UNIT – III: FINANCING AND DIVIDEND DECISIONS

FINANCIAL AND OPERATING LEVERAGE

Leverage means use of assets and sources of funds having fixed costs in order toincrease the
potential returns to shareholders. The term leverage, in general, refers to the relationship
between two interrelated variables. In financial matters, one financial variable influences
another variable. Those financial variables may be cost, sales revenue, earnings before
interest and tax (EBIT), output, earnings per share (EPS), etc.
In the leverage analysis, the emphasis is on the measurement of the relationship of two
variables, rather than on measuring the variables.
Leverage = %change in dependent variable %change in
independent variable
According to James C. Van Horne,“Leverage may be defined as the employment of anasset
of funds for which the firm pays cost or fixed return. The fixed cost or return may be thought
of as the fulcrum of lever”.

According to J.E. Walter,“Leverage may be defined as percentage return on equity

topercentage return on capitalization”.
Types of Leverage
There are three types of leverage. They are:
 Operating Leverage: The leverage associated with investment (asset
acquisition)activities is referred to as operating leverage.
 Financial Leverage: The leverage associated with financing activities is referredto as
operating leverage.
 Composite Leverage: The combination of both operating leverage and
financialleverage is known as composite leverage.

OPERATING LEVERAGE
Operating leveragerefers to the use of fixed costs. The degree of operating leverageisdefined
as the change in a company‟s earnings before interest and tax, due to change in sales.Since
variable costs change indirect proportion of sales and fixed costs remain constant, the
variability in Earnings before Interest and Taxes, or (EBIT), when sales
change is caused by fixed costs. Higher the fixed cost, higher the variability in EBIT for a
given change in sales. Other things remaining the same, companies with higher operating
leverage (because of higher fixed costs) are more risky. Operating leverage intensifies the
effect of cyclicality on a company‟s earnings. As a consequence, companies with higher
degrees of operating leverage have high betas.

Combining Financial and Operating Leverages

Operating leverage affects a firm‟s operating profit (EBIT), while financial leverage affects
after tax or the earnings per share. The combined effect of two leverages can be quite
significant for the earnings available to ordinary shareholders.

Degree of Operating Leverage

The degree of operating leverage (DOL) is defined as the percentage change in the earnings
before interest and taxes relative to a given percentage change in sales.

DOL = % Change in EBIT

% Change in Sales

DOL = ∆EBIT / EBIT

∆Sales / Sales
 DOL = Contribution where, Contribution = EBIT + Fixed cost
EBIT

DOL = Q (s–v) where, Q is the units of output, s is the unit

Q (s– v) – F selling price, v is the unit variable cost and
F is the fixed cost.

DOL = EBIT +Fixed Cost =1 + F

EBIT EBIT

Problem:A firm developed the following income statement based on an expected

salesvolume of 100,000 units. From the particulars given below calculate the degree of
operating leverage.
Rs.
Sales (100,000 units at Rs.8) 800,000
Less: Variable costs (100,000 at Rs.4) 400,000
Contribution 400,000
Less: Fixed costs 280,000
EBIT 120,000

Solution: The following formula is used for computation.

DOL = Q (s–v) where, Q is the units of output, s is the unit

Q (s– v) – F selling price, v is the unit variable cost and
F is the fixed cost.
 DOL = 100,000 (Rs.8 – Rs.4)
100,000 (Rs.8 – Rs.4) – Rs.280,000

 Rs.400,000 = 3.33
120,000
DOL of 3.33 implies that for a given change in the company‟s sales, EBIT will change by 3.33
times.

Problem:
A company which manufactures its product for sale considers automation in its production. The
technical expert appointed by the management tells them that they can choose a more
automated production processes which will reduce unit variable cost to Rs.2, but will increase
fixed costs to Rs.480,000. If the management accepts the expert‟s advice, then the income
statement will look as follows.
Rs.
Sales (100,000 units at Rs.8) 800,000
Less: Variable costs (100,000 at Rs.2) 200,000
Contribution 600,000
Less: Fixed costs 480,000
EBIT 120,000

What will be the DOL with high fixed costs and low variable costs?
Solution:
DOL = Contribution where, Contribution = EBIT + Fixed cost
EBIT

DOL = Rs.600,000 = 5.0

Rs.120,000

If the company chooses the high-automated technology and if its actual sales happen to be more
than expected, its EBIT will increase greatly; an increase of 100 percent in sales will lead to 5
percent increase in EBIT.

Problem:The installed capacity of a factory is 600 units. Actual capacity used is 400units.
Selling price per unit is Rs.10. Variable cost is Rs.6 per unit. Calculate the operating leverage in
each of the following three situations:
o When fixed costs are Rs.400.
p When fixed costs are Rs.1000.
q When fixed costs are Rs.1200.
Solution:
Statement showing Operating Leverage (in Rs)
Particulars Situation 1 Situation 2 Situation 3
Sales 4,000 4,000 4,000
Variable cost (VC) 2,400 2,400 2,400
Less: Contribution (C) [Sales−VC] 1,600 1,600 1,600
Fixed cost (FC) 400 1,000 1,200
Operating profit (OP) [C−FC] 1,200 600 400
Operating leverage (C÷OP) 1600/1200 1600/600 1600/400
= 1.33 = 2.67 = 4.00

From the above it shows that the degree of operating leverage increases with every increase in
share of fixed cost in the total cost structure of the firm.
Operating Risk: Operating risk can be defined as the variability of EBIT (or return onassets).
The environment – internal and external – in which a firm operates, determines the variability
of EBIT. So long as the environment is given to the firm, operating risk is an unavoidable risk.
A firm is better placed to face such risk if it can predict it with a fair degree of accuracy.
The variability of EBIT has two components.
P Variability of sales
Q Variability of expenses

Significance of Operating Leverage

Operating leverage tells the impact of sales on income. Depending on the operating leverage, a
given percentage of increase in sales results in a higher percentage of increase in operating
income and net profit. Equally, a decline in sales may wipe out the operating profit or turn into
loss, even.
FINANCIAL LEVERAGE
Financial Leveragerefers to debt in a firm‟s capital structure. Firms with debt in thecapital
structure are called levered firms. The interest payments on debt are fixed irrespective of the
firm‟s earnings. Hence interest charges are fixed costs of debt financing. The fixed costs of
operations result in operating leverage and cause EBIT to vary changes in sales.

Financial leverage is also known as trading on equity. It is defined as the ability of a firm to use
fixed financial charges to magnify the effects of changes in EBIT on the earnings per share, i.e.
preference share capital and debt capital including debentures with fixed rate of interest.
Characteristics of Financial Leverage
= Concerned with Liabilities side of the Balance Sheet: It is concerned with theliabilities
side of the balance sheet where different type of sources of capital is shown.
o Related to Fixed Cost of Capital: if there is no fixed cost capital, then there willbe no
financial leverage.
1) Financial Risk: The financial risk of the firm increases with the presence offinancial
leverage.

Combining Financial and Operating Leverages

Operating leverage affects a firm‟s operating profit (EBIT), while financial leverage affects
after tax or the earnings per share. The combined effect of two leverages can be quite
significant for the earnings available to ordinary shareholders.

A company can finance its investments by debt and equity. The company may also use
preference capital. The rate of interest on debt is fixed irrespective of the company‟s rate of
return on assets. The company has a legal binding to pay interest on debt. The rate of preference
dividend is also fixed; but preference dividends are paid when the company earns profits.

The use of fixed-charges sources of funds, such as debt and preference capital along with the
owner‟s equity in the capital structure, is described as financial leverage or gearing or trading
on equity.The use of term trading on equity is derived from the factthat it is the owner‟s equity
that is used as a basis to raise debt; that is, the equity that is traded upon. The supplier of debt
has limited participation in the company‟s profits and therefore he will insist on protection in
earnings and protection in values represented by ownership equity.

Measures of Financial Leverage

The most commonly used measures of financial leverage are:

P Debt ratioThe ratio of debt to total capital

L1 = D / D+E = D/V
 Where, D is value of debt, E is value of shareholders‟ equity and V is value of total
capital (i.e. D+E). D and E may be measured in term of book value. The book value of
equity is called net worth. L Shareholder‟s equity may be measured in terms of market
value.

1) Debt-equity ratio The ratio of debt to equity

L2= D/E

1) Interest coverage The ratio of net operating income (or EBIT) to interest charges
L3 = EBIT /Interest

Degree of Financial Leverage

Degree of financial leverage may be defined as the percentage change in taxable profits as a
result of percentage change in operating profit. This may be put in the form of following
equation:
DFL = Percentage change in taxable income Percentage
change in operating income

The financial leverage affects the earnings per share. When the economic conditions are good
and the firm‟s EBIT is increasing, its EPS increases faster with more debt in the capital
structure. The degree of financial leverage (DFL) is defined as the percentage change in EPS
due to a given percentage change in EBIT.

DFL = % Change in EPS

% Change in EBIT
or
DFL = ∆EPS / EPS
∆EBIT/ EBIT

For Example, when EBIT increases from Rs.120,000 to Rs.160,000, EPS increases from
Rs.1.65 to Rs.2.45 when it employs 50 percent debt and pa interest charges of Rs.37500 (in the
earlier problem). Applying equation, DFL at EBIT of Rs.120,000 is
as follows: DFL =

= (2.45 – 1.65) / 1.65 = 0.485 = 1.456

(160,000 – 120,000)/ 120,000 0.333

This implies that for a given change in EBIT, EPS will change by 1.456 times

Significance of Financial Leverage

Financial leverage is employed to plan the ratio between debt and equity so that earnings per
share are magnified. The significance of financial leverage is as under:
1) Planning of Capital Structure:Financial leverage helps in planning the capitalstructure.
The capital structure is concerned with the raising of long term funds, both from
shareholders and long-term creditors. The structure has the implication of cost and risk
that are to be borne in mind, while finalizing the capital structure.

2) Profit Planning: The earning per share is affected by the degree of financialleverage. If
the profitability of the concern is increasing, the fixed costs will help in increasing the
availability of profits for equity shareholders. When profits decline and do not cover the
interest on debt, the sufferers will be equity shareholders. Therefore, financial leverage
is important for profit planning.
 COMPOSITE LEVERAGE
Operating leverage measure percentage change in operating profit due to percentage changes in
sales. It explains the degree of operating risk. Financial leverage measures percentage change
in taxable profit (or EPS) on account of percentage change in operating profit (or EBIT). Thus,
it explains the degree of financial risk. Both these leverages are closely concerned with the
firm‟s capacity to meet its fixed costs (both operating and financial). In case both the leverages
are combined, the results obtained will disclose the effect of change in sales over change in
taxable profit (or EPS).

Composite leverage, thus, expresses the relationship between revenue on account of sales (i.e.
contribution or sales less variable cost) and the taxable income. It helps in finding out the
resulting percentage change in taxable income on account of percentage change in sales.
= Operating leverage × Financial leverage
= C × OP = C
OP PBT PBT

Where, C = Contribution (i.e. sales – variable cost)

OP = Operating Profit (or) EBIT
PBT = Profit before Tax but After Interest

Problem: Following are the figures related to PQR Co:Sales

Rs.10,00,000,
Variable Costs 40% of sales,
Fixed Cost Rs.2,00,000, Interest Rs.15,000
You are required to calculate (i) Operating leverage (ii) Financial leverage and (iii) Combined
leverage. Also state change in the above leverages if selling price is increased by 15%.

Solution:
Particulars Amount (Rs)
Sales 10,00,000
Less: Variable cost (40% of 10,00,000) 4,00,000

Contribution 6,00,000
Less: Fixed cost 2,00,000

Operating profit / EBIT

4,00,000
Less: Interest
15,000

Profit Before Tax / EBT

3,85,000

8) Operating Leverage = Contribution / EBIT = 6,00,000/4,00,000 = 1.5 times

9) Financial Leverage = EBIT / Profit before tax = 4,00,000/3,85,000 = 1.038 times
10)Combined Leverage = Operating leverage × Financial leverage
= 1.5 × 1.038 = 1.557 times
If the selling price is increased by 15%

Particulars Amount (Rs)

Sales (10,00,000× 1.15) 11,50,000
Less: Variable cost (40% of 11,50,000) 4,60,000
 Contribution 6,90,000
Less: Fixed cost 2,00,000

Operating profit / EBIT

4,90,000
Less: Interest
15,000

Profit Before Tax / EBT

4,75,000

1) Operating Leverage = Contribution / EBIT = 6,90,000/4,90,000 = 1.408

times
2) Financial Leverage = EBIT / EBT = 4,90,000/4,75,000 = 1.0315
times
3) Combined Leverage = Operating leverage × Financial leverage
= 1.408 × 1.0315 = 1.452 times

Problem:
A company has sales of Rs.1,00,000. The variable costs are 40% of the sales while the fixed
operating costs amount to Rs.30,000. The amount of interest on long-term debt is Rs.10,000.
You are required to calculate the composite leverage and illustrate its impact if sales increase by
5%.
Solution:
Statement Showing Computation of Composite Leverage
Particulars Amount (Rs)
Sales 1,00,000
Less: Variable cost (40% of sales) 40,000

Contribution (C) 60,000

Less: Fixed Operating cost 30,000

Operating profit / EBIT

30,000
Less: Interest
10,000

Taxable Income (PBT)

20,000

Combined Leverage = C / PBT

=60,000 / 20,000 =3

The composite leverage of „3‟ indicates that with every increase of Re.1 in sales, the taxable
income will increase by Rs.3 (i.e. 1× 3)
This can be verified by the following computations when the sales increase by 5%

Particulars Amount (Rs)

Sales 1,05,000
Less: Variable cost 42,000
 Contribution (C) 63,000
Less: Fixed Operating cost 30,000

Operating profit / EBIT

33,000
Less: Interest
10,000

Taxable Income (PBT)

23,000

It is clear from the above computation that on account of increase in sales by 5% the profit
before tax has increase by 15%. This can be verified as follows:

Increase in percentage profits = Increase in profit × 100

Base profit

= (3,000 / 20,000) × 100 = 15%

Differences between Operating and Financial Leverage

Basis of Difference Operating Leverage Financial Leverage
1) Objective The objective is to magnify The objective is to magnify
the effect of changes in sales the effect of changes in
on operating profit. operating profit on earnings
per share.
2) Relationship It establishes relationship It establishes relationship
between operating profit and between operating profit and
Sales return on equity
3) Measurement It measures a firm‟s ability It measures a firm‟s ability to
to use fixed cost asset to use fixed cost funds to
Magnify the operating magnify the return to equity
Profits shareholders.
4) Relationship It relates to the assets side of It relates to the liability side
the balance sheet of the balance sheet
5) Effect on It effects profit before It effects profit after interest
Income interest and tax and tax
6) Risk It involves operating risk of It involves financial risk of
being unable to cover fixed being unable to cover fixed
operating cost. financial cost.
7) Decision It is concerned with It is concerned with
investment decision. financing decision.
8) Stage It is described as first stage It is described as second
leverage stage leverage
CAPITAL STRUCTURE
In order to achieve the goal of indentify an optimum debt-equity mix, it is necessary for the
finance manager to be conversant with the basic theories underlying the relationship between
capital structure, cost of capital and value of firm.

Meaning and Scope of Capital Structure

Capital structure represents the relationship among different kinds of long term capital.
Normally, a firm raises long term capital through the issue of shares, sometimes accompanied
by preference shares. The share capital is often supplemented by debenture capital and others
long-term borrowed capital.

According to Prasanna Chandra, “The composition of a firm‟s financing consists ofequity,

preference and debt”.

According to James C Van Horne,“The mix of a firm‟s permanent long-termfinancing

represented by debt, preferred stock and common stock equity”.

Capital structure is referred to as the ratio of different kinds of securities raised by a firm as
long-term finance. The capital structure involves two decisions:
t Types of securities to be issued are equity shares, preference shares and long-term
borrowings (debentures).
u Relative ratio of securities can be determined by process of capital gearing. On this basis
the companies are divided into two categories: (a) Highly GearedCompanies whose
promotion of equity capitalization is small and (b) Low Geared Companies who equity
capital dominates total capitalization.

Components of Capital Structure

The long-term funds of capital structure can broadly divided into two categories, viz., owners‟
capital and borrowed capital as follows:
 Owners‟ Capital – (i) Equity capital, (ii) Preference capital and (iii) Retained Earnings.
 Borrowed Capital – (i) Debentures and (ii) Term Loans

Optimal Capital Structure

Optimal Capital Structure is that capital structure or combination of debt and equity that leads
to the maximum value of firm. At this point, average composite cost or weighted average cost is
the minimum. If the borrowing leads the company to increase the market value of its shares, it
is said that the company has drifted away from optimum capital structure. A company should
plan in such as way that the market value of its shares is maximized.

Types of Capital Structure

The capital structure of any concern may be simple, compound and complex.
(a) Simple Capital Structure: A single capital structure consists of single securitybase as a
source of fund to finance the activities of a concern, e.g. equity share

capital issued by a concern. It is safe to use such type of capital structure when the
prospects of earnings are unpredictable and uncertain.
(b) Compound Capital Structure: In compound capital structure a combination oftwo
security bases in the form of equity and preference capital or equity share capital and
debentures are used as a source of funds. It is advisable to use such type of capital
structure when annual earnings of a concern are uncertain but average earnings are
rather good.
(c) Complex Capital Structure: A complex capital structure is made up of multi-security
base, consisting of equity share capital, preference share capital, debentures and loans
from financial institutions. This type of capital structure is advisable where there is
certainly of stable and adequate income to pay-off fixed financial charges.

DESIGNING CAPITAL STRUCTURE

Designing capital structure refers to the designing of an appropriate capital structure in the
context of facts and circumstances of each firm. Designing the capital structure means selecting
a desired debt-equity combination in advance. The initial capital structure is determined at the
time the firm is promoted. So this structure should be designed very carefully.
Capital structure designing is very important to survive the business in long-run. Liability side
of balance sheet is made under perfect capital structure designing. Liability side is the mixture
of finance of company which has collected from internal and external sources. Hence, perfect
capital structure makes strong balance sheet.

The following are the common approaches to determine the firm‟s capital structure:
 EBIT-EPS Analysis: It involves the comparison of alternatives of financing under
various assumptions of EBIT.
 Cost of Capital: Cost is an important consideration in capital structure decision. It helps
in designing the optimal capital structure of the firm.
 Cash Flow Analysis: The focus of this analysis is on the risk of cash insolvency i.e. the
probability of running out the cash – given a particular amount of debt in the capital
structure. The expected cash flows can be categorized into three groups – (i) Operating
Activities, (ii) Investing Activities, and (iii) Financing Activities
 Leverage Analysis: This analysis emphasis on the measurement of the relationship of
the two variables, rather than on measuring the variables. Leverage =

 % change in dependent variable

% change in independent variable

EBIT- EPS ANALYSIS

The EBIT-EPS analysis is one of the important tools in the hands of financial manger to get an
insight into the firm‟s capital structure. The Earnings Before Interest and Tax
(EBIT) and Earnings Per Share (EPS) analysis is useful in examining the effect of financial
leverage to analyze the behavior or EPS with varying levels of EBIT under
alternative financial plans. A capital structure may consist of debt and equity in different
proportions. It should be noted that the 65 percent EPS is the "trailing" number, using the
previous 4 quarters of earnings. Some analysts like to use "projected" EPS to analyze a stock's
current value in respect to these estimates.

EPS and ROE Calculations

EPS is calculated by dividing profit after taxes, PAT also called net income, NI, by the number
of shares outstanding. PAT is found out in two steps. First, the interest on debt, INT, is
deducted from the earnings before interest and taxes, EBIT, to obtain the profit before taxes,
PBT. Then taxes are computed on and subtracted from PBT to arrive at the figure of PAT.
The formula for calculating EPS is as follows:
Earnings per share = Profit after tax
Number of shares

EPS = PAT = (EBIT – INT) (1 – T)

N N
Where T is the corporate tax rate and N is the number of ordinary shares outstanding. If the firm
does not employ any debt, then the formula is:
EPS = EBIT (1–T) N

ROE is obtained by dividing PAT by equity (E). Thus the formula for calculating
ROE is as follows:
Profit after tax
Return on Equity = --------------------------
Value of equity
 ROE = (EBIT – INT) (1 – T)
E
For calculating ROE either the book value or the market value equity may be used.
Earnings per Share (EPS):For computation of earnings per share deduct from earningsbefore
interest and tax both interest and tax. Divide earnings after interest and tax by
number of equity shares.
EPS (for equity shares)
EPS (for preference shares)
Analyzing Alternative Financial Plans: Constant EBIT
Problem:Suppose a new firm, Brightways Ltd, is being formed. The management ofthe firm is
expecting a before-tax rate of return of 24 percent on the estimated total investment of
Rs.500,000. This implies EBIT = 500,000*0.24 = Rs.120,000. The firm is considering two
alternative financial plans: (i) either to raise the entire funds by issuing 50,000 ordinary shares
at Rs.10 per share, or (ii) to raise Rs.250,000 by issuing 25,000 ordinary shares at Rs.10 per
share and borrow Rs.250,000 at 15 percent rate of interest. The tax rate is 50 percent.

What are the effects of the alternative plans for the shareholders‟ earnings?

Solution:The effects of the alternative plans for the shareholders‟ earnings arecalculated as
follows:
Effect of Financial Plans on EPS and ROE: Constant EBIT
Financial Plan
All-equity Debt-equity
(Rs) (Rs)
1. Earnings before interest and taxes, EBIT 120,000 120,000
2. Less: Interest, INT 0 37,500
3. Profit before interest, PBT 120,000 82,500
PBT = EBIT – INT
4. Less: Taxes, T@50% 60,000 41,250
PBT×T
5. Profit after taxes, PAT 60,000 41,250
PAT = (EBIT – INT) (1 – T)
6. Total earnings of investors, 60,000 78,750
PAT + INT
--------------------------------------------
7. Number of ordinary shares, N 50,000 25,000
8. EPS = (EBIT – INT) (1 – T) / N 1.20 1.65
9. ROE = (EBIT – INT) (1 – T) / E 0.12 or 12% 0.165 or 16.5%

The above calculations show the impact of the financial leverage is quite significant when 50
percent debt (debt of Rs.250,000 to total capital of Rs.500,000) is used to finance the
investment. The firm earns Rs.1.65 per share, which is 37.5 percent more than Rs.1.20 per
share earned with no leverage. ROE is greater by the same percentage.
_____________________
Gain from Financial Leverage

1. EBIT on assets financed by debt, Rs.250,000*0.24 Rs.60,000

2. Less: Interest, Rs.250,000*0.15 Rs.37,500
3. Surplus earnings to the shareholders, Rs.250,000*(0.24–0.15) Rs.22,500
4. Less: Taxes at 50 percent Rs.22,500*0.50 Rs.11,250
 5. After tax surplus earnings accruing
to the share holders(leverage gain) Rs.11,250
Calculation of Indifference Point: The break-even or indifference point between
twoalternative methods of financing can be determined by a formula. In the earlier problem,
suppose the firm is considering only two financial plans – an all-equity plan and 50% debt-
equity plan. The firm wants to know the level of EBIT at which EPS would be the same under
both the plans.

The EPS formula under all-equity plan is:

EPS = (1–T) EBIT where N1is number of ordinary share under first
N1 plan and since the firm has no debt, no interest
charges exists.

The EPS formula under debt-equity plan is:

EPS = (1–T) (EBIT–INT) where N2is number of ordinary share 2nd plan
N2 and INT is the interest charges on debt.
Setting the two formulae equal, we have the following:
EPS = (1–T) EBIT = (1–T) (EBIT–INT)
N1 N2
Problem: Calculation of Indifference Points
Calculate the level of EBIT at which the indifference point between the following financing
alternatives will occur:
(i) Ordinary share capital Rs.10 lakh or 15% debenture of Rs.5 lakh and ordinary
share capital of Rs.5 lakh
(ii) Ordinary share capital of Rs.10 lakh or 13% preference share capital of Rs.5 lakh
and ordinary share capital of Rs.5 lakh
Assume that the corporate tax rate is 50 percent and the price of the ordinary share is Rs.10 in
each case.

Solution: The indifference points for the various combinations of the methods offinance are
calculated as follows:

(i) Ordinary shares Vs Ordinary shares and debentures.

EBIT = N1 / N1 − N2 * INT
= 100,000 / 100,000 – 50,000 *75000 = Rs.150,000

(ii) Ordinary shares Vs Ordinary and Preference shares EBIT

= N1 / (N1 − N2)* PDIV
= 100,000 / 100,000 – 50,000 * 65000
= 2 * 65,000 = Rs.130,000

DIVIDEND POLICY
The term dividend policy refers to the policy concerning quantum of profit to be distributed as
dividend. The concept of dividend policies implies that companies through their Board of
Directors evolve a pattern of dividend payment which has a bearing on future action.

According to Weston and Brigham, “Dividend policy determines the division of earnings
between payments to shareholders and retained earnings”.

Dividend is that portion of profits of a company which is distributed among its shareholder
 according to the decision taken and resolution passed in the meeting of Board of Directors.
This may be paid as a fixed percentage on the share capital contributed by them or at a fixed
amount per share. It means only profits after meeting all the expenses and providing for
taxation and for depreciation and transferring a reasonable amount to reserve funds should be
distributed to shareholders as dividend.

Retained earnings are the sources of internal finance for the financing of corporate future
projects but payment of dividend constitute an outflow of cash to shareholders. Although
both-expansion and payment of dividend-are desirable, these two are in conflicts. It is,
therefore, one of the important functions of the financial management to constitute a dividend
policy which can balance these two contradictory view paints and allocate the reasonable
amount of profits after tax between retained earnings and dividend.

Factors Determining Dividend Policy

A number of considerations determine the dividend policy of company.
 Stability of Earnings  Legal Requirements
 Age of corporation  Past dividend Rates
 Liquidity of Funds  Ability to Borrow

Needs for Additional Capital  Policy of Control
 Trade Cycles  Repayments of Loan

 Government Policies Time for Payment of Dividend

 Taxation Policy Regularity in Dividend Payment

Nature of Dividend Policy

The dividend policy has the following natures of its own:
o Tied-up with Retained Earnings:A dividend policy is tied-up with the retainedearnings
policy. It has the effect of dividing net earnings into two parts –
retained earnings and dividends.
o Constitutes Important Areas of Decision-Making:Distribution of dividendsreduces
the cash funds of the business and to that extent it has to depend upon external sources
of finance.
o Impact on Shares: The payment of dividends influences the market price ofshares.
Higher the rate of dividend, greater the price of shares and vice versa.
o Optimal Dividend Policy: A policy marked with few or no dividends
paymentfluctuations, over a long period of time, having a favorable impact on the
wealthof shareholders.

Importance of Dividend Policy

1) The firm has to balance between the growth of the company and the
distribution to the shareholders.
2) It plays an important role in determining the value of a firm.
3) Stockholders visualize dividends as signals of the firm‟s ability to generate
income.
4) The decision to pay dividend is independent of investment decisions dividends can
indirectly influence the external financing plans. For example, a decision to pay high
dividends will leave less internal funds for reinvestment in the firm. This could force the
firm to generate funds from new stocks or bond issues.
5) It has to also to strike a balance between the long term financing decision and the
wealth maximization.
6) The market price gets affects if dividends paid are less.
7) Retained earnings help the firm to concentrate on the growth, expansion and
modernization of the firm.
ASPECTS OF DIVIDEND POLICY
The payment of dividend of a company involves the legal and procedural aspects.
Legal Aspects
The amount of dividend that can be legally distributed is governed by company law, judicial
pronouncements in leading cases, and contractual restrictions. The important provisions of
company law pertaining to dividends are:
i) Companies can pay only cash dividends (with the exception of bonus shares). No
dividend shall be declared or paid by a company for any financial year except out of
the profits earned.
ii) Dividends can only paid out of the profits earned during the financial year after
providing depreciation and after transferring to reserve some percentage.
iii) Due to inadequacy or absence of profits in any year, dividends may be paid out of the
accumulated profits of previous years.
iv) Dividends cannot be declared for past years for which accounts have been closed.
v) Dividend including interim dividend once declared becomes a debt. This can be revoked
with the consent of the shareholders.

Procedural Aspects
The important events and dates in the dividend payment procedure are:
a) Board Resolution: The dividend decision is the prerogative of the board ofdirectors. The
resolution has to be passed in this regard.
b) Shareholder Approval: The resolution of the board of directors to pay thedividend has
to be approved by the shareholders in the annual general meeting.
c) Record Date: The dividend is payable to shareholders whose names appear inthe
Register of Members as on the record date.
d) Dividend Payment: Once a dividend declaration has been, dividend warrantsmust be
posted within 30 days.
e) Unpaid Dividend: Within a period of 7 days, after the expiry of 30 days,
unpaiddividends must be transferred to a special account opened with a scheduled bank.

PRACTICAL CONSIDERATION
There are two important dimensions of a firm‟s dividend policy:
1) What should be the average pay-out ratio?
2) How stable should the dividends be over time?

Pay-out Ratio
A major aspect of the dividend policy of a firm is its dividend payout D/P ratio, that is, the
percentage share of the net earning distributed to the shareholders as dividend. The
considerations relevant for determining the dividend pay-out ratio are as follows:
 Funds Requirement
 Liquidity
 Access to External Sources of Financing
 Shareholder Preference
 Difference in the Cost of External Equity and Retained Earnings
 Control
 Taxes

Stability of Dividends
Irrespective of the long-term pay-out ratio followed, the fluctuation in the year-to-year
dividends may be determined mainly by one of the following guidelines:
 Stable Dividend Pay-out Ratio
 Constant Dividend Per share
 Stable Dividends or Steadily Changing Dividends
 FORMS /TYPES OF DIVIDEND POLICY

Types of Dividend Policy

Regular Dividend Policy Stable Dividend Policy

Irregular Dividend Policy No Dividend Policy

Regular Dividend Policy

Payment of dividend at the usual rate is termed as regular dividend. The investors such as
retired persons, widows and other economically weaker person prefer to get regular dividends.

Advantages of Regular Dividend Policy

A regular dividend policy offers the following advantages:
 It establishes a profitable record of the company.
 It creates confidence among the shareholders.
 It aids in long-term financing and renders financing easier.
 It stabilizes the market value of shares.
 The ordinary shareholders view dividends as a source of funds to meet their day-
today living expenses.
 If profits are not distributed regularly and are retained, the shareholders may have to
pay a higher rate of tax in the year when accumulated profits are distributed.

However, it must be remembered that regular dividends can be maintained only by companies
of long standing and stable earnings. A company should establish the regular dividend at a
lower rate as compared to the average earnings of the company.

Stable Dividend Policy

The term „stability of dividend‟ means consistency or lack of variability in the stream of
dividend payments. In more precise terms, it means payment of certain minimum amount of
dividend regularly. A stable dividend policy may be established in any of the following forms:
(i) Constant Dividend per Share:Some companies follow a policy of payingfixed dividend
per share irrespective of the level of earnings year after year. A policy of constant
dividend per share is most suitable to concerns whose earnings are expected to
remain stable over a number of years.
(ii) Constant Payout Ratio:Constant payout ratio means payment of a fixedpercentage of net
earnings as dividends every year. The amount of dividend of such a policy fluctuates
in direct proportion to the earnings of the company. The policy of constant payout is
preferred by the firms because it is related to their ability to pay dividends.
(iii) Stable Rupee Dividend plus Extra Dividend:Some companies follow apolicy of
paying constant low dividend per share plus an extra dividend in the years of high
profits. Such a policy is most suitable to the firm having fluctuating earnings from
year to year.

Advantages of Regular Dividend Policy

A stable dividend policy is advantageous to both the investors and the company on account
of the following:
 It is sign of continued normal operations of the company
 It stabilizes the market value of shares
 It creates confidence among the investors
 It improves the credit standing and makes financing easier
 It provides a source of livelihood to those investors who view dividends as a source
of funds to meet day-to-day expenses.

Irregular Dividend Policy

Some companies follow irregular dividend payment on account the following:
(i) Uncertainty of earnings
(ii) Unsuccessful business operations
(iii) Lack of liquid resources
(iv)Fear of adverse effects of regular dividends on the financial standing of the company

No Dividend Policy
A company may follow a policy of paying no dividend presently because of its unfavorable
working capital position or on account of requirements of funds for further expansion and
growth.

FORMS OF DIVIDENDS
Dividends can be classified in various forms. Dividends paid in the ordinary course of business
are known as Profit dividends, while dividends paid out of capital are known as Liquidation
dividends. Dividends may also be classified on the basis of medium in which they are paid.

Dividend

On the Basis of On the Basis of On the Basis of

Types of Shares Mode of Payment Time of Payment

Equity Preference InterimRegular Special

Dividend Dividend DividendDividendDividend

Cash Stock Bond Property Composite

Dividend Dividend Dividend Dividend Dividend

On the Basis of Types of Shares

1) Equity Dividend: Dividend paid on equity shares called as equity dividend.
2) Preference Dividend:Preferencedividend is the dividend paid to
preferenceshareholders.

On the Basis of Modes of Payment

1) Cash Dividend:A cash dividend is a usual method of paying dividends.
2) Bonus Share/Stock Dividend: Stock dividend means the issue of bonus shares tothe
existing shareholders.
3) Scrip or Bond Dividend: A scrip dividend promise to pay the shareholders at afuture
specific date.
 4) Property Dividend:Property dividends are paid in the form of some assets otherthan
cash. They are distributed under exceptional circumstances and are not popular in India.
5) Composite Dividend:When dividend is paid partly in the form of cash and partlyin other
form, it is called as composite dividend.

On the Basis of Time of Payment

1) Interim Dividend:It is the dividend paid between two annual general meetings.
2) Regular Dividend:Dividend declared in every Annual General Meeting.
3) Special Dividend:When the company earns abnormal profit it will declarespecial
dividend.
SHARE SPLITS
Share Split or Stock Split is the process of splitting shares with high face value into shares of
lower face value. It‟s like getting an Rs.20 note changed for two Rs.10 notes.
A share split simply involves a company altering the number of its shares outstanding and
proportionally adjusting the share price to compensate.

The most common stock split is two-for-one in which each share becomes two shares. The price
per share immediately adjusts to reflect the stock split, since buyers and sellers of the stock all
know about the stock split. For example, if you owned 25 shares of ABC at Rs.15 per share,
and there was a 2-1 stock split, you would then own 50 shares of Rs.7.5 each.

For example,
Assume that ABC Corporation has 10000 shares of Rs.100 per common stock outstanding with
a current market price of Rs.150 per share. The Board of Directors declares the following stock
split:
1) Each common shareholder will receive 5 shares for each share held. This is called 5-for-
1 stock split. As a result, 50000 shares (10000×5) will be outstanding.
2) The par of each share of common stock will be reduced to Rs.20 (Rs.100/5).

The par value of the common stock outstanding is Rs.10,00,000 both before and after the stock
split as shown below:

Before Split After Split

Number of shares 10,000 50,000
Par value per share × Rs.100 × Rs.20
Total Rs.10,00,000 Rs.10,00,000
A stock split does not require journal entry in the books of accounts, but is
disclosed in the notes of the financial statements.

Since there are more shares outstanding after the stock split, the market price of the stock
should decrease. Thus, the market price of the stock would be expected to fall after stock split.
Reasons for Share Splits
(a) Companies usually split their stock when they think the price of their stock exceeds the
amount smaller investors would be willing to pay.
(b) It is aimed at making the stock more affordable and liquid from retail investor‟s point of
view.
(c) Generally, there are more buyers and sellers of shares trading at Rs.100 than say,
Rs.400, as retail shareholders may find low price stocks to be better bargains.
(d) Stock splits are usually initiated after a huge run-up in the share. This run-up may link to
the performance of the stock.
Difference between Bonus Shares and Share Split
Point of Bonus Share Share Split
Difference
Meaning Bonus shares mean additional It is a process of dividing the
free shares allotted to the existing face value of shares.
shareholders.
Face Value In bonus issue, face value of the In stock split, face value is
share is not changing. changing.
Share Capital In bonus issue, the share capital In stock split, share capital is
and number of shares are not changed, but the number
increased. of shares is changed.
Dividend Company has to give more In stock split, the share
dividends after bonus issue, capital is not increasing. So
because by the increase of the there is no need for more
share capital. dividends in future.
Reserves Only a certain amount of the The reserves are not
reserves is used. capitalized.
 UNIT – IV: WORKING CAPITAL MANAGEMENT

PRINCIPLES OF WORKING CAPITAL

Working Capital refers to the cash a business requires for day-to-day operations or more
specifically, for financing the conversion of raw materials into finished goods, which the
company sells for payment. Among the most important items of working capital are levels of
inventory, debtors and creditors. These items are looked at for signs of a company‟s efficiency
and financial strength.

There are four principles of working capital:

Principles of Working Capital

Principal of Risk Variation

Principle of Cost Capital

Principal of Equity Position Principle of Maturity Payment

Definitions of Working Capital

According to Shubin, “Working capital is the amount of funds necessary to cover the cost of
operating the enterprise”

According to Gerestenberg, “Circulating capital means current assets of a company that are
changed in the ordinary course of business from one form to another, as for example, from cash
to inventories, inventories to receivable, receivables into cash”.

Working capital, in general practice, refers to the excess of current assets over current
liabilities. Management of working capital therefore, is concerned with the problems that arise
in attempting to manage the current assets, the current liabilities and the inter-relationship that
exists between them. In other words it refers to all aspects of administration of both current
assets and current liabilities. It is also known as revolving or circulating capital or short-term
capital.

CONCEPTS OF WORKING CAPITAL

There are two concepts of working capital:
 Gross Working Capital
 New Working Capital
Gross Working Capital
In broad sense, the term working capital refers to the gross working capital and represents the
amount of funds invested in current assets. Thus, the gross working capital is the capital
invested in total current assets of the enterprise. Current assets are those which in the ordinary
course of business can be converted into cash within short period of normally one accounting
year.

Components of Current Assets

 Cash in hand
 Cash at bank
 Bills receivables
 Sundry debtors (or) Accounts receivable
 Short-term loans and advances
 Inventories of stocks
 Temporary investment of surplus funds
 Prepaid expenses
 Accrued incomes
Net Working Capital
In a narrow sense, the term working capital refers to the net working capital is the excess of
current assets over current liabilities.
Net Working Capital = Current Assets – Current Liabilities.

New working capital may be positive or negative. When the current assets exceeds the current
liabilities the working capital is positive and vice versa.
Current liabilities are those which are intended to be paid in the ordinary course of business
within a short period of normally one accounting year out of the current assets or the income of
the business.

Components of Current Liabilities

r Bills payable
s Sundry creditors (or) Accounts payable
t Accrued or Outstanding expenses
u Short-term loans, advances and deposits
v Dividends payable
w Bank overdraft
x Prepaid expenses
y Provision for taxation

NEEDS OF WORKING CAPITAL

Working capital is needed for the following purposes:

Needs for Working Capital

Replenishment of Inventory Provision for Operating Expenses

Support of Credit Sales Provision of a Safety Margin

DETERMINANTS OF WORKING CAPITAL

Following are the determinants generally influencing the working capital requirements.

Factors Determining Working Capital

Rate of Stock Turnover

Nature or Character of Business

Business Cycles
Production Policy

Dividend Policy
Seasonal Variations
Tax Level

Size of Business

Manufacturing Process

Working Capital Cycle

Credit Policy

Rate of Growth of Business

Price Level Changes

Other Factors
 ISSUES OF WORKING CAPITAL
The financial manager must determine levels and composition of current assets. He must see the
right sources are tapped to fiancé current assets, and that current liabilities are paid in time.
There are many aspects of working capital management which make it an important function of
the financial manager:
R Components: Components such as cash, marketable securities, receivables
andinventories.
S Time:Working capital management requires much of the financial manager‟stime. Time
as either permanent or temporary working capital.
T Investment: Working capital represents a large portion of the total investment inassets.
U Criticality: Working capital management has great significance for all firms butit is very
critical for small firms.
V Growth:The need for working capital is directly related to the firm‟s growth.

Profitability-Liquidity Trade-Off
To maximize shareholder‟s wealth, optimal level of current assets should be determined. There
is always a conflict between the liquidity and the profitability objectives. If current assets are
held at a level more than the required one, profitability is eroded; though there is enough
liquidity. If current assets are maintained at a level less than required, the solvency of the firm is
threatened.

Therefore, a proper balance is to be maintained between these two so that profitability is

maximized without sacrificing solvency. Thus, a trade-off between risk and return is attempted
to be struck off. The optimum level is the point where the total cost is the minimum.

Policies/Strategies to Working Capital

So far the banks were the sole source of funds for working capital needs of business sector. At
present more finance options are available to a finance manager to see the operations of his firm
go smoothly. Depending on the risk exposure of business, the following strategies are evolved
to manage the working capital.

Policies/Strategies Working Capital

Zero
Matchin Workin
g Aggressive Conservative g
Policy Policy Policy Capital
Policy

Matching Strategy
The firm can adopt a financial plan which involves the matching of the expected life of assets
with the expected life of the source of funds raised to finance assets. Thus, a ten year loan may
be raised to finance a plant with an expected life of ten years; stock of goods to be sold in thirty
days may be financed with a thirty-day bank loan and soon.

Financing Strategy of Matching Strategy

 Long-term funds = Fixed assets + Total permanent current assets
 Short-term funds = Total temporary current assets
Conservative Strategy
Under a conservative plan, the firm finances its permanent current assets and a part of
temporary current assets with long term finance; it stores liability by investing surplus funds
into marketable securities. The conservative plan relies heavily on long-term financing and
therefore, is less risky.

Financing Strategy of Conservative Strategy


Long-term funds = Fixed assets + Total permanent current assets + Part of
temporary current assets

Short-term funds = Part of temporary current assets
Aggressive Strategy
A firm may be aggressive in financing its assets. An aggressive policy is said to be followed by
the firm when it uses short-term financing than warranted by the matching plan. Under an
aggressive policy, the firm finances a part of its permanent current assets with short-term
financing; some extremely aggressive firms may even finance a part of their fixed assets with
short-term financing. The relatively more use of short-term financing makes the firm more
risky.

Financing Strategy of Aggressive Strategy

 Long-term funds = Fixed assets + Part of temporary current assets

Short-term funds = Part of temporary current assets + Total temporary
current assets

Zero Working Capital Strategy

This is one of the latest trends in working capital management. The idea is to have zero working
capital, i.e. at all times the current assets shall equal the current liabilities. Excess investment in
current assets is avoided and firm meets its current liabilities out of the matching current assets.

Financing Strategy of Zero Working Capital Strategy


Total Current Assets = Total current liabilities (or)

Total Current Assets minusTotal current liabilities = Zero

ESTIMATION OF WORKING CAPITAL

A firm must estimate in advance as to how much net working capital will be required for the
smooth operations of the business. Only then, it can be bifurcated into permanent working
capital and temporary working capital. This bifurcation will help in deciding the financing
pattern i.e. how much working capital should be financed from long term sources and how
much be financed from short term sources.

There are different approaches available to estimate the working capital requirements of a firm
as follows:

= Working Capital as a Percentage of Net Sales: This approach is based on theassumption

that higher the sales level, the greater would be the need for working capital.

+ To estimate total current assets as a % of estimated net sales.

+ To estimate current liabilities as a % of estimated net sales and
+ The difference between the two above is the net working capital as a % of
net sales.
= Working Capital as Percentage of Total Assets or Fixed Assets: This approach
ofestimation of working capital requirement is based on the fact that the total assets of the firm
are consisting of fixed assets and current assets. On the basis of past experience, a relationship
between
 + Total current assets i.e. gross working capital; or net working capital, i.e. current
assets – current liabilities.
+ Total fixed assets or a total asset of the firm is established. For example, a firm is
maintaining 20% of its total assets in the form of current assets and expects to have total
assets of Rs.50,00,000 next year. Thus, the current assets of the firm would be
Rs.10,00,000 (i.e. 20% of Rs.50,00,000).

= Working Capital Based on Operating Cycle: The concept of operating cycle,

helpsdetermining the time scale over which the current assets are maintained. The operating
cycle for different components of working capital gives the time for which an asset is
maintained, once it is acquired. However, the concept of operating cycle does not talk of the
funds invested in maintaining these current assets. It can definitely be used to estimate the
working capital requirements for any firm.

The different components of working capital may be enumerated as follows:

Current Assets Current Liabilities
Cash and Bank balances Creditors for purchases
Inventory of raw material Creditors for expenses
Inventory of work-in-progress
Inventory of finished goods
Receivables
Proforma for Assessment and Computation of Working Capital (For
Trading Concern)
Statement of Working Capital Requirements
Amount Rs.

Current Assets:

i) Cash - -
ii) Debtors or Receivables (for …. month‟s sale) - -
iii) Stocks (for …. month‟s sale) - -
iv) Advance payments, if any - -
v) Others - -
Less: Current Liabilities - -
i) Creditors (for …. month‟s sale) - -
ii) Lag in payment of expenses - -
(outstanding expenses, if any)
Working Capital (CA – CL) - -
Add: Provision / Margin for contingencies - -
Net Working Capital Required - -

Proforma for Assessment and Computation of Working Capital (For

Manufacturing Concern)
Statement of Working Capital Requirements
Amount Rs.

Current Assets:

1) Stock of raw material (for ….. month‟s consumption) -

2) Work-in-progress (for …… months): -
i) Raw materials
ii) Direct labour -
iii) Overheads -
 3) Stock of finished goods (for …. month‟s sale) -
i) Raw materials
ii) Labour -
iii) Overheads -
4) Sundry Debtors or Receivables (for …. month‟s sale) -
i) Raw materials

ii) Labour -
iii) Overheads -
5) Payments in Advance (if any) -
6) Balance of Cash (Required to meet day-to-day expenses) -
7) Any other (if any) -
Less: Current Liabilities -
i) Creditors (for …. month‟s purchases of raw material) -
ii) Lag in payment of expenses (outstanding expenses) -
iii) Others (if any) -
Add: Provision / Margin for Contingencies -
Net Working Capital Required -
Problem: EXELtd. is engaged in large-scale consumer retailing. From the
followinginformation, you are required to forecast their working capital requirement:
 Project annual sales – Rs.65 lacs.
 Percentage of net profit on cost of sales – 25 percent
 Average credit period allowed to debtors – 10 weeks
 Average credit period allowed by creditors – 4 weeks
 Average stock carrying (in terms of sales requirement) – 8 weeks
 Add 10 percent to compute figures to allow for contingencies.

Solution
Rs.
Project annual sales 65,00,000
Project sales per week 1,25,000
Less: Net profit (25% on cost = 20% on sales) 25,000
Projected cost of goods per week 1,00,000
Working Capital Requirement Forecast
1) Current Assets: Rs. Rs.
Stock (1,00,000×8) 8,00,000
Debtors (1,25,000×10) 12,50,000 20,50,000
2) Current Liabilities
Creditors (1,00,000×4) 4,00,000 4,00,000
3) Working Capital (1 – 2) 16,50,000
Add: 10 percent for contingencies 1,65,000
4) Total requirement 18,15,000

Problem: The Board of Directors of Ruby Ltd. requests you to prepare a statementshowing the
working capital requirements forecasts for a level of activity of 1,56,000 units of production.
The following information is available for your calculation.

(Rs. Per Unit)

Raw material 90
Direct labour 40
Overheads 75
205
 Profit 60
Selling pricing per unit 265

 Raw materials are in stock on average one month

 Materials are in process, on average 2 weeks
 Finished goods are in stock, on average one month
 Credit allowed by supplier – one month
 Time lag in payment from debtors – 2 months
 Lag in payment of wages – 1½ weeks
 Lag in payment of overheads – one month
20% of the output is sold against cash. Cash in hand and at bank is expected to be Rs.60,000. It
is to be assumed that production is carried on evenly throughout the year. Wages and overheads
accrue similarly and a time period of 4 weeks is equivalent to a month.

Solution
Statement of Working Capital Required
Current Assets: Rs. Rs.
Cash in hand and cash at bank 60,000
Stock in hand

Raw material 10,80,000

Work-in-process 8,85,000
Finished goods 24,60,000 44,25,000
Sundry Debtors 39,36,000
84,21,000
Current Liabilities:

Sundry creditors 10,80,000

Wages payable 1,80,000
Expenses payable 9,00,000 21,60,000
Net working capital employed (CA–CL) 62,61,000

Working Notes
1) Raw material = 1,56,000 units × 4 weeks×Rs.90 = Rs.10,80,000
52 weeks

2) Work-in-progress= 1,56,000 units × 2weeks = 6,000 units

52 weeks
Raw materials (6,000 units @ Rs.90) 5,40,000
Wages (6,000 units @ Rs.40×½) 1,20,000
Overheads (6,000 units @ Rs.75×½) 2,25,000
Total value of WIP 8,85,000

3) Finished goods = 1,56,000 units × 4 weeks×Rs.205 = Rs.24,60,000

52 weeks

4) Debtors = 1,56,000 units × 8 weeks×Rs.205×80 = Rs.39,36,000

52 weeks 100

5) Creditors = 1,56,000 units × 4 weeks×Rs.90 = Rs.10,80,000

52 weeks
6) Wages = 1,56,000 units × 1.5 weeks×Rs.40 = Rs.1,80,000
52 weeks

7) Expenses = 1,56,000 units × 4 weeks×Rs.75 = Rs.9,00,000

52 weeks
ACCOUNTS RECEIVABLES MANAGEMENT
Receivables represent amounts owed to the firm as a result of sale of goods or services in the
ordinary course of business. These are claims of the firm against its customers and form part of
its current assets. Receivables are also known as accountsreceivable, trade receivables,
customer receivables or book debts.

Meaning of Receivables
Receivables management is the process of making decisions relating to investment in trade
debtors. Certain investment in receivables is necessary to increase the sales and the profits of a
firm. But at the same time investment in this asset involves cost considerations also. Further,
there is always a risk of bad debts too.

Definition of Receivables
According to Hampton, “Receivables are asset accounts representing amount ownedto firm as a
result of sale of goods or services in ordinary course of business.”

Objectives of Receivables Management

The objectives of receivables management are to improve sales, eliminate bad debts and reduce
transaction costs incidental to maintenance of accounts and collection of sales proceeds and
finally enhance profits of the firm. Credit sales help the organization to make extra profit. It is a
known fact; firms charge a higher price, when sold on credit, compared to normal price.
Cost of Maintaining Receivables
 Cost of Financing:
 Administration Cost:
 Delinquency Costs:
 Cost of Default by Customers:

Factors Affecting the Size of Receivables

Besides sales, a number of other factors also influence the size of receivables. The following
factors directly and indirectly affect the size of receivables.
V Size of Credit Sales:
W Credit Policies:
X Terms of Trade:
Y Relation with Profits:
Z Credit Collection Efforts
AAStability of Sales:
BB Size and Policy of Cash Discount:
CC Bill Discounting and Endorsement:

Importance of Receivables Management

 Importance of Receivables Management

Determining Credit Policy

Determining Credit Terms

Evaluating the Credit Application

Determining Collection Policies and
Methods

Control and Analysis of Receivables

FACTORING
The word „factoring’ has its origin from Latin „factor‟ which means „doer‟. The Webster‟s
New Collegiate Dictionary defines a factor as “one who lends money to producers and dealers
on the security of accounts receivables”.

Factoring is a financial transaction whereby a business sells its accounts receivables (i.e.
invoices) to a third party (called a factor) at a discount in exchange for immediate money with
which to finance continued business.

Definition of Factoring
According to C.S.Kalyanasundaram, “Factoring is the outright purchase of creditapproved
account receivables with the factor assuming bad debt losses”.
According to AlamCalpin, “Factoring is a system designated to eliminate payment riskin
overseas sales and ensure that the seller receives prompt settlements”.
A factor is thus a financial institution which manages the collection of account receivables of
the companies on their behalf and bears the credit risk associated with those accounts. In
general, factoring means selling, with or without recourse, the receivables by the firm to a
factor. By factoring, the company relieves itself of the organization, procedures and internal
expenses of collecting its receivables.
There are three main parties in factoring arrangements:
= The Factor
= The Client (seller)
= The Customer (buyer)

The arrangements are governed by a contract between the factor and the client, and this contract
is for a fixed period, usually a year, which is normally renewed automatically. The contract can
be cancelled only with sufficient prior notice.
Features of Factoring
r The period for factoring is 90 to 150 days. Some factoring companies allow even more
than 150 days.
s Factoring is considered to be a costly source of finance compared to other sources of
short-term borrowings.
t Factoring receivables is an ideal financial solution for new and emerging firms without
strong financials.
u Bad debts will not be considered for factoring.
v Credit rating is not mandatory but factoring companies carry out credit risk analysis.
 w Factoring is a method of off balance sheet financing.
x Cost of factoring =Finance cost + Operating cost.
y Indian firms offer factoring for invoices as low as Rs.1000.
z For delayed payments beyond the approved credit period, penal charge of around 1%-
2% per month over and above the normal cost is charged.

Types of Factoring

Types of Factoring

Recourse Factoring
Non-Recourse Factoring

Advance Factoring
Bank Participation Factoring

Maturing Factoring
Notified and Undisclosed
Factoring

Full Factoring
Invoicing Factoring

Buyer-based, Seller-based, and

Selective Factoring Export Factoring

Working/Mechanism of Factoring
Factoring business is generated by credit sales in the normal course of business. The main
function of factor is realization of sales. One the transaction takes place, the role of factor steps,
is to realize the sales/collect receivables. Thus, factor acts as an intermediary between the seller
and sometimes along with the seller‟s bank together.
When the payment is received by the factor, the account of the firm is credited by the factor
after deducting its fees, charges, interest, etc. as agreed.
The mechanism of factoring is described in the following figure:
i) Customer places an order with the client for goods and or service on credit; client
delivers the goods and sends invoice to customers.
ii) Client assigns invoice to factor.
iii) Factor makes pre-payment up to 80 percent and sends periodical statements.
iv) Monthly statement of accounts to customer and follow-up.
v) Customer makes payment to factor.
vi) Factor makes balance 20 percent payment on realization to the client.

CLIENT
1
2 3 Send invoice
Assign Payment 6 to customer
Invoice up to Balance 20% on realization
to factor 4 Statement to customer

FACTOR CUSTOMER
 Figure: Working of Factoring

INVENTORY MANAGEMENT
The word „Inventory‟ is understood differently by various authors. In accounting language it
may mean stock of finished goods only. In a manufacturing concern, it may include raw
materials, work in process and stores, etc.

International Accounting Standard Committeedefines inventories as „Tangible property‟

1) Held for sale in the ordinary course of business
2) In the process of production for such sale or,
3) To be consumed in the process of production of goods or services for sale

The American Institute of Certified Public Account (AICPA) defines “Inventory in thesense
of tangible goods, which are held for sale, in process of production and available for ready
consumption”.

According to Bolten S.E., “Inventory refers to stock-pile of product, a firm is offeringfor sale
and components that make up the product”.

Meaning of Inventory Management

The investment in inventory is very high in most of the undertaking engaged manufacturing,
whole-sale and retail trade. The amount of investment is sometimes more in inventory than in
other assets. About 90 percent part of the working capital invested in inventories. It is necessary
for every management to give proper attention
to inventory management. A proper planning of purchasing, handling, storing and accounting
should form a part of inventory management. An efficient system of inventory manager will
determine (a) What to purchase? (b) How much to purchase?
(c) From where to purchase? (d) Where to store? etc.

Objectives of Inventory Management

The objectives of inventory management may be discussed under two heads:
1. Operating Objectives
2. Financial Objectives

Operational objectives refer to material and other parts which are available
insufficient quantity. It includes:
(a) Availability of Materials
(b) Minimizing the Wastages
(c) Promotion of Manufacturing Efficiency
(d) Better Service to Customers
(e) Control of Production Level
(f) Optimal Level of Inventories

Financial objectives mean that investment in inventories must not remain idle
andminimum capital must be locked in it. It includes:
(a) Economy in Purchasing
(b) Optimum Investment and Efficient
(c) Reasonable Price
(d) Minimizing Costs

Elements of Inventory
Inventory includes the following things:
1) Raw Materials: It includes the materials used in the manufacture of a product.The
purpose of holding raw material is to ensure uninterrupted production in the event of
 delaying delivery.
(a) Direct Materials: It is the primary classification for raw materials inmanufacturing
operations. It is directly related to the final product.
(b) Indirect Materials: It is the class of materials in the manufacturing processthat does
not actually ship to the customer as part of the final product. For example, the gas
used to heat the furnaces that melt the steel in the manufacture of hammers, is an
indirect material.

2) Work-in-progress: It includes partly finished goods and material held

betweenmanufacturing stages. It can also be stated that those raw materials which are
used in production process but are not finally converted into final product are work-in-
progress.

3) Consumables: Consumables are products that consumers buy recurrently, i.e.items

which „get used-up‟ or discarded. For example, consumable office supplies are such
products as paper, pens, file, folders computer disks, etc.
4) Finished Goods: The goods ready for sale or distribution comes under this class.It helps
to reduce the risk associated with stoppage in output on account of strikes, breakdowns,
shortage of materials, etc.

5) Stores and Spares: This category includes those products which are accessoriesto the
main products produced for the purpose of sale. For example, bolts and nuts, clamps,
screws, etc.

The following are a few examples of the type of inventory held by various organizations. Since
the final product (output) of a service organization such as bank, hospital, etc. cannot be stored
for use in the near future; the concept of inventory control for them is associated with the
various forms of productive capacity.

Type of Organizations Type of Inventories Held

Manufacturer Raw materials, spare parts, semi-finished goods,

finished goods
Hospital Number of beds, stock of drugs, specialized personnel

Bank Cash reserves, tellers

Airline company Seating capacity, spare parts, special maintenance crew

Motives of Holding Inventories

There are three main purposes of motives of holding inventories:
 Transaction Motive:
 Precautionary Motive:
 Speculative Motive:

Types of Inventory
 Movement Inventories:
 Buffer Inventories:
 Anticipation Inventories:
 Decoupling Inventories:
 Cycle Inventories:
 Independent Demand Inventory:
 Dependent Demand Inventories:
Costs of Inventory
In determining an optimal inventory policy, the criterion most often is the cost function. The
classical inventory analysis identifies four major cost components:
Cost of Inventory

Purchase Cost Ordering Cost / Set-up Cost

Carrying Cost Stock out Cost

Inventory Management Techniques

Several Techniques of inventory control are in use and it depends on the convenience of the
firm to adopt any of the techniques. What should be stressed, however, is the need to cover all
items of inventory and all stages, i.e. from the stage of receipt from suppliers to the stage of
their use. The techniques most commonly used are the following:
(i) Economic Order Quantity
(ii) Levels of Stock
(iii) Perpetual Inventory System
(iv)ABC Analysis
(v) Just in Time
(vi)Inventory Turnover
(vii) Inventory Control of Spares and Slow Moving Items

Economic Order Quantity:

EOQ is an important factor in controlling the inventory. It is a quantity of inventory which can
reasonably be ordered economically at a time. It is also known as
“Standard Order Quantity”, “Economic Lot Size” or “Economic Ordering Quantity”.
In determining this point ordering costs and carrying costs are taken into consideration.

The quantity may be calculated with the help of the following formula:

EOQ = √2AC † h

where, A = Annual quantity used (in units), C = Cost of placing an order (fixed
cost) and h = Cost of holding one unit.

For example, calculate EOQ from the following data.

Estimated requirement for the year 600 units
Cost per unit Rs.20
Ordering cost (per order) Rs.12
Carrying cost (% of average inventory) 20%

EOQ = √2AC † h = √(2×600×12)÷ (20×20%) = 60 units

CASH MANAGEMENT
Cash is one of the currents of a business. It is needed at all times to keep the business going. A
business concern should always keep sufficient cash for meeting its obligations. Any shortage
of cash will hamper the operation of a concern and any excess of it will be unproductive. Idle
cash is the most unproductive of all the assets. The fixed assets like machinery, plant, etc. and
current assets such as inventory will help the business in increasing its earnings capacity. But
cash in hand idle will not add anything to the concern.
Motives for holding cash
The firm‟s needs for cash may be attributed to the following needs: Transactions motive,
Precautionary motive and Speculative motive. Some people are of the view that a business
requires cash only for the first two motives while others feel that speculative motive also
remains.
Determining Cash Needs
The amount of cash for transaction requirements is predictable and depends upon a variety of
factors which are as follows:
(i) Credit position of the firm
(ii) Status of firm‟s receivable
(iii) Status of firm‟s inventory account
(iv)Nature of business enterprise
(v) Management‟s attitude towards risk
(vi)Amount of sales in relation to assets
(vii) Cash inflows and Cash outflows
(viii) Cost of Cash Balance

Meaning of Cash Management

Cash management refers to management of cash balance and the bank balance including the
short term deposits. For cash management purpose, the term cash is used in this broader sense
i.e. it covers cash, cash equivalents and those assets which are immediately convertible into
cash.

Objectives of Cash Management

The basic objectives of cash management are two-fold:
= Meeting the Payment Schedule:
= Minimizing Funds Committed to Cash Balance:

Advantages of Adequate Cash

= It prevents insolvency or bankruptcy arising out of the inability of a firm to meet its
obligation.
= The relationship with the bank is not strained
= It helps in fostering good relations with trade creditors and suppliers of raw materials as
prompt payment may help their own cash management.
= A trade discount can be availed, if payment is made within the due date.
= It leads to a strong credit rating which enables the firm to purchase goods on favourable
terms.
= The firm can meet unanticipated cash expenditure with a minimum of strain during
emergencies, such as strikes, fires or a new marketing campaign by
competitors.
Keeping large cash balances however, implies a high cost. The advantage of prompt payment
of cash can well be realized by sufficient cash and not excessive cash.

Importance of Cash Management

Cash management consists of taking the necessary actions to maintain adequate levels of cash
to meet operational and capital requirements and to obtain the maximum yield on short-term
investment of pooled, idle cash. A good management program is a very significant component
of the overall financial management of a municipality. Such a program benefits the city or
town by increasing non-tax revenues, improving the control and superintendence of cash. Also
increasing contacts with members of the financial community and lowering borrowing costs,
while at the same time maintaining the safety of the municipality‟s funds.

Basic strategies for Cash Management

The broad cash management strategies are essentially related to the cash turnover process, that
is, the cash cycle together with the cash turnover. The cash cycle refers to the process by
which cash is used to purchase materials from which goods are produced, which are then sold
 to customers, who later pay the bills.

Details of Cash Cycle

A B C D E F GH I

A = Materials ordered; B = Materials received; C = Payments;

D = Cheque clearance; E = Goods sold; F = Customer‟s payments
G = Payment received H = Cheques deposited I = Funds collected
Tools /Techniques of Cash Management
There are some specific techniques and processes for speedy collection of receivables from
customers and slowing disbursements.
i) Cash Management Planning
ii) Cash Management Control
Accelerating Cash Flows,
Controlling Cash Flows
iii) Determining Optimum Cash Balance
Problem
Prepare cash budget for the months of June, July, August, 2011 from the following information:
a) Opening cash balance in June Rs.7000/-
b) Cash sales for June Rs.20,000; July Rs.30,000; and August Rs.40,000
c) Wages payable Rs.6000 per month.
d) Interest receivable Rs.500 in the month of August
e) Purchase of furniture for Rs.16,000 in July.
f) Cash purchases for June Rs.10,000; July Rs.9000; and August Rs.14,000

Solution
Cash Budget for the period June to August 2011
Particulars June July August
Opening Cash Balance 7,000 11,000 10,000
Add: Estimated Cash Receipts
Cash Sales 20,000 30,000 40.000
Interest receivable -- 500
Total Receipts 27,000 41,000 50,500

Less: Estimated Cash Payments

Cash Purchases
10,000 9,000 14,000
Payment of Wages
6,000 6,000 6,000
Purchase of Furniture
-- 16,000 --
Total Payments
16,000 31,000 20,000

Closing Balance (surplus/deficit) 11,000 10,000 30,500

Cash Management Models
Two important cash management models which lead to determination of optimum cash balance.
Cash Management Models

Optimum Cash Balance under Certainty:

Baumol‟s Model
Miller-Orr Model Stone Model

Optimum Cash Balance under

Uncertainty
Optimum Cash Balance under Certainty: Baumol’s Model
The Baumol cash management model provides a formal approach for determining a firm‟s
optimumcash balance under certainty. It considers cash management similar to an inventory
management problem. As such, the firm attempts to minimize the sum of
the cost of holding cash (inventory of cash) and the cost of converting marketable securities
to cash.
Assumptions of Baumol’s Model
1) The firm is able to forecast its cash needs with certainty.
2) The firm‟s cash payment occurs uniformly over a period of time.
3) The opportunity cost of holding cash is known and it does not change over time.
4) The firm will incur the same transaction cost whenever it converts securities to cash.
Let us assume that the firm sells securities and starts with a cash balance of C rupees. As the
firm spends cash, its cash balance decreases steadily and reaches to zero. The firm
replenishes its cash balance to C rupees by selling marketable securities. This pattern
continues over time. Since the cash balance decreases steadily, the average cash balance will
be: C/2. The pattern is shown in the following figure:
Figure: Baumol’s Model for Cash Balance
Cash Balance
C

C/2 Average

Time
0 T1 T2 T3

The firm incurs a holding cost for keeping the cash balance. It is an opportunity cost; that is,
the return foregone on the marketable securities. If the opportunity cost is k, then the firm‟s
holding cost for maintaining an average cash balance is as:
Holding Cost = k(C/2)

The firm incurs a transaction cost whenever it converts its marketable securities to cash.
Total number of transactions during the year will be total funds requirement, T, divided by
the cash balance, C, i.e. T/C. The per-transaction cost is assumed to be constant. If per
transaction cost is c, then the total transaction cost will be:
Transaction cost = c(T/C)

The total annual cost of the demand for cash will be:
Total Cost = k(C/2) + c(T/C)

The holding cost increases as demand for cash, C, increases. However, the transaction cost
reduces because with increasing C the number of transactions will decline. Thus,
there is a trade-off between the holding cost and the transaction cost. The following figure
depicts this trade-off.

Figure: Cost Trade-off Baumol’s Model

 Cost Total
Cost

Holding Cost

Transaction Cost

Cash
Balance

The optimum cash balance, C*, is obtained when the total cost is minimum. The formula for
the optimum cash balance is as:
C* = √2cT /k Where,
C* is the optimum cash balance
c is the cost per transaction
T is the total cash needed during the year
k is the opportunity cost of holding cash balance
The optimum cash balance will increase with increase in per-transaction cost and total funds
required and decrease with the opportunity cost.

Limitations of the Baumol Model

1. Assumes a constant disbursement rate.
2. Ignores cash receipts during the period
3. Does not allow for safety cash reserves.

In spite of limitations, the model has a theoretical value. It gives an idea as to how the
holding cost and transaction cost should optimized by the firm. The cash balance being
maintained by the firm should be a level close to optimum level as given by the model so that
the total cost is minimized.
Optimum Cash Balance under Uncertainty
There are two optimum cash balance under uncertainty.
1) Miller-Orr Model
2) Stone Model
Miller-Orr Model
The Miller-Orr (MO) model is also known as stochastic model. This model overcome the
shortcoming of Baumol’s model and allows for daily cash flow variation. It assumes that net
cash flows are normally distributed with a zero value of mean and a standard deviation. The
MO model provides for two control limits – the upper control limit and the lower control
limit as well as a return point. If the firm‟s cash flows fluctuate randomly and hit the upper
limit, then it buys sufficient marketable securities to come back to normal level of cash
balance (the return point).
Similarly, when the firm‟s cash flows wander and hit the lower limit, it sells sufficient
marketable securities to bring the cash balance back to the normal level i.e. the return point.
 Figure: Miller-Orr Model
Cash Balance
Upper Limit

Purchase of securities

Return point

Sale of securities
Lower Limit

Time

The firm sets the lower control limit as per its requirement of maintaining minimum cash
balance. At what distance the upper control limit will be set? The difference between the
upper limit and the lower limit depends on the following factors:
(1) Transaction Cost (c); (2) Interest Rate (i); (3) standard deviation (σ) of net cash flows.
The formula for determining the distance between upper and lower control limits (called Z) is
as follows:
Upper Limit – Lower Limit)
= (¾ × Transaction Cost × Cash Flow Variance /Interest Rate)⅓
= (¾ × cσ2 /i)⅓

WORKING CAPITAL FINANCE: TRADE CREDIT

Working capital financing concerns how a firm finances its current assets. It is very essential
to any growing business. It helps to keep the business efficient and competitive in the market.

Trade Credit
Trade Credit refers to the credit extended by the suppliers of goods in the normal course of
business. As present day commerce is build upon credit, the trade credit arrangement of a
firm with its suppliers in an important source of short-term finance. The credit-worthiness of
a firm and the confidence of its suppliers are the main basis of securing trade credit.

Management of Trade Credit

The firm should exploit the possibilities of trade credit to the full extent, because it is an
important source of financing working capital needs of the firm. To facilitate the
management‟s decision-making the following financial ratios can be of great use.

Trade Credit to Total Current Assets Ratio: This ratio indicates the magnitude of the useof
trade credit in financing total current assets of a firm. The lower the ratio, the better will be
liquidity position of the firm.
Trade Credit to Total Current Assets Ratio
= Trade Credit / Total Current Assets
Trade Credit to Total Current Liabilities Ratio: This ratio indicates the proportion oftrade
credit to total current liabilities. It speaks on the financing mix adopted by the company. A
high ratio means increased dependence on spontaneous sources and difficult in getting funds
from negotiated sources.
 Trade Credit to Total Current Assets Ratio
= Trade Credit / Total Current Liabilities

Trade Credit to Sales Ratio: This ratio is also very useful form
Trade Credit to Total Current Assets Ratio
= Trade Credit / Total Current Liabilities
Percentage Change in Trade Credit to Percentage Change in Sales Ratio: This
ratioindicates the behavioral relationship between sales and trade credit. Generally speaking,
increasing sales demand increasing use of trade credit facilities. The rate of change in sales
must always be higher than the rate of change in trade credit.
Percentage Change in Trade Credit to Percentage Change in Sales Ratio =
(% Change in Trade Credit) / (% Change in Sales)

BANK FINANCE AND COMMERCIAL PAPER

Banks are the main institutional sources of working capital finance in India. After trade
credit, bank credit is the most important source of financing working capital requirements of
firms in India. The amount approved by the bank for the firm‟s working capital is called
credit limit. Credit limit is the maximum funds which a firm can obtain from the banking
system. Banks are required to fix separate limits, for the
„peak level‟ credit requirements and „normal non-peak level‟ credit requirements indicating
the periods during which the separate limits will be utilized by the borrower.
In practice, banks do not lend 100% of the credit limit; they deduct margin money. Margin
requirement is based on the principle of conservatism and is meant to ensure security. If the
margin requirement is 25%, bank will lend only up to 75% of the value of the asset. This
implies that the security of banks lending should be maintained even if the asset‟s value falls
by 25%.
Forms of Bank Credit
A firm can draw funds from a bank within the maximum credit limit sanctioned. It can draw
funds in the following forms:
 Secured Term Loans/ Bank Loans:
 Cash Credit:
 Overdrafts:
Commercial Paper
Commercial paper (CP) is an important money market instrument in advanced countries like
U.S.A. to raise short-term funds. In India, on the recommendation of the Vaghul Working
Group, the Reserve Bank of India introduced commercial paper in the Indian money market.
Commercial paper, as it is known in the advanced countries, is a form of unsecured
promissory note issued by firms to raise short-term funds. The commercial papermarket in
USA is a blue-chip market where financially sound and highest rated companies are able to
issue commercial papers.
o Duration:
o Denomination and Size: o
Maximum Amount:
Advantages of Commercial Paper
 It is an alternative source of raising short-term finance, and proves to be handy during
periods of tight bank credit.
 It is a cheaper source of finance in comparison to the bank credit. Usually, interest
yield of commercial paper is less than the prime rate of interest.
Disadvantages of Commercial Paper
 It is impersonal method of financing.
 It is available always to financially sound and highest rated companies.
 It cannot be redeemed until maturity.