------------
----------------------
---------------------- 1. To distribute the profits among the shareholders by way of dividend is a
way of rewarding them.
----------------------
2. If the dividend is not declared by the company, shareholders are required to
---------------------- forgo the benefit in the short run, but they get the benefit in the long run.
----------------------
----------------------
----------------------

----------------------
1. Broadly, there are two important factors determining dividend policy:
----------------------
i. External factors
ii. Internal factors ----------------------
2. External factors affecting the decision regarding declaring dividend are: ----------------------
i. Phase of trade cycles ----------------------
ii. Legal restrictions
----------------------
iii. Tax policy
----------------------
1. Khan & Jain. Financial Management ----------------------

2. Christine Robertson. Financial Management: Review of Education’s Grant ----------------------
Back Account
----------------------
Accounting and Financial Management ----------------------
----------------------
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----------------------
----------------------
----------------------
----------------------
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----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Dividend Policy 343

Notes
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FINANCIAL MANAGEMENT

(FOR PRIVATE CIRCULATION ONLY)

COURSE DESIGN AND REVIEW COMMITTEE

Published by Symbiosis Centre for Distance Learning (SCDL), Pune

Copyright © 2018 Symbiosis Open Education Society

Dr. Satish Inamdar

Unit No. TITLE Page No.

---------------------- 1.1 INTRODUCTION

---------------------- 1.2 APPROACHES TO THE TERM FINANCE

Check your Progress 1 ----------------------

---------------------- Prepare a flow chart showing widening scope of finance function.

---------------------- 1.4 GOALS/OBJECTIVES OF FINANCE FUNCTION

---------------------- Profit Maximisation:

---------------------- Multiple Choice Single Response.

1.5 ORGANISATION OF FINANCE FUNCTION ----------------------

---------------------- Vice President Vice President Vice President

---------------------- (1) Accounting and Costing (1) Receivables Management

---------------------- (7) Dividend Distribution

---------------------- Multiple Choice Single Response.

1.7 THE FIELDS OF FINANCE ----------------------

---------------------- Match the following.

---------------------- Answers to Check your Progress

---------------------- Multiple Choice Single Response.

iii. Capital budgeting decisions ----------------------

ii. Wealth maximisation ----------------------

1. Ainapure & Ainapure. Auditing and Assurance. ----------------------

Forms of Business Organisation 19

2. Proprietary is a difficult and expensive form of business organisation. ----------------------

Forms of Business Organisation 21

Forms of Business Organisation 23

---------------------- c. In case of a private limited company, right of the shareholders to

---------------------- i. That the shares to be transferred should be offered to the existing

i. Minimum two and maximum 10 in case of banking ----------------------

iii. Expensive ----------------------

Forms of Business Organisation 25

---------------------- 4. Company can sue but cannot be sued.

12. Private company’s shares are listed in stock exchange. ----------------------

Forms of Business Organisation 27

---------------------- Self-Assessment Questions

---------------------- (c) Joint Stock Companies

---------------------- 5. Write short notes on the following:

Multiple Choice Single Response ----------------------

Forms of Business Organisation 29

---------------------- Suggested Reading

---------------------- 3.1 INTRODUCTION

---------------------- 3.2 NATURE OF FINANCIAL STATEMENTS

---------------------- Any organisation doing the business, whether it is a manufacturing

State True or False. ----------------------

1. ‘Balance sheet’ is an account showing assets and liabilities. ----------------------

Liabilities Rs. Assets Rs. ----------------------

---------------------- 3.4 STRUCTURE OF FINANCIAL STATEMENTS

---------------------- Part I: Structure of Balance Sheet:

---------------------- Following items appear in the Balance Sheet.

a. Capital Reserve. ----------------------

---------------------- f. Proposed additions to reserves.

---------------------- ii. To write off preliminary expenses.

c. Short-term Loans and Advances ----------------------

e. Inter-corporate unsecured deposits and Commercial Papers fall under ----------------------

---------------------- c. Subsidiary Companies

1. ‘Balance sheet’ is an account showing assets and liabilities. ----------------------

e. Inter-corporate unsecured deposits and Commercial Papers fall under ----------------------

---------------------- • nalyse the limitations of various ratios and accordingly apply