203R - Financial Management Full Material

Dr Ravikumar Gunakala FINANCIAL MANAGEMENT
203- FINANCIAL MANAGEMENT

UNIT –I
Goal of Financial Management – Fundamental Principles – Time value of money – Discounting,
compounding - Risk-return trade off- Finance Function-Financial Decisions. Financial markets -
intermediaries.
Meaning of Financial Management
Finance is the lifeline of any business. However, finances, like most other resources, are always limited. On
the other hand, wants are always unlimited. Therefore, it is important for a business to manage its finances
efficiently.
Financial Management means planning, organizing, directing and controlling the financial activities
such as procurement and utilization of funds of the enterprise. It means applying general management
principles to financial resources of the enterprise.
Definitions
“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
“Financial management is the operational activity of a business that is responsible for obtaining and
effectively utilizing the funds necessary for efficient operations.”- Massie
Nature of Financial Management
 It is an indispensable organ of business management.

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 Its function is different from accounting function.
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 It is a centralized function.
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 Helpful in decisions of top management.
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 It applicable to all types of concerns.
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Associate Professor, Wings Business School, Tirupati, A. P. - 517561: Ph. No.: 9642212727 1
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 It needs financial planning, control and follow-up.


 It related with different disciplines like economics, accounting, law, information
technology, mathematics etc.
Scope of Financial Management

The scope of financial management is explained in the diagram below:
Scope/Elements
1. Financial Decisions- They relate to the raising of finance from various resources which will
depend upon decision on type of source, period of financing, cost of financing and the returns
thereby.
Managers also make decisions pertaining to raising finance from long-term sources (called Capital
Structure) and short-term sources (called Working Capital). They are of two types:
Financial Planning decisions which relate to estimating the sources and application of funds.
It means pre-estimating financial needs of an organization to ensure the availability of adequate
finance. The primary objective of financial planning is to plan and ensure that the funds are
available as and when required.
Capital Structure decisions which involve identifying sources of funds. They also involve
decisions with respect to choosing external sources like issuing shares, bonds, borrowing from
banks or internal sources like retained earnings for raising funds.
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2. Investment Decisions includes investment in fixed assets (called as capital budgeting).

Investment in current assets is also a part of investment decisions called as working capital decisions.
Managers need to decide on the amount of investment available out of the existing finance, on a long-term
and short-term basis. They are of two types:
Long-term investment decisions or Capital Budgeting mean committing funds for a long
period of time like fixed assets. These decisions are irreversible and usually include the ones
pertaining to investing in a building and/or land, acquiring new plants/machinery or replacing the
old ones, etc. These decisions determine the financial pursuits and performance of a business.
Short-term investment decisions or Working Capital Management means committing funds

for a short period of time like current assets. These involve decisions pertaining to the
investment of funds in the inventory, cash, bank deposits, and other short-term investments.
They directly affect the liquidity and performance of the business
3. Dividend Decision- These involve decisions related to the portion of profits that will be distributed
as dividend. Shareholders always demand a higher dividend, while the management would want to retain
profits for business needs. Hence, this is a complex managerial decision. The finance manager has to take
decision with regards to the net profit distribution. Net profits are generally divided into two:
a. Dividend for shareholders- Dividend and the rate of it has to be decided.
b. Retained profits- Amount of retained profits has to be finalized which will depend upon
expansion and diversification plans of the enterprise.
Objectives of Financial Management
The financial management is generally concerned with procurement, allocation and control of financial
resources of a concern. The objectives can be-
1) To ensure regular and adequate supply of funds to the concern.
2) To ensure adequate returns to the shareholders which will depend upon the earning capacity,
market price of the share, expectations of the shareholders.
3) To ensure optimum funds utilization. Once the funds are procured, they should be utilized in
maximum possible way at least cost.
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4) To ensure safety on investment,i.e., funds should be invested in safe ventures so that adequate
rate of return can be achieved.
5) To plan a sound capital structure-There should be sound and fair composition of capital so that
a balance is maintained between debt and equity capital.
Objectives of Financial Management
In order to maximise wealth, financial management must achieve the following specific
objectives:
a) To ensure availability of sufficient funds at reasonable cost (liquidity).
b) To ensure effective utilisation of funds (financial control).
c) To ensure safety of funds by creating reserves, re-investing profits, etc. (minimisation of
risk).
d) To ensure adequate return on investment (profitability).
e) To generate and build-up surplus for expansion and growth (growth).
f) To minimise cost of capital by developing a sound and economical combination of
corporate securities (economy).
g) To coordinate the activities of the finance department with the activities of other
departments of the firm (cooperation).
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Goals of Financial Management:
Profit Maximization and Wealth Maximization

Financial Management is concerned with the proper utilization of funds in such a manner that it will
increase the value plus earnings of the firm. Wherever funds are involved, financial management is
there. The firm’s investment and financing decisions are unavoidable and continues.
1. In order to make them rationally the firms must have a goal.

2. It is generally agreed in theory that the financial goal of the firm should be the
maximisation of owners’ economic welfare.
3. Owners’ economic welfare could be maximised by the shareholders wealth as reflected in
the market value of shares.
4. In this section, we show that the Shareholders Wealth Maximization (SWM) is to
theoretically logical and operationally feasible normative goal for guiding the financial
decision making.
There are two paramount objectives of the Financial Management: Profit Maximization and Wealth
Maximization. Profit Maximization as its name signifies refers that the profit of the firm should be
increased while Wealth Maximization aims at accelerating the worth of the entity. Profit
maximization is the primary objective of the concern because of profit act as the measure of efficiency.
On the other hand, wealth maximization aims at increasing the value of the stakeholders.
I. PROFIT MAXIMISATION:
a. Profit maximization means maximising the rupee or any other currency such as dollar,
pound or both income of firms.
b. Profit is a primary motivating force for any economic activity. Firms essentially being an
economic organisation, it has to maximise the interest of its stakeholders. To this the firm
has to earn profit from its operations.
c. In fact, profits are useful intermediate beacon (encouragement/inspiration/ guiding
light/symbol of hope/signal) towards which a firm’s capital should be directed.
d. McAlpine rightly remarked that profit cannot be ignored since it is both a measure of the
success of business and means of its survival and growth.
e. Profit is the positive and fruitful difference between revenues and expenses of a business
enterprise over a period of time.
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f. If an enterprise fails to make a profit, capital invested is eroded

/wrinkled/windswept and this situation prolongs, the enterprise ultimately ceases to exist.
g. The overall objective of business enterprise is to earn at least satisfactory returns on the
funds invested, consistent with maintaining a sound financial position.
Limitations:
The goal of profit maximisation has, however, been criticised in recent times because of the
following reasons:
1. Vague:
a. The term “profit” is vague and it does not clarify what exactly it means. It has
different interpretations for different people. Does it mean short-term or long-
term; total profit or net profit; profit before tax or profit after tax; return on
capital employed.
b. Profit maximisation is taken as objective, the question arises which of the
about concepts of profit should an enterprise try to maximise. Apparently, vague
expression like profit can form the standard of efficiency of financial
management.
2. Ignores Time Value of Money:
a. Time value of money refers a rupee receivable today is more valuable than a
rupee, which is going to be receivable in future period.
b. The profit maximisation goal does not help in distinguishing between the
returns receivable in different periods.
c. It gives equal importance to all earnings through the receivable in different
periods. Hence, it ignores time value of money.
3. Ignores Quality of Benefits:
a. Quality refers to the degree of certainty with which benefits can be expected.
b. The more certain expected benefits, the higher are the quality of the benefits and
vice versa.
c. Two firms may have same expected earnings available to shareholders, but if
the earnings of one firm show variations considerably when compared to the
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other firm, it will be more risky.

 Profit maximization objective leads to exploiting employees and consumers. It also leads
to colossal /vast inequalities and lowers human values that are an essential part of ideal
social systems.
 It assumes perfect competition and in the existence of imperfect competition,
it cannot be a legitimate/lawful/legal objective of any firm. It is suitable for self-
financing, private property and single ownership firms.
 A company is financed by shareholders, creditors and financial institutions and managed
and controlled by professional managers. A part from these people, there are some
others who are interested towards company (i.e., employees, government, customers and
society).
 Hence one has to take into consideration all these parties interests, which is not
possible under the objective of profit maximization. Wealth maximization
objective is the alternative of profit maximization.
II. SHAREHOLDERS WEALTH MAXIMISATION (SWM):

o On account of above discussed limitations of profit maximisations
shareholders wealth maximisation is an appropriate goal for financial decision
making.
o It is operationally feasible since it satisfies all the three requirements of a suitable
operational objective of financial courses of action namely exactness, quality of
benefits and the time value of money.
o The objective of Shareholders wealth maximization is an appropriate and operationally
feasible criterion to choose among the alternative financial actions.
o It provides an unambiguous measure of what financial management should seek to
maximise in making investment and financing decisions on behalf of owners
(shareholders).
o Shareholders Wealth Maximisation means maximising the net present value (or wealth)
of a course of action to shareholders.
o The Net Present Value (NPV) of course of action is the difference between the present
value of its benefits and present value of its costs.
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o A financial action that has a positive NPV creates wealth for ordinary shareholders and
therefore, desirable/preferable and vice versa.
o A financial action resulting in negative NPV should be rejected since it would destroy
shareholders wealth. Between a numbers of mutually exclusive projects the one with the
highest NPV should be adopted.
o The NPV of firm’s projects add. Therefore, the wealth will be maximised if this criterion
is followed in making financial decisions.
o The wealth will be maximised if this criterion is followed in making financial decisions.
o From shareholders point of view, the wealth created by corporation through financial
decisions or any decision is reflected in the market value of company shares.
o For example, take Infosys Co., whose share price is increasing year by year, even by
issue of bonus shares, and the company is trying to put its shares at popular trading level.
o Therefore, the wealth maximisation principle implies that the fundamental objective of a
firm is to maximise market value of its shares.
o In other words, the market value of the firm is represented by its market price, which in
turn is a reflection of a firm’s financial decisions.
o Hence market price acts as a firm’s performance indicator.
o A shareholders wealth at a period of time can be computed by the following formula:
SWt = NS X MPt
Where, SWt = Shareholders wealth at ‘t ’period.
NS = Number of equity shares owned (outstanding)
MPt = Market price of share at ‘t’ period.
Principles of Financial Management

Financial management is the process of managing the funds both for individuals and
organizations to ensure proper utilization of funds. Core principles of finance are applicable in
the case of principles of financial management.
1) Trade-off Risk and Return

2) Formation of Optimal Capital Structure
3) Diversification of both Investment and Borrowing
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4) Aware of Time Value of Money

5) Forecast Cash Flows
6) Take a Right Insurance Plan
7) Concentration on Wealth Maximization
8) Reinvest Rather than Consume
9) Determine Cost of Capital
10) Financial Decision Align with Business Life Cycle
1. Trade-off Risk and Return
Investors must be careful while forming a portfolio from available investment

opportunities, the choice of investment is based on the individual’s trade-off between
risk and return. There is a positive correlation between risk and return. Higher the risk
and higher the expected rate of return. A portfolio should have lower risky
investments combined with higher risk investment. A finance manager carefully deals
with this risk and return which is the core principles of finance and financial
management.
2. Formation of Optimal Capital Structure
Capital structure is the ratio of debt and equity percentage of total assets of a company.
By looking into capital structure an investor easily can understand the financing pattern
of an organization. A financially sound organization is to be more dependent on debt
financing rather than equity financing. The reason is, own fund that is equity is costly
than debt. So, at the time of financing, it is the job of a CFO or finance manager to ensure
the best mixing of debt and equity for the company so that the weighted average cost of
capital remains minimum. You cannot overlook this principle because of its importance.
3. Diversification of both Investment and Borrowing
Forming portfolio through diversification both can be applicable for investment and
borrowing. Keep in mind that, your target is to ensure the minimum cost of borrowing or
financing and a maximum reward of your investment. This you need to concern while
taking a decision is a balance between risk and return. So that overall monetary risk
remains affordable.
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4. Aware of Time Value of Money
Always be aware of the time value of money, otherwise, there is a possibility of

becoming financially looser. Money receives at the current time is more valuable than the
money receives after some time. So, when you are responsible for handling the money,
you have to keep in mind the time value of money and the average rate of that reduction
of value because of inflation or any other factors.
5. Forecast Cash Flows
Cash is the most liquid asset which flows inward or outward. The pattern of flows
influences financial decisions. More reliable cash flows are preferable rather than the
uncertain flow of cash. To ensure supply the required of cash for all the organizational
activities it is necessary to forecast the cash flows and manage the cash based on the
requirements. Holding the right amount of liquid funds is the expression of the utilization
of financial management principles.
6. Take a Right Insurance Plan
A right insurance plan will help the organization to divert the risk to the insurance
company. The diversion of risk possible in exchange for insurance premium which is
paid by the insurance taker. A financial decision is involving with the choice of insurance
policy and the amount of insurance premium is dependent on the nature of insurance
policy. So as a part of financial management, your company should take a proper
insurance plan.
7. Concentration on Wealth Maximization
Wealth maximization is the process of maximizing the value of an organization, i.e. the
maximization of the net present value of an organization. As a finance manager or top
management of an organization if you want to manage your financial condition then you
must focus on how you can maximize the value of your organization. A wealthy
company can invest more in innovative product development. This will help to grow a
company much more smoothly.
8. Reinvest Rather than Consume
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If company has adequate financial strength, then not only consume what business is
generating but also invest in the most beneficial opportunities. Reinvestment helps to
broaden the business which generates employment, value-creating, and exchange of value
to the economy. Good financial management practice is to always look for new
opportunities if you find any worthy investment opportunities then go for reinvestment of
available funds.
9. `Determine Cost of Capital
Here cost of capital indicates the expenses associated with the payment which is charged
on the supply of funds for debt and equity. The weighted average cost of capital is the
actual cost of capital which is the average cost of both equity and debt financing cost.
Effective financial management always does a comparison of financial rewards and the
cost associated with that capital cost. If the expected rates of return are more than the cost
of capital, then you can invest.
10. Financial Decision Align with Business Life Cycle
A business is always undergoing the ups and downs like a cycle. Whenever you make a
financial decision, you must consider the current position in the business life cycle and
forecasted position in the cycle. So, that you can make a plan to ensure the ultimate
financial benefit for your organization. A good financial plan helps to bring out the
sweetest juice from the investment and financing opportunities. At the life span of a
business, there may have a requirement of different financial decisions and that decision
should match with the financial condition of that business.
Time Value of Money - Compounding and Discounting

Time value of money tells, what would be the worth of value of your present money in future. In other
words, it talks about the worth of today’s money in future. Money potential increases with time.
If you invest your today’s money, for which you will get interest, it will automatically increase the
value of money. Factors like inflation and purchasing power are to be considered, while investing the
money because both can erode the value.
Money should have time value for the following reasons:
 Money can be employed productively to generate real returns;

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 In an inflationary period, a rupee today has higher purchasing power than a rupee in the
future;
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 Due to uncertainties in the future, current consumption is preferred to
future Consumption.
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 The three determinants combined together can be expressed too determine the rate of
interest as follows :
Time value of money helps investors to take decisions about where to invest, when to invest. It also
helps us to understand about interest, inflation, risk and return.
Formula
Fv = Pv * [1 + (i/n)] ^ (n*t)
Where:
Fv = future value,
Pv = present value,
i = interest rate,
t = number of years,
n = compounding periods
Important terms
Present Value = It is the value of a sum of money today.
Future Value = It is the value of a sum of money in the future.
Time Value of Money says that the worth of a unit of money is going to be changed in future. Put
simply, the value of one rupee today will be decreased in future. The whole concept is about the present
value and future value of money. There are two methods used for ascertaining the worth of money at
different points of time, namely, compounding and discounting. Compounding method is used to
know the future value of present money. Conversely, discounting is a way to compute the present
value of future money.
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Compounding is helpful to know the future values, of the cash flow, at the end of the particular period,
at a definite rate. Contrary to this, Discounting is used to determine the present value of the future cash
flow, at a certain interest rate. Here, in this article, we’ve described the differences between
compounding and discounting.
Definition of Compounding
For understanding the concept of compounding, first of all, you need to know about the term future
value. The money you invest today, will grow and earn interest on it, after a certain period, which will
automatically change its value in future. So, the worth of the investment in future is known as its Future
Value. Compounding refers to the process of earning interest on both the principal amount, as well as
accrued interest by reinvesting the entire amount to generate more interest.
Compounding is the method used in finding out the future value of the present investment. The future
value can be computed by applying the compound interest formula which is as under:
Where n = number of years, R = Rate of return on investment.
Definition of Discounting
Discounting is the process of converting the future amount into its Present Value. Now you may
wonder what is the present value? The current value of the given future value is known as Present
Value. The discounting technique helps to ascertain the present value of future cash flows by applying
a discount rate. The following formula is used to know the present value of a future sum:
Where:
1,2, 3, ….. n represents future years,
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FV = Cash flows generated in different years,

R = Discount Rate
For calculating the present value of single cash flow and annuity the following formula should be
used:
Where,
R = Discount Rate,
n = number of years
Example: Let's say we have $10,000 today and we want to find the future value if the amount
is invested for 10 years at 10% interest rate compounded annually.
We have
PV = 10000
r = 10% = 10/100 = 0.1
n = 10
So, future value FV = PV (1 + r) n
= 10000(1 + 0.1)10
= 25937.42
Example: Let's say we have the same amount $10,000 today and we want to find the future
value if the amount is invested for 10 years at 10% interest rate compounded half yearly.
We have
PV = 10000
r = 10% = 10/100 = 0.1
f = 2 (as we are compounding half yearly)
r/f = 0.1/2 = 0.05
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n = 10
fn = 2x10 = 20
So, future value FV = PV (1 + r/f) fn

= 10000(1 + 0.05)20
= 26532.98
Example: Let's calculate the present value if we are told that the discount rate is 10% and
future value 10 years from now is $10,000.
We have
FV = 10000
r = 10% = 10/100 = 0.1
n = 10
So, present value will be PV = FV/(1+r)n
= 10000/(1+0.1)10
= 9052.87
Financial Decisions
Every company is required to take three main financial decisions which are as follows:
1. Investment Decision
Resources are scarce and can be put to alternate use. A firm must choose where to invest so as to
earn the highest possible profits.
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Investment decision relates to decisions about how the firm‘s funds are invested in different
assets that is, different investment proposals.
Have two components:
• Working Capital Decisions – Short Term investment decisions.
• Capital Budgeting decisions – Long Term investment decisions
Factors affecting Investment Decisions/Capital Budgeting decisions:
o Cash flows of the project: The series of cash receipts and payments over the life of an
investment proposal should be considered and analyzed for selecting the best proposal.
o Rate of Return: The expected returns from each proposal and risk involved in them should
be taken into account to select the best proposal.
o Investment Criteria Involved: The various investment proposals are evaluated on the basis
of capital budgeting techniques. These involve calculation regarding investment amount,
interest rate, cash flows, rate of return etc.
2. Financing Decision:
 These are decisions w.r.t quantum of finance or composition of funds from various long-
term sources. (Short term = working capital Financial Management)
 Financing decisions involve:
o Decision whether or not to use a combination of ownership and borrowed funds.
o Determining their precise ratio.
 Firm needs a judicious mix of debt and equity as :
 Debt involves ‘Financial Risk‘ = risk of default on payment of interest on borrowed funds
and the repayment of the principle amount whereas
 Shareholders‘funds involve no fixed commitment w.r.t payment of returns or repayment of
capital.
 Ownership fund vs. Debt fund: They can be compared on the basis of factors such as
examples, interest/dividend payout and repayment of principle, tax deductibility, and risk
and floatation costs.
Factors Affecting Financing Decision:
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a. Cost: The cost of raising funds from different sources is different. The cheapest source
should be selected.
b. Risk: The risk associated with different sources is different. More risk is associated with
borrowed funds as compared to owner’s fund as interest is paid on it and it is repaid also,
after a fixed period of time or on expiry of its; tenure.
c. Flotation Cost: The costs involved in issuing securities such as brokers commission,
underwriters’ fees, expenses on prospectus etc. are called flotation costs. Higher the
flotation cost, less attractive is the source of finance.
d. Cash flow position of the business: In case the cash flow position of a company is good
enough then it can easily use borrowed funds and pay interest on time.
e. Control Considerations: In case the existing shareholders want to retain the complete
control of business then finance can be raised through borrowed funds but when they are
ready for dilution of control over business, equity can be used for raising finance.
f. State of Capital Markets: During boom, finance can easily be raised by issuing shares but
during depression period, raising finance by means of debt is easy.
g. Period of Finance: For permanent capital requirement, Equity shares must be issued as
they are not to be paid back and for long and medium term requirement, preference shares
or debentures can be issued.
3. Dividend Decision
 Dividend is that portion of divisible profits that is distributed to the owners i.e. the
shareholders. It results in current income for the shareholders.
 Retained earnings= proportion of profits kept in, that is, reinvested in the business for the
business.
 Dividend decision= whether to distribute earnings to shareholder as dividends or retain
earnings to finance long-term profits of the firm. Must be done keeping in mind the firms
overall objective of maximizing the shareholders wealth.
Factors affecting Dividend Decision:
a. Earnings: Companies having high and stable earning could declare high rate of dividends
as dividends are paid out of current and paste earnings.
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b. Stability of Dividends: Companies generally follow the policy of stable dividend. The
dividend per share is not altered and changed in case earnings change by small proportion
or increase in earnings is temporary in nature.
c. Growth Prospects: In case there are growth prospects for the company in the near future
them it will retain its earning and thus, no or fewer dividends will be declared.
d. Cash Flow Positions: Dividends involve an outflow of cash and thus, availability of
adequate cash is for most requirements for declaration of dividends.
e. Preference of Shareholders: While deciding about dividend the preference of
shareholders is also taken into account. In case shareholders desire for dividend then
company may go for declaring the same.
f. Taxation Policy: A company is required to pay tax on dividend declared by it. If tax on
dividend is higher, company will prefer to pay less by way of dividends whereas if tax rates
are lower than more dividends can be declared by the company.
g. Issue of bonus shares: Companies with large reserves may also distribute bonus shares to
increase their capital base as it signifies growth of the company and enhances its reputation
also.
h. Legal constraints: Under provisions of Companies Act, all earnings can’t be distributed
and the company has to provide for various reserves. This limits the capacity of company
to declare dividend.
Functions of Financial Management

1) Estimation of capital requirements: A finance manager has to make estimation with regards
to capital requirements of the company. This will depend upon expected costs and profits and
future programmes and policies of a concern. Estimations have to be made in an adequate
manner which increases earning capacity of enterprise.
2) Determination of capital composition: Once the estimation has been made, the capital
structure has to be decided. This involves short- term and long- term debt equity analysis. This
will depend upon the proportion of equity capital a company is possessing and additional funds
which have to be raised from outside parties.
3) Choice of sources of funds: For additional funds to be procured, a company has many choices
like-
a. Issue of shares and debentures

b. Loans to be taken from banks and financial institutions
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c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period of
financing.
4) Investment of funds: The finance manager has to decide to allocate funds into profitable
ventures so that there is safety on investment and regular returns is possible.
5) Disposal of surplus: The net profits decision has to be made by the finance manager. This can
be done in two ways:
a. Dividend declaration- It includes identifying the rate of dividends and other benefits
like bonus.
b. Retained profits- The volume has to be decided which will depend upon expansional,
innovation, diversification plans of the company.
6) Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries, payment
of electricity and water bills, payment to creditors, meeting current liabilities, maintenance of
enough stock, purchase of raw materials, etc.
7) Financial controls: The finance manager has not only to plan, procure and utilize the funds but
also has to exercise control over finances. This can be done through many techniques like ratio
analysis, financial forecasting, cost and profit control, etc.
CONCEPT OF RISK AND RETURN
Return expresses the amount which an investor actually earned on an investment
during a certain period. Return includes the interest, dividend and capital gains; while risk
represents the uncertainty associated with a particular task. In financial terms, risk is the
chance or probability that a certain investment may or may not deliver the actual/expected
return s.
Investors make investment with the objective of earning some tangible benefit. This
benefit in financial terminology is termed as return and is a reward for taking a specified amount of
risk.
Risk is defined as the possibility of the actual return being different from the expected
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return on an investment over the period of investment. Low risk leads to low returns. For
instance, in case of government securities, while the rate of return is low, the risk of defaulting
is also low. High risks lead to higher potential returns, but may also lead to higher losses.
Long-term returns on stocks are much higher than the returns on Government securities, but
the risk of losing money is also higher.
The risk and return trade off says that the potential return rises with an increase in
risk. It is important for an investor to decide on a balance between the desire for the lowest
possible risk and highest possible return.
Rate of return on an investment can be calculated using the following formula-
Return = (Amount received - Amount invested) / Amount invested
The functions of Financial Management involves acquiring funds for meeting short term and
long term requirements of the firm, deployment of funds, control over the use of funds and to
trade-off between risk and return.
Financial Intermediaries
A financial intermediary is an institution or individual that serves as a middleman among
diverse parties in order to facilitate financial transactions. Common types include commercial
banks, investment banks, stockbrokers, pooled investment funds, and stock exchanges. Financial
intermediaries reallocate otherwise non-invested capital to productive enterprises through a
variety of debt, equity, or hybrid stake holding structures.
Through the process of financial intermediation, certain assets or liabilities are transformed into
different assets or liabilities. As such, financial intermediaries channel funds from people who
have surplus capital (savers) to those who require liquid funds to carry out a desired activity
(investors).
A financial intermediary is typically an institution that facilitates the channelling

of funds between lenders and borrowers indirectly.
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That is, savers (lenders) give funds to an intermediary institution (such as a bank), and that
institution gives those funds to spenders (borrowers).
In the context of climate finance and development, financial intermediaries generally refer to
private sector intermediaries, such as banks, private equity, venture capital funds, leasing
companies, insurance and pension funds, and micro-creditproviders. Increasingly, international
financial institutions provide funding via companies in the financial sector, rather than directly
financing projects.
Functions performed by financial intermediaries

The hypothesis of financial intermediaries adopted by mainstream economics offers the
following three major functions they are meant to perform:
1. Creditors provide a line of credit to qualified clients and collect the premiums of debt
instruments such as loans for financing homes, education, auto, credit cards, small
businesses, and personal needs.
2. Risk transformation
3. Convenience denomination
Advantages and disadvantages of financial intermediaries

There are two essential advantages from using financial intermediaries:
1. Cost advantage over direct lending/borrowing
2. Market failure protection
The cost advantages of using financial intermediaries include:
1. Reconciling conflicting preferences of lenders and borrowers
2. Risk aversion intermediaries help spread out and decrease the risks
3. Economies of scale - using financial intermediaries reduces the costs of lending and
borrowing
4. Economies of scope - intermediaries concentrate on the demands of the lenders and
borrowers and are able to enhance their products and services
Various disadvantages have also been noted in the context of climate finance and development
finance institutions.
1. Lack of transparency
2. Inadequate attention to social and environmental concerns, and
3. Failure to link directly to proven developmental impacts.
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Types of financial intermediaries

According to the dominant economic view of monetary operations, the following institutions are
or can act as financial intermediaries:
 Banks
 Mutual Savings Banks
 Savings Banks
 Building Societies
 Credit Unions
 Financial Advisers or Brokers
 Insurance Companies
 Collective Investment Schemes
 Pension Funds
 Cooperative Societies
 Stock exchanges
Summary
Financial intermediaries are meant to bring together those economic agents with surplus funds
who want to lend (invest) to those with a shortage of funds who want to borrow. In doing this,
they offer the benefits of maturity and risk transformation. Specialist financial intermediaries are
ostensibly enjoying a related (cost) advantage in offering financial services, which not only
enables them to make profit, but also raises the overall efficiency of the economy.
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UNIT – II
Financial Statement Analysis (Numerical Problems): Analysis of Balance Sheet; Profit
&Loss Account, Ratio analysis (Numerical Problems), common size analysis, cash flow
statement, operating, financial, and combined leverage.
FINANCIAL STATEMENT ANALYSIS / RATIO ANALYSIS

Financial statements aim at providing financial information about a business enterprise to
meet the information needs of the decision-makers. Financial statements prepared by a
business enterprise in the corporate sector are published and are available to the decision-
makers. These statements provide financial data which require analysis, comparison and
interpretation for taking decision by the external as well as internal users of accounting
information. This act is termed as financial statement analysis. It is regarded as an integral
and important part of accounting. As indicated in the previous chapter, the most commonly
used techniques of financial statements analysis are comparative statements, common size
statements, trend analysis, accounting ratios and cash flow analysis. The first three have
been discussed in detail in the previous chapter. This chapter covers the technique of
accounting ratios for analyzing the information contained in financial statements for
assessing the solvency, efficiency and profitability of the enterprises.
Objectives of Ratio Analysis

Ratio analysis is indispensable part of interpretation of results revealed by the financial
statements. It provides users with crucial financial information and points out the areas
which require investigation. Ratio analysis is a technique which involves regrouping of data
by application of arithmetical relationships, though its interpretation is a complex matter. It
requires a fine understanding of the way and the rules used for preparing financial
statements. Once done effectively, it provides a lot of information which helps the analyst:
a) To know the areas of the business which need more attention;
b) To know about the potential areas which can be improved with the effort in
the desired direction;
c) To provide a deeper analysis of the profitability, liquidity, solvency and
efficiency levels in the business;
d) To provide information for making cross-sectional analysis by comparing the
performance with the best industry standards; and
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e) To provide information derived from financial statements useful for making

projections and estimates for the future.
Advantages of Ratio Analysis
The ratio analysis if properly done improves the user’s understanding of the efficiency with
which the business is being conducted. The numerical relationships throw light on many
latent aspects of the business. If properly analyzed, the ratios make us understand various
problem areas as well as the bright spots of the business. The knowledge of problem areas
help management takes care of them in future. The knowledge of areas which are working
better helps you improve the situation further. It must be emphasized that ratios are means
to an end rather than the end in them. Their role is essentially indicative and that of a whistle
blower. There are many advantages derived from ratio analysis. These are summarized as
follows:
1. Helps to understand efficacy of decisions: The ratio analysis helps you to

understand whether the business firm has taken the right kind of operating, investing
and financing decisions. It indicates how far they have helped in improving the
performance.
2. Simplify complex figures and establish relationships: Ratios help in simplifying the
complex accounting figures and bring out their relationships. They help summarise the
financial information effectively and assess the managerial efficiency, firm’s credit
worthiness, earning capacity, etc.
3. Helpful in comparative analysis: The ratios are not be calculated for one year only.
When many year figures are kept side by side, they help a great deal in exploring the
trends visible in the business. The knowledge of trend helps in making projections
about the business which is a very useful feature.
4. Identification of problem areas: Ratios help business in identifying the problem
areas as well as the bright areas of the business. Problem areas would need more
attention and bright areas will need polishing to have still better results.
5. Enables SWOT analysis: Ratios help a great deal in explaining the changes occurring
in the business. The information of change helps the management a great deal in
understanding the current threats and opportunities and allows business to do its own
SWOT (Strength-Weakness-Opportunity-Threat) analysis.
6. Various comparisons: Ratios help comparisons with certain benchmarks to assess as
to whether firm’s performance is better or otherwise. For this purpose, the
profitability, liquidity, solvency, etc., of a business, may be compared: (i) over a
number of accounting periods with itself(Intra-firm Comparison/Time Series
Analysis), (ii) with other business enterprises (Inter-firm Comparison/Cross-sectional
Analysis) and(iii) with standards set for that firm/industry (comparison with
standard(or industry expectations).
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Limitations of Ratio Analysis
Since the ratios are derived from the financial statements, any weakness in the original
financial statements will also creep in the derived analysis in the form of ratio analysis.
Thus, the limitations of financial statements also form the limitations of the ratio analysis.
Hence, to interpret the ratios, the user should be aware of the rules followed in the
preparation of financial statements and also their nature and limitations. The limitations of
ratio analysis which arise primarily from the nature of financial statements are as under:
Limitations of Accounting Data
1. Ignores Price-level Changes

2. Ignore Qualitative or Non-monetary Aspects
Variations in Accounting Practices
3. Forecasting
4. Lack of ability to resolve problems
5. Lack of standardised definitions
6. Lack of universally accepted standard levels
7. Ratios based on unrelated figures
Types of Ratios
There is a two-way classification of ratios are: (1) Traditional classification, (2)

Functional classification. The traditional classification has been on the basis of
financial statements to which the determinants of ratios belong
(1) Traditional Classification

Statement of Profit and Loss Ratios: A ratio of two variables from the
statement of profit and loss is known as statement of profit and loss ratio. For
example, ratio of gross profit to revenue from operations is known as gross profit
ratio. It is calculated using both figures from the statement of profit and loss.
Balance Sheet Ratios: In case both variables are from the balance sheet, it is
classified as balance sheet ratios. For example, ratio of current assets to current
liabilities known as current ratio. It is calculated using both figures from balance
sheet.
Composite Ratios: If a ratio is computed with one variable from the statement
of profit and loss and another variable from the balance sheet, it is called
composite ratio. For example, ratio of credit revenue from operations to trade
receivables (known as trade receivables turnover ratio) is calculated using one figure
from the statement of profit and loss (credit revenue from operations) and another
figure (trade receivables) from the balance sheet.
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(2) Functional Classification.

Although accounting ratios are calculated by taking data from financial statements but
classification of ratios on the basis of financial statements is rarely used in practice. It
must be recalled that basic purpose of accounting is to throw light on the financial
performance (profitability) and financial position (its capacity to raise money and invest
them wisely) as well as changes occurring in financial position (possible explanation of
changes in the activity level). As such, the alternative classification (functional
classification) based on the purpose for which a ratio is computed, is the most
commonly used classification which is as follows:
1. Liquidity Ratios: To meet its commitments, business needs liquid funds. The ability of
the business to pay the amount due to stakeholders as and when it is due is known as
liquidity, and the ratios calculated to measure it are known as ‘Liquidity Ratios’. These
are essentially short-term in nature.
2. Solvency Ratios: Solvency of business is determined by its ability to meet its contractual
obligations towards stakeholders, particularly towards external stakeholders, and the
ratios calculated to measure solvency position are known as ‘Solvency Ratios’. These are
essentially long-term in nature.
3. Activity (or Turnover) Ratios: This refers to the ratios that are calculated for measuring
the efficiency of operations of business based on effective utilisation of resources. Hence,
these are also known as ‘Efficiency Ratios’.
4. Profitability Ratios: It refers to the analysis of profits in relation to revenue from
operations or funds (or assets) employed in the business and the ratios calculated to meet
this objective are known as ‘Profitability Ratios’.
LIQUIDITY RATIOS
Liquidity ratios are calculated to measure the short-term solvency of the business, i.e. the
firm’s ability to meet its current obligations. These are analyzed by looking at the amounts
of current assets and current liabilities in the balance sheet. The two ratios included in this
category are current ratio and liquidity ratio.
Current Ratio
Current ratio is the proportion of current assets to current liabilities. It is expressed as
follows:
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Current Ratio = Current Assets : Current Liabilities or
Current Assets/ Current Liabilities
Current assets include current investments, inventories, trade receivables (debtors and bills
receivables), cash and cash equivalents, short-term loans and advances and other current
assets such as prepaid expenses, advance tax and accrued income, etc.
Current liabilities include short-term borrowings, trade payables (creditors and bills
payables), other current liabilities and short-term provisions.
Quick or Liquid Ratio

It is the ratio of quick (or liquid) asset to current liabilities. It is expressed as
Quick Ratio = Quick Assets: Current Liabilities or
Quick Assets / Current Liabilities
The quick assets are defined as those assets which are quickly convertible into cash. While
calculating quick assets we exclude the inventories at the end and other current assets such
as prepaid expenses, advance tax, etc., from the current assets. Because of exclusion of non-
liquid current assets it is considered better than current ratio as a measure of liquidity
position of the business. It is calculated to serve as a supplementary check on liquidity
position of the business and is therefore, also known as ‘Acid-Test Ratio’.
SOLVENCY RATIOS
The persons who have advanced money to the business on long-term basis are interested in
safety of their periodic payment of interest as well as the repayment of principal amount at
the end of the loan period. Solvency ratios are calculated to determine the ability of the
business to service its debt in the long run. The following ratios are normally computed for
evaluating solvency of the business.
1. Debt-Equity Ratio;
2. Debt to Capital Employed Ratio;
3. Proprietary Ratio;
4. Total Assets to Debt Ratio;
5. Interest Coverage Ratio.
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Debt-Equity Ratio
Debt-Equity Ratio measures the relationship between long-term debt and equity. If debt
component of the total long-term funds employed is small, outsiders feel more secure. From
security point of view, capital structure with less debt and more equity is considered
favorable as it reduces the chances of bankruptcy. Normally, it is considered to be safe if
debt equity ratio is 2: 1. However, it may vary from industry to industry. It is computed as
follows:
Debt-Equity Ratio =Long-term Debt / Shareholders’ Funds
Where:
Shareholders’ Funds (Equity) = Share capital + Reserves and Surplus +Money received
against share warrants +Share application money pending allotment
Share Capital = Equity share capital + Preference share capital
Or
Shareholders’ Funds (Equity) = Non-current Assets + Working capital – non-current liabilities
Working Capital = Current Assets – Current Liabilities
Significance: This ratio measures the degree of indebtedness of an enterprise and gives an
idea to the long-term lender regarding extent of security of the debt. As indicated earlier, a
low debt equity ratio reflects more security. A high ratio, on the other hand, is considered
risky as it may put the firm into difficulty in meeting its obligations to outsiders. However,
from the perspective of the owners, greater use of debt (trading on equity) may help in
ensuring higher returns for them if the rate of earnings on capital employed is higher than
the rate of interest payable.
Debt to Capital Employed Ratio
The Debt to capital employed ratio refers to the ratio of long-term debt to the total of
external and internal funds (capital employed or net assets). It is computed as follows:
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Debt to Capital Employed Ratio = Long-term Debt/Capital Employed(or Net Assets)
Capital employed is equal to the long-term debt + shareholders’ funds.
Alternatively, it may be taken as net assets which are equal to the total assets – current
liabilities
Capital employed shall work out to Rs. 5, 00,000 + Rs. 15,00,000 = Rs. 20,00,000.
Similarly, Net Assets as Rs. 25, 00,000 – Rs. 5,00,000 = Rs. 20,00,000 and the Debt to
capital employed ratio as Rs. 5,00,000/Rs. 20,00,000 = 0.25:1.
Significance: Like debt-equity ratio, it shows proportion of long-term debts in capital

employed. Low ratio provides security to lenders and high ratio helps management in
trading on equity. In the above case, the debt to Capital Employed ratio is less than half
which indicates reasonable funding by debt and adequate security of debt.
Proprietary Ratio
Proprietary ratio expresses relationship of proprietor’s (shareholders) funds to net assets and
is calculated as follows:
Proprietary Ratio = Shareholders’, Funds/Capital employed (or net

assets)
Rs. 15, 00,000/Rs. 20, 00,000 = 0.75: 1
Significance: Higher proportion of shareholders’ funds in financing the assets is a

positive feature as it provides security to creditors. This ratio can also be computed in
relation to total assets instead of net assets (capital employed). It may be noted that the total
of debt to capital employed ratio and proprietary ratio is equal to 1.
The debt to Capital Employed ratio is 0.25: 1 and the Proprietary Ratio 0.75 : 1 the total is
0.25 + 0.75 = 1.
In terms of percentage it can be stated that the 25% of the capital employed is funded by
debts and 75% by owners’ funds.
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Total Assets to Debt Ratio
This ratio measures the extent of the coverage of long-term debts by assets. It is calculated
as
Total assets to Debt Ratio = Total assets/Long-term debts

= Rs. 14, 00,000/Rs. 1, 50,000 = 9.33: 1
The higher ratio indicates that assets have been mainly financed by owners’ funds and the
long-term loans are adequately covered by assets. It is better to take the net assets (capital
employed) instead of total assets for computing this ratio also. It is observed that in that
case, the ratio is the reciprocal of the debt to capital employed ratio. Significance: This ratio
primarily indicates the rate of external funds in financing the assets and the extent of
coverage of their debts are covered by assets.
EXAMPLE:
From the following information, calculate Debt Equity Ratio, Total Asset
to Debt Ratio, and Debt to Capital Employed Ratio:
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Interest Coverage Ratio
It is a ratio which deals with the servicing of interest on loan. It is a measure of security of
interest payable on long-term debts. It expresses the relationship between profits available for
payment of interest and the amount of interest payable. It is calculated as follows:
Interest Coverage Ratio = Net Profit before Interest and Tax / Interest on long-term debts
Significance: It reveals the number of times interest on long-term debts is covered by the
profits available for interest. A higher ratio ensures safety of interest on debts.
Illustration: From the following details, calculate interest coverage ratio.
Net Profit After Tax Rs. 60,000; 15% Long-term debt 10, 00,000; and Tax rate 40%.
Solution:
Net Profit After Tax = Rs. 60,000
Tax Rate = 40%
In the problem NPAT given so we have to calculate NPBT to be calculate
So, Net Profit before tax = Net profit after tax × 100/ (100 – Tax rate)
= Rs. 60,000 × 100/(100 – 40)
= Rs. 1, 00,000
Interest on Long-term Debt = 15% of Rs. 10, 00,000 = Rs. 1,50,000
Net profit before interest and tax = Net profit before tax + Interest
= Rs. 1, 00,000 + Rs. 1, 50,000 = Rs. 2, 50,000
Interest Coverage Ratio = Net Profit before Interest andTax/Interest on long-term debt
= Rs. 2, 50, 000/Rs. 1, 50, 000
= 1. 67 times.
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Solution:
Revenue from Operations = ₹ 30, 00, 000
Capital Employed = Share Capital + Reserves and Surplus + Long-term Debts(or Net
Assets)
= (₹ 4,00,000 + ₹ 6,00,000)+ (₹ 1,00,000 + ₹ 3,00,000)+ (₹ 2,00,000 +₹ 2,00,000)
= ₹ 18,00,000
Fixed Assets = ₹ 8,00,000 +₹ 5,00,000 + ₹ 2,00,000+ ₹ 1,00,000 = ₹ 16,00,000
Working Capital = Current Assets – Current Liabilities
= 4, 00, 000 – 2, 00, 000 = ₹ 2, 00, 000
i. Net Assets Turnover Ratio = 30,00,000/18,00,000 = 1.67 times

ii. Fixed Assets Turnover Ratio = 30,00,000/16,00,000 = 1.88 times
iii. Working Capital Turnover Ratio = 30, 00, 000 /2, 00, 000 = 15 times.
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PROFITABILITY RATIOS
The profitability or financial performance is mainly summarized in the statement of profit
and loss. Profitability ratios are calculated to analyze the earning capacity of the business
which is the outcome of utilization of resources employed in the business. There is a close
relationship between the profit and the efficiency with which the resources employed in the
business are utilized. The various ratios which are commonly used to analyze the
profitability of the business are:
1. Gross Profit Ratio
2. Operating Ratio
3. Operating Profit Ratio
4. Net Profit Ratio
5. Return on Investment (ROI) or Return on Capital Employed (ROCE)
6. Return on Net Worth (RONW)
7. Earnings Per Share (EPS)
8. Book Value Per Share
9. Dividend Payout Ratio
10. Price Earnings Ratio.
Gross Profit Ratio

Gross profit ratio as a percentage of revenue from operations is computed to have an idea
about gross margin. It is computed as follows:
Gross Profit Ratio = Gross Profit/Net Revenue of Operations × 100
Significance: It indicates gross margin on products sold. It also indicates the margin
available to cover operating expenses, non-operating expenses, etc. Change in gross profit
ratio may be due to change in selling price or cost of revenue from operations or a
combination of both. A low ratio may indicate unfavorable purchase and sales policy.
Higher gross profit ratio is always a good sign.
Operating Ratio
It is computed to analyze cost of operation in relation to revenue from operations. It is
calculated as follows:
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Operating Ratio = (Cost of Revenue from Operations + Operating Expenses) / Net

Revenue from Operations × 100
Operating expenses include office expenses, administrative expenses, selling expenses,

distribution expenses, depreciation and employee benefit expenses etc.
Cost of operation is determined by excluding non-operating incomes and expenses such as

loss on sale of assets, interest paid, dividend received, loss by fire, speculation gain and so
on.
Operating Profit Ratio
It is calculated to reveal operating margin. It may be computed directly or as a residual of

operating ratio.
Operating Profit Ratio = 100 – Operating Ratio
Alternatively, it is calculated as under:
Operating Profit Ratio = Operating Profit/ Revenue from Operations ×

100
Where Operating Profit = Revenue from Operations – Operating Cost
Significance: Operating ratio is computed to express cost of operations excluding

financial charges in relation to revenue from operations. A corollary of it is ‘Operating
Profit Ratio’. It helps to analyze the performance of business and throws light on the
operational efficiency of the business. It is very useful forinter-firm as well as intra-firm
comparisons. Lower operating ratio is a very healthy sign.
Net Profit Ratio
Net profit ratio is based on all-inclusive concept of profit. It relates revenue from operations
to net profit after operational as well as non-operational expenses and incomes. It is
calculated as under:
Net Profit Ratio = Net Profit/Revenue from Operations × 100
35
Generally, net profit refers to profit after tax (PAT).
Significance: It is a measure of net profit margin in relation to revenue from operations.

Besides revealing profitability, it is the main variable in computation of Return on
Investment. It reflects the overall efficiency of the business, assumes great significance from
the point of view of investors.
Return on Capital Employed or Investment
It explains the overall utilization of funds by a business enterprise. Capital employed means
the long-term funds employed in the business and includes shareholders’ funds, debentures
and long-term loans. Alternatively, capital employed may be taken as the total of non-
current assets and working capital. Profit refers to the Profit Before Interest and Tax (PBIT)
for computation of this ratio. Thus, it is computed as follows:
Return on Investment (or) Capital Employed
= Profit before Interest and Tax/Capital Employed × 100
Significance: It measures return on capital employed in the business. It reveals the

efficiency of the business in utilization of funds entrusted to it by shareholders, debenture-
holders and long-term loans. For inter-firm comparison, return on capital employed funds is
considered a good measure of profitability. It also helps in assessing whether the firm is
earning a higher return on capital employed as compared to the interest rate paid.
Return on Shareholders’ Funds
This ratio is very important from shareholders’ point of view in assessing whether their
investment in the firm generates a reasonable return or not. It should be higher than the
return on investment otherwise it would imply that company’s funds have not been
employed profitably.
A better measure of profitability from shareholders point of view is obtained by determining

return on total shareholders’ funds; it is also termed as Return on Net Worth (RONW) and is
calculated as under:
36
Return on Shareholders’ Fund = Profit after Tax / Shareholders’ Fund ×

100
Earnings per Share
The ratio is computed as:
EPS = Profit available for Equity Shareholders/Number of Equity Shares
In this context, earnings refer to profit available for equity shareholders which are worked
out as Profit after Tax – Dividend on Preference Shares.
This ratio is very important from equity shareholders point of view and also for the share
price in the stock market. This also helps comparison with other to ascertain its
reasonableness and capacity to pay dividend.
Book Value per Share
This ratio is calculated as:
Book Value per share = Equity Shareholders’ Funds/No. of Equity Shares
Equity shareholder fund refers to Shareholders’ Funds – Preference Share Capital. This ratio
is again very important from equity shareholders point of view as it gives an idea about the
value of their holding and affects market price of the shares.
Dividend Payout Ratio
This refers to the proportion of earning that are distributed to the shareholders. It is
calculated as –
Dividend Payout Ratio = Dividend per Share / Earnings per Share
This reflects company’s dividend policy and growth in owner’s equity.
Price / Earnings Ratio
The ratio is computed as –
P/E Ratio = Market Price of a Share/ Earnings per Share

37
Common Size Statement Analysis

Financial statements are prepared for organizations or businesses to know about the state of
the business at that time or period. For an organization or a business owner, the importance
of financial statements is defined by its interpretation and analysis.
Importance of financial statements is different for different individuals in an organization.

For a manager, it would be the efficiency of the operations, and for a stockholder, it will be
related to the earnings and profits of the company.
What is Common Size Statement?
Common size statement is a form of analysis and interpretation of the financial statement. It
is also known as vertical analysis. This method analyses financial statements by taking into
consideration each of the line items as a percentage of the base amount for that particular
accounting period.
Common size statements are not any kind of financial ratios but are a rather easy way to
express financial statements, which makes it easier to analyze those statements.
Common size statements are always expressed in the form of percentages. Therefore, such
statements are also called 100 per cent statements or component percentage statements as all
the individual items are taken as a percentage of 100.
Types of Common Size Statements
There are two types of common size statements:
 Common size income statement

 Common size balance sheet
1. Common Size Income Statement
This is one type of common size statement where the sales is taken as the base for all
calculations. Therefore, the calculation of each line item will take into account the sales as a
base, and each item will be expressed as a percentage of the sales.
Use of Common Size Income Statement
It helps the business owner in understanding the following points

Whether profits are showing an increase or decrease in relation to the sales obtained.
Percentage change in cost of goods that were sold during the accounting period.
Variation that might have occurred in expense.
If the increase in retained earnings is in proportion to the increase in profit of the
business.
Helps to compare income statements of two or more periods.
38
Recognises the changes happening in the financial statements of the organisation,

which will help investors in making decisions about investing in the business.
2. Common Size Balance Sheet:
A common size balance sheet is a statement in which balance sheet items are being
calculated as the ratio of each asset in relation to the total assets. For the liabilities, each
liability is being calculated as a ratio of the total liabilities.
Common size balance sheets can be used for comparing companies that differ in size. The
comparison of such figures for the different periods is not found to be that useful because
the total figures seem to be affected by a number of factors.
Standard values for various assets cannot be established by this method as the trends of the
figures cannot be studied and may not give proper results.
Preparing Common Size Balance Sheet
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 Take the total of assets or liabilities as 100.

 Each individual asset is expressed as a percentage of the total assets, i.e., 100 and
different liabilities are also calculated aass per total liabilities. For example, suppose
total assets are around Rs. 4 lakhs, and inventory value is Rs. 1 lakh. In that case, it
will be counted as 25% of the total assets.
Limitations of Common Size Statement
 It is not helpful in the decision

decision-making process as it does not have any approved
benchmark.
 For a business that is impacted by fluctuations due to seasonality, it can be
misleading.
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Cash Flow Statement

1. Cash Flow Statement:
Cash flow statement is a statement showing the changes in financial position of a business
concern during different intervals of time in terms of cash and cash equivalents.
The Revised Accounting Standard-3 has made it mandatory for all listed companies to
prepare and present a cash flow statement along with other financial statements on annual
basis.
2. Cash Flows:
Cash flows are inflows and outflows of cash and cash equivalent. It implies movement in
and movement out of cash and cash equivalents. Receipt of cash from a non-cash item is
termed as ‘cash inflow’; while cash payment in respect of such item is termed as ‘cash
outflow’.
Cash:
Cash comprises of cash in hand and demand deposits with the bank.
Cash Equivalents Cash equivalents are ‘short-term highly liquid investments that are j
readily convertible into known amount of cash and which are subjected to an insignificant
risk of change in value’.
3. Objectives of Cash Flow Statement
o Useful in short-term financial planning.
o Useful inefficient cash management.
o Helpful in formulation of business policies.
o Assists in preparation of cash budget.
o Used for assessment of cash flow from various activities, viz operating, investing
and financing activities.
4. Limitations of Cash Flow Statement
o Based on historical cost principle.
o Based on secondary data.
o Ignores non-cash transactions.
o No adherence of basic accounting principles.
o Cash flow statement is not a substitute for income statement.
5. Classification of Business Activities:
Accounting Standard-3 (Revised) requires that the changes resulting in inflows and outflows
of cash and cash equivalents will be classified into following three activities:
o Cash flow from operating activities.
o Cash flow from investing activities.
o Cash flow from financing activities.
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6. Cash Flow from Operating Activities:

Operating activities are the principal revenue producing activities of the enterprise and other
activities that are not investing or financing activities.
7. Cash Flow from Investing Activities:

As per AS-3, investing activities are the acquisition and disposal of the long-term assets and
other investments, not included in cash equivalents.
Cash flow from investing activities are exhibited as follows:
8. Cash Flow from Financing Activities:

Financing activities are the activities which result in change in the size and composition of
the owner’s capital (including preference share capital) and borrowings (including
debentures) of the enterprise from other sources.
Cash flow arising from financing activities are exhibited as follows:
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9. Format of Cash Flow Statement:
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44
Dr Ravikumar Gunakala* Financial Management

UNIT – III
Cost of debt (Numerical Problems), cost of equity (Numerical Problems) – dividend
capitalization, CAPM, cost of preference shares (Numerical Problems), weighted average and
multiple costs of capital (Numerical Problems) – valuation of bonds and shares. Capital
structure planning – EBIT – EPS analysis (Numerical Problems), risks of financial leverage –
margin of safety, interest and debt service. Long term sources of Finance: venture capital.
Cost of Capital
Meaning and definition:
Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of return that
could have been earned by putting the same money into a different investment with equal risk. Thus, the
cost of capital is the rate of return required to persuade the investor to make a given investment.
Cost of capital is determined by the market and represents the degree of perceived risk by investors.
When given the choice between two investments of equal risk, investors will generally choose the one
providing the higher return.
Ezra Solomon defines “Cost of capital is the minimum required rate of earnings or cut off rate
of capital expenditure”.
Factors determining Cost of capital:

 Demand and supply of capital,
 Expected rate of inflation,
 Various risk involved,
 Debt-equity ratio of the firm.
Importance of Cost of Capital:
1. Maximization of the Value of the Firm:

For the purpose of maximization of value of the firm, a firm tries to minimise the average cost of capital.
There should be judicious mix of debt and equity in the capital structure of a firm so that the business
does not to bear undue financial risk.
2. Capital Budgeting Decisions:

Proper estimate of cost of capital is important for a firm in taking capital budgeting decisions. Generally
cost of capital is the discount rate used in evaluating the desirability of the investment project. In the
internal rate of return method, the project will be accepted if it has a rate of return greater than the cost of
capital.
In calculating the net present value of the expected future cash flows from the project, the cost of capital
is used as the rate of discounting. Therefore, cost of capital acts as a standard for allocat ing the firm’s
invest ible funds in the most optimum manner. For this reason, cost of capital is also referred to as cut-off
rate, target rate, hurdle rate, minimum required rate of return etc.
*Associate Professor, Wings Business School, Tirupati, A.P. Contact: 96422 12727 1
45
3. Decisions Regarding Leasing:

Estimation of cost of capital is necessary in taking leasing decisions of business concern.
4. Management of Working Capital:

In management of working capital the cost of capital may be used to calculate the cost of carrying
investment in receivables and to evaluate alternative policies regarding receivables. It is also used in
inventory management also.
5. Dividend Decisions:
Cost of capital is significant factor in taking dividend decisions. The dividend policy of a firm should be
formulated according to the nature of the firm— whether it is a growth firm, normal firm or declining
firm. However, the nature of the firm is determined by comparing the internal rate of return (r) and the
cost of capital (k) i.e., r > k, r = k, or r < k which indicate growth firm, normal firm and decline firm,
respectively.
6. Determination of Capital Structure:

Cost of capital influences the capital structure of a firm. In designing optimum capital structure that is the
proportion of debt and equity, due importance is given to the overall or weighted average cost of capital
of the firm. The objective of the firm should be to choose such a mix of debt and equity so that the overall
cost of capital is minimised.
7. Evaluation of Financial Performance:

The concept of cost of capital can be used to evaluate the financial performance of top management. This
can be done by comparing the actual profitability of the investment project undertaken by the firm with
the overall cost of capital.
Measurement of Cost of Capital:

Cost of capital is measured for different sources of capital structure of a firm. It includes cost of
debenture, cost of equity share capital, cost of preference share capital and weighted average cost of
capital (WACC).
A. Cost of Debentures:
The capital structure of a firm normally includes the debt capital. Debt may be in the form of debentures
bonds, term loans from financial institutions and banks etc. The amount of interest payable for issuing
debenture is considered to be the cost of debenture or debt capital (Kd). Cost of debt capital is much
cheaper than the cost of capital raised from other sources, because interest paid on debt capital is tax
deductible.
The cost of debenture is calculated in the following ways:
(i) When the debentures are issued and redeemable at par: Kd = r (1 – t)
Where, Kd = Cost of debenture

r = Fixed interest rate
t = Tax rate
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(ii) When the debentures are issued at a premium or discount but redeemable at par Kd = I/NP (1 – t)
Where, Kd = Cost of debenture

I = Annual interest payment
t = Tax rate
Np = Net proceeds from the issue of debenture.
(iii) When the debentures are redeemable at a premium or discount and are redeemable after ‘n’ period:
Kd=I(1-t)+1/N(Ry– NP) / ½ (Ry – NP)
Where, Kd = Cost of debenture.
I = Annual interest payment
t = Tax rate
NP = Net proceeds from the issue of debentures
Ry = Redeemable value of debenture at the time of maturity
Example:
B. Cost of Preference Share Capital:

For preference shares, the dividend rate can be considered as its cost, since it is this amount which the
company wants to pay against the preference shares. Like debentures, the issue expenses or the
discount/premium on issue/redemption are also to be taken into account.
(i) The cost of preference shares (KP) = DP / NP

Where, DP = Preference dividend per share
NP = Net proceeds from the issue of preference shares.
(ii) If the preference shares are redeemable after a period of ‘n’, the cost of preference shares (KP) will
be:
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Where, NP = Net proceeds from the issue of preference shares

RV = Net amount required for redemption of preference shares
DP = Annual dividend amount.
There is no tax advantage for cost of preference shares, as its dividend is not allowed deduction from
income for income tax purposes. The students should note that both in the case of debt and preference
shares, the cost of capital is computed with reference to the obligations incurred and proceeds received.
The net proceeds received must be taken into account while computing cost of capital.
C. Cost of Equity or Ordinary Shares:

The funds required for a project may be raised by the issue of equity shares which are of permanent
nature. These funds need not be repayable during the lifetime of the organisation. Calculation of the cost
of equity shares is complicated because, unlike debt and preference shares, there is no fixed rate of
interest or dividend payment.
Cost of equity share is calculated by considering the earnings of the company, market value of the shares,
dividend per share and the growth rate of dividend or earnings.
(i) Dividend/Price Ratio Method:

An Investor buys equity shares of a particular company as he expects a certain return (i.e. dividend). The
expected rate of dividend per share on the current market price per share is the cost of equity share
capital. Thus the cost of equity share capital is computed on the basis of the present value of the expected
future stream of dividends.
Thus, the cost of equity share capital (Ke) is measured by: Ke= D/P
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Where, D = Dividend per share

P = Current market price per share.
If dividends are expected to grow at a constant rate of ‘g’ then cost of equit y share capital (Ke) will be
Ke = D/P + g.
This method is suitable for those entities where growth rate in dividend is relatively stable. But this
method ignores the capital appreciation in the value of shares. A company which declares a higher
amount of dividend out of given quantum of earnings will be placed at a premium as compared to a
company which earns the same amount of profits but utilizes a major part of it in financing its expansion
programme.
(ii) Earnings/Price Ratio Method:

This method takes into consideration the earnings per share (EPS) and the market price of share. Thus, the
cost of equity share capital will be based upon the expected rate of earnings of a company. The argument
is that each investor expects a certain amount of earnings whether distributed or not, from the company in
whose shares he invests.
If the earnings are not distributed as dividends, it is kept in the retained earnings and it causes future
growth in the earnings of the company as well as the increase in market price of the share.
Thus, the cost of equity capital (Ke) is measured by:
Ke= E/P
Where, E = Current earnings per share
P = Market price per share.
If the future earnings per share will grow at a constant rate ‘g’ then cost of equit y share capital (Ke)
will be Ke = E/P+ g.
This method is similar to dividend/price method. But it ignores the factor of capital appreciation or
depreciation in the market value of shares. Adjustment of Floatation Cost There are costs of floating
shares in market and include brokerage, underwriting commission etc. paid to brokers, underwriters etc.
These costs are to be adjusted with the current market price of the share at the time of computing cost of
equity share capital since the full market value per share cannot be realised. So the market price per share
will be adjusted by (1 – f) where ‘f’ stands for the rate of floatation cost.
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Thus, using the Earnings growth model the cost of equity share capital will be:
Ke = E / P (1 – f) + g
D. Weighted Average Cost of Capital:

A firm may procure long-term funds from various sources like equity share capital, preference share
capital, debentures, term loans, retained earnings etc. at different costs depending on the risk perceived by
the investors.
When all these costs of different forms of long-term funds are weighted by their relative proportions to
get overall cost of capital it is termed as weighted average cost of capital. It is also known as composite
cost of capital. While taking financial decisions, the weighted or composite cost of capital is considered.
Importance of Weighted Average Cost of Capital:
i. It is useful in taking capital budgeting/investment decisions.

ii. It recognizes the various sources of finance from which the investment proposal derives its life-
blood (i.e., finance).
iii. It indicates an optimum combination of various sources of finance for the enhancement of the
market value of the firm.
iv. It provides a basis for comparison among projects as a standard or cut-off rate.
Computation of Weighted Average Cost of Capital:
Computation of Weighted Average cost of capital is made in the following ways:

i. The specific cost of each source of funds (i.e., cost of equity, preference shares, debts, retained
earnings etc.) is to be calculated.
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ii. Weights (i.e., proportion of each, source of fund in the capital structure) are to be computed and
assigned to each type of funds. This implies multiplication of each source of capital by appropriate
weights.
Generally, the-following weights are assigned:
 Book values of various sources of funds.
 Market values of various sources of capital.
 Marginal book values of various sources of capital.
Book values of weights are based on the values reflected by the balance sheet of a concern, prepared
under historical basis and ignoring price level changes. Most of the financial analysts prefer to use market
value as the weights to calculate the weighted average cost of capital as it reflects the current cost of
capital.
But the determination of market value involves some difficulties for which the measurement of cost of
capital becomes very difficult.
(iii) Add all the weighted component costs to obtain the firm’s weighted average cost of capital.
Therefore, weighted average cost of capital (Ko) is to be calculated by using the following
formula:
Ko = K1w1 + K2w2 + …………Knwn

Where, K1, K2 ……….. are component costs,
W1, W2 ………….. are weights.
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CAPITAL ASSET PRICING MODEL (CAPM)
William Sharpe, a financial economist developed Capital asset pricing, model in 1970.
According to his book, “portfolio theory and capital markets”, he defined risk as systematic
risk and unsystematic risk.
Systematic risk is related to interest rates, recessions etc., where perils of investing can’t be
diversified. Whereas, unsystematic risk is related to stocks.
Capital Asset pricing model states relationship between systematic risks and expected returns. It
based on mean variation concept. Formula is as follows −
Ra= Rrf+ βa∗ (Rm− Rrf)
Where,
Ra = Expected return on a security,
Rrf = Risk free rate,
Rm = Expected return of the market
Βa = The beta of the security,
(Rm− Rrf) = Equity market premium
Assumptions are mentioned below −
 Preference of investors for risk return.
 Investors’ expectations of risk and return.
 Depending on their assessments of risk and return, they make investment decisions on
rational basis.
 Investors have access to all the information.

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 Investors should have same time horizons.
Advantages of capital asset pricing model are as follows −
 Ease of use.
 Diversified portfolio.
 Systematic risk.
 Business and financial risk variability.
Disadvantages are given below −
 Risk – free rate (Rf)
 Return on market (Rm)
 Ability to borrow at risk
 Determination of project proxy beta.
Uses of CAPM are as follows −
 Security comparison − A firm will compare all the possibilities and calculate all
possibilities of risk and return and invested wisely.
 Portfolio and asset pricing − Models like CAPM, MPT helps in choosing appropriate
investments for portfolio.
 Intrinsic value − Investors takes help from book value and market stick value to
estimate. If trading value is lower than intrinsic value, then it’s a good deal.
 NPV − Since discount rate is same rate in CAPM, so it will have high in quality to NPV.
53
Capital Structure
Definition and Concept
Capital structure is the mix of the long-term sources of funds used by a firm. It is made up of debt and
equity securities and refers to permanent financing of a firm. It is composed of longterm debt, preference
share capital and shareholders’ funds.
Importance of Capital structure:
Value Maximization:
Capital structure maximizes the market value of a firm, i.e. in a firm having a properly designed capital
structure the aggregate value of the claims and ownership interests of the shareholders are maximized.
Cost Minimization:
Capital structure minimizes the firm’s cost of capital or cost of financing. By determining a proper mix of
fund sources, a firm can keep the overall cost of capital to the lowest.
Increase in Share Price:
Capital structure maximizes the company’s market price of share by increas ing earnings per share of the
ordinary shareholders. It also increases dividend receipt of the shareholders.
Investment Opportunity:
Capital structure increases the ability of the company to find new wealth- creating investment
opportunities. With proper capital gearing it also increases the confidence of suppliers of debt.
Growth of the Country:
Capital structure increases the country’s rate of investment and growth by increasing the firm’s
opportunity to engage in future wealth-creating investments.
Factors Determining Capital Structure
 Minimization of Risk :
 Control
 Flexibility
 Profitability
 Solvency
 Financial leverage or Trading on equity.
 Cost of capital.
 Nature and size of the firm.
Process of Capital Structure Decisions
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Theories of Capital Structure
Net Income (NI) Approach

Net income approach suggested by the Durand. According to this approach, the capital structure
decision is relevant to the valuation of the firm. In other words, a change in the capital structure
leads to a corresponding change in the overall cost of capital as well as the total value of the
firm.
According to this approach, use more debt finance to reduce the overall cost of capital and
increase the value of firm.
Net income approach is based on the following three important assumptions:
1. There are no corporate taxes.
2. The cost debt is less than the cost of equity.
3. The use of debt does not change the risk perception of the investor.
Net Operating Income (NOI) Approach

Another modern theory of capital structure, suggested by Durand. This is just the opposite to
the Net Income approach. According to this approach, Capital Structure decision is irrelevant to
the valuation of the firm. The market value of the firm is not at all affected by the capital
structure changes.
According to this approach, the change in capital structure will not lead to any change in the total
value of the firm and market price of shares as well as the overall cost of capital.
Modigliani and Miller (MM) Approach
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Modigliani and Miller, two professors in the 1950s, studied capital-structure theory intensely.
From their analysis, they developed the capital-structure irrelevance proposition. Essentially,
they hypothesized that in perfect markets, it does not matter what capital structure a company
uses to finance its operations. They theorized that the market value of a firm is determined by its
earning power and by the risk of its underlying assets, and that its value is independent of the
way it chooses to finance its investments or distribute dividends.
The basic M&M proposition is based on the following key assumptions:

 No taxes
 No transaction costs
 No bankruptcy costs
 Equivalence in borrowing costs for both companies and investors
 Symmetry of market information, meaning companies and investors have the same
information
 No effect of debt on a company's earnings before interest and taxes
Criticism on MM Theory:
 Lending and borrowing rates discrepancy
 Non-substitutability of personal and corporate leverages
 Transaction costs
 Institutional restrictions
 Existence of corporate tax
Traditional Approach
It is the mix of Net Income approach and Net Operating Income approach. Hence, it is also
called as intermediate approach. According to the traditional approach, mix of debt and equity
capital can increase the value of the firm by reducing overall cost of capital up to certain level of
debt. Traditional approach states that the K decreases only within the responsible limit of
financial leverage and when reaching the minimum level, it starts increasing with financial
leverage.
Assumptions
Capital structure theories are based on certain assumption to analysis in a single and convenient
manner:
 There are only two sources of funds used by a firm; debt and shares.
 The firm pays 100% of its earning as dividend.
 The total assets are given and do not change.
 The total finance remains constant.
 The operating profits (EBIT) are not expected to grow.
 The business risk remains constant.
 The firm has a perpetual life.
 The investors behave rationally.
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EBIT‐EPS Analysis in Leverage:
EBIT‐EPS analysis g i v e s a scientific basis for comparison among various financial plans
and shows ways to maximize EPS. Hence EBIT‐EPS analysis may be defined as ‘a tool of
financial planning that evaluates various alternatives of financing a project under varying
levels of EBIT and suggests the best alternative having highest EPS and determines
the most profitable level of EBIT’.
Concept of EBIT‐EPS Analysis:
The EBIT‐EBT analysis is the method that studies the leverage, i.e. comparing alternative
methods of financing at different levels of EBIT. Simply put, EBIT‐ EPS analysis
examines the effect of financial leverage on the EPS with varying levels of EBIT or under
alternative financial plans.
It examines the effect of financial leverage on the behavior of EPS under different financing
alternatives and with varying levels of EBIT. EBIT‐EPS analysis is used for making the
choice of the combination and of the various sources. It helps select the alternative that yields
the highest EPS.
We know that a firm can finance its investment from various sources such as borrowed
capital or equity capital. The proportion of various sources may also be different under
various financial plans. In every financing plan the firm’s objectives lie in maximizing EPS.
Advantages of EBIT‐EPS Analysis:

We have seen that EBIT‐EPS analysis examines the effect of financial leverage on the
behavior of EPS under various financing plans with varying levels of EBIT. It helps a
firm in determining optimum financial planning having highest EPS.
Various advantages derived from EBIT‐EPS analysis may be enumerated below:

Financial Planning:
Use of EBIT‐EPS analysis is indispensable for determining sources of funds. In case of

financial planning the objective of the firm lies in maximizing EPS. EBIT‐ EPS analysis
evaluates the alternatives and finds the level of EBIT that maximizes EPS.
Comparative Analysis:
EBIT‐EPS analysis is useful in evaluating the relative efficiency of departments, product

lines and markets. It identifies the EBIT earned by these different departments, product lines
and from various markets, which helps financial planners rank them according to
profitability and also assess the risk associated with each.
Performance Evaluation:
This analysis is useful in comparative evaluation of performances of various sources of
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funds. It evaluates whether a fund obtained from a source is used in a project that produces a
rate of return higher than its cost.
Determining Optimum Mix:
EBIT‐EPS analysis is advantageous in selecting the optimum mix of debt and equity. By
emphasizing on the relative value of EPS, this analysis determines the optimum mix of
debt and equity in the capital structure. It helps determine the alternative that gives the
highest value of EPS as the most profitable financing plan or the most profitable level of
EBIT as the case may be.
Limitations of EBIT‐EPS Analysis:
Finance managers are very much interested in knowing the sensitivity of the earnings per
share with the changes in EBIT; this is clearly available with the help of EBIT‐EPS
analysis but this technique also suffers from certain limitations, as described below
No Consideration for Risk:
Leverage increases the level of risk, but this technique ignores the risk factor. When a
corporation, on its borrowed capital, earns more than the interest it has to pay on debt, any
financial planning can be accepted irrespective of risk. But in times of poor business the
reverse of this situation arises—which attracts high degree of risk. This aspect is not dealt
in EBIT‐EPS analysis.
Contradictory Results:
It gives a contradictory result where under different alternative financing plans new equity
shares are not taken into consideration. Even the comparison becomes difficult if the number
of alternatives increase and sometimes it also gives erroneous result under such situation.
Over‐capitalization:
This analysis cannot determine the state of over‐capitalization of a firm. Beyond a

certain point, additional capital cannot be employed to produce a return in excess of the
payments that must be made for its use. But this aspect is ignored in EBIT‐EPS analysis.
Illustration
A Ltd. Has a share capital of Rs .1,00,000 divided into share of Rs. 10 each. It has a
major expansion program requiring an investment of another Rs. 50,000.
The Management is considering the following alternatives for raising this amount :
Issue of 5,000 equity shares of Rs. 10 each
Issue of 5000, 12% preference shares of Rs. 10 each
Issue of 10% debentures of Rs. 50,000
The company’s present Earnings Before Interest and Tax (EBIT) are Rs. 40,000 per
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annum subject to tax @ 50%. You are required to calculate the effect of the above
financial plan on the earnings per share presuming:
(a) EBIT continues to be the same even after expansion
(b) EBIT increases by Rs. 10,000
Solution
(a) When EBIT is Rs. 40,000 Per Annum
PROJECTED EARNING PER SHARE
PLAN I PLAN II PLAN III
EBIT Rs. 40000 Rs. 40,000 Rs. 40,000
‐Interest ‐‐‐‐‐‐ ‐‐‐‐‐‐‐ 5,000
Profit before Tax 40,000 40,000 35,000
‐Tax @ 50% 20,000 20,000 17,000
Profit for Tax 20,000 20,000 17,000
‐Pref. Dividend ‐‐‐‐‐ 6,000 ‐‐‐‐‐‐
Profit for Equity 20,000 14,000 17,000
Number of Equity shares 15,000 10,000 10,000
EPS (Rs) 1.33 1.40 1.75
(b) When EBIT is expected to increase by Rs. 10,000:

PLAN I PLAN II PLAN III
Rs. 50,000 Rs. 50,000 Rs. 50,000

EBIT
‐‐‐‐‐‐ ‐‐‐‐‐‐‐ 5,000
‐Interest
Profit before Tax 50,000 50,000 45,000
‐Tax @ 50% 25,000 25,000 22,000
Profit for Tax 25,000 25,000 22,000
‐Pref. Dividend ‐‐‐‐‐ 6,000 ‐‐‐‐‐‐
Profit for Equity 25,000 19,000 22,000
Number of Equity shares 15,000 10,000 10,000
EPS (Rs) 1.67 1.90 2.25

So, under both assumptions of EBIT, the EPS would be highest in Plan III.
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VENTURE CAPITAL
Venture capital is the capital supplied to start ups or any small business by the investors in the
form of share capital believing they have long term growth in their business.
Though, it involves risk in investing to the investors, they invest by seeing attractive payoff. The
investors are capitalists. In venture capital, ownership is distributed to limited partners.
Methods of venture capital financing are as follows −
 Equity financing − Equity financing is important for new companies, as they are not
able to give returns on time to its investors.
 Conditional loan − Lender will only charge royalty instead of interest.
 Income note − It is a form of hybrid finance but, interest and royalty rates are low.
 Participating debentures − Interest is paid on various rates at various stages.
 Convertible loans
Features of venture capital are as follows −
 High risk.
 Equity participation.
 Long term investment.
 Interest in management of the assisted firms.
Stages in venture capital are mentioned below −
 Idea generation − People who came up with different/new ideas must impress venture
capitalist, so that, they invest their money by believing the long term growth of the
business.
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 Start-up stage − Newly formed firm needs money for marketing and product
development. They already had their business plans ready.
 First stage − This stage requires large amounts, because they are into manufacturing and
sales.
 Expansion stage − After completing the first stage, they need more capital to meet their
demand by expanding their present business or to set up new business which supports
their present ones.
 Exist stage − If there are any acquisitions, mergers or IPOs, venture capitalist can sell
their shares and take their returns.
Advantages of venture capital:
 No monthly payments.
 Experienced investors.
 Network building.
 Industry experts.
 Trustworthy.
Disadvantages of venture capital:
 Dilution of ownership.
 Funds released based on the returns.
 Decision making.
 Funding is not easy.
 Cost of equity.
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UNIT –IV
Capital budgeting (Numerical Problems): Cash flows - traditional methods, discounted cash
flow methods, risk analysis, real options leasing.
Capital budgeting
Investment decision relates to the determination of total amount of assets to be held in the firm, the
composition of these assets and the business risk complexions of the firm as perceived by its
investors .It is the most important financial decision that the firm makes in pursuit of making
shareholders wealth.
Investment decision can be classified under two broad groups.
 Long –term investment decision i.e. Capital budgeting.

 Short-term investment decision i.e. Working Capital Management.
The evaluation of long-term investment decisions or investment analysis to be consistent with the
firm‘s goal involves the following three basic steps.
 Estimation or determination of cash flows.

 Determining the rate of discount or cost of capital.
 Applying the technique of capital budgeting to determine the viability of the
investment proposal.
1. Estimation of relevant cash flows.
If a firm makes an investment today, it will require an immediate cash outlay, but the benefits of
this investment will be received in future .There are two alternative criteria available for
ascertaining future economic benefits of an investment proposal-
 Accounting profit
 Cash flow.
The term accounting profit refers to the figure of profit as determined by the Income statement or
Profit and Loss Account, while cash flow refers to cash revenues minus cash expenses. The
difference between these two criteria arises primarily because of certain non-cash expenses, such as
depreciation, being charged to profit and loss account .Thus, the accounting profits have to be
adjusted for such non-cash charges to determine the actual cash inflows. In fact, cash flows are
considered to be better measure of economic viability as compared to accounting profits.
2. Determining the rate of discount or cost of capital.
It is the evaluation of investment decisions on net present value basis i.e. determine the rate of
discount .Cost of capital is the minimum rate of return expected by its investors.
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3. Applying the technique of capital budgeting to determine the viability of the investment
proposal.
Capital Budgeting is the process of making investment decisions in capital expenditures. A capital
expenditure may be defined as an expenditure the benefit of which are expected to be received over
period of time exceeding one year. Capital Budgeting technique helps to determine the viability of
the investment proposal or taking long-term investment decision.
CAPITAL BUDGETING PRROCESS:
A Capital Budgeting decision involves the following process:
 Identification of investment proposals.
 Screening the proposals.
 Evaluation of various proposals.
 Fixing priorities.
 Final approval and preparation of capital expenditure budget.
 Implementing proposal.
 Performance review.
The overall objective of capital budgeting is to maximize the profitability of a firm or the
return on investment. There are many methods of evaluating profitability of capital
investment proposals.
METHODS OF CAPITAAL BUDGETING (OR)

EVALUATION OF INVESTMENT PROPOSALS
(INVESTMENT APPRAISAL TECHNIQUES)
The various commonly used methods are as follows.
I. Traditional methods
 Payback period method or pay out or pay off method (PBP)
 Accounting Rate of Return method or Average Rate of Return (ARR)
II. Time adjusted method or discounted
method
 Net Present Value method (NPV)
 Profitability Index method (PI)
 Internal Rate of Return method (IRR)
 Net Terminal Value method (NTV)
(1) Payback period method or pay out or pay off method (PBP)
The basic element of this method is to calculate the recovery time, by year
wise accumulation of cash inflows (inclusive of depreciation) until the cash inflows equal the
amount of the original investment. The time taken to recover such original investment is
the payback period for the project.
The shorter the payback period, the more desirable is a project.
The payback period can be calculated in two different situations as follows-
(a)When annual cash inflow are equal
Payback period =
Original cost of the project (cash outlay)/ Annual net cash inflow (net earnings)
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Example. A project cost 1 , 0 0 , 000 and yields an annual cash inflow of 20,000 for 8
years, calculate payback period.
Payback period = Original cost of the project (cash outlay)/ Annual net cash inflow (net
earnings)
= 1, 00, 000/ 20,000
= 5 years.
(b) When annual cash inflows are unequal
It is ascertained by cumulating cash inflows till the time when the cumulative cash inflows
become equal to initial investment.
B
Payback period = Y+
C
Y= No of years immediately preceding the year of final recovery.
B= Balance amount still to be recovered.
C= Cash inflow during the year of final recovery.
Example: Initial Investment = 10,000 in a project

Expected future cash inflows 2000, 4000, 3000, 2000
Solution:
Calculation of Pay Back period:
Year Cash Inflows ( ) Cumulative Cash Inflows ( )
1 2000 2000
2 4000 6000
3 3000 9000
4 2000 11000
The initial investment is recovered between the 3rd and the 4th year.
Payback period = Y+ B = 3+ 1000 years = 3+ 1 years = 3 year 6months

C 2000 2
Merits of Payback period:
 No assumptions about future interest rates.

 In case of uncertainty in future, this method is most appropriate.
 A company is compelled to invest in projects with shortest payback period, if capital is a
constraint.
 It is an indication for the prospective investors specifying the payback period of their
investments.
 Ranking projects as per their payback period may be useful to firms undergoing liquidity
constraints.
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Demerits of Pay back period:
 Cash generation beyond payback period is ignored.

 The timing of returns and the cost of capital is not considered.
 The traditional payback method does not consider the salvage value of an investment.
 Percentage Return on the capital invested is not measured.
 Projects with long payback periods are characteristically those involved in long-term
planning, which are ignored in this approach.
(2) Accounting Rate of Return method or Average Rate of Return (ARRR)
This method measures the increase in profit expected to result from

investment. It is based on accounting profits and not cash flows.
ARR= Average income or return X 100
Average investment
Average investment = Original investment + Salvage value

2
Example:
A project costing 10 lacss. EBITD (Earnings before Depreciation, Interest and Taxes) during
the first five years is expected to be 2,50,000; 3,00,000 ; 3,500,000; 4,00,000 and
5,00,000. Assume 33.99% tax and 30% depreciation on WDV Method.
Solution :
Computation of Project AR R :
Particulars Yr1 Yr 2 Yr3 Yr 4 Yr 5 Average
EBITD 2,50,000 3,00,000 3,50,000 4,00,000 5,00,000 3,60,000

Less : Depreciation 3,00,000 2,10,000 1,47,000 1,02,900 72,030 1,66,386
EBIT (50,000) 90,000 2,03,000 2,97,100 4,27,970 1,93,614
Less : Tax @ 33.99% - 13,596 69,000 1,00,984 1,4 5,467 65,809
Total (50, 000) 76,404 1, 34,000 1, 96,116 2,882,503 1, 27,805
Book Value of Investment:

Beginning 10,00,0000 7, 00,000 4, 90, 000 3, 43,000 2, 40,100
End 7,00,0000 4,90,000 3,43,000 2,40,100 1,68,070

Average 8,50,000 5,95,000 4,16,500 2,91,550 2,004,085 4,71,427
ARR= Average income or return X 100 = 127805 X100 = 27.11%

Average investment 471427
65
Note: Unabsorbed depreciation of Yr. 1 is carried forward and set-off against profits of Yr. 2.
Tax is calculated on the balance off profits
= 33.99% (90,000 – 500,000)
= 13,596/-
Merits of ARR
 This method considers all the years in the life of the project.
 It is based upon profits and not concerned with cash flows.
 Quick decision can be taken when a number of capital investment proposals are being
considered.
Demerits of ARR
 Time Value of Money is not considered.

 It is biased against short-term projects.
 The ARR is not an indicator of acceptance or rejection, unless the rates are compared
with the arbitrary management target.
 It fails to measure the rate of return on a project even if there are uniform cash flows.
Net Present Value Method (NPV)

NPV= Present Value of Cash Inflows – Present Value of Cash Outflows
The discounting is done by thee entity‘s weighted average cost of capital.
The discounting factors are given by:

N (1+ i)
1
Where
i = rate of interest per annum
n = no. of years over which discounting is made.
Example:
Z Ltd. has two projects under consideration A & B, each costing 60 lacs.
The projects are mutually exclusive. Life for project A is 4 years & project B is 3 years. Salvage
value is NIL for both the projects. Tax Rate is 33. 99%. Cost of Capital is 15%.
Net Cash Inflow ( i n Lakhs)
At the end of the year Projec Project P.V. @ 155%
1 6 1 0.870
2 11 1 0.756
3 12 5 0.685
4 5 — 0.572
Solution: 0
Computation of Net Present Value of the Projects. Project A ( in Lakhs)
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Yr1 Yr. 2 Yr. 3 Yr. 4
1. Net Cash Inflow 60.00 110.00 120.00 50.00
2. Depreciation 15.00 15.00 15.00 15.00
3. PBT (1–2) 45.00 95.00 105.00 35.00

4. Tax @ 33.99% 15.30 32.29 35.70 11.90
5. PAT (3–4) 29.70 62.71 69.30 23.10

6. Net Cash Flow 44.70 77.71 84.30 38.10
(PAT+Deprn)
7. Discounting Factor 0.870 0.756 0.685 0.572
8. P.V. of Net Cash Flows 388.89 58.75 57.75 21.79
9. Total P.V. of Net Cash Flow = 177.18

10. P.V. of Cash outflow (Initial Investment) = 60.00
Net Present Value = 117.18
Project B
Yr. 1 Yr. 2 Yr. 3

1. Net Cash Inflow 100.00 130.00 50.00
2. Depreciation 20.00 20.00 20.00
3. PBT (1–2) 80.0 110.00 30.00
4. Tax @ 33.99% 27.19 37.39 10.20
5. PAT (3–4) 52.81 72.61 19.80
6. Next Cash Flow 72.81 92.61 39.80
(PAT+Dep.)
7. Discounting Factor 0.870 0.756 0.685
8. P.V. of Next Cash Flows 63.345 70.013 27.263
9. Total P.V. of Cash Inflows = 160.621
10. P.V. of Cash Outflows = 60.00 (Initial Investment)
Net Present Value = 100.621
As Project ―A has a higher Net Present Value, it has to be taken up.
Merits of Net Present Value method
 It recognizes the Time Value of Money.
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 It considers total benefits during the entire life of the

Project.
 This is applicable in case of mutually exclusive
Projects.
 Since it is based on the assumptions of cash flows, it helps in determining Shareholders
Wealth.
Demerits of Net Present Value method
 This is not an absolute measure.

 Desired rate of return may vary from time to time due to changes in cost of
capital.
 This Method is not effective when there is disparity in economic life of the
projects.
 More emphasis on net present values. Initial investment is not given due
importance.
(4)Profitability Index method (PI)
Profitability Index = P.V. of cash outflow

P.V. of cash inflow
If P.I > 1, project is accepted
P.I < 1, project is rejected
The Profitability Index (PI) signifies present value of inflow per rupee of outflow. It
helps to compare projects involving different amounts of initial investments.
Example
Initial investment 20 lacs. Expected annual cash flows 6 lacs for 10 years.
Cost of Capital @ 15%. Calculate Profitability Index.
Solution:
Cumulative discounting factor @ 15% for 10 years = 5.019
P.V. of inflows = 6.00 × 5.019 = 30.114

lacs. Profitability Index = P.V. of cash
outflow
P.V. of cash
inflow
Profitability Index = 30.114

20
= 1.51
Decision: The project should be accepted.
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Internal Rate of Return method (IRR)

Internal Rate of Return is a percentage discount rate applied in capital investment decisions
which brings the cost of a project and its expected future cash flows into equality, i.e., NPV is zero.
Example:
Project Cost Rs. 1, 10, 000
Cash Inflows:
Year 1 60,000
―2 20,000
―3 10,000
―4 50,000
Calculate the Internal Rate of Return.
Solution:
Internal Rate of Return will be calculated by the trial and error method. The cash flow is not uniform. To
have an approximate idea about such rate, we can calculate the ―Factor. It represents the same
relationship of investment and cash inflows in case of payback calculation i.e.
F= I/C
Where F = Factor
I = Original investmennt
C = Average Cash inflow per annum
Factor for the project = __110000
350000
= 3.14
The factor will be located from the table ―P.V. of an Annuity of 1 representing number of years
corresponding to estimated useful life of the asset.
The approximate value of 3.144 is located against 10% in 4 years.
We will now apply 10% and 12% to get (+) NPV and (–) NPV [Which means IRR lies in between]
Year Cash Inflows P.V. @ 10% DCFAT P.V. @ 12% DCFAT

( ) ( ) ( )
1 60,000 0.909 54,540 0.893 53,580
2 20,000 0.826 16,520 0.797 15,940
3 10,000 0.751 7,510 0.712 7,120
4 50,000 0.683 34,150 0.636 31,800
P.V. of Inflows 1,12,720 1,08,440

Less : Initial Investment 1,10,000 1,10,000
NPV 2,720 (1,560)
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Graphically,
For 2%, Difference = 4,280
↓ ↓
10% 12%
NPV 2,720 (1560)

IRR May be calculated in two ways:
Forward Method: Taking 10%, (+) NPV
IRR =10%+ NPV at 10% X Difference in rate

Total Difference
IRR =10% + 2720 X 2%
= 10% + 1.27% = 11.27%
Backward Method : Taking 12%, (–) NPV
IRR =12%+ (1560) X 2%
= 12% – 0.73% = 11.27%
The decision rule for the internal rate of return is to invest in a project if its rate of return is greater than its
cost of capital.
For independent projects and situations involving no capital rationing, then :
Situation Signifies Decision
IRR = Cost of Capital the investment is expected Indifferent between

not to change shareholder Accepting & Rejecting
wealth.
IRR > Cost of Capital The investment is expected to Accept
increase shareholders wealth
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IRR < Cost of Capital The investment is expected to Reject

decrease shareholders wealth
Merits of Internal Rate of Return method:
 The Time Value of Money is considered.

 All cash flows in the project are considered.
Demerits of Internal Rate of Return method
 Possibility of multiple IRR, interpretation may be difficult.

 If two projects with different inflow/outflow patterns are compared, IRR will lead to peculiar
situations.
 If mutually exclusive projects with different investments, a project with higher investment but
lower IRR contributes more in terms of absolute NPV and increases the shareholders‘ wealth.
When evaluating mutually exclusive projects, the one with the highest IRR may not be the one
with the best NPV.
The conflict between NPV & IRR for the evaluation of mutually exclusive projects is due to the
reinvestment assumption:
o NPV assumes cash flows reinvested at the cost of capital.
o -IRR assumes cash flows reinvested at the internal rate of return.
The reinvestment assumption may cause different decisions due to:

o Timing difference of cash flows.
o Difference in scale of operations.
o -Project life disparity.
Net Terminal Value method (NTV) Assumption:
 Each cash flow is reinvested in another project at a predetermined rate of interest.

 Each cash inflow is reinvested elsewhere immediately after the completion of the project.
Decision-making
If the P.V. of Sum Total of the Compound reinvested cash flows is greater than the P.V. of the
outflows of the project under consideration, the project will be accepted otherwise not.
Example:
Original Investment 40,000
Life of the project 4 years

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Cash Inflows 25,000 for 4 years
Cost of Capital 10% p.a.
Expected interest rates at which the cash inflows will be reinvested:

Year-end 1 2 3 4
% 8 8 8 8
Solution:
First of all, it is necessary to find out the total compounded sum which wiill be discounted back to the
present value.
Year Cash Inflows Rate of Int. (%) Yrs. of Compounding Total

Sum ( )
1 25,000 8 3 1.260 31,500
2 25,000 8 2 1.166 29,150
3 25,000 8 1 1.080 27,000

4 25,000 8 0 1.000 25,000
1 ,12,650
Present Value of the sum of compounded values by applying the discount rate @ 10%
Compounded Value of Cash Inflow = 112650

(1- i)n (1.10)4
= 1,12,650 × 0.683 = 76,940/ -
[0. 683 being the P.V. of 1 receivable after 4 years ]
NTV= 76,940 - 40, 000= 36940

Decision: The present value of reinvested cash flows, i.e., 76,940 is greater than the original cash
outlay of 40,000.
The project should be accepted as per the Net terminal value criterion.
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RISK ANALYSIS IN CAPITAL BUDGETING
It is possible to predict the outcome of some decisions with complete certainty because only one
outcome can arise. However, there are many occasions when decisions can lead to more than one
possible outcome; such situations are surrounded with uncertainty. The traditional difference between
risk and uncertainty is that the uncertainty cannot be quantified while risk can be quantified. Risk is
concerned w i t h the use of quantification of the likelihood of future outcomes. The word uncertainty
is to cover a l l future outcomes, which cannot be predicted with accuracy. People have different attitudes
towards the future. Some welcome the opportunity t o take risk they may be called risk takers or risk
seekers and others are risk averse.
An organisation’s performance i s influenced by the elements contained within its environment.

In turn the organization a l s o has an impact on its environment. The very survival of an o r g a n i s a t i o n
depends critically upon the willingness of its environment to sustain it. It is the role of the management
to predict events that are likely to occur to meet the challenges and to take advantage of any new
opportunity.
Nature of Risk:
Risk analysis should be incorporated in capital budgeting exercise. The capital budgeting decisions are based
on the benefits derived from the project. These benefits measured in terms of cash flows are estimates. The
estimation of future returns is done on the basis of various assumptions. The actual return in terms of cash
inflows depends on a variety of factors such as price, sales volume, effectiveness of advertising, competition,
cost of raw materials, manufacturing cost and so on. Each of these in turn, depends on other variables like
state of the economy, rate of inflation, etc. The accuracy of the estimates of future returns and the reliability of
the investment decision would largely depend upon the accuracy with which these factors are forecasted. The
actual return will vary from the estimated return, which is technically referred to as risk.
Thus risk with reference to investment decision is defined as "the variability in actual returns arise from a
project in future over its working life in relation to the estimated return as forecast at the time of the
initial capital budgeting decisions".
Types of Risk:
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The risk can be broken up into three types
 Certainty: It is a situation w h e r e the returns a r e assured and no variability likely to occur in

future returns. For example investment i n Government b o n d s . Fixed deposits in a
nationalized bank.
 Uncertainty: It is a situation where infinite numbers of outcomes are possible and probabilities
cannot be assigned. .
 Risk: Risk is the variability t h a t is likely, occur in future returns from the investment. In
other words, risk is a situation in which the probabilities o f future cash flows occurring
ar e known.
Source of Risk:
As explained above, risk i s associated with t h e variability of future returns of a project. The
factors which will i n f l u e n c e the f u t u r e returns of t h e p r o j e c t s may b e explained as
follows:
o Size of the investment : The size of the investment in terms o f the amount required will
determine the risk. Large s c a l e p r o j e c t s are more r i s k y t h a n small s c ale projects example,
a project involves for Rs. One cro re i n v e s t m e n t involves more r i s k tha n a project
with R s . O n e l a k h investment.
o Life o f the Project: The l i f e of the project will determine the risk i nvol ved. Longer
the life of projects more i s the risk; s h o r t e r the life of the projects less is the risk.
o Economic conditions: There are certain conditions which will influence the general level of business
activity. For example, economic and p o l i t i c a l situation in the country, Government monetary and
fiscal p o l i c i e s , etc.
o Industry Factors: These factors affect all the companies of the industry in the same w a y .
For example: industrial relations in the industry, innovation, material cost, e t c .
o Company Factors: These are i n t e r n a l to the company which will a f f e c t a

particular company only. For example, change in the management, strike in the company, fire
a c c i d e n t in the company etc.
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Real Options
Real options are a right but not an obligation to make a business decision. The concept of a real
option is crucial to the success of a business as the ability to choose the right business opportunity
bears a significant effect on the company’s profitability and growth. A real option allows the
management team to analyze and evaluate business opportunities and choose the right one.
The concept of real options is based on the concept of financial options; thus, fundamental
knowledge of financial options is crucial to understanding real options.
Types of Real Options
Real options may be classified into different groups. The most common types are: option to expand,
option to abandon, option to wait, option to switch, and option to contract.
 Option to expand is the option to make an investment or undertake a project in the future to
expand the business operations (a fast food chain considers opening new restaurants).
 Option to abandon is the option to cease a project or an asset to realize its salvage value (a
manufacturer can opt to sell old equipment).
 Option to wait is the option of deferring the business decision to the future (a fast food chain
considers opening new restaurants this year or in the next year).
 Option to contract is the option to shut down a project at some point in the future if
conditions are unfavorable (a multinational corporation can stop the operations of its branches
in a country with an unstable political situation).
 Option to switch is the option to shut down a project at some point in the future if the
conditions are unfavorable and resume it when the conditions are favorable (an oil company
can shut down the operation of one of its plants when oil prices are low and resume operation
when prices are high).
Pricing of Real Options:

The NPV method is the most straightforward approach to real options pricing. For example, for an
option to expand the business operation, we can forecast the future cash flows of this project and
discount them to the present value at the opportunity cost. We will use the option if the NPV is
positive and dismiss it if the NPV is negative. However, in a real-life setting, the NPV approach can
be hard to perform correctly.
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76

UNIT – V: (Part- A)
Dividend decisions, influencing factors, forms and special dividends. Walter, Gordon and MM
models (Numerical Problems) Linter’s model dividend practices in India. Buy back of shares,
taxation of dividends and capital gains.
Dividend Policy
Meaning of Dividend
Dividend refers to the business concerns net profits distributed among the shareholders. It may
also be termed as the part of the profit of a business concern, which is distributed among its
shareholders.
According to the Institute of Chartered Accountant of India, dividend is defined as “a

distribution to shareholders out of profits or reserves available for this purpose”.
Definition: A dividend policy can be defined as the dividend distribution guidelines provided by
the board of directors of a company. It sets the parameter for delivering returns to the equity
shareholders, on the capital invested by them in the business.
While taking such decisions, the company has to maintain a proper balance between its debt and
equity composition
What is a Dividend?
A dividend is nothing but the return declared to the equity shareholders through the distribution
of a portion of profits earned by the organization.
FORMs OF DIVIDEND
Dividend may be distributed among the shareholders in the form of cash or stock. Hence,
Dividends are classified into:
 Cash dividend
 Stock dividend
 Bond dividend
 Property dividend
Cash Dividend
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If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid
periodically out the business concerns EAIT (Earnings after interest and tax). Cash dividends are
common and popular types followed by majority of the business concerns.
Stock Dividend
Stock dividend is paid in the form of the company stock due to raising of more finance. Under
this type, cash is retained by the business concern. Stock dividend may be bonus issue. This issue
is given only to the existing shareholders of the business concern.
Bond Dividend
Bond dividend is also known as script dividend. If the company does not have sufficient funds to
pay cash dividend, the company promises to pay the shareholder at a future specific date with the
help of issue of bond or notes.
Property Dividend
Property dividends are paid in the form of some assets other than cash. It will distributed under
the exceptional circumstance. This type of dividend is not published in India.
Factors Affecting Dividend Policy
These dividend decisions of an organization are dependent upon the following determinants:
78
Funds Liquidity: It should be framed in consideration of retaining adequate working capital and
surplus funds for the uninterrupted business functioning.
Past Dividend Rates: There should be a steady rate of return on dividends to maintain stability;
therefore previous year’s allowed return is given due consideration.
Earnings Stability: When the earnings of the company are stable and show profitability, the
company should provide dividends accordingly.
Debt Obligations: The organization which has leveraged funds through debts need to pay
interest on borrowed funds. Therefore, such companies cannot pay a fair dividend to its
shareholders.
Investment Opportunities: One of the significant factors of dividend policy decision making is
determining the future investment needs and maintaining sufficient surplus funds for any further
project.
Control Policy: When the company does not want to increase the shareholders’ control over the
organization, it tries to portray the investment to be unattractive, by giving out fewer dividends.
Shareholders’ Expectations: The investment objectives and intentions of the shareholders

determine their dividend expectations. Some shareholders consider dividends as a regular
income, while the others seek for capital gain or value appraisal.
Nature and Size of Organization: Huge entities have a high capital requirement for expansion,
diversification or other projects. Also, some business may require enormous funds for working
capital and other entities require the same for fixed assets. All this impacts the dividend policy of
the company.
Company’s Financial Policy: If the company’s financial policy is to raise funds through equity,
it will pay higher dividends. On the contrary, if it functions more on leveraged funds, the
dividend payouts will always be minimal.
79
Impact of Trade Cycle: During inflation or when the organization lacks adequate funds for
business expansion, the company is unable to provide handsome dividends.
Borrowings Ability: The company’s with high goodwill has excellent credibility in the capital
as well as financial markets. With a better borrowing capability, the organization can give decent
dividends to the shareholders.
Legal Restrictions: In India, the Companies Act 1956 legally abide the organizations to pay
dividends to the shareholders; thus, resulting in higher goodwill.
Corporate Taxation Policy: If the organization has to pay substantial corporate tax or dividend
tax, it would be left with little profit to pay out as dividends.
Government Policy: If the government intervenes a particular industry and restricts the issue of
shares or debentures, the company’s growth and dividend policy also gets affected.
Divisible Profit: The last but a crucial factor is the company’s profitability itself. If the
organization fails to generate enough profit, it won’t be able to give out decent dividends to the
shareholders.
Types of Dividend Policy:
The following categories of dividend policies provide the answer to the above question:
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Stable Dividend Policy

In this policy, the company decides a fixed amount of dividend for the shareholders, which is
paid periodically. There is no change in the dividend allowed even if the company incurs loss or
generates high profit.
Regular Dividend Policy
Here, a certain percentage of the company’s profit is allowed as dividends to the shareholders.
When the gain is high, the shareholders’ earnings will also hike and vice-versa. It is one of the
most appropriate policy to be adopted for creating goodwill.
Irregular Dividend Policy
Under this changeable policy, the company may or may not pay dividends to the shareholders.
The top management i.e., the board of directors solely take all dividend decisions, as per their
priorities.
No Dividend Policy
Here, the company always retain the profits to fund further projects. Moreover, it has no
intention of declaring any dividends to its shareholders. This strategy may seem to be beneficial
for business growth but usually discourages the investors aiming for sustainable income.
Essentials of a Sound Dividend Policy:

A company’s dividend decisions and policy signify its future and financial well-being.
Therefore, it needs to be systematically framed and implemented.
Let us see the three essential steps to take flawless dividend decisions:
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1. Lower Dividends in Initial Stage: When the company is at the beginning stage and earns
little profit, it should still provide dividends to the shareholders, though less.
2. Gradual Increase in Dividends: As the company prosper and grow, the dividend should
be kept on increasing proportionately, to build shareholders’ confidence.
3. Stability: It is one of the crucial features of a superior dividend policy. When the company
can survive in the market, it should ensure a stable rate of return in the form of dividends
to its shareholders. This leads to retention of shareholders and gains investors interest, all
resulting in the enhancement of shares market value.
Importance of Dividend Policy:
Dividend policy provides as a base for all capital budgeting activities and in designing a
company’s capital structure.
Following are some of the reasons for which dividend policy is essential in every business
organization:
Develop Shareholders’ Trust: When the company has a constant net earnings
percentage, it secures a stable market value and pays suitable dividends. The shareholders
also feel confident about their investment decision, in such an organization.
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Influence Institutional Investors: A fair policy means a strong reputation in the

financial market. Thus, the company’s strong market position attracts organizational
investors who tend to leverage a higher sum to the company.
Future Prospects: The fund adequacy for next project undertaking and investment
opportunities is planned, decides its dividend policy such that to avoid illiquidity.
Equity Evaluation: The value of stocks is usually determined through its dividend policy
since it signifies the organizational growth and efficiency.
Market Value Stability of Shares: A suitable dividend policy means satisfied investors,
who would always prefer to hold the shares for the long term. This leads to stability and a
positive impact on the stocks’ market value.
Market for Preference Shares and Debentures: A company with the proficient
dividend policy may also borrow funds by issuing preference shares and debentures in
the market, along with equity shares.
Degree of Control: It helps the organization to exercise proper control over business
finance. Since, the company may land up with a shortage of funds for future
opportunities, if the company distributes maximum profit as dividends.
Raising of Surplus Funds: It also creates organizational goodwill and image in the
market because of which the company becomes capable of raising additional capital.
Tax Advantage: The tax rates are less on the qualified dividends, which are received as a
capital gain when compared to the percentage of income tax charged.
Example:
A well known Indian company, ‘Tata Chemicals Ltd.’, listed on Bombay Stock Exchange, have
a dividend policy to pay an annual return to its shareholders in the form of dividends.
The company also shares its intention of paying out special dividends on earning extraordinary
profits or other events.
It has also listed all the factors which it considers while dividend decision-making process. These
include past dividend payouts, investment opportunities, debt obligations, earnings, maintaining
reserves for adverse situations, government policy, etc.
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DIVIDEND DECISION
Dividend decision of the business concern is one of the crucial parts of the financial manager,
because it determines the amount of profit to be distributed among shareholders and amount of
profit to be treated as retained earnings for financing its long term growth. Hence, dividend
decision plays very important part in the financial management.
Dividend decision consists of two important concepts which are based on the relationship
between dividend decision and value of the firm.
Walter’s Model
Definition: According to the Walter’s Model, given by prof. James E. Walter, the dividends are
relevant and have a bearing on the firm’s share prices. Also, the investment policy cannot be
separated from the dividend policy since both are interlinked.
Walter’s Model shows the clear relationship between the return on investments or internal
rate of return (r) and the cost of capital (K). The choice of an appropriate dividend policy
affects the overall value of the firm. The efficiency of dividend policy can be shown through a
relationship between returns and the cost.
 If r>K, the firm should retain the earnings because it possesses better investment
opportunities and can gain more than what the shareholder can by re-investing. The firms
with more returns than a cost are called the “Growth firms” and have a zero payout ratio.
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 If r<K, the firm should pay all its earnings to the shareholders in the form of dividends,
because they have better investment opportunities than a firm. Here the payout ratio is
100%.
 If r=K, the firm’s dividend policy has no effect on the firm’s value. Here the firm is
indifferent towards how much is to be retained and how much is to be distributed among
the shareholders. The payout ratio can vary from zero to 100%.
Assumptions of Walter’s Model
 All the financing is done through the retained earnings; no external financing is used.
 The rate of return (r) and the cost of capital (K) remain constant irrespective of any
changes in the investments.
 All the earnings are either retained or distributed completely among the shareholders.
 The earnings per share (EPS) and Dividend per share (DPS) remain constant.
 The firm has a perpetual life.
Criticism of Walter’s Model
 It is assumed that the investment opportunities of the firm are financed through the
retained earnings and no external financing such as debt, or equity is used. In such a case
either the investment policy or the dividend policy or both will be below the standards.
 The Walter’s Model is only applicable to all equity firms. Also, it is assumed that the rate
of return (r) is constant, but, however, it decreases with more investments.
 It is assumed that the cost of capital (K) remains constant, but, however, it is not realistic
since it ignores the business risk of the firm, that has a direct impact on the firm’s value.
Note: Here, the cost of capital (K) = Cost of equity (Ke), because no external source of
financing is used.
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Illustration-1: Santosh Limited earns Rs.5 per share is capitalized at a rate of 10% and has
a rate of return on investments of 18%. According the Walter's Formula:
(i) What should be the price per share at 25% dividend pay-out ratio?
(ii) Is this optimum pay-out ratio?
Solution:
(i) Value per share as per Walter formula
(ii) As per above calculation at 25% dividend pay-out, the value of share is Rs.80. But, according
to Walter's model, it is not an optimum dividend pay-out because, in such case where internal
rate of return is more than the cost of capital (r > Ke), he has suggested zero dividend pay-out.
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Illustration-2: The details regarding three companies are given below:
Compute the value of an equity share of each of these companies applying Walter's
formula when dividend pay-out ratio is (a) 0%, (b) 20%, (c) 40%, (d) 80%, and (e) 100%.
Comment on the conclusions drawn.
Solution:
Value per share as per Walter formula
Effect of Dividend Policy on Market Price of Shares
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Miller and Modigliani theory on Dividend Policy
Definition: According to Miller and Modigliani Hypothesis or MM Approach, dividend policy

has no effect on the price of the shares of the firm and believes that it is the investment policy
that increases the firm’s share value.
The investors are satisfied with the firm’s retained earnings as long as the returns are more than
the equity capitalization rate “Ke”. What is an equity capitalization rate? The rate at which the
earnings, dividends or cash flows are converted into equity or value of the firm. If the returns are
less than “Ke” then, the shareholders would like to receive the earnings in the form of dividends.
Miller and Modigliani have given the proof of their argument, that dividends have no effect on
the firm’s share price, in the form of a set of equations, which are explained in the content below:
Assumptions of Miller and Modigliani Hypothesis
 There is a perfect capital market, i.e. investors are rational and have access to all the
information free of cost. There are no floatation or transaction costs, no investor is large
enough to influence the market price, and the securities are infinitely divisible.
 There are no taxes. Both the dividends and the capital gains are taxed at the similar rate.
 It is assumed that a company follows a constant investment policy. This implies that there
is no change in the business risk position and the rate of return on the investments in new
projects.
 There is no uncertainty about the future profits, all the investors are certain about the
future investments, dividends and the profits of the firm, as there is no risk involved.
Criticism of Miller and Modigliani Hypothesis
 It is assumed that a perfect capital market exists, which implies no taxes, no flotation, and
the transaction costs are there, but, however, these are untenable in the real life situations.
 The Floatation cost is incurred when the capital is raised from the market and thus cannot
be ignored since the underwriting commission, brokerage and other costs have to be paid.
 The transaction cost is incurred when the investors sell their securities. It is believed that
in case no dividends are paid; the investors can sell their securities to realize cash. But
however, there is a cost involved in making the sale of securities, i.e. the investors in the
desire of current income has to sell a higher number of shares.
 There are taxes imposed on the dividend and the capital gains. However, the tax paid on
the dividend is high as compared to the tax paid on capital gains. The tax on capital gains
is a deferred tax, paid only when the shares are sold.
 The assumption of certain future profits is uncertain. The future is full of uncertainties,
and the dividend policy does get affected by the economic conditions.
Thus, the MM Approach posits that the shareholders are indifferent between the dividends
and the capital gains, i.e., the increased value of capital assets.
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Gordon’s Model
Definition: The Gordon’s Model, given by Myron Gordon, also supports the doctrine that
dividends are relevant to the share prices of a firm. Here the Dividend Capitalization Model is
used to study the effects of dividend policy on a stock price of the firm.
Gordon’s Model assumes that the investors are risk averse i.e. not willing to take risks and
prefers certain returns to uncertain returns. Therefore, they put a premium on a certain return
and a discount on the uncertain returns. The investors prefer current dividends to avoid risk;
here the risk is the possibility of not getting the returns from the investments.
But in case, the company retains the earnings; then the investors can expect a dividend in future.
But the future dividends are uncertain with respect to the amount as well as the time, i.e. how
much and when the dividends will be received. Thus, an investor would discount the future
dividends, i.e. puts less importance on it as compared to the current dividends.
According to the Gordon’s Model, the market value of the share is equal to the present value of
future dividends. It is represented as:
P = [E (1-b)] / Ke-br
Where, P = price of a share
E = Earnings per share
b = retention ratio
1-b = proportion of earnings distributed as dividends
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Ke = capitalization rate
Br = growth rate
Assumptions of Gordon’s Model
 The firm is an all-equity firm; only the retained earnings are used to finance the
investments, no external source of financing is used.
 The rate of return (r) and cost of capital (K) are constant.
 The life of a firm is indefinite.
 Retention ratio once decided remains constant.
 Growth rate is constant (g = br)
 Cost of Capital is greater than br
Criticism of Gordon’s Model
 It is assumed that firm’s investment opportunities are financed only through the retained
earnings and no external financing viz. Debt or equity is raised. Thus, the investment
policy or the dividend policy or both can be sub-optimal.
 The Gordon’s Model is only applicable to all equity firms. It is assumed that the rate of
returns is constant, but, however, it decreases with more and more investments.
 It is assumed that the cost of capital (K) remains constant but, however, it is not realistic
in the real life situations, as it ignores the business risk, which has a direct impact on the
firm’s value.
Thus, Gordon model posits that the dividend plays an important role in determining the share
price of the firm.
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The Lintner Model

The Lintner model is an economic formula for determining an optimal corporate dividend
policy. It was proposed in 1956 by former Harvard Business School professor John Lintner and
focuses on two core notions:
 A company's target payout ratio.
 The speed at which current dividends adjust to the target.
Though originally a descriptive model intended to explain how firms are observed to set
dividends, the model has also been used as a prescriptive model of how firms should set
dividend policy.
Understanding the Lintner Model:

The following formula describes a mature corporation’s dividend payout:
Dt= k+ PAC(TDt − Dt − 1)+et

where:
D=Dividend
Dt= Dividend at time t, the change from the previousdividend at period (t−1)
PAC= PAC<1 is a partial adjustment coefficient
TD= Target Dividend
k= A constant
et= The error term
In 1956, John Lintner developed this dividend model through inductive research with 28 large,
public manufacturing firms.2 Although Lintner passed away years ago, his model remains the
accepted starting point for understanding how companies’ dividends behave over time.
Lintner observed the following important facets of corporate dividend policies:
1. Companies tend to set long-run target dividends-to-earnings ratios according to the

amount of positive net present value (NPV) projects they have available.
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2. Earnings increases are not always sustainable. As a result, dividend policy will not
materially change until managers can see that new earnings levels are sustainable.
While all companies wish to sustain a constant dividend payout to maximize shareholder
wealth, natural business fluctuations force companies to project the dividends in the long run,
based on their target payout ratio.
From Lintner’s formula, a company’s board of directors thus bases its decisions about dividends
on the firm’s current net income, yet adjusts them for certain systemic shocks, gradually
adapting them to shifts in income over time.
The Lintner Model and Setting Corporate Dividends
A company’s board of directors sets the dividend policy, including the rate of payout and the
date(s) of distribution. This is one case in which shareholders are not able to vote on a corporate
measure—unlike a merger or acquisition, and additional critical issues such as executive
compensation.
The three main approaches to corporate dividend policy are as follows:
1. The residual approach, in which dividend payments come out of the residual or leftover
equity only after specific project capital requirements are met. Companies using the
residual dividend approach usually attempt to maintain balance in their debt-to-equity
(D/E) ratios before making any distributions.
2. The stability approach, in which the board often sets quarterly dividends at a fraction of
yearly earnings. This reduces uncertainty for investors and provides them with a steady
source of income.
3. A hybrid of both the residual approach and stability approach, in which a company’s
board views the D/E ratio as a longer-term goal. In these cases, companies usually
decide on one set dividend that is a relatively small portion of yearly income and can be
easily maintained, as well as an extra dividend payment to distribute only when income
exceeds general levels.
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BUY-BACK OF SHARES AND SECURITIES

Definitions:
Buy-back is the process by which Company buy-back it’s Shares from the existing
Shareholders usually at a price higher than the market price. When the Company buy-back the
Shares, the number of Shares outstanding in the market reduces/fall. It is the option
available to Shareholder to exit from the Company business. It is governed by section 68 of the
Companies Act, 2013.
Reasons of Buy-back:
To improve Earnings per Share;

To use ideal cash;
To give confidence to the Shareholders at the time of falling price;
To increase promoters shareholding to reduce the chances of takeover;
To improve return on capital ,return on net-worth;
To return surplus cash to the Shareholder.
Modes of Buy-back:
A Company may buy-back its Shares or other specified Securities by any of the following
method-
 From the existing shareholders or other specified holders on a proportionate

basis through the tender offer;
 From the open market through-
 Book-Building process
 Stock Exchange
Provided that no buy-back for fifteen percent or more of the paid up capital
and reserves of the Company can be made through open market.
 From odd-lot holders.
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Sources of Buy-back:
A Company can purchase its own shares and other specified securities out of –
 Its free reserve; or

 The securities premium account; or
 The proceeds of the issue of any shares or other specified securities.
However, Buy-back of any kind of shares or other specified securities cannot be made out
of the proceeds of the earlier issue of same kind of shares or same kind of other specified
securities.
Conditions of Buy-back:-
As per Section 68 of the Companies Act, 2013 the conditions for Buy-back of shares are-
Articles must authorize otherwise Amend the Article by passing Special Resolution in
General Meeting.
For buy-back we need to pass Special Resolution in General Meeting, but if the buy-
back is up to 10%, then a Resolution at Board Meeting need to be passed .
Maximum number of Shares that can be brought back in a financial year is twenty-five
percent of it’s paid up share capital.
Maximum amount of Shares that can be brought back in a financial year is twenty-five
percent of paid up share capital and free reserves (where paid up share capital includes
equity share capital and preference share capital; & free reserves includes securities
premium).
Post buy-back debt-equity ratio cannot exceed 2:1.
Only fully paid up shares can be brought back in a financial year.
Company must declare its insolvency in Form SH-9 to Register of Companies,
signed by At least 2 Directors out of which one must be a Managing Director, if any.
The notice of the meeting for which the Special Resolution is proposed to be passed
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shall be accompanied by a explanatory statement stating-

A full and complete disclosure of all the material facts;
The necessity of buy-back;
The class of shares intended to be bought back;
The amount invested under the buyback;
The time limit for completion of buyback;
The Company must maintain a Register of buy-back in Form SH-10.
Now, Submit Return of buy-back in Form SH-11 Annexed with Compliance
Certificate in Form SH-15, Signed by 2 Directors out of which One must be a Managing
Director, if any.
A Company should extinguish and physically destroy shares bought back within 7 days
of completion of the buy-back.
Observe 6 months cooling period i.e. no fresh issue of share is allowed.
No offer of buy-back should be made by a company within a period of one year from
the date of the closure of the preceding offer of buy-back.
The buy-back should be completed within a period of one year from the date of
passing of Special Resolution or Board Resolution, as the case may be.
Transfer of certain sum to Capital Redemption Reserve Account (CRR)
According to section 69 of the Companies Act, 2013, where a Company brought back
shares out of free reserves or out of the securities premium account, then an amount equal to
the nominal value of the shares need to be transferred to the Capital Redemption Reserve
Account. Such transfer detailed to be disclosed in the Balance sheet.
The Capital Redemption Reserve account may be utilized for paying unissued shares of the
company to the members as fully paid bonus shares.
Restrictions on Buy-back of Securities in certain circumstances
According to section 70 of the Companies Act, 2013, A Company should not buy-back its
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securities or other specified securities , directly or indirectly -
Through any subsidiary including its own subsidiaries; or

Through investment or group of investment Companies; or
When Company has defaulted in repayment of deposits or interest payable
thereon, or in redemption of debentures or preference shares or repayment of any term
loan.
The prohibition is lifted if the default has been remedied and a period of 3 years has
elapsed after such default ceased to subsist.
When Company has defaulted in filing of Annual Return, declaration of dividend &
financial statement.
Conclusion
Thus, it can be concluded that Indian companies announce buyback in response to

undervaluation position of their stocks in capital markets and they are well supported by
availability of sufficient cash balance available for the same. Thus, on one hand, premium
offered in terms of buyback prices announced offers an exit opportunity for shareholders and
on the other hand, it offers an opportunity for the company to use its liquidity position to
extinguish its shares today and issue them again in future.
It prevents takeovers and mergers thus preventing monopolization and aiding the survival of
consumer sovereignty. On the other hand Buy back can help in manipulating the records in
flatting share prices Price- Earnings Ratio, Earning per share, thus misleading shareholders.
Thus, knowledge of the impacts of Buy-back becomes vital and every shareholder must
reconsider all his views before purchasing the shares of companies involved in the process
of Buy- back.
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UNIT – V: (Part- B)
Working capital Management (Numerical Problems): Operating cycle estimation (Numerical

Problems), cash, inventory and receivables management (Numerical Problems).
WORKING CAPITAL
According to the definition of J.S.Mill, “The sum of the current asset is the working capital of
a business”.
According to the definition of Weston and Brigham, “Working Capital refers to a firm’s
investment in short-term assets, cash, short-term securities, accounts receivables and
inventories”.
Gross Working Capital
Gross Working Capital is the general concept which determines the working capital concept.
Thus, the gross working capital is the capital invested in total current assets of the business
concern.
Gross Working Capital is simply called as the total current assets of the concern.
GWC = CA
Net Working Capital
Net Working Capital is the specific concept, which considers both current assets and current
liability of the concern.
Net Working Capital is the excess of current assets over the current liability of the concern
during a particular period.
If the current assets exceed the current liabilities it is said to be positive working capital; it is
reverse, it is said to be Negative working capital.
NWC = C A – CL
FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS:
1. Nature of business: Working Capital of the business concerns largely depend upon the
nature of the business. If the business concerns follow rigid credit policy and sell goods
only for cash, they can maintain lesser amount of Working Capital. A transport company
maintains lesser amount of Working Capital while a construction company maintains
larger amount of Working Capital.
2. Production cycle: Amount of Working Capital depends upon the length of the production
cycle. If the production cycle length is small, they need to maintain lesser amount of
Working Capital. If it is not, they have to maintain large amount of Working Capital.
3. Business cycle: Business fluctuations lead to cyclical and seasonal changes in the
business condition and it will affect the requirements of the Working Capital. In the
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booming conditions, the Working Capital requirement is larger and in the depression
condition, requirement of Working Capital will reduce. Better business results lead to
increase the Working Capital requirements.
4. Production policy: It is also one of the factors which affect the Working Capital
requirement of the business concern. If the company maintains the continues production
policy, there is a need of regular Working Capital. If the production policy of the company
depends upon the situation or conditions, Working Capital requirement will depend upon
the conditions laid down by the company.
5. Credit policy: Credit policy of sales and purchase also affect the Working Capital
requirements of the business concern. If the company maintains liberal credit policy to
collect the payments from its customers, they have to maintain more Working Capital. If
the company pays the dues on the last date it will create the cash maintenance in hand and
bank.
6. Growth and expansion: During the growth and expansion of the business concern,
Working Capital requirements are higher, because it needs some additional Working
Capital and incurs some extra expenses at the initial stages.
7. Availability of raw materials: Major parts of the Working Capital requirements are
largely depend on the availability of raw materials. Raw materials are the basic
components of the production process. If the raw material is not readily available, it leads
to production stoppage. So, the concern must maintain adequate raw material; for that
purpose, they have to spend some amount of Working Capital.
8. Earning capacity: If the business concern consists of high level of earning capacity,
they can generate more Working Capital, with the help of cash from operation. Earning
capacity is also one of the factors which determine the Working Capital requirements of
the business concern.
COMPUTATION (OR ESTIMATION) OF WORKING CAPITAL
Working Capital requirement depends upon number of factors, which are already discussed
in the previous parts. Now the discussion is on how to calculate the Working Capital needs
of the business concern. It may also depend upon various factors but some of the common
methods are used to estimate the Working Capital.
A. Estimation of components of working capital method
Working capital consists of various current assets and current liabilities. Hence, we have
to estimate how much current assets as inventories required and how much cash required
meeting the short term obligations.
Finance Manager first estimates the assets and required Working Capital for a particular
period.
B. Percent of sales method
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Based on the past experience between Sales and Working Capital requirements, a ratio
can be determined for estimating the Working Capital requirement in future. It is the
simple and tradition method to estimate the Working Capital requirements.
Under this method, first we have to find out the sales to Working Capital ratio and
based on that we have to estimate Working Capital requirements. This method also
expresses the relationship between the Sales and Working Capital.
C. Operating cycle
Working Capital requirements depend upon the operating cycle of the business. The
operating cycle begins with the acquisition of raw material and ends with the collection of
receivables.
Operating cycle consists of the following important s t a g e s :
Raw Material and Storage Stage, (R)
Work in Process Stage, (W)
Finished Goods Stage, (F)
Debtors Collection Stage, (D)
Creditors Payment Period Stage. (C)
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Cash Management
Definition: Cash Management refers to the collection, handling, control and investment of the
organizational cash and cash equivalents, to ensure optimum utilization of the firm’s liquid
resources. Money is the lifeline of the business, and therefore it is essential to maintain a sound
cash flow position in the organization.
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Objectives of Cash Management:
Fulfil Working Capital Requirement: The organization needs to maintain ample liquid
cash to meet its routine expenses which possible only through effective cash
management.
Planning Capital Expenditure: It helps in planning the capital expenditure and
determining the ratio of debt and equity to acquire finance for this purpose.
Handling Unorganized Costs: There are times when the company encounters
unexpected circumstances like the breakdown of machinery. These are unforeseen
expenses to cope up with; cash surplus is a lifesaver in such conditions.
Initiates Investment: The other aim of cash management is to invest the idle funds in the
right opportunity and the correct proportion.
Better Utilization of Funds: It ensures the optimum utilization of the available funds by
creating a proper balance between the cash in hand and investment.
Avoiding Insolvency: If the business does not plan for efficient cash management, the
situation of insolvency may arise. It is either due to lack of liquid cash or not making a
profit out of the money available.
Cash Management Models
Cash management requires a practical approach and a strong base to determine the requirement
of cash by the organization to meet its daily expenses. For this purpose, some models were
designed to determine the level of money on different parameters.
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The two most important models are discussed in detail below:
The Baumol’s EOQ Model
Based on the Economic Order Quantity (EOQ), in the year 1952, William J. Baumol gave the
Baumol’s EOQ model, which influences the cash management of the company.
This model emphasizes on maintaining the optimum cash balance in a year to meet the business
expenses on the one hand and grab the profitable investment opportunities on the other side.
The following formula of the Baumol’s EOQ Model determines the level of cash which is to be
maintained by the organization:
Where,
‘C’ is the optimum cash balance;
‘F’ is the fixed transaction cost;
‘T’ is the total cash requirement for that period;
‘i’ is the rate of interest during the period
The Miller – Orr’ Model
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According to Merton H. Miller and Daniel Orr, Baumol’s model only determines the cash
withdrawal; however, cash is the most uncertain element of the business.
There may be times when the organization will have surplus cash, thus discouraging
withdrawals; instead, it may require to make investments. Therefore, the company needs to
decide the return point or the level of money to be maintained, instead of determining the
withdrawal amount.
This model emphasizes on withdrawing the cash only if the available fund is below the return
point of money whereas investing the surplus amount exceeding this level.
Given below is the graphical representation of this model:
Where,
‘Z’ is the spread of cash;
‘UL’ is the upper limit or maximum level
‘LL’ is the lower limit or the minimum level
‘RP’ is the Return Point of cash
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We can see that the above graph indicates a lower limit which is the minimum cash a business
requires to function. Adding up the spread of cash (Z) to this lower limit gives us the return point
or the average cash requirement.
However, the company should not invest the sum until it reaches the upper limit to ensure
maximum return on investment. This upper limit is derived by adding the lower limit to the three
times of spread (Z). The movement of cash is generally seen across the lower limit and the upper
limit.
Let us now discuss the formula of the Miller – Orr’ model to find out the return point of cash and
the spread across the minimum level and the maximum level:
Where,
‘Return Point’ is the point at which money is to be invested or withdrawn;
‘Minimum Level’ is the minimum cash required for business sustainability;
‘Z’ is the spread across the minimum level and the maximum level;
‘T’ is the transaction cost per transfer;
‘V’ is the variance of daily cash flow per annum;
‘i’ is the daily interest rate
Functions of Cash Management
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Cash management is required by all kinds of organizations irrespective of their size, type and
location. Following are the multiple managerial functions related to cash management:
Investing Idle Cash: The company needs to look for various short term investment
alternatives to utilize surplus funds.
Controlling Cash Flows: Restricting the cash outflow and accelerating the cash inflow is
an essential function of the business.
Planning of Cash: Cash management is all about planning and decision making in terms
of maintaining sufficient cash in hand and making wise investments.
Managing Cash Flows: Maintaining the proper flow of cash in the organization through
cost-cutting and profit generation from investments is necessary to attain a positive cash
flow.
Optimizing Cash Level: The organization should continuously function to maintain the
required level of liquidity and cash for business operations.
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Cash Management Strategies
Cash management involves decision making at every step. It is not an immediate solution but a
strategical approach to financial problems. Following are the strategies of cash management:
Business Line of Credit: The organization should opt for a business line of credit at an
initial stage to meet the urgent cash requirements and unexpected expenses.
Money Market Fund: While carrying on a business, the surplus fund should be invested
in the money market funds. These are readily convertible into cash whenever required
and yield a considerable profit over the period.
Lockbox Account: This facility provided by the banks enable the companies to get their
payments mailed to its post office box. This lockbox is managed by the banks to avoid
manual deposit of cash regularly.
Sweep Account: The organizations should avail the facility of sweep accounts which is a
mix of savings and fixed deposit account. Thus, the minimum balance of the savings
account is automatically maintained, and the excess sum is transferred to the fixed
deposit account.
Cash Deposits (CDs): If the company has a sound financial position and can predict the
expenses well along with availing of a lengthy period, it can invest the surplus cash in the
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cash deposits. These CDs yield good interest, but early withdrawals are liable to
penalties.
Cash Flow Management Techniques
Managing cash flow is a contemplative process and requires a lot of analytical thinking. The
various techniques or tools used by the managers to practice cash flow management are as
follows:
Accelerating Collection of Accounts Receivable: One of the best ways to improve cash
inflow and increase liquid cash by collecting the debts and dues from the debtors readily.
Stretching of Accounts Payable: On the other hand, the company should try to extend
the payment of dues by acquiring an extended credit period from the creditors.
Cost Cutting: The company must look for the ways of reducing its operating cost to
main a good cash flow in the business and improve profitability.
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Regular Cash Flow Monitoring: Keeping an eye on the cash inflow and outflow,
prioritizing the expenses and reducing the debts to be recovered, makes the
organization’s financial position sound.
Wisely Using Banking Services: The services such as a business line of credit, cash
deposits, lockbox account and sweep account should be used efficiently and intelligently.
Upgrading with Technology: Digitalization makes it convenient for the organizations to
maintain the financial database and spreadsheets to be assessed from anywhere anytime.
Limitations of Cash Management
Cash management is an inevitable part of business organizations. However, it has a few

shortcomings which make it unsuitable for small organizations; these are as follows:
Cash management is a very time consuming and skilful activity which is required to be
performed regularly.
As it requires financial expertise, the company may need to hire consultants or other experts to
perform the task by paying administrative and consultation charges.
Small business entities which are managed solely face problems such as lack of skills,
knowledge, time and risk-taking ability to practice cash management.
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Inventory Management
Definition: Inventory management is an approach for keeping track of the flow of inventory. It
starts right from the procurement of goods and its warehousing and continues to the outflow of
the raw material or stock to reach the manufacturing units or to the market, respectively. The
process can be carried out manually or by using an automated system.
When the goods arrive at the premises, inventory management ensures receiving, counting,
sorting, arrangement, storage and maintenance of these items, i.e. stock, raw material,
components, tools, etc., efficiently.
To see how this whole system functions, we should first understand the flow of inventory in an
organization. The same has been represented in the following diagram:
Here, the goods which are stored in the warehouse can be utilized in the following two ways:
 Direct distribution in the market i.e., to the wholesalers, dealers, retailers or customer; or
 Sent to the production units for manufacturing of finished goods.
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There are many inventory management techniques available for organizations to choose from.
Some of the most common ones are EOQ (economic order quantity), ABC analysis, just-in-time
management, EQR model, VED analysis, LIFO (last in last out) and FIFO (first in first out).
Inventory Management Objectives:
Inventory management is performed to simplify the operational activities. Some of the primary
objectives for which it is carried out are as follows:
 Preventing Dead Stock or Perishability: With an optimal inventory level, the chances of
wastage in the form of goods spoilage or dead stock.
 Optimizing Storage Cost: It reduces the chances of maintaining excessive stock, even the
requirements are pre-determined, which ultimately cuts done the unnecessary warehousing
costs.
 Maintaining Sufficient Stock: Now, the production department need not worry about the
shortage of raw material or goods because of its constant supply.
 Enhancing Cash Flow: Inventory has a significant impact on the cash flow of the
company. With effective inventory management, the organization can ensure sufficient
liquid cash to enhance its operational efficiency.
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 Reducing the Inventories’ Cost Value: When there is a constant purchase of goods or
stock, the organization can ask for discounts and other benefits to decrease the purchase
price.
Types of Inventory Management
While installing an inventory management system, the organization has to consider the various
aspects like cost, budget, utility and accessibility. However, it can be classified into the following
types:
Bar-code Inventory Management
The barcode system is its automated and simplified version. The management can find out the
stock remaining with just one click on a computer device. The scanned barcodes enable the
software to maintain a track of all the purchases and the flow of inventory.
Continuous Inventory Management
It links the barcode and radio frequency identification with the accounting inventory system,
inventory received, and point of sales systems along with the production system, to trace the path
of inventory movement. It is mostly beneficial for accounting purpose. This is also termed as
perpetual inventory management.
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Periodic Inventory Management
It is a manual process, which is used for determining the closing inventory value, for putting it
up in the ledger at the end of a financial year. Depending on the organizational need, it can also
be analyzed quarterly. However, it is a time-consuming way, since the inventory has to be
physically counted.
Inventory Management Process
Since it is a process of identifying and resolving inventory-related obstacles. Given below is the
step by step method of improving the organization’s inventory management system:
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Step 1: Determining the Loopholes
The foremost step is to evaluate the inventory requirement and the actual stock of the goods.
Also, the reasons for this gap between the demand and inventory should be ascertained.
Step 2: Analyzing Consumer Demand and Spending Patterns
The market demand forecasting holds equal importance. This is because it helps the organization
to estimate the production quantity, which ultimately leads to the maintenance of adequate
inventory.
Step 3: Evaluating the Cost Involved
Its implementation involves different types of expenses such as warehousing, maintenance,

transport, bulk discounts and supply chain costs. Each of these should be well analyzed.
Step 4: Identifying the Extent of Process Automation
It is not possible for every organization to completely automate the inventory management
process. However, the management can recognize those particular areas where there are
possibilities of automation.
Step 5: Inspecting Supplier’s Practices and Performance
The next step is to find out the suppliers’ inventory management practices since this strategy
cannot be implemented solely. If the supplier is resistant to change and tends to proceed with the
traditional means, the organization needs to look for alternative vendors.
Step 6: Classifying Inventories into Different Categories
The goods have to be segregated into various categories depending upon the product type,
customer class, maintenance cost or profit margin.
Step 7: Setting Objectives for Each Inventory Category
To efficiently manage and track the performance of the applied technique for each category, it is
essential to set individual goals. It not only provides a base for benchmarking but also identifies
the problems and issues faced in each of these categories.
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Step 8: Prioritizing the Areas of Improvement
Now, that we are aware of the problems, the next step is about finding out the density of each
issue and its impact. The concerns which can be resolved immediately needs to be addressed
first. And then, the ones which are complex and requires restoration should be considered.
Step 9: Taking Advice or Opinion from Experts
Designing an appropriate inventory management system is the task of the personnel who
specialize in the field. Thus, at this stage, the organization needs to hire consultants or experts for
advice and opinion on current technology and problem fixation within the desired budget.
Step 10: Framing Suitable Inventory Management Policy
The last step is to implement a satisfactory inventory management strategy for the desired
change. This improvement should be incorporated as an inventory management policy to deal
with the changes in demand and add value to customer experience.
Importance of Inventory Management
The evolving technology and changing consumer preference have significantly brought forward
the need for a robust inventory management system. Given below are some of the most
prominent reason for which it is considered beneficial for every business entity:
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Enables Enterprise Resource Planning (ERP)
The ERP software accommodates and links the different business operations. These are
inventory procurement, warehousing, production, human resource, finance, marketing and sales
to one another. In this process, inventory management contributes its part of providing the
necessary data.
Proper Warehouse Management
The barcode system, LIFO and FIFO techniques provide a clear picture of the past and present
inventory available with the company to optimize the warehousing functions.
Efficient Inventory Valuation
It provides for proper evaluation of the different types of inventory, i.e., stock in hand, opening
and closing stocks, raw material, finished goods, etc. This data is also used to prepare the cost
sheet.
Supports Supply Chain Management
Being a segment of supply chain management, it is responsible for streamlining all the
warehousing operations and flow of raw material or stock.
Manages Sales Operations
Sales, as we know, is a continuous process which depends upon the production of goods or
services. If there is inefficient inventory management in the organization, the chances of
unavailability of raw material for manufacturing may arise.
Challenges Faced in Inventory Management
Inventory management has become an inevitable part of significant business entities. Also, many
small organizations have adopted the concept to keep track of their stock and raw material.
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But while practically implementing it, the companies have to deal with the following limitations:
 Lack of Knowledge: The personnel at the receiving and warehousing departments may
lack the required expertise and adequate knowledge of segregating the regular and seasonal
goods out of the whole stock.
 Expanding Product Portfolios: The customers’ demand and requirements for a wide range
of products have tremendously increased the inventory size, making it difficult to manage,
manually.
 Supply Chain Complexity: The organization, at times, fail to track the stock or goods
during the supply chain process. Moreover, it is not necessary that the business partners
also maintain an inventory management system, creating hurdles.
Conclusion
Inventory management is a useful method for simplifying all the warehousing activities of the
organization. With this technique, the company can now access and determine its stock and
inventory with efficiency to smoothen all the business operations.
It has also proved to be a valuable tool for maintaining the working capital requirement.
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Inventory Management Techniques

Definition: Inventory management techniques can be seen as a useful tool in the hands of the
management. It ensures the availability of the right type of stock, at the right time, at the right
place and in the desired quantity. It also enables the managers to match the inventory shown in
the books of accounts with that available.
Example: A garment manufacturing industry found that in the financial year 2018-19, it ha
increased its sales by 33%. However, the Cash Flow statement depicted a very low balance,
indicating that the company lacks sufficient operating capital.
On analyzing the books of accounts, it was found that the company has blocked its working
capital in the excess inventory.
The stock was maintained in a vast quantity taking up the warehouse space, demanding high
maintenance cost and some of the stock even became obsolete.
All this is the result of substandard and unplanned inventory management.
Different Techniques of Inventory Management
Before starting with the explanation of each of these methods; please note that there is no perfect
way of inventory management. Instead, an organization can go for one or more techniques to
plan, manage and optimize its inventory.
Now, let’s move on to the detailed description of various inventory management techniques:
First-In, First-Out (FIFO)
First in, first out is the most prominent inventory valuation method for managing the perishable
goods. These include flowers, fruits, vegetables, fish and meat products, dairy items, chemicals
and pharmaceuticals.
FIFO states that the goods which were received first (old stock) needs to be consumed initially.
Thus, reducing the spoilage of those goods which have a short shelf life.
For this purpose, the store in-charge must ensure proper arrangement of stock. It should be
such that the newest batches should be placed in the last shelves, whereas the oldest ones should
be kept in front.
One of the ways of organizing the goods is through their batch numbers or expiry dates.
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In reselling businesses, this method also optimizes the inventory for non-perishable items that
have occupied the store space, since a long time.
When the same product is ready to be launched with new features look, packaging or design;
FIFO is used to avoid antiquity of the left out old stock.
Last-In, Last-Out (LIFO)
Last in last out is an inventory valuation technique used for the goods which are non-perishable
and homogeneous. Some of these are bricks, cement, stones, sand, etc.
Since this type of stock is usually arranged in piles, the newest lot is on the top. Therefore, the
most recent goods have to be used first, followed by the oldest stock, which is at the bottom.
Though, this technique shows a superior income statement; the balance sheet is poorly
valued with old stock.
Also, the International Financing Reporting Standards (IFRS) and the Accounting Standards for
Private Enterprises (ASPE) forbids the use of LIFO in accounting. In the US, Generally
Accepted Accounting Principles (GAAP) has not imposed any such restrictions.
Economic Order Quantity (EOQ)
EOQ is used as an inventory management method to estimate the optimum quantity of material
to be purchased. It is to fulfil the production requirement such that the inventory maintenance
cost is minimal.
Following are the two main objectives of EOQ:
Reducing the total inventory cost is the primary aim of this method. These costs involve order
cost, holding expense and shortage cost.
Next, is assuring that the right quantity of goods is ordered in each batch. It will not only reduce
the frequency of order placement; but will also keep a check over the surplus inventory.
The formula of EOQ for inventory management is:
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Where:
Q is the optimum order units;
D is the periodic demand (in units);
S is the cost of each purchase order;
H is the per-unit annual holding cost.
Later on, Baumol’s EOQ model was developed as a cash management technique for maintaining
the optimum level of cash in the business.
ABC Analysis
Another inventory control method is ABC analysis that lists out the goods under three classes as
follows:
1. A, i.e., Highly Important: These are the goods which cost high and therefore, maintained
in small quantity.
2. B, i.e., Moderately Important: It constitutes the inventory which has an average value
maintained in fair quantity.
3. C, i.e., Less Important: These goods are available in huge quantity due to their low value
or cost.
Thus, category A being quite expensive, requires constant monitoring through EOQ, periodic
check on available quantity, inventory budgeting and ratio analysis.
The goods under category B should be ordered as per the market or production requirements.
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Moreover, the ones that belong to category C does not require much control. Instead, only the
cost monitoring approach is enough for such goods.
Vital, Essential and Desirable (VED) Classification
The VED classification is mostly used in industries where machines are used for production. It
distinguishes the stock according to the significance of its usage into the following three
categories:
1. Vital: Items signifying the lifeline of the production process are termed as vital items. In
the absence of these, the whole process would halt.
2. Essential: The stockout cost of the essential items is quite high. Thus, their absence leads
to a significant loss.
3. Desirable: The desirable items does not immediately hamper the production and also have
a minimal stock out the cost.
In the above classification, we can see that the essential items hold the highest significance since
its non-availability would pause the production process. These items usually comprise of
machinery which requires excessive control.
Drop shipping
Drop shipping is that form of business which ensures inventory control for resellers. The
organization does not maintain any inventory.
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On receiving the order from a customer, the company forwards it to manufacturer, supplier or
wholesaler. Then, the vendor directly ships the product to the customer.
Thus, cross-docking has the following advantages:
 Minimal inventory cost;

 Meagre startup investment;
 Scalability with low risk;
 Minimal order fulfilment expense.
Contingency Planning
Contingency strategy can be seen as a backup plan. Thus, this type of inventory management
technique helps to deal with any of the following adverse business circumstances:
 Shortage of space in warehouses;

 False inventory valuation or calculation;
 Vendor runs out of stock and cannot meet the order deadlines;
 A sudden increase in demand leads to stock over-valuation;
 The manufacturer or vendor stops dealing in particular goods without any prior
information;
 The company runs out of sufficient working capital to acquire essential products.
In this method, the organization should foresee the inventory-related risk and its impact.
Accordingly, it should plan what actions are to be taken, if any of the above problems arise.
Along with this, a constant effort should be made to build strong public relations for long-term
existence.
Therefore, contingency planning is essential for effective inventory management.
Accurate Forecasting
In inventory management, market demand analysis and estimation of sales, play a significant
role. If the organization lacks proper information about a precise number of future sales units,
there are high chances of stock wastage or shortage.
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While accurate demand forecasting the organization must look into the following factors:
 Economic conditions;
 Market trends;
 Planned advertisements and promotion;
 Marketing cost;
 Consumers’ growth rate;
 Seasonal impact on demand;
 Previous year’s sales record.
Set PAR Levels
Minimum safety stock or Periodic Automatic Replenishment (PAR) level refers to

establishing minimum stock criteria for each type of goods. If the inventory goes down the set
limit, it is an indication that the new minimum order needs to be placed.
For such decision making, the store manager needs to analyze the frequency of sales or
production and procurement period. With the changing market demand, production capacity,
warehousing capacity, maintenance cost and various other factors; the PAR levels can be altered.
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Therefore, the organization must review the PAR levels considering these factors, from time to
time. In the absence of the manager, safety stock levels also aid the employees to take
prompt inventory procurement decisions.
Inventory Kitting
Product bundling as we call it is a method of creating a bundle by grouping different products,

packaging and merchandising them together as a single unit.
In the inventory management, on selling a bundle, the system automatically associates the
pack’s sale to the sale of items included in it, separately.
Some of the benefits of this method are as follows:
 Spontaneous selling of different products helps to minimize inventory obsoletion; along

with clearance of the old stock.
 It reduces the overall warehousing, maintenance and shipping costs.
 It initiates inventory tracking and its minimum level maintenance.
 It improves the average order values and enhances sales revenue.
Just-In-Time (JIT) Inventory Management

Just-in-time is one of the Japanese inventory management techniques, that emphasizes keeping a
‘zero inventory‘.
As the name suggests, it refers to maintaining only that much stock which is required at present,
for carrying out the production or merchandising process.
Some organizations first receive the order from the clients, and then they proceed with the
inventory procurement and manufacturing activities.
Following are the various advantages of JIT:
 JIT benefits through ordering the new stock only when the old one is about to finish. Thus,
it reduces obsoletion or expiry of the existing stock.
 It ensures a positive cash flow, with less working capital engaged in inventory.
 It also provides for optimizing the inventory cost by reducing the warehousing and
insurance expenses.
However, one of the most significant drawbacks of this technique is it may result in stock-out.
Since there is a possibility that the procurement team fails to order the goods on time or the
delivery of stock is delayed.
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Material Requirement Planning (MRP)
Commonly known as MRP method, it is an analytical approach. The manager places the order
with the vendors, for new stock only after finding out the market demand and sales forecast,
acquired from the different business areas.
For the manufacturers, merchandisers, wholesalers and stockists; it is a beneficial technique

since it provides for price risk optimization and also reduces the overstock uncertainties.
Perpetual Inventory Management
It is a continuous inventory system that helps in regular tracking of the real-time stock
movements.
In this method, the inventory is promptly updated in the books of accounts, as soon as the
purchase or sale of goods is made.
Thus, this is a superior technique to the periodic inventory system which initiates only an
occasional or random check of inventory through physical counting of goods.
Given below are the various plus points of perpetual inventory system:
 Efficient inventory forecasting;

 Immediate recording of the stock information;
 Competent in terms of time and cost;
 Error-free due to validated data.
Fast, Slow and Non-Moving (FSN) Inventory
The critical function of the FSN inventory technique is understanding the frequency with which a
specific product is consumed for production or merchandising. Let us now go through its
following three elements:
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1. Fast-Moving Inventory: The goods which are readily saleable or consumed in bulk, are
termed as fast-moving inventory. The inventory turnover ratios of such stock are quite high.
2. Slow-Moving Inventory: The stock which is not consumed that frequently resulting in low
turnover ratio, is categorized under slow-moving inventory.
3. Non-Moving Inventory: Some goods in the warehouse, goes out of demand and therefore,
becomes obsolete. Many times, such non-moving inventory leads to dead stock.
The manager should take steps to use or eradicate the non-moving inventory for creating space in
the warehouse. Also, the slow-moving goods should be stored in a limited quantity to avoid the
chances of obsoletion.
On the other hand, the fast-moving stock should be maintained in a sufficient quantity for
uninterrupted production or supply of goods.
Batch Tracking
Throughout the supply chain management, goods are recorded and traced as per their batch
numbers, to facilitate lot tracking.
It is widely used to figure out where the inventory is, right from its receiving and warehousing to
production or sales. It even keeps track of the products’ expiration date (if available).
Given below are the benefits of batch tracking to the organizations:
 Batch tracking is a more efficient method of inventory management when compared to the
manual process.
 It improves vendor relationship through the identification and selection of prominent
suppliers.
 It helps to make out defective products in a batch, and thus, reduces the chances of loss.
 A robust quality control system can be established through a lot tracking system. Since
the expiry date of each product or batch is known, the chances of quality degradation
reduce.
Conclusion
We have seen that managing inventory is a vital task for any business organization. In large scale
companies, this process becomes even more complicated. Thus, automated ways of inventory
management came into action for simplifying the entire process.
We have discussed the most common methods above. Other than these, there are multiple small
techniques which also facilitate the inventory management process. Some of these include
inventory turnover ratio, regular inventory audit, periodic inventory system, cycle counting,
backordering, consignment, etc.
125
Receivable Management
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:
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.
126
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.
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
127
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.
Objectives or Features of Receivable Management
Monitor And Improve Cash Flow

Receivable management monitors and control all cash movements of organisations. 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 organisation.
128
Minimises Bad Debt Losses

Bad debts are harmful to organisations 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 organisations.
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.
129
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.
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.
130
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.
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Dr Ravikumar Gunakala FINANCIAL MANAGEMENT

203- FINANCIAL MANAGEMENT

Nature of Financial Management

 It is an indispensable organ of business management.

 It needs financial planning, control and follow-up.

Scope of Financial Management

2. Investment Decisions includes investment in fixed assets (called as capital budgeting).

Short-term investment decisions or Working Capital Management means committing funds

a. Dividend for shareholders- Dividend and the rate of it has to be decided.

Objectives of Financial Management

1) To ensure regular and adequate supply of funds to the concern.

Objectives of Financial Management

Goals of Financial Management:

Profit Maximization and Wealth Maximization

1. In order to make them rationally the firms must have a goal.

f. If an enterprise fails to make a profit, capital invested is eroded

3. Ignores Quality of Benefits:

other firm, it will be more risky.

II. SHAREHOLDERS WEALTH MAXIMISATION (SWM):

NS = Number of equity shares owned (outstanding)

MPt = Market price of share at ‘t’ period.

Principles of Financial Management

1) Trade-off Risk and Return

4) Aware of Time Value of Money

1. Trade-off Risk and Return

Investors must be careful while forming a portfolio from available investment

2. Formation of Optimal Capital Structure

3. Diversification of both Investment and Borrowing

4. Aware of Time Value of Money

Always be aware of the time value of money, otherwise, there is a possibility of

5. Forecast Cash Flows

6. Take a Right Insurance Plan

7. Concentration on Wealth Maximization

8. Reinvest Rather than Consume

9. `Determine Cost of Capital

10. Financial Decision Align with Business Life Cycle

Time Value of Money - Compounding and Discounting

Money should have time value for the following reasons:

 Money can be employed productively to generate real returns;

Present Value = It is the value of a sum of money today.

Future Value = It is the value of a sum of money in the future.

Where n = number of years, R = Rate of return on investment.

1,2, 3, ….. n represents future years,

FV = Cash flows generated in different years,

So, future value FV = PV (1 + r/f) fn

Have two components:

• Working Capital Decisions – Short Term investment decisions.

• Capital Budgeting decisions – Long Term investment decisions

Factors affecting Investment Decisions/Capital Budgeting decisions:

Factors Affecting Financing Decision:

Factors affecting Dividend Decision:

Functions of Financial Management

a. Issue of shares and debentures

c. Public deposits to be drawn like in form of bonds.

CONCEPT OF RISK AND RETURN

Return expresses the amount which an investor actually earned on an investment

the risk of losing money is also higher.

possible risk and highest possible return.

Rate of return on an investment can be calculated using the following formula-

Return = (Amount received - Amount invested) / Amount invested

trade-off between risk and return.

A financial intermediary is typically an institution that facilitates the channelling