CORPORATE FINANCE

What Is Financial Management?

At its core, financial management is the practice of making a business plan and
then ensuring all departments stay on track. Solid financial management
enables the CFO or VP of finance to provide data that supports creation of a
long-range vision, informs decisions on where to invest, and yields insights on
how to fund those investments, liquidity, profitability, cash runway and more.

“Financial management is the activity concerned with planning, raising,

controlling and administering of funds used in the business.” – Guthman and
Dougal

“Financial management is that area of business management devoted to a

judicious use of capital and a careful selection of the source of capital in order to
enable a spending unit to move in the direction of reaching the goals.” – J.F.
Brandley

Objectives of Financial Management

Building on those pillars, financial managers help their companies in a variety of

ways, including but not limited to:

Maximizing profits
Provide insights on, for example, rising costs of raw materials that might trigger
an increase in the cost of goods sold.

Tracking liquidity and cash flow

Ensure the company has enough money on hand to meet its obligations.

Ensuring compliance
Keep up with state, federal and industry-specific regulations.
Developing financial scenarios
These are based on the business’ current state and forecasts that assume a
wide range of outcomes based on possible market conditions.

Manage relationships
Dealing effectively with investors and the boards of directors.

Ultimately, it’s about applying effective management principles to the company’s

financial structure.

Wealth Maximization
One of the main objectives of Financial Management is to maximize
shareholder’s wealth, for which achievement of optimum capital structure and
proper utilization of funds is very necessary. Be mindful that wealth
maximization is different than profit maximization. Wealth maximization is a
more holistic approach, aimed at the growth of the organization

To Ensure Availability of Funds

The sound financial condition of business is a must for any business to survive.
The availability of funds at the proper time of need is an important objective of
business. The organization will not be able to function without funds, and
activities will come to a halt.

Attain Optimum Capital Structure

To maintain the optimum capital structure, a perfect combination of debentures
and shares is a requirement. The organization will not want to give away too
much equity, and also control the cost of capital. It is a delicate balance.

Effective Utilisation of Funds

Business not only needs a large number of funds but also skills to handle such
large amounts. To cut down unnecessary costs and to save funds from wasting
in useless assets is crucial for business. An example of such misuse of funds
would be investing in extra raw material, in quantities not required.
Ensuring the Safety of Funds
The vital objective of financial management is to ensure the security of its funds
through the creation of reserves. The chances of risk in investment should be
minimum possible. Some of the reserves created for this purpose are Sinking
Funds, General Reserves etc

Scope of Financial Management

Financial management encompasses four major areas:

1. Planning

The financial manager projects how much money the company will need
in order to maintain positive cash flow, allocate funds to grow or add new
products or services and cope with unexpected events, and shares that
information with business colleagues.

Planning may be broken down into categories including capital expenses,

T&E and workforce and indirect and operational expenses.

2. Budgeting

The financial manager allocates the company’s available funds to meet

costs, such as mortgages or rents, salaries, raw materials, employee T&E
and other obligations. Ideally there will be some left to put aside for
emergencies and to fund new business opportunities.

Companies generally have a master budget and may have separate sub
documents covering, for example, cash flow and operations; budgets may
be static or flexible.

Static vs. Flexible Budgeting

Static Flexible
Remains the same even if there are Adjusts based on changes in
 Static Flexible
significant changes from the the assumptions used in the
assumptions made during planning. planning process.
3. Managing and assessing risk

Line-of-business executives look to their financial managers to assess

and provide compensating controls for a variety of risks, including:

 Market risk

Affects the business’ investments as well as, for public companies,

reporting and stock performance. May also reflect financial risk particular
to the industry, such as a pandemic affecting restaurants or the shift of
retail to a direct-to-consumer model.

 Credit risk
4. The effects of, for example, customers not paying their invoices on time
and thus the business not having funds to meet obligations, which may
adversely affect creditworthiness and valuation, which dictates ability to
borrow at favorable rates.

 Liquidity risk

Finance teams must track current cash flow, estimate future cash needs
and be prepared to free up working capital as needed.

 Operational risk

This is a catch-all category , and one new to some finance teams. It may
include, for example, the risk of a cyber-attack and whether to purchase
cyber security insurance, what disaster recovery and business continuity
plans are in place and what crisis management practices are triggered if a
senior executive is accused of fraud or misconduct.

5. Procedures
 The financial manager sets procedures regarding how the finance team
will process and distribute financial data, like invoices, payments and
reports, with security and accuracy. These written procedures also outline
who is responsible for making financial decisions at the company — and
who signs off on those decisions.

Companies don’t need to start from scratch; there are policy and
procedure templates available for a variety of organization types, such as
this one for nonprofits.

Functions of Financial Management

More practically, a financial manager’s activities in the above areas revolve

around planning and forecasting and controlling expenditures.

The FP&A function includes issuing P&L statements, analyzing which product
lines or services have the highest profit margin or contribute the most to net
profitability, maintaining the budget and forecasting the company’s future
financial performance and scenario planning.

Managing cash flow is also key. The financial manager must make sure there’s
enough cash on hand for day-to-day operations, like paying workers and
purchasing raw materials for production. This involves overseeing cash as it
flows both in and out of the business, a practice called cash management.

1. Invoice regularly and accurately. If invoices don’t go out on time,

money will not come in on time.
2. Always state payment terms. You can’t enforce policies that you
haven’t communicated to clients. If you make changes, call them out.
3. Offer multiple ways to pay. New B2B options are coming online. Have
you considered a payment gateway?
4. Set follow-up reminders. Don’t wait until customers are in arrears to
start collection procedures. Be proactive, but not annoying, with
reminders.
5. Consider offering discounts for cash and prepayments. Cash(less) is
king in retail, and you can reduce AR costs by encouraging
 customers to pay ahead rather than on your normal customer credit
terms.
Finally, managing financial controls involves analyzing how the company is
performing financially compared with its plans and budgets. Methods for doing
this include financial ratio analysis, in which the financial manager compares line
items on the company’s financial statements.

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, personel, 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.

Time Value of Money

The time value of money is one of the basic theories of financial management, it
states that ‘the value of money you have now is greater than a reliable promise
to receive the same amount of money at a future date’.

The time value of money (TVM) is the idea that money available at the present
time is worth more than the same amount in the future due to its potential
earning capacity. This core principle of finance holds that, provided money can
earn interest, any amount of money is worth more the sooner it is received.

The time value of money is the greater benefit of receiving money now rather
than receiving later. It is founded on time preference. The principle of the time
value of money explains why interest is paid or earned? Interest, whether it is on
a bank deposit or debt, compensates the depositor or lender for the time value
of money. 

Important terms or concepts used in computing the time value of money are-

(1) Cash-flow

2) Cash inflow

(3) Cash outflow

(4) Discounted Cash flow

(5) Even cash flows /Annuity cash flows

(6) Uneven/mixed streams of cash flows

(7) Single cash flows

(8) Multiple cash flows

(9) Future value

(10) Present value

(11) Compounding

(12) Discounting

(13) Effective interest rate / Time preference rate

(14) Risks and types of risks

(1) Cash-Flow:

Cash flow is either a single sum or the series of receipts or payments occurring
over a specified period of time. Cash flows are of two types namely, cash inflow
and cash outflow and cash flow may be of much variety namely; single cash
flow, mixed cash flow streams, even cash flows or uneven cash flows.

(2) Cash Inflow:

Cash inflows refer to the receipts of cash, for the investment made on the
asset/project, which comes into the hands of an individual or into the business
organisation account at a point of time/s. Cash inflow may be a single sum or
series of sums (even or uneven/mixed) over a period of time.

(3) Cash Outflow:

Cash outflow is just opposite to cash inflow, which is the original investment
made on the project or the asset, which results in the payment/s made towards
the acquisition of asset or getting the project over a period of time/s.
(4) Discounted Cash Flow- The Mechanics of Time Value:

The present value of a future cash flow (inflows or outflows) is the amount of
current cash that is of equivalent value to the decision maker today. The process
of determining present value of a future payment (or receipts) or a series of
future payments (or receipts) is called discounting. The compound interest rate
used for discounting cash flows is called discount rate.

(5) Even Cash Flows /Annuity Cash Flows:

Even cash flows, also known as annuities, are the existence of equal/even/fixed
streams of cash flows may be a cash inflow or outflow over a specified period of
time, which exists from the beginning of the year.

Annuities are also defined as ‘a series of uniform receipts or payments occurring

over a number of years, which results from an initial deposit.’

In simple words, constant periodic sums are called annuities.

Annuity Aspects:

It is essential to discuss some of the aspects related to annuities, which are

discussed as below:

1. Annuitant

2. Status

3. Perpetuity

4. Various types of Annuity-

i. Annuity Certain

ii. Annuity Contingent

iii. Immediate or Ordinary annuity

iv. Annuity due

v. Perpetual annuity

vi. Deferred annuity

5. Annuity factor-

(i) Present Value Annuity factor, and

(ii) Compound value annuity factor.

A brief description each of the above aspects is as follows:

i. Annuitant is a person or an institution, who receives the annuity.

ii. Status refers to the period for which the annuity is payable or
receivable.
iii. iii. Perpetuity is an infinite or indefinite period for which the amount
exists.
iv. iv. a. Annuity Certain refers to an annuity which is payable or receivable
for a fixed number of years.
v. b. Annuity Contingent refers to the payment/receipt of an annuity till the
happening of a certain event/incident.
vi. c. Immediate annuities are those receipts or payments, which are made
at the end of the each period.
vii. d. A series of cash flows (i.e., receipts or payments) starting at the
beginning of each period for a specified number of periods is called an
Annuity due. This implies that the first cash flow has occurred today.
viii. e. Perpetual annuities when, annuities payments are made for ever or
for an indefinite or infinite periods.
ix. f. Deferred annuities are those receipts or payments, which starts after
a certain number of years.
x. (a) Present Value of Annuity factor is the sum of the present value of
Re. 1 for the given period of time duration at the given rate of interest;
xi. (b) Compound value/Future value of annuity factor is the sum of the
future value of Re. 1 for the given period of time duration at the given
 rate of interest. This is the reciprocal of the present value annuity
discount factor.
xii. Note – When the interest rate rises, the present value of a lump sum or
an annuity declines. The present value factor declines with higher
interest rate, other things remaining the same.
xiii. vi. Sinking fund is a fund which is created out of fixed payments each
period (annuities) to accumulate to a future some after a specified
period. The compound value of an annuity can be used to calculate an
annuity to be deposited to a sinking fund for ‘n’ period at ‘i’ rate of
interest to accumulate to a given sum.

(6) Uneven/Mixed Streams of Cash Flows:

Uneven cash flows, as the concept itself states, is the existence of un-equal
or mixed streams of cash inflows emanating from the investment made on the
assets or the project.

(7) Single Cash Inflows:

A single cash inflow is a single sum of receipt of cash generated from the
project during the given period, for which the present value is ascertained by
multiplying the cash inflow by the discount factor.

(8) Multiple Cash Inflows:

Multiple cash inflows (even or mixed cash inflows) are the series of cash
flows, may be annuities/mixed streams of cash inflows which are generated
from the project over the entire life of the asset.

(9) Future Value/Compound Value [FV/CV]:

The future value concept states as to how much is the value of current cash
flow or streams of cash flows at the end of specified time periods at a given
discount rate or interest rate. Future value refers to the worth of the current
sum or series of cash flows invested or lent at a specified rate of return or rate
of interest at the end of specified period.
In simple terms, future value refers to the value of a cash flow or series of
cash flows at some specified future time at specified time preference rate for
money.

(10) Compounding:

The process of determining the future value of present money is called

compounding. In other words, compounding is a process of investing money,
reinvesting the interest earned & finding value at the end of specified period is
called compounding.

In simple words, calculation of maturity value of an investment from the

amount of investment made is called compounding.

Under compounding technique the interest earned on the initial principal

become part of principal at the end of compounding period. Since interest
goes on earning interest over the life of the asset, this technique of time value
of money is also known as ‘compounding’.

The simple formula to calculate Compound Value in different interest time

periods is-

(a) If Interest is added at the end of each year or compounded annually-

FV or CV = PV (1 + i)n

Where, FV or CV = Future Value or Compound Value, PV= Present Value,

(1 + i)n = Compound Value factor of Re.1 at a given interest rate for a certain
number of years.

(b) If Interest is added/computed semi-annually and other compounding

periods/multi- compounding-
Say for example;

(i) When Compounding is made semi-annually, then m=2 (because two half
years in one year).

(ii) When Compounding is made quarterly, then m= 4 (because, 4 quarter

years in one year).

(iii) When Compounding is made monthly, then m= 12 (because, 12 months in

one year).

(11) Present Value:

The present value is just opposite to the future value. Present value refers to
the present worth of a future sum of money or streams of cash flows at a
specified interest rate or rate of return. It is also called a discounted value.

In simple terms it refers to the current value of a future cash flow or series of
cash flows.

(12) Discounting:

The inverse of the compounding process is discounting technique. The

process of determining the present value of future cash flows is called
discounting.

Discounting or Present Value technique is more popular than compounding

technique, since every individual or an organisation intends to have/hold
present sums, rather than getting some amount of money after some time,
because of time preference for money. 

(13) Effective Interest Rate / Time Preference Rate:

Time preference rate is used to translate the different amounts received at

different time periods; to amounts equivalent in value to the firm/individual in
the present at common point reference. This time preference rate is normally
expressed in ‘percent’ to find out the value of money at present or in future.

(14) Risk:

In business, the finance manager is supposed to take number of decisions

under different situations. In all such decisions, there is an existence of risk
and uncertainty.

Risk is the ‘variability of returns’ or the ‘chance of financial losses’ associated

with the given asset. Assets that are having higher chances of loss or the
higher rate of variability in returns are viewed as ‘risky assets’ and vice versa.
Hence care should be taken to recognize and to measure the extent of risk
associated with the assets, before taking the decision to invest on such risky
assets. 

Importance of Time Value of Money

The Consideration of time is important and its adjustment in financial decision
making is also equally important and inevitable. Most financial decisions, such
as the procurement of funds, purchase of assets, maintenance of liquidity and
distribution of profits etc., affect the firm’s cash flows/movement of cash in
and out of the organization in different time periods.
Cash flows occurring in different time periods are not comparable, but they
should be properly measurable. Hence, it is required to adjust the cash flows
for their differences in timing and risk. The value of cash flows to a common
time point should be calculated.

To maximize the owner’s equity, it’s extremely vital to consider the timing and
risk of cash flows. The choice of the risk adjusted discount rate (interest rate)
is important for calculating the present value of cash flows.

For instance, if the time preference rate is 10 percent, it implies that an

investor can accept receiving Rs.1000 if he is offered Rs.1100 after one year.
Rs.1100 is the future value of Rs.1000 today at 10% interest rate. 

Thus, the individual is indifferent between Rs.1000 and Rs.1100 a year from
now as he/she considers these two amounts equivalent in value. You can
also say that Rs.1000 today is the present value of Rs.1100 after a year at
10% interest rate.

Time value adjustment is important for both short-term and long-term

decisions. If the amounts involved are very large, time value adjustment even
for a short period will have significant implications. 

However, other things being same, adjustment of time is relatively more

important for financial decisions with long range implications than with short
range implications. Present value of sums far in the future will be less than the
present value of sums in the near future.

The concept of time value of money is of immense use in all financial

decisions.

The time value concept is used

1. To compare the investment alternatives to judge the feasibility of proposals.

2. In choosing the best investment proposals to accept or to reject the

proposal for investment.
 3. In determining the interest rates, thereby solving the problems involving
loans, mortgages, leases, savings and annuities.

4. To find the feasible time period to get back the original investment or to
earn the expected rate of return.

5. Helps in wage and price fixation. 

Long -Term Finance: Source # 1. Equity and Loans from the Government:
We know the equity capital represents the interest free perpetual capital and as
such, the right as well as control always go with the ownership of equity. In the
case of public sector undertakings such right and control lies in the hands of
Government or by a holding of apex bodies or partly by financial institutions and
partly by the public.

Of course, usually the Government supplies only equity and/or loans and not the
redeemable preference share capital although the later has been some distinct
edges over the others, viz., a fixed return can be obtained when the sector earns
profit.

ADVERTISEMENTS:

Usually, out of the total capital, 50% is being financed by way of long-term loans
although their rate of interest depends on the varying period of loans. Needless
to say that such rate of interest is ascertained on the basis of the bank rate and
Government of India Securities/Bonds.

No doubt, loan capital invites a problem public sector since the same must have
to be repaid along with the interest. For this purpose, the same must be adjusted
against the cash flow pattern of the sector, its earning capacity and many other
related factors.

But, at present, the Government has decided to compose capital 50-50 i.e.,
equity and loan equally It is interesting to note that this acts in an adverse
manner particularly to those which bears a long period of construction and
gestation as well.
In 1968, a circular was issued by the Government which contained that loan
capital had direct impact on the profitability of the enterprises and the same
should be considered while preparing the feasibility studies and DPRs. For this,
the debt-equity ratio should be ascertained.

1. Equity and Loans from the Government:

We know the equity capital represents the interest free perpetual capital and as
such, the right as well as control always go with the ownership of equity. In the
case of public sector undertakings such right and control lies in the hands of
Government or by a holding of apex bodies or partly by financial institutions and
partly by the public.

Of course, usually the Government supplies only equity and/or loans and not the
redeemable preference share capital although the later has been some distinct
edges over the others, viz., a fixed return can be obtained when the sector earns
profit.

Long -Term Finance: Source # 2. Loan from Public Financial Institutions:

In 1967 when the IDBI was set up it was decided by the Government that no
public sector undertaking will take any loans either from 1FC or from IDBI since
routine Government funds must not serve the required purposes of the public
sector. They are primarily meant for private sector undertakings.

But in 1969, the Government changed its decisions and thought that a good
tradition would be established if public sector undertakings

3. Public Deposits:
Public deposit is a good source of finance for short-term working capital
requirements of a private sector undertaking. In private sector undertaking,
however, these are unsecured deposits taken for a short period, usually I to 3
years. But in public sector, they carry a hidden security.
 UNIT-2

Meaning of Investment Decisions:

In the terminology of financial management, the investment decision means
capital budgeting. Investment decision and capital budgeting are not considered
different acts in business world. In investment decision, the word ‘Capital’ is
exclusively understood to refer to real assets which may assume any shape viz.
building, plant and machinery, raw material and so on and so forth, whereas
investment refers to any such real assets

Investment decisions are concerned with the question whether adding to capital
assets today will increase the revenues of tomorrow to cover costs. Thus
investment decisions are commitment of money resources at different time in
expectation of economic returns in future dates.

Categories of Investment Decisions:

There are several categories of investment decisions.
The common categories are as follows:

(i) Inventory Investment:

Holding of stocks of materials is unavoidable for smooth running of a business.

The expenditure on stocks comes in the category of investments.

(ii) Strategic Investment Expenditure:

In this case, the firm makes investment decisions in order to strengthen its
market power. The return on such investment will not be immediate.

(iii)Modernization Investment Expenditure:

In this case, the firm decides to adopt a new and better technology in place of
the old one for the sake of cost reduction. It is also known as capital deepening
process.

(iv) Expansion Investment on a New Business:

In this case, the firm decides to start a new business or diversify into new lines
of production for which a new set of machines are to be purchased.

(v) Replacement Investment:

In this category, the firm takes decisions about the replacement of worn out and
obsolete assets by new ones.

(vi) Expansion Investment:

In this case, the firm decides to expand the productive capacity for existing
products and thus grows further in a uni-direction. This type of investment is also
called capital widening.

Need for Investment Decisions:

The need for investment decisions arrives for attaining the long term objective of
the firm viz. survival or growth, preserving share of a particular market and retain
leadership in a particular aspect of economic activity.
The firm may like to make investment decision to avail of the economic
opportunities which may arise due to the following reasons:

(i) Expansion of the productive process to meet the existing excessive demand
in local market to exploit the international markets and to avail the benefits of
economies of scale.

(ii) Replacement of an existing asset, plant, machinery or building may become

necessary for reaping advantages of technological innovations, minimising cost
of products and increasing the efficiency of labour.

(iii) Buy or hire on rent or lease a particular asset is another important

consideration which establishes the need for making investment decisions.

Factors affecting Investment Decisions:

According to Prof. Ezra Solomon, for making optimum investment decisions, the
following three types of information is required:

i) Estimate of capital outlays and the future earnings of the proposed project
focusing on the task of value engineering and market forecasting,

(ii) Availability of capital and consideration of cost-focusing attention as financial

analysis, and

(iii) A correct set of standards by which to select projects for execution to

maximize return-focusing attention on logic and arithmetic.

Importance of Investment Decisions

Affects Firm Growth

Investment decisions have long term effects on the earning potential and growth
rate of a firm. TheInvestors can choose to invest by themselves, or they can
involve investment planners to suggest a creative investment plan. Whatever the
source, every prudent investor needs to examine the pros and cons of an
investment decision before implementing it. Make sure you are getting the best
investment tips decade to decade to avoid these consequences of a wrong plan:
 1. Not meeting goals or targets: Investors suffer setbacks when an
investment does not perform as intended. Good financial plans have a
focus and a goal. Failure to achieve your financial goals owing to wrong
decisions can affect your personal and corporate finances. An abortion of
objectives may also erode confidence in one’s ability or the expertise of a
financial planner.
2. Loss of funds: A poor investment decision almost always means that
some or all monies allocated to the investment have been lost. The
primary aim of the investment is, after all, to make money, and it follows
that failure automatically can mean either loss of profits or even the capital
itself.
3. Debt: You may find yourself in debt purely on account of a deal gone bad.
The specter of debt is almost always a possibility in any serious business
endeavor. However, you can do a lot to avoid the boogeyman by looking
well before you leap financially.
4. Liquidation or Bankruptcy: Your business can face liquidation, or you
personally may face bankruptcy with poor investment decisions. No
business or person ever wants to hear those two words in relation to
them. However, it is a real and very possible outcome of investing
unwisely.
5. Broken trust: It’s a mess when things go south on an investment. If you
have convinced partners, family, and friends to bank on you, the after-
effects of failure in investing may include feelings of acrimony or betrayed
trust.
6. Lawsuits: Yep, don’t be surprised if you find yourself on the wrong end of
a judge’s gavel following a poor investment decision. Breach of trust or
contract can be inferred from any number of circumstances or clauses
inherent in the initial agreement you had with any partners. 

Difficulties in Determining Incremental Cash Flows

Financial analysts use incremental cash flow analysis to determine how
profitable a project will be for a company. To perform this analysis, the analyst
must identify what additional costs, or cash outflows, the project creates for the
company. Since a business incurs a wide variety of costs, it can be difficult to
determine which costs are appropriate to include in cash flow calculations.

Sunk Costs

Cash flow analysis is concerned with analyzing future costs, not past ones.
Analysts must be careful to exclude sunk costs from any cash flow calculations.
Even if the sunk costs seem relevant to the project, they shouldn't be included if
they occurred before the investment decision. For example, a company may
have paid for marketing tests a few years back to determine the viability of new
products they want to invest in. Even though it might seem relevant to the
product investment, sunk costs shouldn't be included in the initial cash outflow
decision.

Opportunity Costs

Financial professionals often forget to include opportunity costs in calculations.

Opportunity costs are the missed revenues from alternative uses for the project
assets. Although opportunity costs aren't a true cash outflow, they should be
factored into capital budgeting decisions. For example, say a project requires a
set of machinery that the company already owns but was planning to sell for
$50,000. Even though the company doesn't incur a cash outflow in keeping the
machinery, the $50,000 cost should still be deducted from cash flows.

Cannibalization

Another effect that can be difficult to quantify for cash flow purposes is
cannibalization. Cannibalization happens when a new project takes sales away
from an existing company product. For example, a clothing distributor that sells
directly to consumers may consider investing in a new line of low-priced jeans. If
the company already manufactures high-end jeans, the sales for the low-priced
jeans may not be unique sales. That is to say, customers may forgo purchasing
the high-end jeans and purchase the lower-priced jeans instead.

Capital budgeting, also known as an investment appraisal, is a financial

management tool you can ensure it is adding the expected value and continue
to measure the progress of the project. It determines the number of years it
takes for a project’s cash flow to pay back the initial cash investment, an
assessment of risk, and various other factors

Capital budgeting is an important financial management tool because when you

need to assess and rank the value of projects or investments that require a large
capital investment to determine whether they are worth pursuing. For example,
investors can use capital budgeting to analyze investment options and decide
which ones are worth investing in.

Capital Budgeting
Definition: Capital budgeting is the method of determining and estimating the
potential of long-term investment options involving enormous capital
expenditure. It is all about the company’s strategic decision making, which acts
as a milestone in the business.

For Example; Let us now consider capital budgeting for buying a new printing
machine by a publishing house. The machine is worth $15000 and will generate
a return of $3000 annually. Thus the payback period of the machine is five
years. The expected annual rise in inflation is 10%.

Let us calculate the real investment value after the first year:

We can say that the company’s actual profit after a year is estimated at $1636
instead of $3000.
Features of Capital Budgeting
Capital budgeting is a crucial decision and to understand the concept in a better
way, let us go through its following features:

 Huge Funds: Capital budgeting involves expenditures of high value which

makes it a crucial function for the management.
 High Degree of Risk: To take decisions which involve huge financial
burden can be risky for the company.
 Affects Future Competitive Strengths: The company’s future is based on
such capital expenditure decisions. Sensible investing can improve its
competitiveness, whereas a wrong investment may lead to business
failure.
 Difficult Decision: When the future is dependant on capital budgeting
decisions, it becomes difficult for the management to grab the most
appropriate investment opportunity.
 Estimation of Large Profits: Any investment decision taken by the
company is made with the perspective of earning desirable profits in the
long term.
 Long Term Effect: The effect of the decisions taken today, whether
favourable or unfavourable, will be visible in the future or the long term.
 Affects Cost Structure: The company’s cost structure changes with the
capital budgeting; for instance, it may increase the fixed cost such as
insurance charges, interest, depreciation, rent, etc.
  Irreversible Decision: A decision once taken is tough to be amended since
it involves a high-value asset which may not be sold at the same price
once purchased.

Factors Affecting Capital Budgeting

The capital budgeting decisions influenced by various elements present in the
internal and external business environment. Following are some of the
significant factors affecting investment decisions:

Capital Structure: The company’s capital structure, i.e., the composition of

shareholder’s funds and borrowed funds, determines its capital budgeting
decisions.

Working Capital: The availability of capital required by the company to carry out
day to day business operations influences its long-term decisions.
Capital Return: The management estimates the expected return from the
prospective capital investment while planning the company’s capital budget.

Availability of Funds: The company’s potential for capital budgeting is dependant

on its dividivent policy, availability of funds and the ability to acquire funds from
the other sources.

Earnings: If the company has a stable earning, it may plan for massive
investment projects on leveraged funds, but the same is not suitable in case of
irregular earnings.

Capital Budgeting Process:

 Project identification and generation:

The company has various options for capital employment on a long-term basis.
In the initial stage, the management needs to analyze the strengths and
weaknesses of every project for foreseeing the potential of each option.

 Evaluating and Assembling Investment Proposals: 

In the next step, the management assembles and compiles all the investment
proposals on the grounds of cost, risk involvement, future profits, return on
investment, etc.

 Project Selection:

Once the proposal has been finalized, the different alternatives for raising or
acquiring funds have to be explored by the finance team. This is called
preparing the capital budget. The average cost of funds has to be reduced. A
detailed procedure for periodical reports and tracking the project for the lifetime
needs to be streamlined in the initial phase itself. The final approvals are based
on profitability, Economic constituents, viability, and market conditions.

 Implementation:

After the apportioning of the long-term investment, the company comes into
action for the execution of its decision. To avoid complications and excess time
consumption, the management should lay out a detailed plan of the project in
advance.

 Performance review:

The final stage of capital budgeting involves the comparison of actual results
with the standard ones. The management needs to measure and correlate the
actual performance with that of the estimated one to figure out the deviation and
take corrective actions for the same.

Techniques/Methods of Capital Budgeting

In addition to the many capital budgeting methods available, the following list outlines
a few by which companies can decide which projects to explore:

#1 Payback Period Method

It refers to the time taken by a proposed project to generate enough income to cover
the initial investment. The project with the quickest payback is chosen by the
company.

Formula:

Initial Cash Investment 

Payback Period =
Annual Cash Flow
Example of Payback Period Method:
An enterprise plans to invest $100,000 to enhance its manufacturing process. It has
two mutually independent options in front: Product A and Product B. Product A
exhibits a contribution of $25 and Product B of $15. The expansion plan is projected
to increase the output by 500 units for Product A and 1,000 units for Product B.

Here, the incremental cash flow will be calculated as:

(25*500) = 12,500 for Product A

(15*1000) = 15,000 for Product B

The Payback Period for Product A is calculated as:

2 Initial Cash Investment $100,000

3 Incremental Cash Flow $12,500
4 Payback Period of Product A (Years) 8
Product A = 100,000 / 12,500 = 8 years

Now, the  Payback Period for Product B is calculated as:

2 Initial Cash Investment $100,000

3 Incremental Cash Flow $15,000
4 Payback Period of Product A (Years) 6.7
Product B = 100,000 / 15,000 = 6.7 years

This brings the enterprise to conclude that Product B has a shorter payback period
and therefore, it will invest in Product B.
Despite being an easy and time-efficient method, the Payback Period cannot be
called optimum as it does not consider the time value of money. The cash flows at
the earlier stages are better than the ones coming in at later stages. The company
may encounter two projections with the same payback period, where one depicts
higher cash flows in the earlier stages/years. In such as case, the Payback Period
may not be appropriate.

A similar consideration is that of a longer period, potentially bringing in greater cash

flows during a payback period. In such a case, if the company selects the projects
based solely on the payback period and without considering the cash flows, then this
could prove detrimental for the financial prospects of the company.

#2 Net Present Value Method (NPV)

Evaluating capital investment projects is what the NPV method helps the companies
with. There may be inconsistencies in the cash flows created over time. The cost of
capital is used to discount

An evaluation is done based on the investment made. Whether a project is accepted

or rejected depends on the value of inflows over current outflows.

This method considers the time value of money and attributes it to the company's
objective, which is to maximize profits for its owners. The capital cost factors in the
cash flow during the entire lifespan of the product and the risks associated with such
a cash flow. Then, the capital cost is calculated with the help of an estimate.

Formula:

Net Present Value (NPV) =

t = time of cash flow

i = discount rate
 Rt  = net cash flow
Example of Net Present Value (with 9% Discount Rate ):

For a company, let’s assume the following conditions:

Capital investment = $10,000

Expected Inflow in First Year = $1,000

Expected Inflow in Second Year = $2,500

Expected Inflow in Third Year = $3,500

Expected Inflow in Fourth Year = $2,650

Expected Inflow in Fifth Year = $4,150

Discount Rate = 9%

Calculation
Flow Present Value
Year
0 -$10,000 -$10,000 -
1 1,000 9,174 1,000/(1.09)1
2 2,500 2,104 2,500/(1.09)2
3 3,500 2,692 3,500/(1.09)3
4 2,650 1,892 2,600/(1.09)4
5 4,150 2,767 4,000/(1.09)5
 Total $18,629

Net Present Value achieved at the end of the calculation is:

With 9% Discount Rate  = $18,629

This indicates that if the NPV comes out to be positive and indicates profit.
Therefore, the company shall move ahead with the project.

#3 Internal Rate of Return (IRR)

IRR refers to the method where the NPV is zero. In such as condition, the cash
inflow rate equals the cash outflow rate. Although it considers the time value of
money, it is one of the complicated methods.

It follows the rule that if the IRR is more than the average cost of the capital, then the
company accepts the project, or else it rejects the project. If the company faces a
situation with multiple projects, then the project offering the highest IRR is selected
by them.

Discount
Internal
rate
Rate
thatofmakes
Return=
NPV=0; 
implies discounted cash inflows are equal to discounted cash outflows

Return Rule = Accept investments if IRR greater than Threshold Rate of Return, else reject.

Example:

We shall assume the possibilities exhibited in the table here for a company that has
2 projects: Project A and Project B.

Project B
Project A
Year
0 -$10,000 -$10,000
1 $2,500 $3,000
2 $2,500 $3,000
3 $2,500 $3,000
4 $2,500 $3,000
5 $2,500 $3,000
Total $12,500 $15,000
IRR 7.9% 15.2%
Here, The IRR of Project A is 7.9% which is above the Threshold Rate of Return
(We assume it is 7% in this case.) So, the company will accept the project. However,
if the Threshold Rate of Return would be 10%, then it would be rejected as the IRR
would if the Threshold Rate of Return would be 10%, then it would be rejected as the
IRR would be lower. In that case, the company will choose Project B which shows a
higher IRR as compared to the Threshold Rate of Return.

#4 Profitability Index
This method provides the ratio of the present value of future cash inflows to the initial
investment. A Profitability Index that presents a value lower than 1.0 is indicative of
lower cash inflows than the initial cost of investment. Aligned with this, a profitability
index great than 1.0 presents better cash inflows and therefore, the project will be
accepted.

Formula:

Present value of Cash Inflows

Profitability Index =
Initial Investment
Example:
Assuming the values given in the table, we shall calculate the profitability index for a
discount rate of 10%.

Cash Flows 10% Discount

Year
0 -$10,000 -$10,000
1 $3,000 $2,727
2 $5,000 $4,132
3 $2,000 $1,538
4 $6,000 $4,285
5 $5,000 $3,125
Total $15,807

So, Profitability Index with 10% discount = $15,807/$10,000  = 1.5807

As per the rule of the method, the profitability index is positive for the 10% discount
rate, and therefore, it will be selected.

Definition of Risk Analysis

Risk analysis is a small component of risk management technique, wherein the

risk manager conducts a pro-active evaluation of risks associated with a
particular project or event or the whole organisation through risk assessment
procedures, develops a risk mitigation plan accordingly to manage those
identified risks & makes sure that the plan is implemented in the organisation.
Explanation

 Suppose you want to invest in a stock. What do we expect after such an

investment? A positive return. What if the return turns negative? That’s
called a risk to the investment.
 Risk can be any negative outcome of any event or transaction or any
business transaction. Analysing the risk means identifying the possible
issues that may affect the key objectives.
 Risk analysis is not an assured event to happen but just a probability of
the occurrence of an adverse event within the entity that may affect an
entity’s operations.
 The risk analysis concept can be applied to various events or transactions
or situations, or entities. Some of the examples of risk analysis are the
chances of success or failure of a business plan, a standard deviation of a
portfolio return, volatility in the stock market, etc.
 Risk analysis may be classified either as quantitative risk analysis or
qualitative risk analysis. Quantitative risk analysis is based on simulation
or deterministic method (i.e. based on some quantities of data). The
variables are mostly based on certain logical assumptions. An example of
quantitative risk analysis includes the Monte Carlo simulation.
 On the other hand, qualitative risk analysis is based on a textual
description of uncertainties prevailing, the impact of such uncertainties &
counter measures available for mitigation. The best example of qualitative
risk analysis is SWOT Analysis.

Process of Risk Analysis

The main steps in the risk analysis process are described as below:

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 Risk Assessment Survey: This is the first step in the risk analysis process.
This step involves obtaining sufficient information from the management of
the entity for whom the analysis is being done. In case of any back-
 holding by the management, the objective of risk analysis may not be
served. Under this step, specific risks relevant to the situation are
analysed. In terms of risk analysis of a stock, data regarding past returns
are obtained under this step.
 Identification of Probable Risk: The above step provides inputs for the
second step. The survey helps the risk manager to identify various events
due to which risk can occur. Risks can be an occurrence of human error
or fire or natural calamity or any potential outburst, etc. For a stock,
identification of risk is associated with attributes of the company.
 Analyse the risk: After identification of risk in the second step, the risk
manager needs to perform an analysis of risk. Here, analysis means
assessment of the likelihood of occurrence of the adverse event. This step
should provide inputs regarding the possible implications of risk
occurrence & the impact on the objectives of the entity. For a stock, this
step simply means the percentage of loss to be suffered in case of a
downfall in the price of stock & consideration of available hedging
instruments to hedge the occurrence of loss.
 Risk Mitigation Plan: This is part & parcel of the above step. Here, a
formal plan is formulated to mitigate the risk to the extent possible. Here,
recommendations are provided to mitigate the risk for each valuable
asset. For a stock, the mitigation plan is choosing a derivative to cover the
loss suffered.
 Implement the plan: After the preparation of the risk mitigation plan, it is
critically analysed whether the plan will be effective for the said purpose.
Measures are taken to reduce the risks. Priority attention is given to high-
risk category events. For a stock, this step means buying or selling the
derivative to recover the loss in stock.
 Monitor Risks: The job is not done just at the implementation stage.
Regular scrutiny is made to ensure that the plan is working well within the
set parameters. In case of deviation or in case the plan does not protect
from risk, the plan needs to be revised to consider new risks. For a stock,
this step means monitoring the returns of a derivative instrument.
Example of Risk Analysis
Lets’ consider that a company needs to purchase a new type of raw material for
its new business segment. Should it purchase the raw material from any of the
available contacts? Each decision has some impact.

There are few risks, such as purchases are made from unapproved vendors,
purchases are made at higher prices than market prices, or supplier provides
quality materials. In this example, we have devised a risk analysis plan which
identifies the risk, provides mitigations & provide control parameters for
mitigation of risks. The details of the matrix are as under:

Process Step
Risk Matrix Process Step I Process Step II
III

To ensure that
To ensure that purchases are To ensure that,
purchases are made within a supplier meets
Control Objective made through reasonable price with the quality
an approved and in standard of the
vendor accordance with company
T&C

Risk of material Purchases are Purchase is not The supplier

misstatement made from an made within a did not meet
unapproved reasonable price the quality
vendor and in standard of the
accordance with company
 T&C

Control No. AP 1 AP 2 AP 3

Control Description The company Quotations are Before placing

has a standard invited from at the final order
category wise least three with the newly
procedure for vendors, except selected
vendor for cases where vendor, the
selection-          there are specific purchase team
1. Direct asset/material ask for a
purchase / requirements sample order
Diesel which a delivery for a
Procurement – specific/existing small quantity
Vendors are vendor can fulfil; from the
fixed in the further quotations vendor, which
system, and no are not invited. is scrutinized in
further selection The purchase all parameters
is made. team negotiates as per quality
on price and T&C standard of the
with all vendors company at the
2. Purchase of and finalises the vendor’s place,
Auxiliary, vendor along with for which no
Indirect items – the prices and separate
vendor T&C. invoicing is
selection done by the
procedure vendor.
 Clearing the
should be Scrutiny stage
followed. is the
prerequisite for
a final order.

Person in charge of
Mr. XYZ Mr. XYZ Mr. XYZ
control

Nature of control
Non-Key Non-Key Non-Key
(Key/Non-Key)

Risk Category
(H) High, (M) M H L
Medium, (L) Low

Frequency of As and when

As and when As and when
control required

Automatic/
Control type Manual Manual
Manual

Preventive/
Preventive Preventive Detective
Detective

Control O O O
Classification
(O) Operating,(F)
 Financial,(C)
Compliance

Control performed Purchase Purchase Purchase

by Department Department Department

Accuracy /
Applicable Applicable Not Applicable
Occurrence

Completeness Applicable Applicable Applicable

Valuation Not Applicable Applicable Not Applicable

Cut Off Not Applicable Not Applicable Not Applicable

Control Control
Primary COSO Control Activities
Activities Activities

Types of Risk Analysis

Types of risk analysis include analysis of different genres of risk. A company
may face business-related risk, non-business related risk & finance related risk.
Each one of these is discussed as below:

 Business Related Risk: This is the normal risk suffered by the owners of
an entity. Every business has some inherent risks in it. The risk managers
are here the analysers of business who takes care of possible risks.
Business related risks can be stock out a situation in the company, non-
availability of key resources to run the operations of the entity, increase in
competitors, etc.
  Non-Business Related Risk: These risks are around the business & not
directly relation. Due to no direct link with the businesses, such risks are
not controllable by an entity. Examples can be political risk, economic
downturns for an entire industry, Covid-2019, etc. Such risks are difficult
to deal with since it completely depends on the outsiders of the business
(such as Government policies, demand cycle, a vaccine for a virus, etc.)
 Financial Related Risk: Finance is the blood for the smooth running of the
business. Non-availability of liquidity to expand an entity’s operations,
non-availability of potential investors for business, etc., are some of the
finance-related risks. These risks can be eliminated but not that easy. It
requires the expertise of professional risk managers.

What is Risk-Adjusted Discount Rate

The risk-adjusted method combines an expected risk premium with a risk-free

rate to calculate the present value of an investment.

 Risky investments include investments in real estate and other high-level

risk projects. Although the market rate is considered as the discount rate,
in some cases, a risk-adjusted rate for the investments becomes crucial
for the investors.
 The risk-adjusted discount rate method correlates risks and returns while
signifying the requisite returns of an investment. This means that a project
that is exposed to high risks also entails higher returns as the possible
potential for returns are high. Such a relation is useful because returns are
dependent on the magnitude of risks involved in a project.

The Certainty-Equivalent Method

The certainty-equivalent method shows an amount of investment in the future an

investor will forego for a lesser amount of money now. That may happen
because the future is uncertain and higher levels of risks are associated with a
higher potential of losses. Therefore, risk-averse investors tend to use this
method to avoid unnecessary risks in the investments.
  The certainty-equivalent approach is usually based on the certainty of
returns and hence, the probable outcome of an investment.
 The concept of certainty-equivalent is useful in the case of ascertaining
the risk tolerance of the investors.
 It is heavily used by investors who are risk-averse and do not wish to
expose their investments to higher levels of risk.

Which is Better?

The certainty-equivalent approach usually recognizes the risk in capital

budgeting analysis by adjusting and calculating the estimated cash flows. It
employs a risk-free rate to discount the given adjusted cash flows. Although
often debated heavily, the certainty-equivalent is advantageous than the risk-
adjusted discount rate method in general.

On the other hand, the risk-adjusted discount rate usually adjusts for risk by
aligning the discount rate. It is therefore easy to understand that the certainty-
equivalent approach is theoretically more sound technique than the risk-adjusted
discount approach because it measures risk more accurately. This is so
because adjusting the discount rate is far more inaccurate to calculate than
adjusting the cash flows.

However, both methods are used according to their potential in finance and
economics. The usability of each is different and using any one of the methods
is related to its functionality to serve the purpose of calculation.

Benefits of Risk Analysis

 Early identification of risks is possible.

 Early mitigation of those risk is possible with a better mitigation program.
 It provides pro-active disclosure of the situation to the owners of the entity.
 It also identifies the gaps in the existing control mechanism.
 It provides an analysis of the overall impact of those assessed risks on the
organisation as a whole & its business.
  It further enhances the communication within the entity.
 The objectives of a business are upheld & help a business survive in
critical times as well.

Disadvantages of Risk Analysis

 The risks are not sure to happen. There is an element of probability. The
actual risk may or may not crystalise.
 Risk analysis only discloses the situation but does not measure the
financial impact of such risk.
 Data is open for manipulations. The first step of risk analysis is a risk
assessment survey, wherein the risk manager depends on inputs from the
entity itself.
 Incorrect inputs result in incorrect evaluation, which results in incorrect
analysis & inefficient risk mitigation measures. This derails the basic
objective of risk analysis.
 The analysis is subjective for each person & some sort of professional
judgement is involved.

Cost of Capital

Cost of Capital is the rate of return the firm expects to earn from its investment
in order to increase the value of the firm in the market place. In other words, it is
the rate of return that the suppliers of capital require as compensation for their
contribution of capital.  

Accounting solutions to help you manage your business just the way you want.

Source of Cost of Capital

The source of capital employed by the firm is usually in the following form:
Components of Cost of Capital

There are three factors to the cost of capital explained below:

Zero Risk Return

It talks about the expected rate of return when a project involves no financial or
business risks.

Premium for the Business Risk

Business risk is determined by the capital budgeting decisions that a firm takes
for its investment proposals. So, if a firm selects a project that has more than
normal risk, then it is obvious that the providers of capital would require or
demand a higher rate of return than the normal rate.

Thus the premium factor plays an important role here as it increases the Cost of
Capital. But how much premium? it’s up to the firm’s project selection decision
which alienates with the firm’s goal and objectives and how badly they want the
project to increase their market value. 

Premium for the Financial Risk

Financial risk is associated with the capital structure pattern of the firm. Here,
the premium finds its way to the picture depending on the volume of debts the
firm owes. The higher the debt capital, the more is the risk compared to a firm
that has relatively low debts.

Cost of Capital Formula

The three components of cost of capital discussed above can be written in an

equation as follows:

K = Cost of Capital
r0 = Return at zero risk level

1. = Premium for business risk

2. = Premium for finance risk

How to Calculate of Cost of Capital

In calculating the cost of capital, the following methods can be used:

1. Computation of Specific Cost of Capital

Specific Cost refers to the cost which is associated with the source of capital.
Eg. Cost of equity. Computing specific cost of capital involves summing up of all
forms of capital listed below

 Cost of debt
 Cost of preference shares
 Cost of equity shares
 Cost of retained earnings

2. Computation of Composite Cost of Capital

Composite capital is the combined cost of different sources of capital taken

together. It is also called a Weighted Average Cost of Capital (WACC).
Following are steps involved in the calculation of WACC. The formula to arrive is
given below

Ko = Overall cost of capital

Wd = Weight of debt
Wp = Weight of preference share of capital
Wr = Weight of retained earnings
We = Weight of equity share capital
Kd = Specific cost of debt
Kp = Specific cost of preference share capital
Kr = Specific cost of retained earnings
Ke = Specific cost of equity share capital
Example of Cost of Capital calculations using WACC

Aero Ltd had the following cost capital structure employed for financing its
projects and would like to calculate the cost of capital.
Weight Average Cost of Capital here is 13% (0.13*100). This implies that the
overall cost of capital employed by Aero Ltd is 13%. In other words, we can say
that the company is paying a premium of 13% to the lenders of capital as a
return for their risk.

You can use the formula we discussed, and the result will be similar.

= (6,00,000 / 24,00,000) * 0.09 + (6,00,000 / 24,00,000) * 0.12 + ( 4,00,000 /

24,00,000 ) * 0.15 + ( 8,00,000 / 24,00,000) * 0.16 = 13%
 What is Capital Structure

The most crucial component of starting a business is capital. It acts as the

foundation of the company. Debt and Equity are the two primary types of capital
sources for a business. Capital structure is defined as the combination of equity
and debt that is put into use by a company in order to finance the overall
operations of the company and for its growth.

Types of Capital Structure

The meaning of Capital structure can be described as the arrangement of capital

by using different sources of long term funds which consists of two broad types,
equity and debt. The different types of funds that are raised by a firm include
preference shares, equity shares, retained earnings, long-term loans etc. These
funds are raised for running the business.

Equity Capital
Equity capital is the money owned by the shareholders or owners. It consists of
two different types

a) Retained earnings: Retained earnings are part of the profit that has been kept
separately by the organisation and which will help in strengthening the business.

b) Contributed Capital: Contributed capital is the amount of money which the

company owners have invested at the time of opening the company or received
from shareholders as a price for ownership of the company.

Debt Capital
Debt capital is referred to as the borrowed money that is utilised in business.
There are different forms of debt capital.

1. Long Term Bonds: These types of bonds are considered the safest of the
debts as they have an extended repayment period, and only interest
needs to be repaid while the principal needs to be paid at maturity.
 2. Short Term Commercial Paper: This is a type of short term debt
instrument that is used by companies to raise capital for a short period of
time

Optimal Capital Structure

Optimal capital structure is referred to as the perfect mix of debt and equity
financing that helps in maximising the value of a company in the market while at
the same time minimises its cost of capital.

Capital structure varies across industries. For a company involved in mining or

petroleum and oil extraction, a high debt ratio is not suitable, but some industries
like insurance or banking have a high amount of debt as part of their capital
structure.

Financial Leverage
Financial leverage is defined as the proportion of debt that is part of the total
capital of the firm. It is also known as capital gearing. A firm having a high level
of debt is called a highly levered firm while a firm having a lower ratio of debt is
known as a low levered firm.

Importance of Capital Structure

Capital structure is vital for a firm as it determines the overall stability of a firm.
Here are some of the other factors that highlight the importance of capital
structure

1. A firm having a sound capital structure has a higher chance of increasing

the market price of the shares and securities that it possesses. It will lead
to a higher valuation in the market.
2. A good capital structure ensures that the available funds are used
effectively. It prevents over or under capitalization.
3. It helps the company in increasing its profits in the form of higher returns
to stakeholders.
4. A proper capital structure helps in maximising shareholder’s capital while
minimising the overall cost of the capital.
5. A good capital structure provides firms with the flexibility of increasing or
decreasing the debt capital as per the situation.
Factors Determining Capital Structure

Following are the factors that play an important role in determining the capital
structure:

1. Costs of capital: It is the cost that is incurred in raising capital from different
fund sources. A firm or a business should generate sufficient revenue so that
the cost of capital can be met and growth can be financed.
2. Degree of Control: The equity shareholders have more rights in a company
than the preference shareholders or the debenture shareholders. The capital
structure of a firm will be determined by the type of shareholders and the limit
of their voting rights.
3. Trading on Equity: For a firm which uses more equity as a source of finance
to borrow new funds to increase returns. Trading on equity is said to occur
when the rate of return on total capital is more than the rate of interest paid
on debentures or rate of interest on the new debt borrowed.
4. Government Policies: The capital structure is also impacted by the rules and
policies set by the government. Changes in monetary and fiscal policies
result in bringing about changes in capital structure decisions.

Leverage refers to the employment of assets or sources of fund bearing fixed

payment to magnify EBIT or EPS respectively. So it may be associated with
investment activities or financing activities.

According to its association we find mainly two types of leverages:

1. Operating leverage and

2.Financial Leverage

It is to be noted here that these two leverages are not independent of each
other; rather they form a part of the whole process. So we want to know the
combined effect of both investment and financing decisions. The combined
effect of operating and financial leverage is measured with the help of
combined leverage.
 1. Operating Leverage:
Operating leverage is concerned with the investment activities of the firm. It
relates to the incurrence of fixed operating costs in the firm’s income stream.
The operating cost of a firm is classified into three types: Fixed cost, variable
cost and semi-variable or semi-fixed cost. Fixed cost is a contractual cost
and is a function of time. So it does not change with the change in sales and
is paid regardless of the sales volume.

Variable costs vary directly with the sales revenue. If no sales are made
variable costs will be nil. Semi-variable or semi-fixed costs vary partly with
sales and remain partly fixed. These change over a range of sales and then
remain fixed. In the context of operating leverage, semi-variable or semi-fixed
cost is broken down into fixed and variable portions and is merged
accordingly with variable or fixed cost. Investment decision goes in favor of
employing assets having fixed costs because fixed operating costs can be
used as a lever.

With the use of fixed costs, the firm can magnify the effect of change in sales
on change in EBIT. Hence the firm’s ability to use fixed operating costs to
magnify the effects of changes in sales on its earnings before interest and taxes
is termed as operating leverage. This leverage relates to variation in sales and
profit. Operating leverage is measured by computing the Degree of Operating
Leverage (DOL). DOL expresses operating leverage in quantitative terms.

The higher the proportion of fixed operating cost in the cost structure, higher is
the degree of operating leverage. The percentage change in the earnings before
interest and taxes relative to a given percentage change in sales and output is
defined as the DOL. Therefore,
5.

It is an interesting fact that a change in the volume of sales leads to a

proportionate change in the operating profit of a firm due to the ability of the
firm to use fixed operating costs. The value of degree of operating leverage
should be greater than 1. If it is equal to 1, it can be said that operating
leverage does not exist.

Example 5.1:

Calculate the degree of operating leverage from the following data:

Sales: 1, 50,000 units at Rs 4 per unit.

Variable cost per unit Rs 2.

Fixed cost Rs 1, 50,000.

Interest charges Rs 25,000.

2. Financial Leverage:
Financial leverage is mainly related to the mix of debt and equity in the
capital structure of a firm. It exists due to the existence of fixed financial
charges that do not depend on the operating profits of the firm. Various
sources from which funds are used in financing of a business can be
categorized into funds having fixed financial charges and funds with no
fixed financial charges. Debentures, bonds, long-term loans and preference
shares are included in the first category and equity shares are included in
the second category.

Financing decision goes in favour of employing funds having fixed

financial charges because it can be used as a lever. Financial leverage
results from the existence of fixed financial charges in the firm’s income
stream. With the use of fixed financial charges, a firm can magnify the
effect of change in EBIT on change in EPS. Hence financial leverage
may be defined as the firm’s ability to use fixed financial charges to
magnify the effects of changes in EBIT on its EPS.

The higher the proportion of fixed charge bearing fund in the capital
structure of a firm, higher is the Degree of Financial Leverage (DFL) and
vice-versa. Financial leverage is computed by the DFL. DEL expresses
financial leverage in quantitative terms. The percentage change in the
earning per share to a given percentage changes in earnings before
interest and taxes is defined as Degree of Financial Leverage (DFL).
Therefore
 A firm is said to be highly financially leveraged if the proportion of fixed
interest bearing securities, i.e. long term debt and preference share capital
in the capital structure is higher in comparison to equity share capital. Like
operating leverage, the value of financial leverage must be greater than 1.
It is to be noted here that if the preference share capital is given in the
problem the degree of financial leverage shall be computed by using the
following formula

Example 5.2:

Calculate the degree of financial leverage from the following information:

Capital structure: 10,000, Equity Shares of Rs 10 each Rs 1, 00,000.

5,000, 11 % Preference Shares of Rs 10 each Rs 50,000.

9% Debentures of Rs 100 each Rs 50,000.

The EBIT of the company is Rs 50,000 and corporate tax rate is 45%.
 3. Combined Leverage:
A firm incurs total fixed charges in the form of fixed operating cost and fixed
financial charges. Operating leverage is concerned with operating risk and
is expressed quantitatively by DOL. Financial leverage is associated with
financial risk and is expressed quantitatively by DFL. Both the leverages
are concerned with fixed charges. If we combine these two we will get the
total risk of a firm that is associated with total leverage or combined
leverage of the firm. Combined leverage is mainly related with the risk of
not being able to cover total fixed charges.

The firm’s ability to cover the aggregate of fixed operating and financial charges
is termed as combined leverage. The percentage change in EPS to a given
percentage change in sales is defined as Degree of Combined Leverage (DCL).
DCL expresses combined leverage in quantitative terms. The higher the
proportion of fixed operating cost and financial charges, higher is the degree of
combined leverage. Like other two leverages the value of combined leverage
must be greater than 1.

DCL can be computed in the following manner:

 Example 5.3:

X Limited has given the following information:

Capital Structure theories are:

1. Net Income Approach

2. Net Operating Income Approach

3. Traditional Approach

4. Modigliani-Miller Approach.

1. Net Income (NI) Approach:

David Durand’ suggested the two famous capital structure theories, viz, Net
Income

Approach and the Operating Income Approach:

According to NI approach a firm may increase the total value of the firm by
lowering its cost of capital. When cost of capital is lowest and the value of the
firm is greatest, we call it the optimum capital structure for the firms and at this
point, the market price per share is maximised.

The same is possible continuously by lowering its cost of capital by the use of
debt capital. In other words, using more debt capital with a corresponding
reduction in cost of capital, the value of the firm will increase.

The same is possible only when:

i. Cost of Debt (Kd) is less then Cost of Equity (Ke);

ii. There are no taxes, and

iii. The use of debt does not change the risk perception of the investors since the
degree of leverage is increased to that extent.

Since the amount of debt in the capital structure increases, weighted average
cost of capital decreases which leads to increase the total value of the firm. So,
the increased amount of debt with constant amount of cost of equity and cost of
debt will highlight the earnings of the shareholders.

Illustration:

X Ltd. presents the following particulars:

EBIT (i.e., Net Operating income) is Rs. 30,000

The equity capitalisation ratio (i.e., cost of equity) is 15% (K.)

Cost of debt is 10% (Kd)

Total Capital amounted to Rs. 2,00,000

Calculate the cost of capital and the value of the firm for each of the following
alternative leverage after applying the NI approach

Leverage (Debt to total Capital) 0%, 20%, 50%. 70% and 100%

Solution:

Workings:

Average Cost of Capital is computed as under (under various financing plans):

From the above table it is quite clear that the value of the firm (V) will be
increased if there is a proportionate increase in debt capital but there will be a
reduction in overall cost of capital. So, Cost of Capital is increased and the value
of the firm is maximum if a firm uses 100% debt capital.

It is interesting to note that the NI approach can also be graphically presented as

under (with the help of the above illustration):

The degree of leverage is plotted along with the X-axis whereas Ke Kw and Kd
on the Y- axis. It reveals that when the cheaper debt capital in the capital
structure is proportionally increased, the weighted average cost of capital K w,
decreases and consequently the cost of debt Kd. Thus, it is needless to say that
the optimal capital structure is the minimum cost of capital, if financial leverage
is one, in other words, the maximum application of debt capital.

The value of the firm (V) will also be the maximum at this point.

2. Net Operating Income Approach:

Now we want to highlight the Net Operating Income (NOI) Approach which was
advocated by David Durand based on certain assumptions.

They are:

(i) The overall capitalization rate of the firm Kw is constant for all degree of
leverage;

(ii) Net operating income is capitalized at an overall capitalisation rate in order to

have the total market value of the firm.

Thus, the value of the firm, V, is ascertained at overall cost of capital (K w):

V = EBIT/ Kw (Since both are constant and independent of leverage)

(iii) The market value of the debt is then subtracted from the total market value
in order to get the market value of equity.

S = V-T
(iv) As the Cost of Debt is constant, the cost of equity will be:

Ke = EBIT – I / S

The NOI Approach can be illustrated with the help of the following diagram:

Under this approach, the most significant assumption is that the Ku is constant
irrespective of the degree of leverage. The segregation of debt and equity is not
important here and the market capitalizes the value of the firm as a whole. Thus,
an increase in the use of apparently cheaper debt funds is offset exactly by the
corresponding increase in the equity-capitalization rate.

So, the weighted average Cost of Capital Kw and Kd remain unchanged for all
degrees of leverage. Needless to mention here that as the firm increases its
degree of leverage it becomes more risky proposition and investors are to make
some sacrifice by having a low P/E ratio.

Although the value of the firm Rs. 2,50,000 is constant at all levels, the cost of
equity is increased with the corresponding increase in leverage. Thus, if the
cheaper debt capital is used, that will be offset by the increase in the total cost of
equity, Ks and as such, both Ke and Kd remain unchanged for all degrees of
leverage i.e., if cheaper debt capital is proportionately increased and used, the
same will offset the increase of cost of equity.

3. Traditional Approach:
It is accepted by all that the judicious use of debt will increase the value of the
firm and reduce the cost of capital. So, the optimum capital structure is the point
at which the value of the firm is highest and the cost of capital is at its lowest
point. Practically, this approach encompasses all the ground between the net
income approach and the net operating income approach i.e., it may be said as
intermediate approach.

The traditional approach explains that up to a certain point, debt-equity mix will
cause the market value of the firm to rise and the cost of capital to decline. But
after attaining the optimum level, any additional debt will cause to decrease the
market value and to increase the cost of capital.
In other words, after attaining the optimum level, any additional debt taken, will
offset the use of cheaper debt capital since the average cost of capital will
increase along with a corresponding increase in the average cost of debt capital.

Thus, the basic, proposition of this approach are enumerated below:

(a) The cost of debt capital, Kd, remains constant more or less up to a certain
level and thereafter rises.

(b) The cost of equity Capital, Ke, remains constant more or less or rise
gradually up to a certain level and thereafter increases rapidly.

(c) The average cost of capital, Kw, decreases up to a certain level, remains
unchanged more or less and thereafter rises after attaining a certain level.

The traditional approach can graphically be represented as under taking the

data from the previous illustration.

It is found from the above, the average cost curve is U-shaped. That is, at this
stage the cost of capital would be minimum which is expressed by the letter ‘A’
in the graph. If we draw a perpendicular to the X-axis, the same will indicate the
optimum capital structure for the firm.

Thus, the traditional position implies that the cost of capital is not independent of
the capital structure of the firm and that there is an optimal capital structure. At
that optimal structure, the marginal real cost of debt (explicit and implicit) is the
same as the marginal Real cost of equity in equilibrium.

For degree of leverage before that point, the marginal real cost of debt is less
than of equity, beyond that point the marginal real cost of debt excess that of
equity.
Variations on the Traditional Theory:

We know that this theory underlies between the Net Income Approach and the
Net Operating Income Approach. Thus, there are some distinct variations in this
theory. Some followers of the traditional school of thought suggest that Ke does
not practically rise till some critical conditions arise.

After attaining that level only, the investors apprehend the increasing financial
risk and penalize the market price of the shares. This variation expresses that a
firm can have lower cost of capital with the initial use of leverage significantly.

This variation in Traditional Approach is depicted as under:

Other followers e.g., Solomon, are of opinion that K is as being saucer shaped
along with a horizontal middle range. It explains that optimum capital structure
has a range where the cost of capital is rather minimised and where the total
value of the firm is maximised.

Under the circumstances, a change in leverage has, practically, no effect on the

total firm’s value. So, this approach grants some sorts of variation in the optimal
capital structure for various firms under debt-equity mix.
Theory # 4. Modigliani-Miller Approach:
Modigliani-Miller (MM) advocated that the relationship between the cost of
capital, capital structure and the valuation of the firm, should be explained by
NOI (Net Income Operating Approach) by making an attack on the Traditional
Approach.

The Net Income Operating Approach, we know, supply proper justification for
the irrelevance of the capital structure. In this context, MM support the NOI
approach on the principle that the cost of capital is not dependent on the degree
of leverage irrespective of the debt-equity mix.

In other words, according to their thesis, the total market value of the firm and
the cost of capital are independent of the capital structure. They advocated that
the weighted average cost of capital does not make any change with a
proportionate change in debt-equity mix in the total capital structure of the firm.

The same can be shown with the help of the following diagram:
 Dividend Policy

The term dividend refers to that part of profits of a company which is distributed
by the company among its shareholders. It is the reward of the shareholders for
investments made by them in the shares of the company. The investors are
interested in earning maximum return to maximize their wealth.

A firm needs funds to meet its long-term growth. If a company pays most of the
profit as dividend, then for business requirement or further expansion then it will
have to depend on outsiders for funds. Such as issue of debt or new shares.

Firms decision to pay dividend in equitable proportion of dividend and retained

earnings.
 

Determinants Of Dividend Policy

1. Legal restrictions

Legal provision related to dividends are laid down in sec 93,205,205A, 206 and
207 of companies act.Dividend can be paid only out of current profit or past
profit after providing depreciation Company providing more than 10% dividend to
transfer certain percentage of current year profit to reserves.

2. Magnitude and trend of earning 

The amount and trend of earnings is an important in dividend policy. Dividend

can be paid only out of present or past year‘s profit; earnings of a company fix
the upper limit on dividends. Past trend is kept in mind while decision dividend
decision .

3. Desire and type of shareholders

 Discretion to declare dividend or not is decided by the board of directors.

Directors give importance to the desire of the shareholder in declaration of
dividends. Desire for dividend depends on their economic status. Investor such
as retired person, widows and other economically weaker person view dividend
as a source of funds to meet their day-to-day living expenses – the company will
pay regular dividend. Investor with high income tax bracket will not prefer current
dividend they will expect only capital gains. 

4. Nature of industry
Nature of industry to which the company is engaged also affects dividend policy.
Certain industry has steady and stable demand irrespective of prevailing
economic condition. Eg : people used to drink liquor both in boom and in
recession. Such firm gets regular earning and hence follows consistent dividend
policy. Earning are uncertain in such case conservative dividend policy is used.
Such firms should retain substantial part of their current earnings during boom
period in order to provide funds to pay dividends in recession period

5. Age of the company

Age also influence the dividend decision of the company. Newly established
concern has limit in payment of dividend and retain substantial part for financing
future growth and development Older company has sufficient reserves can pay
liberal dividends.

6. Future financial requirement

 Future financial requirement is to be considered while deciding dividend.

Company has profitable investment opportunities then the firm will pay limited
amount as dividend and invest the remaining amount. If there is no investment
opportunities then the company will pay more dividend

 7. Government economic policy

 The dividend policy of a firm has also to be adjusted to the economic policy of
the government
 In 1974 and 1975 companies were allowed to pay dividends not more than 33
% of their profits or 12% on paid-up value of the shares, whichever was lower

Dividend Models

 Walter’s Approach

According to James Walter, dividend policy always affects the goodwill of a

company. Walter argued that dividend policy reflects the relationship between
the firm’s return on investment or internal rate of return and the cost of capital or
required rate of return.

Suppose that r is the internal rate of return and K is the cost of equity capital.
Then, for any given company, we have the following cases:

Case 1: When r > k

Firms with r > k are termed growth firms. Their optimal dividend policy involves
ploughing back the company’s entire earnings. Thus, the dividend payment ratio
would be zero. This would also maximize the market value of the company’s
shares.

Case 2: When r < k

Firms with r < k do not offer profitable investment opportunities. For these firms,
the optimal dividend policy involves distributing the entire earnings in the form of
dividends.
Shareholders can use dividends to receive in other channels when they can get
a higher rate of dividends. Thus, 100% dividend payout ratio in their case would
result in maximizing the value of the equity shares.

Case 3: When r = k

For firms with r = k, it does not matter whether the firm retains or distributes its
earnings. In their case, the share price would not fluctuate with a change in
dividend rates. Thus, no optimal dividend policy exists for such firms.

Assumptions in Models Based on Walter’s Approach

(i) The firm undertakes its financing entirely through retained earnings. It does
not use external sources of funds such as debts or new equity capital.

(ii) The firm’s business risk does not change with additional investment. This
means that the firm’s internal rate of return and cost of capital remain constant.

(iii) Initially, earnings per share (EPS) and dividend per share (DPS) remain
constant. The choice of values for EPS and DPS varies depending on the
model, but any given values are assumed to remain constant.

(iv) The firm has a very long life.

Formula for Walter’s Approach

The market value of a share (P) can be expressed as follows:

P = (D + r) (E – D) / KE

or

P = (D + (r / KE) E-D) / KE

where

 P = Market price of an equity share

 D = Dividend per share
  r = Internal rate of return
 E = Earnings per share
 KE = Cost of equity capital or capitalization rate

Example
Required: Based on the table shown below concerning companies A, B, and C,
calculate the value of each share using Walter’s approach when the dividend
payment ratio is 50%, 75%, and 25%. 

In addition,

 D = (50 x 8) / 100 = 4
 D = (75 x 8) / 100 = 6
 D = (25 x 8) / 100 = 2

A Ltd. B Ltd. C Ltd.

r 15% 5% 10%
Ke 10% 10% 10%
e $8 $8 $8
Solution

Comment: A Ltd. is a growth firm because its internal rate of return exceeds the
cost of capital. Here, it is better to retain the earnings rather than to distribute
them as dividends. As is shown, when the D.P. Ratio is 25%, the share price is
$110.
Criticisms:

 The assumption that investments are financed through internal sources is

not true. External sources are also used for financing.
 The ratio between r and k is not constant in an organization. As
investment increases, r also increases.
 Earnings and dividends do not charge while determining the value.
 The assumption that a firm will have a long life is difficult to predict.

Gorden’s Approach

Gorden proposed a model along the lines of Walter, suggesting that dividends
are relevant and that the dividends of a firm influence its value.

The defining feature of Gorden’s model is that the value of a dollar in dividend
income is greater than the value of a dollar in capital gain. This is due to the
uncertainty of the future and the shareholder’s discount future dividends at a
higher rate.

According to Gorden, the market value of a share is equal to the present value
of the future stream of dividends.

Formula for Gorden’s Approach

The formula is given as follows:

P = E (1 – b) / (Ke – br)

or

P = D / (Ke – g)

where

 P = Share price
 E = Earnings per share
 b = Retention ratio
  Ke = Cost of equity capital
 br = g
 r = Rate of return on investment
 D = Dividend per share

A high or low rate of business taxation affect the net earnings of company and
thereby its dividend policy. A firm‘s dividend policy may be dictated by the
income-tax status of its shareholders. If the dividend income of shareholders is
heavily taxed being in high income bracket, then the shareholder will prefer
capital gains and bonus shares.

UNIT-4

What is working capital?

Working capital is the amount used to meet the day to day operation activities of
a business. In the broad sense, the term working capital is used to denote the
total value of current assets.
Needs for working capital

An effective operation of a business is based on the proper management of

working capital. Initially, the business unit should forecast the adequate working
capital. In this context, working capital forecasting is getting more importance
than the management of working capital. Generally, each business unit requires
adequate amount of capital. The reason is that capital is required for the
establishment of a business units and its proper functioning.

Fixed assets such as Land and Building, fixtures, furniture, machinery, plant and
other fixed assets are required for the establishment of a business. A portion of
capital is used to acquire the fixed assets. Such capital is called fixed capital.
After the establishment, the business unit should function properly.

 Functioning means carrying the activities like trading, service or

manufacturing.
 Trading means buying and selling of goods without making any alteration
in the goods.
 Service means rendering of intangible things like electricity, parcel
service, courier service, telephone, lorry service and the like.
Manufacturing means conversion of raw materials into finished goods
which is meant for sale.

Therefore, the business unit requires capital for its proper functioning i.e.
meeting the expenses of day to day activities. Such capital is called working
capital. The other names of working capital are Circulating Capital and
Revolving Capital.

Balance sheet concept of working capital

The working capital can be classified into two types under the balance sheet
concept. They are
 1. Gross Working Capital;
2. Net Working Capital

1. Gross Working Capital:

Gross working capital means an amount of funds invested in the various forms
of current assets in total. Current assets are those assets which are bought in
the ordinary course of business and converted into cash within a short period
which is normally one accounting year.

2. Net working capital:

Net working capital is the excess of current assets over current liabilities. Again,
the net working capital is divided into two types. They are

 Positive net working capital and

 Negative net working capital.

The positive net working capital exists, whenever the current assets exceeds
current liabilities. The negative net working capital exists whenever the current
liabilities exceeds the current assets. Current liability means a liability payable
within one accounting year in the ordinary course of business or payable out of
the current assets within a short period normally one year or payable out of the
revenue income of the business.

Why is Gross working capital preferable?

Both gross working capital and net working capital concepts are used for
financial management purposes. But, gross working capital concept is
preferable to net working capital concept due to the following reasons.

l. It helps the business concern to provide adequate amount of working capital at

the time of requirements.
2. Every business concern is interested to know the gross value of current
assets since its effective operation lies on the value of current assets rather than
the source of short term finance.

3. Every increase in current assets leads to increase in the gross working

capital.

4. It is highly useful in determining the rate of return on investments in working

capital.

Why is Net working capital preferable?

Sometimes, net working capital concept is preferable to gross working capital
concept due to the following reasons.

1. It indicates the ability of the concern to meet its operating expenses and short
term liabilities.

2. It discloses the financial soundness of the business concern.

3. It shows the margin of protection available to the short term creditors i.e. the
excess of current assets over current liabilities.

4. It suggests the need for using a part of working capital requirements out of
long term or permanent source of funds.

Net or Gross
In nutshell, either gross working capital concept or net working capital concept is
applicable to a business concern. The net working capital concept is suitable to
sole-trade concern and partnership firm. But, gross working capital is highly
suitable to private limited company and public limited company form of business
organization where there is a distinction between ownership, management and
control. Generally, working capital refers to net working capital.

Determinants of Working Capital

 Nature of Business is one of the factors. Usually in trading businesses the
working capital needs are higher as most of their investment is found
concentrated in stock. On the other hand, manufacturing/processing business
need a relatively lower compared to that of trading business/level of working
capital. The terms of ‘higher’ and ‘lower’ used above are relative and not
absolute. That is, of the total capital employed in the businesses a higher or
lower, as the case may be, portion is employed in current assets.
 Sales and Demand Conditions  of a firm also affect its working capital position. It
is difficult to precisely determine the relationship between volume of sales and
working capital needs. Sales depend on the demand conditions. Most of the
firms experience seasonal and cyclical fluctuations in the demand of their
products and services. These business variations affect the working capital
requirement, particularly the temporary working capital requirement of the firm.
When there is an upward swing in the economy, the sales will increase and
untimely the firm’s investment in inventories and debtors will also increase. On
the other hand, when there is a decline in the economy, the sales will fall and
ultimately, the level of inventories and debtors will also fall. Under recessionary
conditions firms try to reduce their short-term borrowings.
 Manufacturing Policy: The manufacturing cycle of the firm also affects the
requirement of the working capital. The manufacturing cycle comprises the
purchase and use of raw material and production of finished goods. Longer the
manufacturing cycle, larger will be the firm’s working capital requirements and
vice versa. An extended manufacturing time span means a larger tie-up of funds
in inventories. Further, the requirement of working capital also depends on
whether the firm has adopted steady production policy or variable production
policy.
 Credit Policy: In the present day circumstances, almost all units have to sell
goods on credit. The nature of credit policy is an important consideration in
deciding the amount of working capital requirement. The larger the volume of
credit sales, the greater will be the requirement of working capital. Generally, the
credit policy of an individual firm depends on the norms of the industry to which
the firm belongs. Credit periods also influence the size and composition of
working capital. When longer credit period is allowed to customers as against
the one extended to the firm by its suppliers, more working capital is needed and
 vice versa In the former case, there will be a relatively higher trade debtors and
in the latter there will be a higher trade creditors.
 Collection policy is another influencing factor. A stringent collection policy might
not only deter away some credit seeking customers, also force existing
customers to be prompt in settling dues resulting in lower level of working
capital. The opposite is true with a liberal collection policy. Collection procedures
do influence the level of working capital. A decentralized collection of dues from
customers and centralized payments to suppliers, shall reduce the size of
working capital. Centralized collections and centralized payments or
decentralized collections and decentralized payments would lead to a moderate
level of working capital. But with centralized collections and decentralized
payments, the working capital need will be the highest.
 The Availability of Credit   from banks and financial institutions also influences
the working capital requirement of a firm. The availability of credit to a firm
depends upon the creditworthiness of the firm in the money market. If a firm has
good credit standing in the market, it can get credit easily on favorable terms
and hence it will require less working capital.
 The Operating Efficiency of the firm relates to the optimum utilization of
resources at minimum costs. If the firm is efficient in controlling its operating
costs and utilizing its current assets, than it helps in keeping the working capital
at a lower level. The use of working capital is improved and pace of cash
conversion cycle is accelerated with operating efficiency.
 The Price Level Changes also affect the level of working capital. Generally,
rising price levels will require a firm to maintain higher amount of working capital.
However, the effect of rising prices may be different for different companies, as
though the general price level increases, the individual prices may move
differently. Therefor some firms may require more working capital, while other
may require less working capital in case of price rise.
 Inflation has a bearing on level of working capital . Under inflationary conditions
generally working capital increases, since with rising prices demand reduces
resulting in stock pile-up and consequent increase in working capital.
 Level of trading is another factor. There are two levels of trading, viz. over
trading and under trading. Over trading means the business wants to maximize
turnover with inadequate stock level, hastened production cycle and swiftest
collection from debtors. Eventually the working capital will be lower. It is no
 good, however, for the business is starved of its legitimate working capital
needs. Under trading is the opposite of over-trading. There is lethargy and overt
lags. There results a higher work-capital. This is no good either, since the
working capital is not effectively utilized. It is wastage of capital.
 The Growth and Expansion Plans to be undertaken by a firm also affect its
requirements of working capital.   Hence the planning of the working capital
requirements and its procurements must go hand in hand with the planning of
the growth and expansion of the firm. Even the expansion of the sales also
increases the requirements of working capital.
 System of production process is another factor that has a bearing. If capital
intensive, high technology automated system is adopted for production, more
investment in fixed assets and less investment is current asses are involved.
Also, the conversion time is likely to be lower, resulting in further drop in the
level of working capital. On the other hand, if labor intensive technology is
adopted less investment in fixed assets and more investment in current assets
(especially work-in-progress due to inclusion of an enhanced wage component
and prolonged processing) result.
 Dividend policy:  A desire to maintain an established dividend policy may affect
working capital, often changes in working capital bring about an adjustment of
dividend policy. The relationship between dividend policy and working capital is
well established and very few companies declare a dividend without giving due
consideration to its effects on cash and their needs for cash. A shortage of
working capital often acts as a powerful reason for reducing or skipping a cash
dividend. On the other hand, a strong position may justify continuing dividend
payment.
 Finally rapidity of turnover comes. There is a negative correlation between
rapidity of turnover and size of working capital. When sales are fast and swift,
lower is the investment in working capital. Actually stock of inventory is very
minimum. But, when sales are happening far and in-between, i.e. rather slow, as
in the case of jewellery, elaborate investment in working capital results. Thus
faster sales lead to lower working capital and vice versa.
 Methods for Estimating Working Capital Requirement
There are broadly three methods of estimating or analyzing the requirement of
working capital of a company, viz. percentage of revenue or sales, regression
analysis, and operating cycle method. Estimating working capital means
calculating future working capital. It should be as accurate as possible because
the working capital planning would be based on these estimates, and banks and
other financial institutes finance the working capital needs to be based only on
such estimates.

3 Methods for Estimating Working Capital requirement are as follows:

Table of Contents

1. Percentage of Sales Method

2. Regression Analysis Method
3. Operating Cycle Method

Percentage of Sales Method

Percentage of Sales Method is the easiest of the methods for calculating the
working capital requirement of a company. This method is based on the principle
of ‘history repeats itself.’ For estimating, a relationship of sales and working
capital is worked out for, say last 5 years. If it is constantly coming near, say
40%, i.e., working capital level is 40% of sales, the following year’s estimation is
done based on this estimate. If the expected sales are 500 million dollars, 200
million dollars would be required as working capital.

The advantage of this method is that it is very simple to understand and

calculate also. The disadvantage includes its assumption, which is difficult to be
true for many organizations. So, this method is not useful where there is no
linear relationship between the revenue and working capital. In new startup
projects, this method is not applicable because there is no past.
Regression Analysis Method

Regression Analysis Method is a statistical estimation tool utilized by mass for

various types of estimation. It tries to establish a trend relationship. We will use it
for working capital estimation. This method expresses the relationship between
revenue & working capital in the form of an equation (Working Capital =
Intercept + Slope * Revenue). The slope is the rate of change of working capital
with one unit change in revenue. Intercept is the point where regression line and
working capital axis meet (Will not go deeper into statistical details). At the end
of the statistical exercise with past revenue and working capital  data, we will get
an equation like the below:

Working Capital = -6.34 + 0.46 * Revenue

To calculate working capital, just put the targeted revenue figure in the above
equation, say 200 million dollars.

Working Capital = -6.34 + 0.46 * 200 = -6.34 + 92 = 85.66 ~ 86 Million Dollar.

Therefore, we need 86 million dollars of working capital to achieve a revenue of

200 million dollars.

Operating Cycle Method

The operating cycle method is probably the best of the methods because it
considers the actual business or industry situation while giving an estimate of
working capital. A general rule can be stated in this method. The longer the
working capital operating cycle, the higher the requirement for working capital
and vice versa. We would agree on the point also. The following formula can be
used to estimate or calculate the working capital

Working Capital = Cost of Goods Sold (Estimated) * (No. of Days of Operating

Cycle / 365 Days) + Bank and Cash Balance.

If the cost of goods sold (estimated) is $35 million and the operating cycle is 75
days, the bank balance required is 1.25 million. Therefore, Working Capital = 35
* 75/365 + 1.25 = $8.44 Million.

In this method, each component can also be calculated. It means a bifurcation of

$8.44 million can be done in inventory, cash, accounts receivable, accounts
payable, etc.

Cash of Management

Cash management is also known as treasury management, refers to the

process of collection, management, and usage of cash flows for the purpose of
maintaining a decent level of liquidity, and it involves financial instruments such
as treasury bills, certificate of deposit, and money market funds making the
same substance for not just individuals but organizations too.

Explanation:

It is a process in which the cash is collected, disbursed, and invested so that

there is maximum liquidity. It also helps in maximizing profitability by optimizing
cash utilization. It also helps in creating provisions for future contingencies such
as economic slowdown, bad debts, etc.

Types of Cash Management

Following are the types given below:

 Cash Flow from Operating Activities: It is found on an organization’s cash

flow statement, and it does not include cash flow from investing.
 Free Cash Flow to Equity: Free Cash Flow to Equity represents the
amount of cash that is available after the capital is reinvested.
 Free Cash Flow to The Firm: It is used for the purpose of valuation and
financial modeling.
 The Net Change in Cash: It refers to the movement in the total amount of
cash flow from a particular accounting period to another.

Roles and Functions of Cash Management

The roles and functions are explained below-

1. Inventory Management
Cash management helps an organization in managing its inventories. Higher
inventory in hand indicates trapped sales, and this further leads to less liquidity.
Therefore, a company must always focus on fast pacing its stock out for allowing
the movement of cash.

2. Receivables Management
A company focuses on raising its invoices so that sales can be boosted. The
credit period with respect to receiving cash might range between a minimum of
30 and a maximum of 90 days. This means that the organization has recorded
all its sales, but the cash with respect to these transactions has not yet been
received.

In such a scenario, cash management’s function will ensure that there is a faster
recovery of all the receivables to avoid a probable cash crunch. It also includes
a follow-up mechanism that ensures there is faster recovery and will also make
the company aware of future contingencies like bad debts, etc.

3. Payables Management
This is also an important function of cash management where the companies
can avail benefits like cash discounts and credit period.

Objectives of Cash Management

The objectives of cash management include fulfilling working capital
requirements, handling unorganized costs, planning capital expenditure,
appropriate utilization of funds, planning capital expenditure, initiating
investments, etc. The other objectives of cash management are maximizing
liquidity, regulation of cash flows, maximizing the value of available funds, and
lowering the costs pertaining to funds.

On the other hand, lesser the amount of cash balance, more will be the
profitability and lesser will be the liquidity of business. This is true to a certain
limit. After this limit, lesser liquidity will reduce the profitability.

The following are two main objectives of cash Management:

(1) To make payment according to the payment schedule.

(2) To minimise cash balance.

(1) To Make Payment According to Payment Schedule:

One basic objective of cash management is to meet the cash requirements of

business i.e., to pay its liabilities in time. In other words, firm needs cash to meet
its routine expenses including wages, salary, interest, dividend, taxes, etc.

Following are the main advantages of adequate cash:

(i) It prevents the firm from being insolvent.

(ii) The relation of the firm with bank does not deteriorate.

(iii) It helps the firm to maintain good relations with the suppliers.

(iv) Advantage of trade discount can be taken by making payment in time.

(v) Advantage of favourable business opportunities can be taken

(vi) Contingencies can be met easily.

(2) To Minimise Cash Balance:

The second objective of cash management is to minimise cash balance. In order

to minimise cash balance, there is need to co-ordinate two contradictory
aspects. Excessive amount of cash balance helps in quicker payments and all
advantages relating to such payments can be taken. But it would mean that a
large amount of cash funds will remain unused. It will reduce profitability of
business.

Contrarily, when cash available with firm is less, the firm is unable to pay its
liabilities in time. Therefore, the level of cash in the firm should be optimum. Firm
should, therefore, determine its cash requirements considering all the factors
affecting such requirement.
Efficient Cash Management
In an efficient cash management, cash at hand and at bank, in spite of all its
significance, should be optimum. That is, it should be at a minimum level that
will take care of the immediate needs and the contingent requirements of the
firm.

For an overall efficient, effective and economical cash management, one needs
to emphasise on efficient collections, efficient use of short-term money,
discouragement of idle funds, efficient disbursements and monitoring of cash
movement from the firm’s bank branch to its headquarter.

Efficient cash management is supported by the fact that the firm develops and
uses different sources of short-term money that are flexible enough and readily
available at nominal cost.

The firm discourages usable funds (collections or borrowed capital) to stand idle
for more than a day.

For profitable and flexible investment of cash, surplus that arises should be
profitably invested in marketable securities so that as long as this cash is not
required it generates profits, and as soon as it is needed it can be encashed
quickly.

Effective cash management involves the following:

i. Efficient collections

ii. Efficient disbursements

iii. Continuous and dynamic monitoring of cash movement.

Collections are the sale receipts received by the firm from its customers by
selling its products or services to them. More efficient the collection of the sale
proceeds, the more cash the firm has, and the availability of funds increases as
collection time decreases.
Efficient collection management can be done by speeding up collections,
decentralisation of collection systems, etc. There are two popular decentralised
collection systems that speed up cash collection and reduce the float time.

These are as follows:

1. Lockbox System,

2. Concentration Banking.

1. The Lockbox System:

It is a simple method used in reducing collection float and accelerating firm’s

collections or remittances. When a firm adopts the lockbox system, it takes a
post office box in its name, called lockbox, and requests its customers to mail
their payments to these lockboxes.

These lockboxes are attended by local collection banks or local branch or depot
personnel one or more times every day (if possible even on holidays). These
cheques are deposited directly into the local bank account of the firm. If it is
through the local bank, then the company authorises its bank to collect its sale
receipts from the lockboxes.

The bank then sends particulars of cheques along with letters or other
accompanying materials to the firm for information. After the cheques are
realised, surplus funds from the local banks are transferred (usually by wire) to
the central account or accounts of the firm.

Thus the lockbox system helps to reduce the mailing time, because cheques are
received at a nearby post office instead of at corporate headquarters, and
deposited and cleared locally. It also helps in reducing the processing time as
the deposits are made by the local bank.

Hence, firm saves on its time and efforts for processing the mails and reduces
the availability delay as the firm encourages its customers to draw the cheque
on local banks.
In this way, the firm is in a better position to use its collections immediately. This
system reduces mail float, clearing float as well as processing float. Banks do
charge some fee against these services.

Whenever firms analyse the possibility of adopting such systems, they must
evaluate the cost and benefits attached. The benefits derived from the speeding
up of collections must be greater than the costs of the lockbox system.

Lockboxes are widely dispersed because they are usually adopted by

multinationals, large and big companies, which have their branches in many
states.

Advantages:

i. A lockbox system reduces the mail float because lockboxes can be

established at different geographical locations and thus reduces mailing time.

ii. To ensure that check processing time is minimised, some banks offering
lockbox services pick up and process mail on a continuing basis and process
checks on a 24-hour basis.

iii. Another advantage is that the bank performs the clerical work for processing
the incoming cheques prior to deposits. In this respect, it is superior to the
concentration banking system.

iv. The lockbox system enjoys the additional advantages of eliminating the
cheque processing float completely because they do not record the checks until
it has been deposited.

Disadvantages:

The main disadvantage of this system is the cost. The bank will provide a
number of additional services, to the usual clearing of cheques.

Accordingly, it will require compensation for the additional services—usually in

the form of increased deposits from the firm. Because the cost is almost directly
proportional to the number of cheques deposited, this system is not profitable if
the average remittance is small.

2. Concentration Banking:

In concentration banking, the company establishes a number of strategic

collection centres in different regions instead of a single collection centre at the
head office. When the firms open up different collection centres in different parts
of the country in order to reduce the postal delays, it is known as concentration
banking.

It is one of the important and popular ways of reducing the size of the float. Here
the firm requests its customers to mail their payments to a local or regional
collection centre instead of mailing it to the head office.

This system reduces the period between the times a customer mails in his
remittances and the time when they become spendable funds with the company.
Payments received by the different collection centres are deposited with their
respective local banks, which in turn transfer all surplus funds to the
concentration bank of the head office.

The concentration bank with which the company has its major bank account is
generally located at the headquarter.

Surplus funds from the local banks are transferred by mail or wire form the local
bank accounts to a concentration bank or banks. The choice between a wire or
mail transfer depends on two factors – the amount involved and the cost of
finance.

In general, wire transfers are economical only when large sums of money are
involved and the firm can earn a reasonable return on short term, low risk and
highly liquid investments.

Advantages:

i. It reduces mail float significantly. The customers receive the bills from the
collection centres instead of from head office, and secondly when they send
their cheques to the collection centres, the mailing time is shorter than the time
required for mailing them to the head office.

ii. Average bank float is also reduced. This is mainly because of reduction in the
volume of outstation cheques as most of the cheques deposited in the collection
centre’s bank are drawn on banks in that area.

iii. This system reduces the time of collection and hence results in better cash
management.

iv. Cash concentration improves the control of the firm over inflows and outflows
of cash.

v. Disbursing cash from one place becomes easier and efficient.

vi. Cash concentration also reduces idle cash balances.

vii. The balance at regional offices is kept low, which is almost equal to the
actual total expenses of the regional branches.

viii. Any excess funds are moved to the concentration bank(s). Excess funds in
concentration banks(s) are invested for short-term periods to provide better
yields to the firm.

However, cash concentration is encouraged by timely transfer of funds to and

from concentration banks and regional branches. For efficient fund transfer,
firms use cheques and drafts as a payment and receipt mode. The other
methods like automated clearing house (ACH), electronic transfer and wire
transfer are also used for remitting funds.

The main issue here is selecting the collection centres, which largely depends
on the volume of billing/business in a particular geographical area. However, the
cost of concentration system is the minimum account balance required to be
maintained in these current accounts.
Cash Management Strategies
The strategies pertaining to cash management are:

 One must always ask for a milestone or deposit payment

 The customers must be encouraged to clear their bills faster
 One must always make sure that the expenses are always bare minimum
or even delayed.
 One must request the vendors to modify their payment terms
 Finance and fulfill purchase orders
 Idle equipment must be put for sale or on lease
 Boost profit margins
 Invoice factoring/ invoice discounting/ invoice financing/ sale invoices.

Different Types of Cash Management Tools

Following are the different types as given below:

 Short-term instruments such as Money Market instruments and mutual

funds, Treasury Bills, certificates of deposit (CD), etc.
 Checking account
 Savings account
 Long term low-risk savings instrument

Limitations of Cash Management

The limitations are as follows:

 Cash management ignores the accrual concept of accounting

 It is historical in nature; that is; it rearranges the current information which
is provided in the profit and loss statement and the balance sheet.
 It is not a substitute for a profit and loss statement.
 It ignores non-cash transactions.

Advantages and Disadvantages

Following are the advantages and disadvantages as given below:

Advantages
The advantages listed below are as follows

 Cash management allows estimating the cash profits and not just profits
from outstanding incomes and credit sales.
 It helps in detecting cash embezzlement.
 It allows in speeding up the working capital cycle.
 It helps in rewarding such debtors that make quicker payments.
 It speeds up the operations of an organization.

Disadvantages
The disadvantages listed below are as follows.

 Management of the cash requires the specified skills of the person

managing it.
 It is a time-consuming process.

Conclusion
It is also better known as treasury management. A treasurer of an organization
looks after the overall cash management for the same. It helps in estimating the
cash profits instead of profits earned through credit sales. It can also help in
tracing cash embezzlement.

What Is Inventory Management?

Inventory management helps companies identify which and how much stock to
order at what time. It tracks inventory from purchase to the sale of goods. The
practice identifies and responds to trends to ensure there’s always enough stock
to fulfill customer orders and proper warning of a shortage.

Once sold, inventory becomes revenue. Before it sells, inventory (although

reported as an asset on the balance sheet) ties up cash. Therefore, too much
stock costs money and reduces cash flow.

One measurement of good inventory management is inventory turnover. An

accounting measurement, inventory turnover reflects how often stock is sold in a
 period. A business does not want more stock than sales. Poor inventory
turnover can lead to deadstock, or unsold stock.

Why Is Inventory Management Important?

Inventory management is vital to a company’s health because it helps make
sure there is rarely too much or too little stock on hand, limiting the risk of
stockouts and inaccurate records.

Public companies must track inventory as a requirement for compliance with

Securities and Exchange Commission (SEC) rules and the Sarbanes-Oxley
(SOX) Act. Companies must document their management processes to prove
compliance.

Benefits of Inventory Management

The two main benefits of inventory management are that it ensures you’re able
to fulfill incoming or open orders and raises profits. Inventory management also:

 Saves Money:
Understanding stock trends means you see how much of and where you have
something in stock so you’re better able to use the stock you have. This also
allows you to keep less stock at each location (store, warehouse), as you’re able
to pull from anywhere to fulfill orders — all of this decreases costs tied up in
inventory and decreases the amount of stock that goes unsold before it’s
obsolete.
 Improves Cash Flow:
With proper inventory management, you spend money on inventory that sells, so
cash is always moving through the business.

 Satisfies Customers: One element of developing loyal customers is ensuring

they receive the items they want without waiting.

Inventory Management Challenges

The primary challenges of inventory management are having too much inventory
and not being able to sell it, not having enough inventory to fulfill orders, and not
understanding what items you have in inventory and where they’re located.
Other obstacles include:
 Getting Accurate Stock Details:
If you don’t have accurate stock details,there’s no way to know when to refill
stock or which stock moves well.
 Poor Processes:
Outdated or manual processes can make work error-prone and slow down
operations.
 Changing Customer Demand:
Customer tastes and needs change constantly. If your system can’t track trends,
how will you know when their preferences change and why?
 Using Warehouse Space Well:
Staff wastes time if like products are hard to locate. Mastering inventory
management can help eliminate this challenge.

Inventory Management Techniques and Terms

Some inventory management techniques use formulas and analysis to plan
stock. Others rely on procedures. All methods aim to improve accuracy. The
techniques a company uses depend on its needs and stock.

Find out which technique works best for your business by reading the guide to
inventory management techniques. Here’s a summary of them:

 ABC Analysis:
This method works by identifying the most and least popular types of stock.
 Batch Tracking:
This method groups similar items to track expiration dates and trace defective
items.
 Bulk Shipments:
This method considers unpacked materials that suppliers load directly into ships
or trucks. It involves buying, storing and shipping inventory in bulk.
 Consignment:
When practicing consignment inventory management, your business won’t pay
its supplier until a given product is sold. That supplier also retains ownership of
the inventory until your company sells it.
 Cross-Docking:
Using this method, you’ll unload items directly from a supplier truck to the
delivery truck. Warehousing is essentially eliminated.
 Demand Forecasting:
This form of predictive analytics helps predict customer demand.
 Dropshipping:
In the practice of dropshipping, the supplier ships items directly from its
warehouse to the customer.
 Economic Order Quantity (EOQ):
This formula shows exactly how much inventory a company should order to
reduce holding and other costs.
 FIFO and LIFO:
First in, first out (FIFO) means you move the oldest stock first. Last in, first out
(LIFO) considers that prices always rise, so the most recently-purchased
inventory is the most expensive and thus sold first.
 Just-In-Time Inventory (JIT):
Companies use this method in an effort to maintain the lowest stock levels
possible before a refill.
 Lean Manufacturing:
This methodology focuses on removing waste or any item that does not provide
value to the customer from the manufacturing system.
 Materials Requirements Planning (MRP):
This system handles planning, scheduling and inventory control for
manufacturing.

 Minimum Order Quantity:

A company that relies on minimum order quantity will order minimum amounts of
inventory from wholesalers in each order to keep costs low.

 Reorder Point Formula:

Businesses use this formula to find the minimum amount of stock they should
have before reordering, then manage their inventory accordingly.
 Perpetual Inventory Management:
This technique entails recording stock sales and usage in real-time. Read “The
Definitive Guide to Perpetual Inventory” to learn more about this practice.
 Safety Stock:
An inventory management ethos that prioritizes safety stock will ensure there’s
always extra stock set aside in case the company can’t replenish those items.
 Six Sigma:
This is a data-based method for removing waste from businesses as it relates to
inventory.
 Lean Six Sigma:
This method combines lean management and Six Sigma practices to remove
waste and raise efficiency.
 Meaning of Receivable Management
 Receivable management is a process of managing the account
receivables within a business organisation. Account receivables simply
mean credit extended by the company to its customers and are treated as
liquid assets. It involves taking decisions regarding the investment to be
made in trade debtors by organisation. Deciding the proper amount be
lent by the company to its customers in the form of credit sales is quite
important. It affects the overall cash availability for undertaking various
operations.
 Receivable management business ensures that a sufficient amount of
cash is always maintained within the business so that operations can
continue uninterrupted. It helps in deciding the optimum proportion of
credit sales. The overall process of receivable management involves
properly recording all credit sales invoices, sending notices on due date to
collection department, recording all collections, calculation of outstanding
interest on late payments etc.
 Receivable management aims at raising the sales volumes and profit of
the business by managing and providing credit facilities to customers. A
proper receivable management process aims at monitoring and avoidance
of occurrence of any overdue payment and non-payment. It is an effective
way of improving the financial and liquidity position of the company. Credit
facilities are important for attracting and retaining customers and this
makes management of credit facilities by business crucial. Objectives of
receivable management are as follows:
Monitor and Improve Cash Flow
Receivable management monitors and control all cash movements of
organizations. It maintains a systematic record of all sales transactions.
Receivable management helps business in deciding appropriate investment in
trade debtors. It aims that a sufficient amount of cash needed for day-to-day
activities is maintained at business. Credit facilities are extended by doing
proper analysis and planning to ensure optimum cash flow in a business
organization.

Minimizes bad debt losses

Bad debts are harmful to organizations and may lead to heavy losses.
Receivable management takes all necessary steps to avoid bad debts in
business transactions. It designs and implement schedules for collection of
outstanding amount timely and informs the collection department on due dates.
Customers are notified for amount standing against them and charges interest
on delay in payments. 
Avoids invoice disputes
Receivable management has an efficient role in avoiding any disputes arising in
business. Disputes adversely affect the relationship between customers and
business organizations. Complete and fair record of all transactions with
customers are maintained on a daily basis. There is no chance of confusion and
dispute arising as all sales transactions are accurately maintained. Automated
receivable management systems present full evidence in a short time in case of
dispute arising for resolving them.

Boost up sales volume

Receivable management increase the sales and the profitability of the
organisation. By extending the credit facilities to their customers business are
able to boost up their sales volume. More and more customers are able to do
transactions with the business by purchasing products on a credit basis.
Receivable management helps business in managing and deciding their
investment in credit sales. This leads to increase in the number of sales and
profit level.

Improve customer satisfaction

Customer satisfaction and retention are key goals of every business. By lending
credit, it supports financially weaken customers who can’t purchase business
products fully on a cash basis. This strengthens the relationship between
customer and organisation. Customers are happy with the services of their
business partners. Receivable management help in organising better credit
facilities for their customers.

Helps in facing competition

Receivable management helps in facing stiff competition in the market. Several
competitors existing in market offers different credit options to attract more and
more customers. Receivable management process analysis all information
about market and helps the business in farming its credit lending policies.
Customers are provided better services by extending credit at convenient rates.
Appropriate amount and rates of credit transactions can be easily decided
through receivable management process. All credit and payment terms are
decided for every customer as per their needs. 
Nature of Receivable Management

Regulate Cash Flow

Receivable management regulates all cash flows in an organization. It controls
all inflow and outflow of funds and ensure that an efficient amount of cash is
always available. Proper management of receivables enables organizations in
efficient functioning at all the times.

Credit Analysis
It perform proper analysis of customer credentials for determining their credit
ratings. Monitoring and scanning of customers before provide them any credit
facility helps in minimizing the credit risk.

Decide Credit Policy

Receivable management decides the credit policy and standards as per which
credit facility should be extended to customers. A company may have a lenient
credit policy where customer credit-worthiness is not at all considered or a
stringent policy where credit-worthiness is considered for providing credit.

Credit Collection
Receivable management focuses on efficient and timely collection of business
payments from its customers. It works towards reducing the time gap in between
the moments when bills are raised and payment is collected.

Maintain Up-to-date Records

Receivable management maintains a systematic record of all business
transactions on a regular basis. All transactions are maintained fairly in the form
of proper billing and invoices which helps in avoiding any confusion or settling of
disputes arising later.

Importance and Function of Receivable Management

Evaluates Customer Credit Ratings

Receivable management evaluates its customers borrowing capacity and
repaying ability for determining their credit ratings. It approves any credit facility
to its customers after analyzing their information both qualitatively and
quantitatively. Proper investigation of client details helps in reducing the credit
risk.

Minimizes investment in Receivables

It reduces investment in receivable by ensuring optimum funds are available
within organization at all the times. Receivable management decides proper
credit limit and credit period for avoiding any bankruptcy situations. Attempts are
made to collect account receivable as soon as they become due for payment
which reduces the overall investment in receivables.

Optimize Sales
Efficient receivable management assist business in raising their sales volume.
Business are able to attract more and more customers by providing them credit
facilities. They are able to properly decide and monitor credit facilities with the
help of a receivable management.

Reduce risk of bad Debts

It takes all steps to avoid any instances of bad debts. Receivable management
notify all customers for the payment as soon as the amount gets due. It charges
interest on delay payments and aims at optimum collection of all payment timely.
Implementation of proper schedule and monitoring of collection process results
in minimizing the risk of bad debts. 

Maintain Efficient Cash

Maintaince of efficient cash is crucial for the survival of every organization.
Receivables management properly records all cash inflows and outflows of a
business. All credit facilities are extended after analyzing the capability of
organization and due payments are collected timely. This results in steady cash
flow within the organization.

Lower cost of Credit

Receivable management helps business in lowering its cost of credit by limiting
the credit amount and credit period for its customers. It performs all processes
such as acquiring credit information of clients and collecting all due payments in
an efficient way which lower the overall cost associated with credit facilities.

Scope of Receivable Management

Formulation of Credit Policy

Receivable management is the one which formulates and implements an
effective credit policy in an organization. Credit policies are decided as per the
capabilities of an organization. A company may either follow a liberal policy or
stringent credit policy for providing credit facilities to its customers.

Credit Evaluation
Credit evaluation involves examining the credit worthiness of customer before
approving any credit amount. Proper investigation of customer’s information
lowers the risk of bad debts. Receivable management acquire all credentials of
client for determining their borrowing capacity and repaying ability.

Credit Control
Receivable management implement a proper structure for monitoring all credit
functions of business. It records credit sales with proper documents on a daily
basis. Invoices are raised immediately after goods get dispatch and amount are
collected soon as they become due for payment.  

Maximize Profit
It plays an efficient role in maximizing the profit of organizations. Receivable
management helps in boosting the sales volume by providing credit facilities to
customers. More and more people are able to purchase goods on credit which
maximizes the overall profit level.

Better Competition
Efficient account receivable management helps business in facing the strong
competition in market. It enables in providing credit facilities to customers as per
their needs and capabilities. Receivable management analyses the credit
strategies adopted by competitors and according frame policy for an
 organization. It attracts more and more customers by offering them credit
facilities at convenient rates.