Accounts 4

84 Accounting & Financial Management
Unit 4: Financial Management

Notes
Structure
4.1 Introduction
4.2 Meaning
4.3 Functions
4.4 Importance of Financial Management
4.5 Risk and Return
4.6 Various Functional areas of Financial Management
4.7 Capital Budgeting
4.8 Cost of Capital
4.9 Ratio Analysis
4.10 Some Important Ratios
4.11 Summary
4.12 Check Your Progress
4.13 Questions and Exercises
4.14 Key Terms
4.15 Further Readings
Objectives
After studying this unit, you should be able to:
z Understand the Concept and meaning of Financial Management
z Discuss the risk and return, various functional areas of financial management
– capital budgeting
z Explain the cost of capital, ratio analysis
4.1 Introduction
Financial Management means planning, organizing, directing and controlling the
financial activities such as procurement and utilization of funds of the enterprise. It
means applying general management principles to financial resources of the enterprise.
Scope/Elements
Investment decisions includes investment in fixed assets (called as capital budgeting).
Investment in current assets is also a part of investment decisions called as working
capital decisions.
z Financial decisions: They relate to the raising of finance from various resources
which will depend upon decision on type of source, period of financing, cost of
financing and the returns thereby.
z Dividend decision: The finance manager has to take decision with regards to the
net profit distribution. Net profits are generally divided into two:
z Dividend for shareholders: Dividend and the rate of it has to be decided.
z Retained profits: Amount of retained profits has to be finalized which will depend
upon expansion and diversification plans of the enterprise.
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Financial Management 85
Objectives of Financial Management
The financial management is generally concerned with procurement, allocation and Notes
control of financial resources of a concern. The objectives can be:
z To ensure regular and adequate supply of funds to the concern.
z To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders.
z To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
z To ensure safety on investment, i.e., funds should be invested in safe ventures so
that adequate rate of return can be achieved.
z To plan a sound capital structure: There should be sound and fair composition of
capital so that a balance is maintained between debt and equity capital.
Functions of Financial Management

z Estimation of capital requirements: A finance manager has to make estimation
with regards to capital requirements of the company. This will depend upon
expected costs and profits and future programmes and policies of a concern.
Estimations have to be made in an adequate manner which increases earning
capacity of enterprise.
z Determination of capital composition: Once the estimation has been made, the
capital structure has to be decided. This involves short- term and long- term debt
equity analysis. This will depend upon the proportion of equity capital a company is
possessing and additional funds which have to be raised from outside parties.
z Choice of sources of funds: For additional funds to be procured, a company has
many choices like-
Issue of shares and debentures
Loans to be taken from banks and financial institutions
Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and demerits of each source and
period of financing.
z Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns is
possible.
z Disposal of surplus: The net profits decision has to be made by the finance
manager. This can be done in two ways:
z Dividend declaration: It includes identifying the rate of dividends and other
benefits like bonus.
z Retained profits: The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.
z Management of cash: Finance manager has to make decisions with regards to
cash management. Cash is required for many purposes like payment of wages and
salaries, payment of electricity and water bills, payment to creditors, meeting
current liabilities, maintenance of enough stock, purchase of raw materials, etc.
z Financial controls: The finance manager has not only to plan, procure and utilize
the funds but he also has to exercise control over finances. This can be done
through many techniques like ratio analysis, financial forecasting, cost and profit
control, etc.
4.2 Meaning
One needs money to make money. Finance is the life-blood of business and there must
be a continuous flow of funds in and out of a business enterprise. Money makes the

wheels of business run smoothly. Sound plans, efficient production system and
excellent marketing network are all hampered in the absence of an adequate and timely
Notes supply of funds.
Sound financial management is as important in business as production and
marketing. A business firm requires finance to commence its operations, to continue
operations and for expansion or growth. Finance is, therefore, an important operative
function of business.
A large business firm has to raise funds from several sources and has to utilise
those funds in alternative investment opportunities. In order to ensure the most
judicious utilisation of funds and to provide a reasonable rate of return on the
investment, sound financial policies and programmes are required. Unwise financing
can drive a business into bankruptcy just as easily as a poor product, inept marketing or
high production costs.
On the other hand, adequate and economical financing can provide the firm a
differential advantage in the market place. The success of a business enterprise is
largely determined by the way its capital funds are raised, utilised and disbursed. In the
modern money-using economy, the importance of finance has increased further due to
increasing scale of operations and capital intensive techniques of production and
distribution.
In fact, finance is the bright thread running through all business activity. It influences
and limits the activities of marketing, production, purchasing and personnel
management. The success of a business is measured largely in financial terms. The
efficient organisation and administration of the finance function is thus vital to the
successful functioning of every business enterprise.
Meaning of Financial Management

Financial management may be defined as planning, organising, directing and controlling
the financial activities of an organisation. According to Guthman and Dougal, financial
management means, “the activity concerned with the planning, raising, controlling and
administering of funds used in the business.” It is concerned with the procurement and
utilisation of funds in the proper manner.
Financial activities deal with not only the procurement and utilisation of funds but
also with the assessing of needs for funds, raising required finance, capital budgeting,
distribution of surplus, financial controls, etc.
Ezra Solomon has described the nature of financial management as follows:
“Financial management is properly viewed as an integral part of overall management
rather than as a staff specially concerned with funds raising operations.
In this broader view, the central issue of financial policy is the wise use of funds and
the central process involved is a rational matching of the advantage of potential uses
against the cost of alternative potential sources so as to achieve the broad financial
goals which an enterprise sets for itself.
In addition to raising funds, financial management is directly concerned with
production, marketing and other functions within an enterprise whenever decisions are
made about the acquisition or distribution of funds.”
Objectives of Financial Management

Financial management is one of the functional areas of business. Therefore, its
objectives must be consistent with the overall objectives of business. The overall
objective of financial management is to provide maximum return to the owners on their
investment in the long- term.

This is known as wealth maximisation. Maximisation of owners’ wealth is possible
when the capital invested initially increases over a period of time. Wealth maximisation
means maximising the market value of investment in shares of the company. Notes
Wealth of shareholders = Number of shares held ×Market price per share.
In order to maximise wealth, financial management must achieve the following
specific objectives:
z To ensure availability of sufficient funds at reasonable cost (liquidity).
z To ensure effective utilisation of funds (financial control).
z To ensure safety of funds by creating reserves, re-investing profits, etc.
(minimisation of risk).
z To ensure adequate return on investment (profitability).
z To generate and build-up surplus for expansion and growth (growth).
z To minimise cost of capital by developing a sound and economical combination of
corporate securities (economy).
z To coordinate the activities of the finance department with the activities of other
departments of the firm (cooperation).
Profit Maximisation
Very often maximisation of profits is considered to be the main objective of financial
management. Profitability is an operational concept that signifies economic efficiency.
Some writers on finance believe that it leads to efficient allocation of resources and
optimum use of capital.
It is said that profit maximisation is a simple and straightforward objective. It also
ensures the survival and growth of a business firm. But modern authors on financial
management have criticised the goal of profit maximisation.
Ezra Solomon has raised the following objections against the profit maximisation
objective:
Objections against the Profit Maximisation Objectives

z The concept is ambiguous or vague. It is amenable to different interpretations, e.g.,
long run profits, short run profits, volume of profits, rate of profit, etc.
z It ignores the timing of returns. It is based on the assumption of bigger the better
and does not take into account the time value of money. The value of benefits
received today and those received a year later are not the same.
z It ignores the quality of the expected benefits or the risk involved in prospective
earnings stream. The streams of benefits may have varying degrees of uncertainty.
Two projects may have same total expected earnings but if the earnings of one
fluctuate less widely than those of the other it will be less risky and more preferable.
More uncertain or fluctuating the expected earnings, lower is their quality.
z It does not consider the effect of dividend policy on the market price of the share.
The goal of profit maximisation implies maximising earnings per share which is not
necessarily the same as maximising market-price share. According to Solomon, “to
the extent payment of dividends can affect the market price of “the stock (or share),
the maximisation of earnings per share will not be a satisfactory objective by itself.”
z Profit maximisation objective does not take into consideration the social
responsibilities of business. It ignores the interests of workers, consumers,
government and the public in general. The exclusive attention on profit
maximisation may misguide managers to the point where they may endanger the
survival of the firm by ignoring research, executive development and other
intangible investments.

Wealth Maximisation
Notes Prof. Ezra Solomon has advocated wealth maximisation as the goal of financial
decision-making. Wealth maximisation or net present worth maximisation is defined as
follows: “The gross present worth of a course of action is equal to the capitalised value
of the flow of future expected benefits, discounted (or as capitalised) at a rate which
reflects their certainty or uncertainty.
Wealth or net present worth is the difference between gross present worth and the
amount of capital investment required to achieve the benefits being discussed. Any
financial action which creates wealth or which has a net present worth above zero is a
desirable one and should be undertaken.
Any financial action which does not meet this test should be rejected. If two or more
desirable courses of action are mutually exclusive (i.e., if only one can be undertaken),
then the decision should be to do that which creates most wealth or shows the greatest
amount of net present worth. In short, the operating objective for financial management
is to maximise wealth or net present worth.”
Wealth maximisation is more operationally viable and valid criterion because of the
following reasons:
z It is a precise and unambiguous concept. The wealth maximisation means
maximising the market value of shares.
z It takes into account both the quantity and quality of the expected steam of future
benefits. Adjustments are made for risk (uncertainty of expected returns) and timing
(time value of money) by discounting the cash flows,
z As a decision criterion, wealth maximisation involves a comparison of value of cost.
It is a long-term strategy emphasising the use of resources to yield economic values
higher than joint values of inputs.
z Wealth maximisation is not in conflict with the other motives like maximisation of
sales or market share. It rather helps in the achievement of these other objectives.
In fact, achievement of wealth maximisation also maximises the achievement of the
other objectives. Therefore, maximisation of wealth is the operating objective by
which financial decisions should be guided.
The above description reveals that wealth maximisation is more useful if objective
than profit maximisation. It views profits from the long-term perspective. The true index
of the value of a firm is the market price of its shares as it reflects the influence of all
such factors as earnings per share, timing of earnings, risk involved, etc.
z Thus, the wealth maximisation objective implies that the objective of financial
management should be to maximise the market price of the company’s shares in
the long-term. It is a true indicator of the company’s progress and the shareholder’s
wealth.
However, “profit maximisation can be part of a wealth maximisation strategy. Quite
often the two objectives can be pursued simultaneously but the maximisation of profits
should never be permitted to overshadow the broader objectives of wealth
maximisation.
Approaches to Financial Management

Financial management approach measures the scope of the financial management
in various fields, which include the essential part of the finance. Financial
management is not a revolutionary concept but an evolutionary. The definition and
scope of financial management has been changed from one period to another
period and applied various innovations. Theoretical points of view, financial
management approach may be broadly divided into two major parts.

Traditional Approach
Notes
Traditional approach is the initial stage of financial management, which was followed,
in the early part of during the year 1920 to 1950. This approach is based on the past
experience and the traditionally accepted methods. Main part of the traditional approach
is rising of funds for the business concern.
Traditional approach consists of the following important area:
z Arrangement of funds from lending body.
z Arrangement of funds through various financial instruments.
z Finding out the various sources of funds.
4.3 Functions
Finance function is one of the major parts of business organization, which involves the
permanent, and continuous process of the business concern. Finance is one of the
interrelated functions which deal with personal function, marketing function, production
function and research and development activities of the business concern. At present,
every business concern concentrates more on the field of finance because, it is a very
emerging part which reflects the entire operational and profit ability position of the
concern. Deciding the proper financial function is the essential and ultimate goal of the
business organization. Finance manager is one of the important role players in the field
of finance function. He must have entire knowledge in the area of accounting, finance,
economics and management. His position is highly critical and analytical to solve
various problems related to finance. A person who deals finance related activities may
be called finance manager.
Finance manager performs the following major functions:
1. Forecasting Financial Requirements: It is the primary function of the Finance
Manager. He is responsible to estimate the financial requirement of the business
concern. He should estimate, how much finances required to acquire fixed assets
and forecast the amount needed to meet the working capital requirements in future.
2. Acquiring Necessary Capital: After deciding the financial requirement, the finance
manager should concentrate how the finance is mobilized and where it will be
available. It is also highly critical in nature.
3. Investment Decision: The finance manager must carefully select best investment
alternatives and consider the reasonable and stable return from the investment. He
must be well versed in the field of capital budgeting techniques to determine the
effective utilization of investment. The finance manager must concentrate to
principles of safety, liquidity and profitability while investing capital.
4. Cash Management: Present days cash management plays a major role in the area
of finance because proper cash management is not only essential for effective
utilization of cash but it also helps to meet the short-term liquidity position of the
concern.
5. Interrelation with Other Departments: Finance manager deals with various
functional departments such as marketing, production, personal, system, research,
development, etc. Finance manager should have sound knowledge not only in
finance related area but also well versed in other areas. He must maintain a good
relationship with all the functional departments of the business organization.
4.4 Importance of Financial Management

Finance is the lifeblood of business organization. It needs to meet the requirement of
the business concern. Each and every business concern must maintain adequate
amount of finance for their smooth running of the business concern and also maintain
the business carefully to achieve the goal of the business concern. The business goal

can be achieved only with the help of effective management of finance. We can’t
neglect the importance of finance at any time at and at any situation. Some of the
Notes importance of the financial management is as follows:
z Financial Planning: Financial management helps to determine the financial
requirement of the business concern and leads to take financial planning of the
concern. Financial planning is an important part of the business concern, which
helps to promotion of an enterprise.
z Acquisition of Funds: Financial management involves the acquisition of required
finance to the business concern. Acquiring needed funds play a major part of
the financial management, which involve possible source of finance at minimum
cost.
z Proper Use of Funds: Proper use and allocation of funds leads to improve the
operational efficiency of the business concern. When the finance manager uses the
funds properly, they can reduce the cost of capital and increase the value of the
firm.
z Financial Decision: Financial management helps to take sound financial decision
in the business concern. Financial decision will affect the entire business operation
of the concern. Because there is a direct relationship with various department
functions such as marketing, production personnel, etc.
z Improve Profitability: Profitability of the concern purely depends on the
effectiveness and proper utilization of funds by the business concern. Financial
management helps to improve the profitability position of the concern with the help
of strong financial control devices such as budgetary control, ratio analysis and cost
volume profit analysis.
z Increase the Value of the Firm: Financial management is very important in the
field of increasing the wealth of the investors and the business concern. Ultimate
aim of any business concern will achieve the maximum profit and higher profitability
leads to maximize the wealth of the investors as well as the nation.
z Promoting Savings: Savings are possible only when the business concern earns
higher profitability and maximizing wealth. Effective financial management helps to
promoting and mobilizing individual and corporate savings. Nowadays financial
management is also popularly known as business finance or corporate finances.
The business concern or corporate sectors cannot function without the importance
of the financial management.
Relationship of Financial Management with other Branches

Financial management is one of the important parts of overall management, which is
directly related with various functional departments like personnel, marketing and
production.
Financial management covers wide area with multidimensional approaches.
1. Financial Management and Economics: Economic concepts like micro and
macroeconomics are directly applied with the financial management approaches.
Investment decisions, micro and macro environmental factors are closely
associated with the functions of financial manager. Financial management also
uses the economic equations like money value discount factor, economic order
quantity etc. Financial economics is one of the emerging area, which provides
immense opportunities to finance, and economical areas.
2. Financial Management and Accounting: Accounting records includes the
financial information of the business concern. Hence, we can easily understand the
relationship between the financial management and accounting. In the olden
periods, both financial management and accounting are treated as a same
discipline and then it has been merged as Management Accounting because this
part is very much helpful to finance manager to take decisions. But

nowadays financial management and accounting discipline are separate and
interrelated.
3. Financial Management or Mathematics: Modern approaches of the financial
Notes
management applied large number of mathematical and statistical tools and
techniques. They are also called as econometrics. Economic order quantity,
discount factor, time value of money, present value of money, cost of capital,
capital structure theories, dividend theories, ratio analysis and working capital
analysis are used as mathematical and statistical tools and techniques in the field
of financial management.
4. Financial Management and Production Management: Production management
is the operational part of the business concern, which helps to multiple the money
into profit. Profit of the concern depends upon the production performance.
Production performance needs finance, because production department requires
raw material, machinery, wages, operating expenses etc. These expenditures are
decided and estimated by the financial department and the finance manager
allocates the appropriate finance to production department. The financial manager
must be aware of the operational process and finance required for each process of
production activities.
5. Financial Management and Marketing: Produced goods are sold in the market
with innovative and modern approaches. For this, the marketing department needs
finance to meet their requirements. The financial manager or finance department is
responsible to allocate the adequate finance to the marketing department. Hence,
marketing and financial management are interrelated and depends on each other.
6. Financial Management and Human Resource: Financial management is also
related with human resource department, which provides manpower to all the
functional areas of the management. Financial manager should carefully evaluate
the requirement of manpower to each department and allocate the finance to the
human resource department as wages, salary, remuneration, commission, bonus,
pension and other monetary benefits to the human resource department.
Hence, financial management is directly related with human resource
management.
4.5 Risk and Return

The world of investing can be a cold, chaotic, and confusing place. In this tutorial, we'll
go through some of the theories that investors have developed in an effort to explain the
behaviour of the market. We will discuss concepts, like risk return trade-off, rupee cost
averaging and diversification, that are especially useful for individual investors.
Here are some of the fundamental concepts of finance and investment.
The Risk Return trade-off

Deciding what amount of risk you can take while remaining comfortable with your
investments is very important.
In the investing world, the dictionary definition of risk is the chance that an
investment's actual return will be different than expected. Technically, this is measured
in statistics by standard deviation. Practically, risk means you have the possibility of
losing some or even all of your original investment.
Low risks are associated with low potential returns. High risks are associated with
high potential returns. The risk return trade-off is an effort to achieve a balance between
the desire for the lowest possible risk and the highest possible return. The risk return
trade-off theory is aptly demonstrated graphically in the chart below. A higher standard
deviation means a higher risk and therefore a higher possible return.

Notes
A common misconception is that higher risk equals greater return. The risk return
trade-off tells us that the higher risk gives us the possibility of higher returns. There are
no guarantees. Just as risk means higher potential returns, it also means higher
potential losses.
On the lower end of the risk scale is a measure called the risk-free rate of return. It
is represented by the return on 10 year Government of India Securities because their
chance of default (i.e. not being able to repay principal and interest) is next to nothing.
This risk free rate is used as a reference for equity markets whereas the overnight repo
rate is used as a reference for debt markets. If the risk-free rate is currently 6 per cent,
this means, with virtually no risk, we can earn 6 per cent per year on our money.
The common question arises: who wants 6 per cent when index funds average 13
per cent per year over the long run (last five years)? The answer to this is that even the
entire market (represented by the index fund) carries risk. The return on index funds is
not 13 per cent every year, but rather -5 per cent one year, 25 per cent the next year,
and so on. An investor still faces substantially greater risk and volatility to get an overall
return that is higher than a predictable government security. We call this additional
return, the risk premium, which in this case is 7 per cent (13 per cent - 6 per cent).
How do you know what risk level is most appropriate for you? This isn't an easy
question to answer. Risk tolerance differs from person to person. It depends on goals,
income, personal situation, etc. Hence, an individual investor needs to arrive at his own
individual risk return trade-off based on his investment objectives, his life-stage and his
risk appetite.
Diversification
Diversification is a risk-management technique that mixes a wide variety of investments
within a portfolio in order to minimize the impact that any one security will have on the
overall performance of the portfolio.
Diversification essentially lowers the risk of your portfolio. There are three main
practices that can help you ensure the best diversification:
z Spread your portfolio among multiple investment vehicles such as cash,
stocks, bonds, mutual funds, and perhaps even some real estate. Alternately you
could invest only in mutual funds but of varied types. For example you could invest
30 per cent in equity schemes, 40 per cent in debt/income schemes and 30 per cent
in money market schemes. You could also invest in commodity funds although as
and when permitted by SEBI.
z Vary the risk in your securities: If you are investing in equity funds, then consider
large cap as well as small cap funds. And if you are investing in debt, you could
consider both long term and short term debt. It would be wise to pick investments
with varied risk levels; this will ensure that large losses are offset by other areas.

z Vary your securities by industry: This will minimize the impact of specific risks of
certain industries
Notes
Diversification is the most important component in helping you reach your long-
range financial goals while minimizing your risk. At the same time, diversification is not
an ironclad guarantee against loss. No matter how much diversification you employ,
investing involves taking on some sort of risk.
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Rupee Cost Averaging

If you ask any professional investor what their hardest task is, he or she will tell you that
it is timing the market. Trying to time the market is a very tricky strategy. Buying at the
absolute low and selling at the peak is nearly impossible in practice. This is why
investment professionals preach rupee cost averaging (RCA).
RCA is the process of buying fixed amounts into a security/stock/mutual fund at
fixed points in time regardless of the prevailing price. This means you buy more units of
the security at lower prices, and fewer units at higher prices. The cost per unit/share
over time therefore averages out. This reduces the risk of investing a large amount in a
single security/mutual fund at the wrong time.
This principle is very powerful and works best over long periods of time. The
Systematic Investment Plans (SIPs) launched by mutual funds work on this principle
and are therefore a highly recommended investment option.
Asset Allocation
Asset allocation is an investment portfolio technique that aims to balance risk and
create diversification by dividing assets among major categories such as bonds, stocks,
real estate, and cash. Each asset class has different levels of return and risk, so each
will behave differently over time. At the same time that one asset is increasing in value,
another may be decreasing or not increasing as much.
The underlying principle of asset allocation is that the older a person gets, the less
risk he or she should face. After you retire you may have to depend on your savings as
your only source of income. It follows that you should invest more conservatively at this
time since asset preservation is crucial.
Determining the proper mix of investments in your portfolio is extremely important.
Deciding what percentage of your portfolio you should put into stocks, mutual funds,
and low risk instruments like bonds and treasuries isn't simple, particularly for those
reaching retirement age. Imagine saving for 30 or more years in the stock market only
to see the stock market decline in the years just before your retirement! Therefore one
must change asset allocation over time to move more towards safer asset classes
(bonds, treasuries) as one gets older. To determine your asset allocation plan, we
suggest you speak to an investment advisor who can customize a plan that is right for
you.
4.6 Various Functional areas of Financial Management

Some of the functional areas covered in financial management are discussed as such:
z Determining Financial Needs: A finance manager is supposed to meet financial
needs of the enterprise. For this purpose, he should determine financial needs of
the concern. Funds are needed to meet promotional expenses, fixed and working
capital needs. The requirement of fixed assets is related to the type of industry. A
manufacturing concern will require more investments in fixed assets than a trading
concern. The working capital needs depend upon the scale of operations, larger the
scale of operations, the higher will be the needs for working capital. A wrong
assessment of financial needs may jeopardies the survival of a concern.

z Selecting the Sources of Funds: A number of sources may be available for
raising funds. A concern may resort to issue of share capital and debentures.
Notes Financial institutions may be requested to provide long-term funds. The working
capital needs may be met by getting cash credit or overdraft facilities from
commercial banks. A finance manager has to be very careful and cautious in
approaching different sources. The terms and conditions of banks may not be
favourable to the concern. A small concern may find difficulties in raising funds for
want of adequate securities or due to its reputation. The selection of a suitable
source of funds will influence the profitability of the concern. This selection should
be made with great caution.
z Financial Analysis and Interpretation: The analysis and interpretation of financial
statements is an important task of a finance manager. He is expected to know
about the profitability, liquidity position, short-term and long-term financial position
of the concern. For this purpose, a number of ratios have to be calculated. The
interpretation of various ratios is also essential to reach certain conclusions.
Financial analysis and interpretation has become an important area of financial
management.
z Cost-Volume-Profit Analysis: Cost-volume-profit analysis is an important tool of
profit planning. It answers questions like, what is the behaviour of cost and volume?
At what point of production a firm will be able to recover its costs? How much a firm
should produce to earn a desired profit? To understand cost-volume-profit
relationship, one should know the behaviour of costs. The costs may be subdivided
as: fixed costs, variable costs and semi-variable costs. Fixed costs remain constant
irrespective of changes in production.
An increase or decrease in volume of production will not influence fixed costs.
Variable costs, on the other hand, vary in direct proportion to change in production.
Semi-variable costs remain constant for a period and then become variable for a
short period. These costs change with the change in output but not in the same
proportion.
The first concern of a finance manager will be to recover all costs. He will aspire to
achieve break-even point at the earliest. It is a point of no-profit no-loss. Any
production beyond break-even point will bring profits to the concern. The volume of
sales, to earn a desired profit, can also be ascertained. This analysis is very helpful
in deciding the volume of output or sales. The knowledge of cost-volume profit
analysis is essential for taking important decisions about production and profits.
z Capital Budgeting: Capital budgeting is the process of making investment
decisions in capital expenditures. It is an expenditure the benefits of which are
expected to be received over a period of time exceeding one year. It is an
expenditure incurred for acquiring or improving the fixed assets, the benefits of
which are expected to be received over a number of years in future. Capital
budgeting decisions are vital to any organization. An unsound investment decision
may prove to be fatal for the very existence of the concern.
4.7 Capital Budgeting

Capital budgeting is the process of planning for projects on assets with cash flows of a
period greater than one year. These projects can be classified as:
z Replacement decisions to maintain the business
z Existing product or market expansion
z New products and services
z Regulatory, safety and environmental
z Other, including pet projects or difficult-to-evaluate projects

Additionally, projects can be classified as mutually exclusive or independent:
Mutually exclusive projects are potential projects that are unrelated, and any
combination of those projects can be accepted. Notes
Independent projects indicate there is only one project among all possible projects
that can be accepted.
The Importance of Capital Budgeting

Capital budgeting is important for many reasons:
z Since projects approved via capital budgeting are long term, the firm becomes tied
to the project and loses some of its flexibility during that period.
z When making the decision to purchase an asset, managers need to forecast the
revenue over the life of that asset.
z Lastly, given the length of the projects, capital-budgeting decisions ultimately define
the strategic plan of the company.
(To learn about the importance of budgeting on a personal level, read 6 Reasons Why
You Need a Budget and 11 Most Common Budgeting Mistakes.)
In capital budgeting, there are a number of different approaches that can be used to
evaluate any given project, and each approach has its own distinct advantages and
disadvantages.
All other things being equal, using internal rate of return (IRR) and net present
value (NPV) measurements to evaluate projects often results in the same findings.
However, there are a number of projects for which using IRR is not as effective as using
NPV to discount cash flows. IRR's major limitation is also its greatest strength: it uses
one single discount rate to evaluate every investment.
Although using one discount rate simplifies matters, there are a number of situations
that cause problems for IRR. If an analyst is evaluating two projects, both of which
share a common discount rate, predictable cash flows, equal risk and a shorter time
horizon, IRR will probably work. The catch is that discount rates usually change
substantially over time. For example, think about using the rate of return on a T-bill in
the last 20 years as a discount rate. One-year T-bills returned between 1- 12% in the
last 20 years, so clearly the discount rate is changing.
Without modification, IRR does not account for changing discount rates, so it's just not
adequate for longer-term projects with discount rates that are expected to vary.
Another type of project for which a basic IRR calculation is ineffective is a project with a
mixture of multiple positive and negative cash flows. For example, consider a project for
which marketers must reinvent the style every couple of years to stay current in a fickle,
trendy niche market. If the project has cash flows of -$50,000 in year one (initial capital
outlay), returns of $115,000 in year two and costs of $66,000 in year three because the
marketing department needed to revise the look of the project, a single IRR can't be
used. Recall that IRR is the discount rate that makes a project break even. If market
conditions change over the years, this project can have two or more IRRs, as seen
below.

Thus, there are at least two solutions for IRR that make the equation equal to zero,
so there are multiple rates of return for the project that produce multiple IRRs. The
Notes advantage to using the NPV method here is that NPV can handle multiple discount
rates without any problems. Each cash flow can be discounted separately from the
others.
Another situation that causes problems for users of the IRR method is when the
discount rate of a project is not known. In order for the IRR to be considered a valid way
to evaluate a project, it must be compared to a discount rate. If the IRR is above the
discount rate, the project is feasible; if it is below, the project is considered infeasible. If
a discount rate is not known, or cannot be applied to a specific project for whatever
reason, the IRR is of limited value. In cases like this, the NPV method is superior. If a
project's NPV is above zero, then it is considered to be financially worthwhile.
So, why is the IRR method still commonly used in capital budgeting? Its popularity is
probably a direct result of its reporting simplicity. The NPV method is inherently complex
and requires assumptions at each stage - discount rate, likelihood of receiving the cash
payment, etc. The IRR method simplifies projects to a single number that management
can use to determine whether or not a project is economically viable. The result is
simple, but for any project that is long-term, that has multiple cash flows at different
discount rates or that has uncertain cash flows - in fact, for almost any project at all -
simple IRR isn't good for much more than presentation value.
Some of the major techniques used in capital budgeting are as follows: 1. Payback
period 2. Accounting Rate of Return method 3. Net present value method 4. Internal
Rate of Return Method 5. Profitability index.
Payback Period
The payback (or payout) period is one of the most popular and widely recognized
traditional methods of evaluating investment proposals, it is defined as the number of
years required to recover the original cash outlay invested in a project, if the project
generates constant annual cash inflows, the payback period can be computed dividing
cash outlay by the annual cash inflow.
Payback period = Cash outlay (investment) / Annual cash inflow = C / A
Advantages:
z A company can have more favourable short-run effects on earnings per share by
setting up a shorter payback period.
z The riskiness of the project can be tackled by having a shorter payback period as it
may ensure guarantee against loss.
z As the emphasis in pay back is on the early recovery of investment, it gives an
insight to the liquidity of the project.
Limitations:
z It fails to take account of the cash inflows earned after the payback period.
z It is not an appropriate method of measuring the profitability of an investment
project, as it does not consider the entire cash inflows yielded by the project.
z It fails to consider the pattern of cash inflows, i.e., magnitude and timing of cash
inflows.
z Administrative difficulties may be faced in determining the maximum acceptable
payback period.
Accounting Rate of Return Method

The Accounting rate of return (ARR) method uses accounting information, as revealed
by financial statements, to measure the profit abilities of the investment proposals. The

accounting rate of return is found out by dividing the average income after taxes by the
average investment.
Notes
ARR= Average income/Average Investment
Advantages:
z It is very simple to understand and use.
z It can be readily calculated using the accounting data.
z It uses the entire stream of incomes in calculating the accounting rate.
Limitations:
z It uses accounting, profits, not cash flows in appraising the projects.
z It ignores the time value of money; profits occurring in different periods are valued
equally.
z It does not consider the lengths of projects lives.
z It does not allow for the fact that the profit can be reinvested.
Net Present Value Method

The net present value (NPV) method is a process of calculating the present value of
cash flows (inflows and outflows) of an investment proposal, using the cost of capital as
the appropriate discounting rate, and finding out the net profit value, by subtracting the
present value of cash outflows from the present value of cash inflows.
The equation for the net present value, assuming that all cash outflows are made in
the initial year (tg), will be:
Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost
of the investment proposal and n is the expected life of the proposal. It should be noted
that the cost of capital, K, is assumed to be known, otherwise the net present, value
cannot be known.
Advantages:
z It recognizes the time value of money
z It considers all cash flows over the entire life of the project in its calculations.
z It is consistent with the objective of maximizing the welfare of the owners.
Limitations:
z It is difficult to use
z It presupposes that the discount rate which is usually the firm’s cost of capital is
known. But in practice, to understand cost of capital is quite a difficult concept.
z It may not give satisfactory answer when the projects being compared involve
different amounts of investment.
Internal Rate of Return Method

The internal rate of return (IRR) equates the present value cash inflows with the present
value of cash outflows of an investment. It is called internal rate because it depends
solely on the outlay and proceeds associated with the project and not any rate

determined outside the investment, it can be determined by solving the following
equation:
Notes
Advantages:
z Like the NPV method, it considers the time value of money.
z It considers cash flows over the entire life of the project.
z It satisfies the users in terms of the rate of return on capital.
z Unlike the NPV method, the calculation of the cost of capital is not a precondition.
z It is compatible with the firm’s maximising owners’ welfare.
Limitations:
z It involves complicated computation problems.
z It may not give unique answer in all situations. It may yield negative rate or multiple
rates under certain circumstances.
z It implies that the intermediate cash inflows generated by the project are reinvested
at the internal rate unlike at the firm’s cost of capital under NPV method. The latter
assumption seems to be more appropriate.
Profitability Index
It is the ratio of the present value of future cash benefits, at the required rate of return to
the initial cash outflow of the investment. It may be gross or net, net being simply gross
minus one. The formula to calculate profitability index (PI) or benefit cost (BC) ratio is as
follows.
PI = PV cash inflows/Initial cash outlay A,
z It gives due consideration to the time value of money.

z It requires more computation than the traditional method but less than the IRR
method.
z It can also be used to choose between mutually exclusive projects by calculating
the incremental benefit cost ratio.
4.8 Cost of Capital

The cost of capital is the minimum rate of return required on the investment projects to
keep the market value per share unchanged.
In other words, the cost of capital is simply the rate of return the funds used should
produce to justify their use within the firm in the light of the wealth maximisation
objective.
z Future cost and Historical cost: It is commonly known that, in decision-making,
the relevant costs are future costs are not the historical costs. The financial
decision-making is no exception. It is future cost of capital which is significant in
making financial decisions.
z Specific cost and combined cost: The cost of each component of capital (ex-
common shares, debt etc.,) is known as specific cost of capital. The combined or
composite cost of capital is an inclusive: cost of capital from all sources. It is, thus, Notes
the weighted average cost of capital.
z Explicit cost and implicit cost: The explicit cost of capital is the internal rate of
return of the financial opportunity and arises when the capital is raised. The implicit
of capital arises when the firm considers alternative uses of the funds rained. The
methods of calculating the specific costs of different sources of funds are
discussed.
Cost of Debt
It is relatively easy to calculate cost of debt, it is rate of return or the rate of interest
specified at the time of debt issue. When a bond or debenture is issued at full face
value and to be redeemed after some period, then the before tax cost of debt is simply
the normal rate of interest.
Before tax cost of debt, Kd = Interest/ Principal
Cost of Preference Capital

The measurement of the cost of preference capital poses some conceptual difficulty. In
the case of debt, there is a binding legal obligation on the firm to pay interest and the
interest constitutes the basis to calculate the cost of debt.
However, when reference to the preference capital, it may be stated that the
payment of dividends on preference capital is not legally binding on the firm and even if
the dividends are paid, it is not a charge on earnings, rather it is a distribution or
appropriation of earnings to a class of owners. It may, therefore, be concluded, that the
dividends on preference capital do not constitute cost. This is not true.
The cost of preference capital is a function of the dividend expected by investors;
preference capital is never issued with an intention not to pay dividends. Although it is
not legally binding upon the firm to pay dividends on preference capital, yet it is
generally paid when the firm makes sufficient profits.
The preference share may be treated as a perpetual security it is irredeemable.
Thus, its cost is given by the following equation.
Where Kp is the cost of preference share, Dp represents the fixed dividend per
preference share and P is the price per- preference share.
Cost of Equity Capital

It is sometimes argued that tine equity capital is free of cost. This is not true. The
reason for advancing such an argument is that it is not legally binding on the company
to pay dividends to the common shareholders. Also, unlike the interest rate on debt or
the rate of dividend on preference capital, the dividend rate to the common
shareholders is not fixed. However, the shareholders invest their money in common
shares with an expectation of receiving dividends.
The market value of the share depends on the dividends expected by the
shareholders. Therefore, the required rate of return which equates the present value of
the expected dividends with the market value of share is the equity capita).
For the purpose of measuring the cost of equity, the equity capital will be divided
into two parts a) external equity b) retained earnings.
z External equity: The minimum rate of return which is required on the new
investment, financed by the new issue of common shares, to keep the market value
of the share unchanged is the cost of new issue of common shares (or external
equity).

z Retained earnings: The companies are not required to pay any dividends on
retained earnings. Therefore, it is sometimes observed that this source of finance is
Notes cost free. But retained earnings are the dividend foregone by the share holders.
The cost of retained earnings is measured by the following equation:
Kr = D/Po + g
Where Kr = Cost of retained earnings
D = Dividend
g = growth rate
Po =Market price of the share
Cost of Convertible Securities

In recent times, companies are raising finance by a new financial instrument called the
“convertible security”. It may be a bond or a debenture or a preference share.
Convertible security is considered as a means of deferred equity, financing and its cost
should, therefore, be treated so.
The expected stream of receipts from a convertible security will consist of interest/
dividend plus the expected conversion price. The expected conversion price can be
represented by the expected future market price per equity share at some future date
times the number of shares into which the security is convertible.
The cost of a convertible security, therefore is the discount rate which equates the
after tax interest or preference dividend plus the expected conversion price with the
issue price of the convertible security.
If it is assumed that all investors will convert their bonds on the same day, the cost
of a convertible bond can be found by the following equation.
Where Vc = issue price of convertible bond at time 0

R = Annual interest Payment
4.9 Ratio Analysis

Ratio is an expression of relationship between two or more items in mathematical
terms. Exhibition of meaningful and useful relation between different accounting data is
called Accounting Ratio. Ratio may be expressed as a:b (a is to b), in terms of simple
fraction, integer, or percentage.
If the current assets of a concern is ` 4,00,000 and the current liabilities is
` 2,00,000, then the ratio of current assets to current liabilities is given as 4,00,000 /
2,00,000 = 2. This is called simple ratio. Multiply a ratio by 100 to express it in terms of
percentage.
We can express the ratio between 200 and 100 in any of the following ways:
2:1
2/1
200%
2 to 1
2

Ratios are extremely useful in drawing the financial position of a concern.
Accounting Analysis Notes

Comparative analysis and interpretation of accounting data is called Accounting
Analysis. When accounting data is expressed in relation to some other data, it conveys
some significant information to the users of data.
Ratio Analysis and its Applications

Ratio analysis is a medium to understand the financial weakness and soundness of an
organization. Keeping in mind the objective of analysis, the analyst has to select
appropriate data to calculate appropriate ratios. Interpretation depends upon the caliber
of the analyst.
Ratio analysis is useful in many ways to different concerned parties according to
their respective requirements. Ratio analysis can be used in the following ways:
z To know the financial strength and weakness of an organization.
z To measure operative efficiency of a concern.
z For the management to review past year’s activity.
z To assess level of efficiency.
z To predict the future plans of a business.
z To optimize capital structure.
z In inter and intra company comparisons.
z To measure liquidity, solvency, profitability and managerial efficiency of a concern.
z In proper utilization of assets of a company.
z In budget preparation.
z In assessing solvency of a firm, bankruptcy position of a firm, and chances of
corporate sickness.
Advantages of Ratio Analysis

z It is powerful tool to measure short and long-term solvency of a company.
z It is a tool to measure profitability and managerial efficiency of a company.
z It is an important tool to measure operating activities of a business.
z It helps in analyzing the capital structure of a company.
z Large quantitative data may be summarized using ratio analysis.
z It relates past accounting performances with the current.
z It is useful in coordinating the different functional machineries of a company.
z It helps the management in future decision-making.
z It helps in maintaining a reasonable balance between sales and purchase and
estimating working capital requirements.
Limitations of Ratio Analysis

Although Ratio Analysis is a very useful accounting tools to analyze and interpret
different accounting equations, it comes with its own set of limitations:
z If the data received from financial accounting is incorrect, then the information
derived from ratio analysis could not be reliable.
z Unauthenticated data may lead to misinterpretation of ratio analysis.
z Future prediction may not be always dependable, as ratio analysis is based on the
past performance.

z To get a conclusive idea about the business, a series of ratios is to be calculated. A
single ratio cannot serve the purpose.
Notes z It is not necessary that a ratio can give the real present situation of a business, as
the result is based on historical data.
z Trend analysis is done with the help of various calculated ratios that can be
distorted due to the changes in the price level.
z Ratio analysis is effective only where same accounting principles and policies are
adopted by other concerns too, otherwise inter-company comparison will not exhibit
a real picture at all.
z Through ratio analysis, special events cannot be identified. For example, maturity of
debentures cannot be identified with ratio analysis.
z For effective ratio analysis, practical experience and knowledge about particular
industry is essential. Otherwise, it may prove worthless.
z Ratio analysis is a useful tool only in the hands of an expert.
Types of Ratio
Ratios can be classified on the basis of financial statements or on the basis of functional
aspects.
Classification on the Basis of Financial Statement

z Balance Sheet Ratios: Ratios calculated from taking various data from the balance
sheet are called balance sheet ratio. For example, current ratio, liquid ratio, capital
gearing ratio, debt equity ratio, and proprietary ratio, etc.
z Revenue Statement Ratio: Ratios calculated on the basis of data appearing in the
trading account or the profit and loss account are called revenue statement ratios.
For example, operating ratio, net profit ratio, gross profit ratio, stock turnover ratio.
z Mixed or Composite Ratio: When the data from both balance sheet and revenue
statements are used, it is called mixed or composite ratio. For example, working
capital turnover ratio, inventory turnover ratio, accounts payable turnover ratio, fixed
assets turnover ratio, return of net worth ratio, return on investment ratio.
Classification of Ratios on the Basis of Financial Statements
Balance Sheet Ratios Profit and Loss A/c Composite or Mixed Ratios
Ratios
Current Ratio Gross Profit Ratio Stock Turnover Ratio

Liquid Ratio Operating Ratio Receivable Turnover Ratio
Absolute Liquid Ratio Operating Profit Ratio Payable Turnover Ratio
Debt Equity Ratio Net Profit Ratio Fixed Assets Turnover Ratio
Proprietorship Ratio Cash Profit Ratio Total Assets Turnover Ratio
Capita Gearing Ratio Expenses Ratio Working Capital Turnover
Assets Proprietorship Ratio Interest Coverage Ratio
Capital Inventory to Ratio Capital Turnover Ratio
Working Capital Ratio Return on Capital Employed
Ratio of Current Assets to Return on Equity Ratio
Fixed Assets Return on Shareholders Fund
Capital Turnover Ratio
Classification on the Basis of Financial Aspects

Ratios can be further classified based on their functional aspects as discussed below.
z Liquidity Ratios: Liquidity ratios are used to find out the short-term paying capacity
of a firm, to comment short term solvency of the firm, or to meet its current liabilities.
Similarly, turnover ratios are calculated to know the efficiency of liquid resources of Notes
the firm, Accounts Receivable (Debtors) Turnover Ratio and Accounts Payable
(Creditors).
z Long-Term Solvency and Leverage Ratios: Debt equity ratio and interest
coverage ratio are calculated to know the efficiency of a firm to pay long-term debts
and to meet interest costs. Leverage ratios are calculated to know the proportion of
debt and equity in the financing of a firm.
z Activity Ratios: Activity ratios are also called turnover ratios. Activity ratios
measure the efficiency with which the resources of a firm are employed.
z Profitability Ratios: The results of business operations can be calculated through
profitability ratios. These ratios can also be used to know the overall performance
and effectiveness of a firm. Two types of profitability ratios are calculated in relation
to sales and investments.
Functional Classification of Ratios
Liquidity Long-Term Activity Ratios Profit Abilities
Ratios Solvency and Asset Management Ratios
Leverage Ratios Ratios
(A) Current Debt/Equity Ratio Inventory Turnover (A) In relation to
Ratio Debt to total Ratio sales
Liquid Ratio Capital Ratio Debtors Turnover Gross Profit Ratio
Absolute Liquid Interest Coverage Ratio Operating Ratio
or Cash Ratios Ratio Fixed Assets Operating Ratio
Interval Cash Flow/ Debt Turnover Ratio Operative Profit Ratio
Measure Capital Gearing Total Assets Net Profit Ratio
(B) Debtors Turnover Ratio
Expenses Ratio
Turnover Ratio Working Capital
(B) In relation to
Creditor Turnover Ratio
Investments
Turnover Ratio Payable Turnover
Return on Investment
Inventory Ratio
Return on Capital
Turnover Ratio Capital Employed
Turnover Ratio Return on Equity
Return on Total
Resources
Earnings per Share
Price Earnings Ratio
4.10 Some Important Ratios

In themselves, the raw numbers on your balance sheet, income statement and cash
flow statement have limited value. Of far greater value, when it comes to evaluating
your company's financial performance and making critical management decisions, are
certain ratios that you can extract from these documents.
When tracked and measured on a regular basis, these key financial ratios allow you to:
z get a more accurate reading of your company's financial performance
z compare performance against the previous year, the current budget and your
industry as a whole
z establish benchmarks to see where you are going and how you are doing.
The secret to effective financial management lies in knowing which ratios to track
and what they tell you about the state of your business.

Too many CEOs look at gross sales and revenues on the income statement and
nothing else. If sales look good, they figure everything else must be in order. In reality,
Notes you can have healthy sales growth and still be headed for financial disaster. The only
way to know that is to pay attention to the ratios that tell you what's really going on in
the business.
These ratios can be divided into three categories:
z Balance sheet ratios
z Profit and loss ratios
z Key operating ratios.
z Balance sheet ratios: The balance sheet gives the truest picture of the overall
health of the business. It acts as a snapshot, telling you where the business stands
at a given point in time. Unlike the profit and loss (income) statement, which gives a
historical record that never changes, the balance sheet is a living, breathing
document that changes on a daily basis.
The three most important balance sheet ratios are as follows.
Current ratio measures whether you have enough current assets (defined as
anything that can be turned into cash within a year) to meet your current liabilities.
Current ratio formula: Current assets divided by current liabilities
Quick ratio measures the company's ability to meet financial obligations using
only liquid current assets: cash or assets that can be turned into cash within 90
days. (The quick ratio does not include inventory because, if you have to
liquidate, you never get full value for inventory.)
Quick ratio formula: (Current assets minus inventory) divided by current liabilities
Debt-to-equity ratio measures how much of the company is financed by
borrowing versus owner equity. This ratio plays a major role in determining how
much you can borrow and at what interest rate.
Debt-to-equity ratio formula: Net worth divided by total liabilities
Uses of balance sheet ratios: Balance sheet ratios are crucial because they
measure the amount of risk in the business. The current and quick ratios (also
known as liquidity ratios) measure the company's ability to survive a short-term
financial crisis. The debt-to-equity ratio (also known as the safety ratio)
measures the company's ability to survive over the long term.
If sales and revenues continue to climb while these three measures show a
decline – a frequent scenario in fast-growth companies – you have a real
problem on your hands.
Profit and loss ratios: The profit and loss (P&L) statement focuses on revenues,
expenses and net income (or loss) over a defined period of time. It measures
the company's ability to turn sales and revenues into profits – a key ingredient
for long-term success.
The most important P&L ratios include the following.
Gross profit ratio measures how much money you bring in after subtracting the
costs of goods sold.
Gross profit ratio formula: Revenues minus cost of goods sold
Gross margin ratio measures how much it costs to obtain sales.
Gross margin ratio formula: Net sales minus cost of goods sold
Net operating profit ratio represents how much money you have left over,
before interest, depreciation and taxes, after all expenses are taken out. Some

people also refer to this as EBITDA (earnings before interest, taxes,
depreciation and amortisation).
Notes
Net operating profit ratio formula: Gross margin minus selling, general and
administrative expenses
Net profit ratio measures how much money is left over after all expenses are
taken out.
Net profit ratio formula: (Net operating profit plus income) minus (other
expenses plus taxes)
Uses of profit and loss ratios: In our opinion, gross margin (and its relationship
to expenses) is the most important P&L ratio. You need to pay attention to all of
the P&L ratios, because they affect your profitability. But if you lose the gross
margin battle, you can do a lot of other things right and still go out of business.
You can have a high gross margin and still have expenses higher than your
gross margin. The key is the relationship of gross margin to expenses.
z Key operating ratios: The following ratios combine information from the balance
sheet and income statement to provide a more sophisticated picture of what is
happening in the business.
Gross profit ratio measures the percentage of every £ of sales that becomes gross
profit. For example, a gross profit ratio of 40% means that you earn 40 pence at the
gross profit level for every £ of sales.
Gross profit ratio formula: Gross profit divided by sales
Pre-tax profit ratio measures how much you make at the net profit level for every £
of sales you generate.
Pre-tax profit ratio formula: Pre-tax profit divided by sales
Sales-to-assets ratio measures the amount of sales generated for every £ of assets
employed in the business. For example, a sales-to-assets ratio of 2.5 means that
you generate £2.50 in sales for every £ of assets in the business.
Sales-to-assets ratio formula: Total assets divided by sales
Return on assets ratio measures how much profit you generate for every £ in
assets.
Return on assets ratio formula: Pre-tax profits divided by total assets
Return on equity ratio measures the return on every £ you have invested in the
business.
Return on equity ratio formula: Pre-tax profit divided by equity
Inventory turnover ratio measures how many times a year you turn over your
inventory. If you use sales cost, you must also use inventory cost. If you use selling
price (which retail businesses typically do), you must also use inventory selling
price. You can use either cost or selling price, so long as you are consistent.
Inventory turnover ratio formula: Sales divided by average inventory
Days in inventory ratio measures how long, on average, it takes to turn over your
inventory.
Days in inventory ratio formula: Inventory turnover divided by 365 days
Accounts receivable turnover ratio measures how many times a year you collect
your accounts receivable.
Accounts receivable turnover ratio formula: Sales divided by accounts receivable

Collection period ratio measures how often, on average, you collect your
accounts receivable.
Notes
Collection period ratio formula: Accounts receivable turnover divided by 365 days
Accounts payable turnover ratio measures how many times a year you pay your
accounts payable. As with the inventory turnover ratio, you can use cost or selling
price, as long as you use the same factor on both sides of the equation.
Accounts payable turnover ratio formula: Cost of goods sold divided by average
accounts payable
Payable period ratio measures, on average, how often you pay your accounts
payable.
Payable period ratio formula: Accounts payable turnover divided by 365 days
Uses of key operating ratios

Why bother tracking these seemingly arcane ratios? Because they tell you how efficient
your company is at generating and using cash. More important, they tell you what's
happening to your cash flow.
The raw numbers on the monthly cash flow statement are important because they
tell you how much cash you have on hand and how the cash got used last month. But
these operating ratios tell you what's going to happen to your cash flow in the near
future. If you're going to run out of cash, you need to know while you still have time to
do something about it.
How to get better ratios

The whole purpose of studying ratios is to make them better. To improve your ratios, we
recommend the following.
To improve your balance sheet ratios:
z Speed up inventory turnover: This improves cash flow and reduces risk, because
inventory always carries a certain amount of obsolescence risk.
z Consider leasing rather than purchasing equipment: In many cases leasing is
more cost effective, especially if the technology is changing quickly in your industry.
z Reduce the time it takes to collect receivables: This is one of the easiest ways
to increase cash flow, if you pay attention to it.
z Get increased day terms: If you can extend your payables to 60 or 90 days
without increasing the cost of goods, in essence you get your vendors to finance the
business. However, get your price first and then go for additional days.
z To improve your profit and loss ratios:
z Leverage sales over fixed costs: Strive to get more effective and efficient so that
you can improve sales without increasing costs. We recommend the following:
Sell more to existing customers.
Work on closing skills.
Sell at the right level. Don't waste time trying to sell to people who can't make
the decision.
Identify segments of your business where more potential exists.
Review how you incentive your sales mix. Make sure the compensation
programme for your sales team is in alignment with the best interests of the
company.
Pay sales people for receivables that get collected, not just for making sales.
Hold the sales team accountable for desired results.

z Increase gross margins: We suggest attacking margins from three angles:
z Cost: Constantly work to lower your cost of goods sold.
Notes
z Value: Are you getting paid for all the value you provide customers?
z Velocity: The faster you move things through the business, the faster you collect
cash. Focus on increasing velocity to generate more cash and improve margins.
z Review pricing opportunities: Consider giving lower costs in rebate form after
customers achieve certain purchasing levels. This allows you to keep the cash flow
while forcing customers to buy more in order to receive the discount.
z Use zero-based budgeting: Don't let your people automatically submit budget
increases every year. Instead, have them start with a blank piece of paper and cost-
justify everything they do.
z Compensate people for productivity rather than time: Have some element in
your compensation programme that is tied to productivity. When you pay for time,
you get time, which requires more supervision and increases costs.
z Outsource when it's economically advantageous: Study your non-core
processes and look for things that other companies can do more cheaply.
Conversely, there may be things you are so good at that you can do them for other
companies.
4.11 Summary
Financial management refers to the efficient and effective management of money
(funds) in such a manner as to accomplish the objectives of the organization. It is the
specialized function directly associated with the top management. The significance of
this function is not seen in the 'Line' but also in the capacity of 'Staff' in overall of a
company. It has been defined differently by different experts in the field.
The term typically applies to an organization or company's financial strategy,
while personal finance or financial life management refers to an individual's
management strategy. It includes how to raise the capital and how to allocate capital,
i.e. capital budgeting. Not only for long term budgeting, but also how to allocate the
short term resources like current liabilities. It also deals with the dividend policies of the
share holders.

Multiple Choice Questions
1. The only feasible purpose of financial management is:
(a) Wealth Maximization
(b) Sales Maximization
(c) Profit Maximization
(d) Assets maximization
2. Financial management process deals with:
(a) Investments
(b) Financing decisions
(c) Both a and b
(d) None of the above
3. Agency cost consists of:
(a) Binding
(b) Monitoring
(c) Opportunity and structure cost
(d) All of the above
4. Finance Function comprises:
(a) Safe custody of funds only
Notes
(b) Expenditure of funds only
(c) Procurement of finance only
(d) Procurement & effective use of funds
5. The objective of wealth maximization takes into account:
(a) Amount of returns expected
(b) Timing of anticipated returns
(c) Risk associated with uncertainty of returns
(d) All of the above
6. Financial management mainly focuses on:
(a) Efficient management of every business
(b) Brand dimension
(c) Arrangement of funds
(d) All elements of acquiring and using means of financial resources for financial
activities
7. Time value of money indicates that:
(a) A unit of money obtained today is worth more than a unit of money obtained in
future
(b) A unit of money obtained today is worth less than a unit of money obtained in
future
(c) There is no difference in the value of money obtained today and tomorrow
(d) None of the above
8. Time value of money supports the comparison of cash flows recorded at different
time period by
(a) Discounting all cash flows to a common point of time
(b) Compounding all cash flows to a common point of time
(c) Using either a or b
(d) None of the above.
9. If the nominal rate of interest is 10% per annum and there is quarterly
compounding, the effective rate of interest will be:
(a) 10% per annum
(b) 10.10 per annum
(c) 10.25% per annum
(d) 10.38% per annum
10. Relationship between annual nominal rate of interest and annual effective rate of
interest, if frequency of compounding is greater than one:
(a) Effective rate > Nominal rate
(b) Effective rate < Nominal rate
(c) Effective rate = Nominal rate
(d None of the above

1. Define Financial Management.
2. What are the functions of Financial Management?
3. Define risk and return.
4. What are the various functional areas of financial management?
Notes
5. Define capital budgeting.
6. What is Cost of capital?
7. Define ratio analysis.
8. Differentiate cost of capital and ratio analysis.
4.14 Key Terms

z Cost-Benefit Analysis: A process by which you weigh expected costs against
expected benefits to determine the best (or most profitable) course of action
z Assets: The value of any tangible property and property rights owned by a
company less any reserves set aside for depreciation. Assets don't reflect any
appreciation in value unless they're sold for the greater value.
z Debt-to-Equity Ratio: A measure of the extent to which a firm's capital is provided
by owners or lenders, calculated by dividing debt by equity.
z Deductible Expenses: Expenditures for business items that have no future life
(such as rent, utilities or wages) and are incurred in conducting normal business
activities which a business owner may deduct from gross earned income for federal
tax purposes
z Break-Even Analysis: A technique for analyzing how revenue, expenses and profit
vary with changes in sales volume
Check Your Progress: Answers

1. (a) Wealth Maximization
2. (b) Financing decisions
3. (d) All of the above
4. (d) Procurement & effective use of funds
5. (d) All of the above
6. (d) All elements of acquiring and using means of financial resources for financial
activities
7. (a) A unit of money obtained today is worth more than a unit of money obtained in
future
8. (c) Using either a or b
9. (d) 10.38% per annum
10. (a) Effective rate > Nominal rate

z Accounting for Beginners, Shlomo Simanovsky – 2010
z Jain & Narang – Cost Accountancy- 2005
z Financial Accounting, V.K. Goyal - 2007
z S.N. Maheswari – Management Accounting-2010

Unit 5: Working Capital Management

Notes
Structure
5.1 Introduction
5.2 Meaning
5.3 Nature of Working Capital
5.4 Need for Working Capital
5.5 Types of Working Capital
5.6 Changes in Working Capital
5.7 Determinants of Working Capital
5.8 Summary
5.11 Key Terms
Objectives
After studying this unit, you should be able to:
z Understand the Concept and meaning of Working Capital Management
z Discuss the Changes in Working Capital
z Explain the Determinants of Working Capital
5.1 Introduction
Working capital management refers to a company's managerial accounting
strategy designed to monitor and utilize the two components of working
capital, current assets and current liabilities, to ensure the most financially
efficient operation of the company. The primary purpose of working capital
management is to make sure the company always maintains sufficient cash flow to
meet its short-term operating costs and short-term debt obligations.
Breaking Down 'Working Capital Management'

Working capital management commonly involves monitoring cash flow, assets and
liabilities through ratio analysis of key elements of operating expenses, including the
working capital ratio, collection ratio and the inventory turnover ratio. Efficient
working capital management helps with a company's smooth financial operation, and
can also help to improve the company's earnings and profitability. Management of
working capital includes inventory management and management of accounts
receivables and accounts payables.
Elements of Working Capital Management

The working capital ratio, calculated as current assets divided by current liabilities, is
considered a key indicator of a company's fundamental financial health since it
indicates the company's ability to successfully meet all of its short-term financial
obligations. Although numbers vary by industry, a working capital ratio below 1.0 is
generally indicative of a company having trouble meeting short-term obligations,
usually due to insufficient cash flow. Working capital ratios of 1.2 to 2.0 are considered
desirable, but a ratio higher than 2.0 may indicate a company is not making the most
effective use of its assets to increase revenues.

Working Capital Management 111
The collection ratio, also known as the average collection period ratio, is a
principal measure of how efficiently a company manages its accounts receivables. The
collection ratio is calculated as the number of days in an accounting period, such as Notes
one month, multiplied by the average amount of outstanding accounts receivables,
with that total then divided by the total amount of net credit sales during the accounting
period. The collection ratio calculation provides the average number of days it takes a
company to receive payment, in other words, to convert sales into cash. The lower a
company's collection ratio, the more efficient its cash flow.
The final element of working capital management is inventory management. To
operate with maximum efficiency and maintain a comfortably high level of working
capital, a company has to carefully balance sufficient inventory on hand to meet
customers' needs while avoiding unnecessary inventory that ties up working capital for
a long period of time before it is converted into cash. Companies typically measure
how efficiently that balance is maintained by monitoring the inventory turnover ratio.
The inventory turnover ratio, calculated as revenues divided by inventory cost, reveals
how rapidly a company's inventory is being sold and replenished. A relatively low ratio
compared to industry peers indicates inventory levels are excessively high, while a
relatively high ratio indicates the efficiency of inventory ordering can be improved.
5.2 Meaning
Working capital management is a tactical focus on maintaining a sufficient amount of
working capital to support a business, while minimizing the investment in this area.
The core goal in working capital management is to ensure that there is always
sufficient cash on hand to pay for liabilities as they come due for payment. Since there
can be a high cost associated with the funding of working capital, there is an offsetting
pressure to keep funding levels low. This latter goal is achieved by closely monitoring
the turnover levels for accounts receivable, inventory, and accounts payable, and
taking action when the turnover levels vary from expectations. An additional tool used
to monitor working capital levels is the short-term and medium-term cash forecast,
which tells management when unusually high or low cash levels are expected.
Working capital is part of the total capital employed by a company and is often
defined as the difference between short-term liabilities and short-term assets.
Practically speaking, it is the cash required to run the daily, weekly and monthly
operations of a business. Working capital management is, therefore, the process of
managing the short-term assets and liabilities so that a firm has sufficient liquidity to
run its operations smoothly.
The components and determinants of working capital are summarized in the table
below.

The efficiency of working capital management can be measured through a variety
of methods and ratios. Financial analysts typically compare the working capital cycle
Notes and other working capital ratios against industry benchmarks or a company’s peers.
The most commonly used ratios and measures are the current ratio, days of sales
outstanding, days of inventory outstanding and days of payables outstanding.
Liquidity is often tight in small businesses due to the scale of their operations and
investment in working capital is a drag on liquidity. The majority of small businesses
are not able to fund the operating cycle with account payables so they have to rely on
the cash generated internally or, in some cases, a cash injection from their owner. An
efficient working capital management will, therefore, allow a business to run efficiently
and potentially free up some cash which could be used to pay down debt or invest in a
profitable project.
Importance of Working Capital

Working capital is a vital part of a business and can provide the following advantages
to a business:
z Higher Return on Capital: Firms with lower working capital will post a higher
return on capital so shareholders will benefit from a higher return for every dollar
invested in the business.
z Improved Credit Profile and Solvency: The ability to meet short-term obligations
is a pre-requisite to long-term solvency and often a good indication of
counterparty’s credit risk. Adequate working capital management will allow a
business to pay on time its short-term obligations which could include raw
materials, salaries, and other operating expenses.
z Higher Profitability: According to a research conducted by Tauringana and
Adjapong Afrifa, the management of account payables and receivables is an
important driver of small businesses’ profitability.
z Higher Liquidity: A large amount of cash can be tied up in working capital, so a
company managing it efficiently could benefit from additional liquidity and be less
dependent on external financing. This is especially important for smaller
businesses as they typically have a limited access to external funding sources.
Also, small businesses often pay their bills in cash from earnings so an efficient
working capital management will allow a business to better allocate its resources
and improve its cash management.
z Increased Business Value: Firms with more efficient working capital
management will generate more free cash flows which will result in a higher
business valuation and enterprise value.
z Favorable Financing Conditions: A firm with a good relationship with its trade
partners and paying its suppliers on time will benefit from favorable financing terms
such as discount payments from its suppliers and banking partners.
z Uninterrupted Production: A firm paying its suppliers on time will also benefit
from a regular flow of raw materials, ensuring that the production remains
uninterrupted and clients receive their goods on time.
z Ability to Face Shocks and Peak Demand: An efficient working capital
management will help a firm to survive through a crisis or ramp up production in
case of an unexpectedly large order.
5.3 Nature of Working Capital

In an ordinary sense, working capital denotes the amount of funds needed for meeting
day-to-day operations of a concern.
This is related to short-term assets and short-term sources of financing. Hence it
deals with both, assets and liabilities—in the sense of managing working capital it is
the excess of current assets over current liabilities.

Concept of Working Capital
The funds invested in current assets are termed as working capital. It is the fund that is Notes
needed to run the day-to-day operations. It circulates in the business like the blood
circulates in a living body. Generally, working capital refers to the current assets of a
company that are changed from one form to another in the ordinary course of
business, i.e. from cash to inventory, inventory to work in progress (WIP), WIP to
finished goods, finished goods to receivables and from receivables to cash.
There are two concepts in respect of working capital:
z Gross working capital and
z Networking capital.
z Gross Working Capital: The sum total of all current assets of a business concern
is termed as gross working capital. So,
Gross working capital = Stock + Debtors + Receivables + Cash.
z Net Working Capital: The difference between current assets and current liabilities
of a business concern is termed as the Net working capital.
Hence,
Net Working Capital = Stock + Debtors + Receivables + Cash – Creditors –
Payables.
The nature of working capital is as discussed below:
It is used for purchase of raw materials, payment of wages and expenses.
It changes form constantly to keep the wheels of business moving.
Working capital enhances liquidity, solvency, creditworthiness and reputation
of the enterprise.
It generates the elements of cost namely: Materials, wages and expenses.
It enables the enterprise to avail the cash discount facilities offered by its
suppliers.
It helps improve the morale of business executives and their efficiency
reaches at the highest climax.
It facilitates expansion programmes of the enterprise and helps in maintaining
operational efficiency of fixed assets.
Need for Working Capital

Working capital plays a vital role in business. This capital remains blocked in raw
materials, work in progress, finished products and with customers.
The needs for working capital are as given below:
z Adequate working capital is needed to maintain a regular supply of raw materials,
which in turn facilitates smoother running of production process.
z Working capital ensures the regular and timely payment of wages and salaries,
thereby improving the morale and efficiency of employees.
z Working capital is needed for the efficient use of fixed assets.
z In order to enhance goodwill a healthy level of working capital is needed. It is
necessary to build a good reputation and to make payments to creditors in time.
z Working capital helps avoid the possibility of under-capitalization.
z It is needed to pick up stock of raw materials even during economic depression.
z Working capital is needed in order to pay fair rate of dividend and interest in time,
which increases the confidence of the investors in the firm.

Notes It is said that working capital is the lifeblood of a business. Every business needs funds
in order to run its day-to-day activities.
The importance of working capital can be better understood by the following:
z It helps measure profitability of an enterprise. In its absence, there would be
neither production nor profit.
z Without adequate working capital an entity cannot meet its short-term liabilities in
time.
z A firm having a healthy working capital position can get loans easily from the
market due to its high reputation or goodwill.
z Sufficient working capital helps maintain an uninterrupted flow of production by
supplying raw materials and payment of wages.
z Sound working capital helps maintain optimum level of investment in current
assets.
z It enhances liquidity, solvency, credit worthiness and reputation of enterprise.
z It provides necessary funds to meet unforeseen contingencies and thus helps the
enterprise run successfully during periods of crisis.
Classification of Working Capital

Working capital may be of different types as follows:
z Gross Working Capital: Gross working capital refers to the amount of funds
invested in various components of current assets. It consists of raw materials,
work in progress, debtors, finished goods, etc.
z Net Working Capital: The excess of current assets over current liabilities is
known as Net working capital. The principal objective here is to learn the
composition and magnitude of current assets required to meet current liabilities.
z Positive Working Capital: This refers to the surplus of current assets over current
liabilities.
z Negative Working Capital: Negative working capital refers to the excess of
current liabilities over current assets.
z Permanent Working Capital: The minimum amount of working capital which even
required during the dullest season of the year is known as Permanent working
capital.
z Temporary or Variable Working Capital: It represents the additional current
assets required at different times during the operating year to meet additional
inventory, extra cash, etc.
It can be said that Permanent working capital represents minimum amount of the
current assets required throughout the year for normal production whereas Temporary
working capital is the additional capital required at different time of the year to finance
the fluctuations in production due to seasonal change. A firm having constant annual
production will also have constant Permanent working capital and only Variable
working capital changes due to change in production caused by seasonal changes.

Notes
Similarly, a growth firm is the firm having unutilized capacity, however, production
and operation continues to grow naturally. As its volume of production rises with the
passage of time so also does the quantum of the Permanent working capital.
Components of Working Capital

Working capital is composed of various current assets and current liabilities, which are
as follows:
(A) Current Assets

These assets are generally realized within a short period of time, i.e. within one year.
Current assets include:
z Inventories or Stocks
Raw materials
Work in progress
Consumable Stores
Finished goods
z Sundry Debtors
z Bills Receivable
z Pre-payments
z Short-term Investments
z Accrued Income and
z Cash and Bank Balances

(B) Current Liabilities
Notes Current liabilities are those which are generally paid in the ordinary course of business
within a short period of time, i.e. one year.
Current liabilities include:
(a) Sundry Creditors
(b) Bills Payable
(c) Accrued Expenses
(d) Bank Overdrafts
(e) Bank Loans (short-term)
(f) Proposed Dividends
(g) Short-term Loans
(h) Tax Payments Due
5.3 Concepts
Business organization requires adequate capital to establish business and operate
their activities. The total capital of a business can be classified as fixed capital and
working capital. Fixed capital is required for the purchase of fixed assets like building,
land, machinery, furniture etc. Fixed capital is invested for long period, therefore it is
known as long-term capital. Similarly, the capital, which is needed for investing in
current assets, is called working capital.
The capital which is needed for the regular operation of business is called working
capital. Working capital is also called circulating capital or revolving capital or short-
term capital. Working capital is used for regular business activities like for the
purchase of raw materials, for the payment of wages, payment of rent and of other
expenses. Working capital is kept in the form of cash, debtors, raw materials inventory,
stock of finished goods, bills receivable etc.
Concept of Working Capital

Generally, there are two concepts of working capital i.e. gross concept and net
concept.
z Gross Concept of Working Capital: According to gross concept, working capital
refers to all the current assets and represents the amount of funds invested in
current assets. Thus, gross working capital is the capital invested in current
assets. Current assets are those assets which can be converted into cash within
the short-time period.
Gross Working Capital = Total current assets
In this way, gross working capital refers to the firm's investment in current assets.
Gross working capital represents total of current assets which includes cash in
hand, cash at bank, inventory, prepaid expenses, bills receivable etc.
z Net Concept of Working Capital: According to the net concept, working capital is
the excess of current assets over current liabilities. In other words, the difference
between current assets and current liabilities is called net working capital.
Net Working Capital = Current Assets - Current liabilities
5.4 Need for Working Capital

Working capital is the life blood and nerve center of business. Working capital is very
essential to maintain smooth running of a business. No business can run successfully

without an adequate amount of working capital. The main advantages or importance of
working capital are as follows:
1. Strengthen the Solvency: Working capital helps to operate the business
Notes
smoothly without any financial problem for making the payment of short-term
liabilities. Purchase of raw materials and payment of salary, wages and overhead
can be made without any delay. Adequate working capital helps in maintaining
solvency of the business by providing uninterrupted flow of production.
2. Enhance Goodwill Sufficient working capital enables a business concern to make
prompt payments and hence helps in creating and maintaining goodwill. Goodwill
is enhanced because all current liabilities and operating expenses are paid on
time.
3. Easy Obtaining Loan: A firm having adequate working capital, high solvency and
good credit rating can arrange loans from banks and financial institutions in easy
and favorable terms.
4. Regular Supply of Raw Material: Quick payment of credit purchase of raw
materials ensures the regular supply of raw materials fro suppliers. Suppliers are
satisfied by the payment on time. It ensures regular supply of raw materials and
continuous production.
5. Smooth Business Operation: Working capital is really a life blood of
any business organization which maintains the firm in well condition. Any day to
day financial requirement can be met without any shortage of fund. All expenses
and current liabilities are paid on time.
6. Ability to Face Crisis: Adequate working capital enables a firm to face business
crisis in emergencies such as depression.
The Importance of Working Capital

Working capital is a daily necessity for businesses, as they require a regular amount of
cash to make routine payments, cover unexpected costs and purchase basic materials
used in production of goods. Working capital is an easily understandable concept, as it
is linked to an individual’s cost of living and, thus, can be understood in a more
personal way. Individuals need to collect money they are owed and maintain a certain
amount on a daily basis to cover day-to-day expenses, bills and other regular
expenditures.
Working capital is a prevalent metric for the efficiency, liquidity and overall health
of a company. It is a reflection of the results of various company activities, including
revenue collection, debt management, inventory management and payments to
suppliers. This is because it includes inventory, accounts payable and receivable,
cash, portions of debt due within the period of a year and other short-term accounts.
The needs for working capital vary from industry to industry, and they can even
vary among similar companies. This is due to several factors, including differences in
collection and payment policies, the timing of asset purchases, the likelihood of a
company writing off some of its past-due accounts receivable, and in some instances,
capital-raising efforts a company is undertaking.
The Importance of Working Capital Management

When a company does not have enough working capital to cover its obligations,
financial insolvency can result and lead to legal troubles, liquidation of assets and
potential bankruptcy. Thus, it is vital to all businesses to have adequate management
of working capital.
Working capital management is essentially an accounting strategy with a focus on
the maintenance of a sufficient balance between a company’s current assets and
liabilities. An effective working capital management system allows businesses to not
only cover their financial obligations, but it is also a way to help companies boost their

earnings. Managing working capital means managing inventories, cash, accounts
payable and accounts receivable. An efficient working capital management system
Notes often uses key performance ratios, such as the working capital ratio, the
inventory turnover ratio and the collection ratio, to help identify areas that require focus
in order to maintain liquidity and profitability.
5.5 Types of Working Capital

Working Capital is divided into various types based balance sheet view and operating
cycle view. Balance sheet view divides working capital into gross working capital and
net working capital and the operating cycle view divides the working capital into
permanent and temporary working capital. Permanent working capital is further divided
into seasonal and special working capital whereas temporary working capital into
regular and reserve working capital.
Working capital is the capital / funds required for day to day operations of the
business. Working capital is invested usually in all types of inventories such as raw
materials, spares, finished goods etc and credit extension to debtors and cash in hand.
Types of Working Capital

Working capital is classified into different types and the classification is based on the
following views:
z Balance Sheet View
z Operating Cycle View
On the basis of Balance Sheet View, types of working capital are described below:
z Gross Working Capital (GWC): Current assets in the balance sheet of a
company are known as gross working capital. Current assets are those short term
assets which can be converted into cash within a period of one year. The grey
area in the management of current assets or gross working capital is its
unpredictability i.e. it is very difficult to ascertain the exact time of conversion of
such assets. Why is such a nature problematic? It is because the liabilities occur at
their time and do not wait for our current asset to realize. This mismatch or the gap
creates a need for arranging working capital financing.
z Net Working Capital (NWC): Net working capital is a very frequently used term.
There are two ways to understand networking capital. First, one says it is simply
the difference between current assets and the current liabilities on the balance
sheet of a business. The other understanding discloses little deeper or hidden
meaning of the term. As per that, NWC is that part of current assets which are
indirectly financed by long-term assets. Compared to gross working capital, net
working capital is considered more relevant for effective working capital financing
and management.
On the basis of Operating Cycle View, types of working capital are as below:
Permanent / Fixed Working Capital: Dealing with current asset and fixed assets is
totally different. Determining the financing requirement in the case of fixed assets
is simply the cost of the asset. Same is not true for current assets because the
value of current assets is constantly changing and it is difficult to accurately
forecast that value at any point of time. To simplify the complexity to some extent,
on the basis of past trend and experience, we can find a level below which current
asset has never gone. The current assets below this level are called permanent or
fixed working capital. See the example below:

Types of Working Capital
Net Working Permanent / Fixed Temporary / Variable Working Notes
Capital Working Capital Capital Requirement
3000 2500 500
2500 2500 0
2800 2500 300
3200 2500 700
In the example, 2500 is the permanent working capital below which the net
working capital has not gone.
z Regular Working Capital: It is the permanent working capital which is normally
required in the normal course of business for the working capital cycle to flow
smoothly.
z Reserve Working Capital: It is the working capital available over and above the
regular working capital. It is kept for contingencies which may arise due to
unexpected situations.
z Temporary / Variable WC: Temporary working capital is easy to understand after
getting hold over the permanent working capital. In simple terms, it is the
difference between net working capital and permanent working capital. The main
characteristic which can be made out of the example is “fluctuation”. The
temporary working capital, therefore, cannot be forecasted. In the interest of
measurability, this can be further bifurcated as below which can create at least
some base to forecast.
z Seasonal Working Capital: Seasonal working capital is that temporary increase
in working capital which is caused due to some relevant season for the business. It
is applicable to businesses having the impact of seasons, for example, the
manufacturer of sweaters for whom relevant season is the winters. Normally, their
working capital requirement would increase in that season due to higher sales in
that period and then go down as the collection from debtors is more than sales.
z Special Working Capital: Special working capital is that rise in the temporary
working capital which occurs due to a special event which otherwise normally does
not take place. It has no basis to forecast and has rare occurrence normally. For
example, a country where Olympic Games are held, all the business requires extra
working capital due to a sudden rise in business activity.
It was all about the types of working capital. It needs to be managed with several
working capital techniques so as to have the effective working capital management.
5.6 Changes in Working Capital

The impact of working capital changes are reflected in a firm’s cash flow statement.
Specifically, the operating cash flow section of the cash flow statement details changes
in its shorter-term working capital needs. A positive working capital figure (current
assets are greater than current liabilities) means a cash inflow for the period
measured. In contrast, a negative working capital position means the firm has spent
more cash out than it brought in managing its working capital, or commitments, within
a year. Analyzing changes in working capital can be important for any business, but is
especially important for firms with seasonal or erratic cash flow needs.
For instance, retailing giant Wal-Mart Stores Inc (WMT), like most retailers,
spends a considerable amount of working capital prior to the all-important holiday
selling season.
Looking at Wal-Mart’s 2013 quarterly cash flow statement (fiscal third quarter
ended October) prior to the calendar fourth quarter, we can see that it spent nearly $7
billion (reflected as a cash outflow) on inventory. This contrasts sharply with the other

three quarters. In its first and second quarters, spending on inventory was minimal and
came in at $584 million (a cash inflow) and negative $15 million. In the fourth quarter,
Notes inventory decreased by a wide margin and brought in nearly $4.5 billion in working
capital.
On the other side, Blockbuster, the video rental chain that went bankrupt, had a
working capital situation that was much grimmer. In fiscal 2010, its change
in accounts payable and accrued expenses totaled a cash outflow of nearly $250
million and it came following a reported loss of close to $600 million. At the time, cash
on hand was only $190 million. With a negative working capital, the company was not
able to meet its short-term obligations. Later that year, the firm filed for bankruptcy.
The Bottom Line

Most of the time, a company’s working capital is simply a core part of its daily
operations. But it can indicate financial problems, especially when working capital runs
in the negative for an extended period of time.
In ordinary parlance, working capital denotes a ready amount of fund available for
carrying out the day-to-day activities of a business enterprise.
It is considered to be the life-blood of the business and its effective and efficient
management is necessary for the very survival of the business.
There are two concepts of working capital:
z Gross concept, and
z Net concept.
Gross Concept of Working Capital

The gross working capital refers to the total fund invested in current assets. Current
assets are those assets which are easily converted into cash within a time period of
one year. It includes cash in hand and at bank, short term securities, debtors, bills
receivable, prepaid expenses, accrued expenses and inventories like raw materials,
work-in-progress, stores and spare parts, finished goods.
The gross concept of working capital refers to the firm’s investment in above
current assets.
It is useful for the following purposes:
z It is the total investment in current assets which earns profit.
z Management can give attention to manage very efficiently and carefully each item
of the current assets in order to minimise bad debt, slow-moving and non-moving
items, idle cash etc.
z It takes into consideration of the fact that, if other things remain constant, infusion
of fund in the business increases its working capital.
z It enables management to compute the rate of return on total investment in current
assets.
Net Concept of Working Capital

The term net working capital refers to the excess of current assets over current
liabilities. In other words, the amount of current assets that would remain in a firm after
all its current liabilities are paid.
Current liabilities are those claims of outsiders to the business enterprise which
are payable within a period of one year, and include sundry creditors, bills payable,
outstanding expenses, short-term loans, advances and deposits, bank overdraft,
proposed dividend, provision for taxation etc.

The net concept of working is useful for the following reasons:
z It indicates the liquidity position of the firm i.e., ability of the firm to meet its short-
term obligations.
Notes
z It helps creditors and other potential investors to judge the financial health of the
firm.
z Gross concept of working capital may lead to incorrect conclusion regarding
financial stability of firms having the same amount of current assets.
z It indicates the extent of long-term sources of fund used in financing current assets
of a business enterprise.
So both gross concept of working capital and net concept of working capital are
useful for working capital management. However, while preparing a vertical form of
balance sheet, the Institute of Chartered Accountants of India has defined and shown
working capital as the difference between current assets and current liabilities.
There is yet another view, according to which the net working capital may be
referred to as the qualitative—and the gross working capital as the quantitative—
aspects of the idea. These two concepts of working capital are generally known as the
balance sheet concepts as they depend upon the contents of balance sheet items.
Types of Net Working Capital

If gross concept of working capital is used, there will always be positive working capital
as it represents only current assets. On the other hand, if net concept of working
capital is used, there may be positive, negative or zero (nil) working capital.
z Positive Working Capital: Positive working capital refers to excess of current
assets over current liabilities. It indicates the extent of long-term sources of funds
such as equity share, preference share, retained earnings, long-term loans and
debentures etc. used to finance the current assets of a business concern.
z Negative Working Capital: If current liabilities of a firm exceed current assets it is
called negative working capital. In other words, working capital is said to be
negative when the current assets fall short of the current liabilities. The excess of
current liabilities over current assets is supposed to have been used in procuring
fixed assets of the firm.
So, it indicates the extent of short-term sources of fund used to finance the fixed
assets of the firm. A negative working capital means a negative liquidity and is
disastrous for the firm.
z Zero Working Capital: If the current assets are equal to current liabilities, it is
called zero or nil working capital.
Working Capital = Current Assets – Current Liabilities

A Ltd : ` 8,000 – ` 6,000 = (+) ` 2,000
B Ltd : ` 8,000 – ` 10,000 = (-) ` 2,000

In the case of A Ltd., a part of long-term funds (i.e., ` 14,000 – 12,000) or ` 2,000
is invested for financing current assets while ` 6,000 is available from short-term
Notes funds. As a result, working capital is positive. In the case of B Ltd. long-term funds
(i.e., ` 6,000 + ` 4,000 = ` 10,000) is not sufficient to finance fixed assets.
As a result, a part of short-term sources (i.e., ` 10,000 – ` 8,000) or ` 2,000 is
used for financing fixed assets. Hence, working capital is negative.

The importance of sufficient working capital in any business concern can never be
overemphasized. A concern requires adequate working capital to carry on its day-to-
day operations smoothly and efficiently. Lack of adequate working capital not only
impairs firm’s profitability but also results in stoppage in production and efficiency in
payment of its current obligations.
Thus working capital is considered the life-blood of the business.
The advantages of having adequate working capital may be summarised:
1. Smooth Flow of Production: To maintain a smooth flow of production, it is
necessary that adequate working capital is available for paying trade suppliers,
hiring labour and incurring other operating expenses.
2. Increase in Liquidity and Solvency Position: It enhances the liquidity and
solvency position of the business concern.
3. Goodwill: A firm with sound working capital position can make timely payment of
its outstanding bills. This enhances the reputation of the firm.
4. Advantages of Cash Discount: It enables the firm to avail itself of the facilities
like cash discount by making prompt payments.
5. Easy Loan: Adequate amount of working capital builds a sound credit-worthiness
of the firm. As a result it becomes easier for the firm to obtain additional loans in
favourable terms and conditions in order to meet seasonal increase in demand or
to finance the increased working capital resulting from expansion.
6. Regular Payment of Wages and Salaries: The firm can make regular and timely
payment of wages and salaries to its employees. This increases the morale and
efficiency of employees.
7. Security and Confidence: It creates a sense of security and confidence in the
mind of management or officials of the firm.
8. Efficient Use of Fixed Assets: Adequate amount of working capital enables the
firm to use its fixed assets more efficiently and extensively. If the fixed assets
remain idle due to paucity of working capital, depreciation of fixed assets and
interest on borrowed capital invested in fixed assets will have to be incurred
unnecessarily.
9. Meeting of Contingencies: It can meet unforeseen contingencies of the firm.
Unforeseen contingencies like business depression, financial crisis due to huge
losses etc. can easily be overcome, if adequate working capital is maintained by a
firm.
10. Completing operating cycle: A sound management of working capital helps in
completing the operating cycle quickly. This enables a firm to increase its
profitability.
11. Timely Payment of Dividend: Adequate working capital ensures regular payment
of dividends to the shareholders.
Components or Composition of Working Capital

There are two components of working capital viz., current assets and current liabilities.

Current Assets
Current assets generally mean those assets which, in the normal and ordinary course Notes
of business, will be or are likely to be converted into cash within a year.
Examples of current assets are:
z Inventories like raw materials, work-in-progress, stores and spare parts, finished
goods
z Sundry Debtors (net of provision)
z Short-term investment or marketable securities
z Short-term loans and advances
z Bills receivable or accounts receivable
z Pre-paid expenses
z Accrued Income
z Cash in hand and bank balances.
Current Liabilities
Current liabilities mean those liabilities repayable within the same period, i.e., a year.
In other words, current liabilities are those which are to be repaid in the ordinary
course of the business within a year.
Examples of current liabilities are:
z Sundry creditors
z Bills payable
z Outstanding expenses
z Short-term loans, advances and deposits
z Provision for tax
z Proposed dividend
z Bank overdraft.
Different Sources of Working Capital

A firm can use two types of sources to finance its working capital, namely:
z Long-term source, and
z Short-term source.
z Long-Term Sources: Every business organisation is required to maintain a
minimum balance of cash and other current assets at all the times—irrespective of
the ups and downs in the level of activity. The portion of working capital which is
continuously maintained by the business at all times to carry on its minimum level
of activities is called permanent working capital.
This type of working capital should be arranged from long-term sources of fund.
The following are the long-term sources of financing permanent working capital:
Issue of Equity shares
Issue of Preference shares
Retained earnings (ploughed-back profits)
Issue of Debentures and other long-term bonds
Long-term loans taken from financial institutions etc.
z Short-Term Sources: The short-term financing of working capital is generally
used to support the temporary working capital which is usually needed to meet the
seasonal increase or sudden spurt in demand.

Various short-term sources of financing of temporary working capital are:
Bank credit (e.g., cash credit, letter of credit, bills finance, working capital
Notes demand loan, overdraft facility etc.)
Public deposits
Trade credit
Outstanding expenses
Provision for depreciation
Provision for taxation
Advances from customers
Loans from directors
Security money received from employees
Receipts from factoring.
Determinants of Working Capital

A firm should always maintain a requisite amount of working capital for smooth and
efficient functioning of its operations. The total working capital requirement is
determined by a wide variety of factors. These factors affect different enterprises
differently. They also vary from time to time.
In general, the following factors are to be considered in determining the working
capital requirement of a firm:
1. Nature of Business: The working capital requirements of a firm are widely
influenced by the nature of business. Public utilities like bus service, railways,
water supply etc. have the lowest requirements for working capital—partly
because of the cash nature of their business and partly because of their rendering
service rather than manufacturing product and there is no need of maintaining any
inventory or book debt except capital assets.
On the contrary, trading concerns are required to maintain more working capital
because they have to carry stock-in-trade, receivables and liquid cash.
Manufacturing concerns also require large amount of working capital because of
the time lag involved in the conversion of raw materials into finished products and,
finally, into cash.
2. Size of the Business: The amount of working capital requirement also depends
upon the size of the business. The size can be measured in terms of the scale of
operations. A large firm with a high scale of operation will require to maintain a
large amount of working capital than a firm with a small scale of operation.
3. Production Cycle: Production cycle is the time involved in manufacturing or
processing a product. It starts when raw materials are put in the production
process and ends with the completion of manufacturing of the product. Longer the
production cycle, higher is the need of working capital.
This is because funds remain blocked in work-in-progress for long periods of time.
For example, the working capital needs of a ship-building industry will be much
longer than those of a bakery.
4. Business Cycle: The working capital requirements are also determined by the
nature of the business cycle. During the boom period, the need for working capital
will increase to meet the requirements of increased production and sales. On the
other hand, in a slack period, the reduced volume of operation will require
relatively lower amount of working capital.
5. Credit terms of Purchase and Sale: The period of credit given by the suppliers
and the period of credit granted to the customers will affect the working capital
needs of a firm. If a firm allows a very short credit period, cash will be realised very
soon from debtors. So the need for the working capital will be less.

On the other hand, a liberal credit policy will result in higher amount of book debts.
Higher book debts will mean more working capital requirement. If the firm has to
purchase raw materials in cash or gets credit for shorter period, it has to arrange Notes
for relatively higher amount of working capital.
6. Seasonal Variations: There are industries like cold drinks, ice-cream and woolen
where the goods are either produced or sold seasonally. So, in such industries,
working capital requirements during production or sale seasons will be large and
these will start decreasing when the season starts coming-to end.
However, much depends on the policy of management with regard to production or
sale of goods. For example, the management of a woolen industry wants to carry
on production evenly throughout the year rather than concentrating on its
production only in the busy season. In that case the working capital requirements
will be low.
7. Operating Efficiency: If the operating efficiency of a firm is very high, the
resources will be properly utilised. As a result, it improves the profitability of the
firm which ultimately, helps in releasing the pressure of working capital. On other
hand, inefficiency compels the firm to maintain relatively a high level of working
capital.
8. Price level changes: If prices of input rise, the firm requires additional working
capital to maintain the same level of production.
9. Growth and Expansion of the Business: Every concern wants to grow over a
period of time and with the increase in its size, so the working capital requirements
are bound to increase. A growing firm would require greater working capital than a
static one.
10. Profitability and Retention Money: The net profit earned by the firm goes to
increase the working capital to the extent it has been earned in cash. The cash
profit can be found by adjusting non-cash items such as depreciation, outstanding
expenses and losses or intangible assets written-off in the net profit.
But what portion of this profit will be reinvested as working capital will depend upon
the retention policy of a firm which is, again influenced by corporate tax structure
and dividend policy. So, if the amount of retained profit is not immediately invested
outside the business, it would increase the amount of working capital.
11. Relationship of Material Cost to Total Cost: In manufacturing concerns, where
raw material costs bear a large proportion to the total cost of production, a greater
amount of working capital will have to be maintained. For example, in industries
like textile and electronics, large sums are required to maintain the inventory of
such raw materials.
12. Turnover of Current Assets: The speed with which the current assets revolve
around also affects working capital requirements of a firm. In few cases like
vegetables or fruit shops, stocks get sold very quickly and, for this reason, a little
or no working capital is required in carrying over the stock.
On the other hand, there are some businesses, like jewellery, having very slow
turnover of the stocks—leading to the need for a larger amount of working capital.
5.7 Determinants of Working Capital

Some of the most determinants of working capital are:
1. Nature of business 2. Length of period of manufacture 3. Volume of business 4.
The proportion of the cost of raw materials to total cost 5. Use of Manual Labour or
Mechanisation 6. Need to keep large stocks of raw materials of finished goods 7.
Turnover of working capital 8. Terms of Credit 9. Seasonal Variations 10.
Requirements of Cash and 11. Other Factors.

The requirements of working capital are not uniform in all enterprises, and
therefore, factors responsible for a particular size of working capital in one company
Notes are different than in other enterprise. Therefore, a set pattern of factors determining
the optimum size of working capital is difficult to suggest.
1. Nature of business: It is an important factor for determining the amount of
working capital needed by various companies. The trading or manufacturing
concerns will require more amount of working capital along-with their fixed
investment of stock, raw materials and finished products.
Public utilities and railway companies with huge fixed investment usually have the
lowest needs for current assets, partly because of cash, nature of their business
and partly due to their selling a service instead of a commodity. Similarly, basic
and key industries or those engaged in the manufacture of producer’s goods
usually have less proportion of working capital to fixed capital than industries
producing consumer goods.
2. Length of period of manufacture: The average length of the period of
manufacture, i.e., the time which elapses between the commencement and end of
the manufacturing process is an important factor in determining the amount of the
working capital.
If it takes less time to make the finished product, the working capital required will
be less. To give an example, a baker requires one night time to bake his daily
quota of bread. His working capital is, therefore, much less than that of a ship-
building concern which takes three to five years to build a ship. Between these two
cases may fall other business concerns with varying periods of manufacture
requiring different amounts of working capital.
3. Volume of business: Generally, the size of the company has a direct relation with
the working capital needs. Big concerns have to keep higher working capital for
investment in current assets and for paying current liabilities.
4. The proportion of the cost of raw materials to total cost: Where the cost of raw
materials to be used in manufacturing of a product is very large in proportion to the
total cost and its final value, working capital required will also be more.
That is why, in a cotton textile mill or in a sugar mill, huge funds are required for
this purpose. A building contractor also needs huge working capital for this reason.
If the importance of materials is less, as for example in an oxygen company, the
needs of working capital will be naturally not more.
5. Use of Manual Labour or Mechanisation: In labour intensive industries, larger
working capital will be required than in the highly mechanized ones. The latter will
have a large proportion of fixed capital. It may be remembered, however, that to
some extent the decision to use manual labour or machinery lies with the
management. Therefore, it is possible in most cases to reduce the requirements of
working capital and increase investments in fixed assets and vice versa.
6. Need to keep large stocks of raw materials of finished goods: The
manufacturing concerns generally have to carry stocks of raw materials and other
stores and also finished goods. The larger the stocks (whether of raw materials or
finished goods) more will be the needs of working capital.
In certain lines of business, e.g., where the materials are bulky and have to be
purchased in large quantities, (as in cement manufacturing), stock piling of raw-
material is used.
Similarly, in public utilities, which must have adequate supplies of coal to assure
regular service, stock piling of coal is necessary. In seasonal industries finished
goods stocks have to be stored during off seasons. All these require large working
capital.
7. Turnover of working capital: Turnover means the speed with which the working
capital is recovered by the sale of goods. In certain businesses, sales are made

quickly and the stocks are soon exhausted and new purchases have to be made.
In this manner, a small amount of money invested in stocks will result in sales of
much larger amount. Notes
Considering the volume of sales, the amount of working capital requirements will
be rather small in such type of business. There are other businesses where sales
are made irregularly. For example, in case of jewellers, a costly jewellery may
remain locked up in the show-window for a long period before it catches the fancy
of a rich lady.
In such cases, large sums of money have to be kept invested in stocks. But a
baker or a news-hawker may be able to dispose of his stocks quickly, and may,
therefore, need much smaller amounts by way of working capital.
8. Terms of Credit: A company purchasing all raw-materials for cash and selling on
credit will be requiring more amount of working capital. Contrary to this, if the
enterprise is in a position to buy on credit and sell it for cash, it will need less
amount of working capital. The length of the period of credit has a direct bearing
on working capital.
The essence of this is that the period which elapses between the purchase of
materials and sale of finished goods and receipts of sale proceeds, will determine
the requirements of working capital.
9. Seasonal Variations: There are some industries which either produce goods or
make sales only seasonally. For example, the sugar industry produces practically
all the sugar between December and April and the woollen textile industry makes
its sales generally during winter.
In both these cases the needs of working capital will be very large, during few
months {i.e., season). The working capital requirements will gradually decrease as
and when the sales are made.
10. Requirements of Cash: The need to have cash in hand to meet various
requirements e.g., payment of salaries, rents, rates etc., has an effect on the
working capital. The more the cash requirements the higher will be working capital
needs of the company and vice versa.
11. Other Factors: In addition to the above mentioned considerations there are also a
number of other factors which affect the requirements of working capital. Some of
them are given below:
(a) Degree of co-ordination between production and distribution policies.
(b) Specialisation in the field of distribution.
(c) Developments of means of transportation and communications.
(d) The hazards and contingencies inherent in the type of business.
5.8 Summary
Working capital (abbreviated WC) is a financial metric which represents operating
liquidity available to a business, organization or other entity, including governmental
entity. Along with fixed assets such as plant and equipment, working capital is
considered a part of operating capital. Gross working capital equals to current assets.
Working capital is calculated as current assets minus current liabilities. If current
assets are less than current liabilities, an entity has a working capital deficiency,
also called a working capital deficit.
A company can be endowed with assets and profitability but short of liquidity if its
assets cannot readily be converted into cash. Positive working capital is required to
ensure that a firm is able to continue its operations and that it has sufficient funds to
satisfy both maturing short-term debt and upcoming operational expenses. The

management of working capital involves managing inventories, accounts receivable
and payable, and cash.
Notes
Multiple Choice Questions
1. "Shareholder wealth" in a firm is represented by:
(a) the number of people employed in the firm
(b) the book value of the firm's assets less the book value of its liabilities
(c) the amount of salary paid to its employees
(d) the market price per share of the firm's common stock
2. The long-run objective of financial management is to:
(a) maximize earnings per share
(b) maximize the value of the firm's common stock
(c) maximize return on investment
(d) maximize market share
3. What are the earnings per share (EPS) for a company that earned ` 100,000 last
year in after-tax profits, has 200,000 common shares outstanding and ` 1.2 million
in retained earning at the year end?
(a) ` 100,000
(b) ` 6.00
(c) ` 0.50
(d) ` 6.50
4. A(n) would be an example of a principal, while a(n) would be an example of an
agent.
(a) shareholder; manager
(b) manager; owner
(c) accountant; bondholder
(d) shareholder; bondholder
5. The market price of a share of common stock is determined by:
(a) the board of directors of the firm
(b) the stock exchange on which the stock is listed
(c) the president of the company
(d) individuals buying and selling the stock
6. The focal point of financial management in a firm is:
(a) the number and types of products or services provided by the firm
(b) the minimization of the amount of taxes paid by the firm
(c) the creation of value for shareholders
(d) the dollars profits earned by the firm
7. …………… of a firm refers to the composition of its long-term funds and its capital
structure.
(a) Capitalisation
(b) Over-capitalisation
(c) Under-capitalisation
(d) Market capitalization

8. In the ……………., the future value of all cash inflow at the end of time horizon at a
particular rate of interest is calculated.
(a) Risk-free rate
Notes
(b) Compounding technique
(c) Discounting technique
(d) Risk Premium
9. ……………. is the price at which the bond is traded in the stock exchange.
(a) Redemption value
(b) Face value
(c) Market value
(d) Maturity value
10. ……………. enhance the market value of shares and therefore equity capital is not
free of cost.
(a) Face value
(b) Dividends
(c) Redemption value
(d) Book value

1. Define Working Capital Management.
2. What is the Nature of Working Capital?
3. Explain the Concepts of Working Capital.
4. What is the need for Working Capital?
5. What are the different types of working capital?
6. Define the changes in Working Capital.
7. What are the determinants of Working Capital?
5.11 Key Terms

z Assets: These assets count toward the value of a business, since they could be
sold if the business experienced difficult times.
z Liabilities: This includes any debt accrued by a business in the course of starting,
growing and maintaining its operations, including bank loans, credit card debts,
and monies owed to vendors and product manufacturers.
z Expenses: Business expenses are the costs the company incurs each month in
order to operate, including rent, utilities, legal costs, employee salaries, contractor
pay, and marketing and advertising costs. To remain financially solid, businesses
are often encouraged to keep expenses as low as possible.
z Cash Flow: cash flow is the overall movement of funds through your business
each month, including income and expenses. Businesses track general cash flow
to determine long-term solvency. A business’ cash flow can be determined by
comparing its available cash balance at the beginning and end of a specified
period.
z Bottom Line: This is the total amount a business has earned or lost at the end of
the month. The bottom line is the last financial figure on a ledger. The term can
also be used in the context of a business’ earnings either increasing or decreasing.

Check Your Progress: Answers

Notes 1. (d) the market price per share of the firm's common stock
2. (b) maximize the value of the firm's common stock
3. (c) ` 0.50
4. (d) shareholder; bondholder
5. (a) the board of directors of the firm
6. (c) the creation of value for shareholders
7. (a) Capitalisation
8. (c) Discounting technique
9. (c) Market value
10. (b) Dividends

z Accounting for Beginners, Shlomo Simanovsky – 2010
z Financial Accounting, V.K. Goyal - 2007
z S.N. Maheswari – Management Accounting-2010
z Jain & Narang – Cost Accountancy- 2005

Accounts 4

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84 Accounting & Financial Management

Unit 4: Financial Management

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Functions of Financial Management

Amity Directorate of Distance & Online Education

Meaning of Financial Management

Objectives of Financial Management

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Objections against the Profit Maximisation Objectives

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Approaches to Financial Management

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4.4 Importance of Financial Management

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Relationship of Financial Management with other Branches

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4.5 Risk and Return

The Risk Return trade-off

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Amity Directorate of Distance & Online Education

Rupee Cost Averaging

4.6 Various Functional areas of Financial Management

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4.7 Capital Budgeting

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The Importance of Capital Budgeting

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Accounting Rate of Return Method

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Net Present Value Method

Internal Rate of Return Method

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z It gives due consideration to the time value of money.

4.8 Cost of Capital

Cost of Preference Capital

Cost of Equity Capital

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Cost of Convertible Securities

Where Vc = issue price of convertible bond at time 0

4.9 Ratio Analysis

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Accounting Analysis Notes

Ratio Analysis and its Applications

Advantages of Ratio Analysis

Limitations of Ratio Analysis

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Classification on the Basis of Financial Statement

Classification of Ratios on the Basis of Financial Statements

Current Ratio Gross Profit Ratio Stock Turnover Ratio

Classification on the Basis of Financial Aspects

4.10 Some Important Ratios

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Amity Directorate of Distance & Online Education

Amity Directorate of Distance & Online Education

Uses of key operating ratios

How to get better ratios

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4.12 Check Your Progress

4.13 Questions and Exercises

4.14 Key Terms

Check Your Progress: Answers

4.15 Further Readings