Chapter 1

Introduction

Table of Contents

Chapter 1 : Introduction

1. Working Capital - A Theoretical Aspect...............................................................................................7

2. Factors affecting working Capital.........................................................................................................8
3. Cost of Capital......................................................................................................................................9
4. Factors Affecting cost of Capital........................................................................................................11
4.1. Risk-free Interest Rate:..............................................................................................................11
4.1.1. Real Interest Rate:.............................................................................................................12
4.1.2. Purchasing Power Risk Premium:.......................................................................................12
4.2. Business Risk:.............................................................................................................................12
4.3. Financial Risk:............................................................................................................................12
4.4. Other Considerations:................................................................................................................13
5. Determination of cost of capital........................................................................................................13
5.1. Debt Capital Cost:......................................................................................................................13
5.2. Cost of Debt :-............................................................................................................................14
5.2.1. Cost of Perpetual or irredeemable debt-...........................................................................14
5.2.2. Cost of Redeemable Debt..................................................................................................15
5.3. Cost of Preferred Share Capital..................................................................................................15
5.3.1. Types of Preference Share:................................................................................................15
5.4. Cost of Equity Share Capital.......................................................................................................17
5.4.1. Dividend Yield Method......................................................................................................17
5.4.2. Earnings Yield Method.......................................................................................................18
5.4.3. Dividend Yield plus Dividend Growth Method:..................................................................18
5.4.4. When dividends are anticipated to increase consistently throughout time:.....................19
5.5. Retained Earnings Cost:.............................................................................................................19
5.6. Weighted Average Cost of Capital.............................................................................................20
6. The Management of Working Capital................................................................................................21
6.1. Current Assets :.........................................................................................................................21

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6.2. Current Liabilities :.....................................................................................................................22

7. Working Capital - A Theoretical Discussion.......................................................................................22
“Working Capital is the excess of current assets over current liabilities.” - H.G, Guthmann....................23
8. Working Capital Concept...................................................................................................................24
8.1. Current Assets:..........................................................................................................................24
8.1.1. Inventories or stocks,.........................................................................................................25
8.1.2. raw materials,....................................................................................................................25
8.1.3. work-in-progress,...............................................................................................................25
8.1.4. finished goods,...................................................................................................................25
8.1.5. consumable stores,............................................................................................................25
8.1.6. bills receivable,..................................................................................................................25
8.1.7. short-term investments,....................................................................................................25
8.1.8. Prepayments,.....................................................................................................................25
8.1.9. accrued income,.................................................................................................................25
8.1.10. Balances in Cash and Banks...............................................................................................25
8.2. Current liabilities:......................................................................................................................25
8.2.1. sundry Creditors................................................................................................................26
8.2.2. Bills Payable.......................................................................................................................26
8.2.3. Accrued Expenses..............................................................................................................26
8.2.4. Bank Overdrafts.................................................................................................................26
8.2.5. Short-Term Bank Loans......................................................................................................26
8.2.6. Proposed Dividends...........................................................................................................26
8.2.7. Short-Term Loans...............................................................................................................26
8.2.8. Tax Payments Due..............................................................................................................26
9. Working Capital Circulating Cycle......................................................................................................26
10. Gross Working Capital...................................................................................................................28
11. Net Working Capital.......................................................................................................................29
12. working capital types.....................................................................................................................30
12.1. Classification on the Basis of Financial Statement."...............................................................30
12.1.1. Balance Sheet: Working capital is referred to as as based on balance sheet , when
information about it is gathered from the balance sheet, namely from the items that appear there.
30

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12.1.2. Profit and Loss Account.....................................................................................................30

12.2. Classification based on Variability..........................................................................................31
12.2.1. Permanent Working Money:..............................................................................................31
12.2.2. Variable working capital :..................................................................................................32
12.3. Percentage on Sales Method.................................................................................................33
12.3.1. Operating Cycle Method:...................................................................................................33
12.3.2. Regression Analysis Method:.............................................................................................34
13. Advantages of sufficient working capital.......................................................................................35
14. Disadvantages of Excess OR Inadequate Working Capital.............................................................36
15. Factors Influencing Working Capital..............................................................................................37
16. Current Assets components:.........................................................................................................39
We have discussed above about what current assets are. Now we will see in detail about the major
component of the current assets. The major and prominent components of the current assets are -..........39
16.1. Cash.......................................................................................................................................39
16.2. Debtors or Accounts receivables :.........................................................................................41
16.2.1. Debtors typically exhibit three key characteristics:...........................................................41
16.2.2. Receivables are related with the following costs:..............................................................41
16.3. Inventory...............................................................................................................................42
17. Current Liabilities...........................................................................................................................44
18. Working Capital Policy...................................................................................................................45
18.1. Defensive Strategy................................................................................................................45
18.2. Aggressive Strategy...............................................................................................................46
18.3. Conservative Strategy...........................................................................................................47
18.4. Techniques for Analysis of Working Capital...........................................................................47
19. Ratio Analysis.................................................................................................................................48
Classification of Ratios according to its nature..........................................................................................48
19.1. Current Ratio.........................................................................................................................49
19.2. Quick ratio or Acid Test ratio.................................................................................................50
19.3. Absolute liquidity ratio/cash ratio:........................................................................................51
19.4. Basic Defense Interval/ Interval Measure:.............................................................................52
19.5. Equity Ratio............................................................................................................................52
19.6. Debt Ratio..............................................................................................................................53

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19.7. Debt to Equity Ratio:..............................................................................................................53

19.8. Debt to Total Assets Ratio:.....................................................................................................53
19.9. Capital Gearing Ratio:............................................................................................................54
19.10. Proprietary Ratio:...................................................................................................................54
19.11. Total Asset Turnover Ratio:....................................................................................................55
19.12. Fixed Asset Turnover Ratio:...................................................................................................55
19.13. Capital Turnover Ratio/ Net Asset Turnover Ratio:................................................................55
19.14. Current Assets Turnover Ratio:..............................................................................................55
19.15. Working Capital Turnover Ratio:............................................................................................56
19.16. Inventory / Stock Turnover Ratio:..........................................................................................56
19.17. Raw Material Inventory Turnover Ratio –..............................................................................56
19.18. Receivables (Debtors) Turnover Ratio:..................................................................................57
19.19. Receivables (Debtors’) Velocity:............................................................................................57
19.20. Payables Turnover Ratio:.......................................................................................................57
19.21. Payable Velocity/ Average payment period can be calculated using:....................................58
19.22. Gross Profit Ratio or Gross Profit Margin..............................................................................58
19.23. Net Profit Ratio/ Net Profit Margin:.......................................................................................59
19.24. Operating Profit Ratio:...........................................................................................................59
19.25. Cost of Goods Sold (COGS) Ratio...........................................................................................60
19.26. Operating Expenses Ratio......................................................................................................60
19.27. Operating Ratio......................................................................................................................60
19.28. Financial Expenses Ratio........................................................................................................61
19.29. ROI ( Return on Investment )..............................................................................................61
19.30. Profitability Ratio...................................................................................................................61
19.31. Investment Turnover Ratio....................................................................................................61
19.32. Return on Assets (ROA):.........................................................................................................62
19.33. Return on Capital Employed (ROCE):.....................................................................................62
19.34. Return on Equity (ROE):.........................................................................................................63
19.35. Profitability / Net Profit Margin:............................................................................................64
19.36. Investment Turnover/Capital Turnover / asset Turnover :....................................................64
19.37. Return on Equity....................................................................................................................64

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19.38. Dividend per Share (DPS):......................................................................................................65

19.39. Dividend Payout Ratio (DP):...................................................................................................66
19.40. Price- Earnings Ratio (P/E Ratio):...........................................................................................66
19.41. Dividend and Earning Yield:...................................................................................................66
19.42. Market Value /Book Value per Share (MVBV):......................................................................67
19.43. Quick Ratio -...........................................................................................................................67
20. Trend Analysis:...............................................................................................................................72
21. Common Size Statement:..............................................................................................................72
22. Fund Flow Analysis:.......................................................................................................................73
23. Cash Flow Analysis:........................................................................................................................74
24. Arithmetic Mean:...........................................................................................................................74
25. Co-efficient of Variation:................................................................................................................75
26. Simple Growth Rates:....................................................................................................................76
27. Trend Indices:................................................................................................................................76
28. Co-relation Co-efficient:.................................................................................................................77
29. ANOVA (Single Factor) F test:........................................................................................................79

List of Figures

Figure 1 : Working Capital Management in Balanced Way........................................................................11

Figure 2 : Working Capital Management to Increase Wealth....................................................................13
Figure 3 :Working Capital Calculation........................................................................................................21
Figure 4 : Working capital Flow................................................................................................................27
Figure 5 : Components of Gross Working capital......................................................................................28
Figure 6 : Net Working capital..................................................................................................................29
Figure 7 : Factors Effecting Working capital.............................................................................................37
Figure 8 : Motive of Holding cash.............................................................................................................40
Figure 9 : Financing of Current Assets......................................................................................................47
Figure 10 : Types Of Ratio Analysis.........................................................................................................50
Figure 11 : Current ratio Formula..............................................................................................................50
Figure 12 : Quick ratio Formula................................................................................................................52
Figure 13 : cash ratio Formula...................................................................................................................52
Figure 14 : Basic Defence Interval Formula..............................................................................................53
Figure 15 : Correlation Coefficient............................................................................................................78

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Chapter 1
Introduction

1. Working Capital - A Theoretical Aspect

A crucial responsibility of the finance manager is the management of working

capital. He must make sure that the amount of the working capital available is sufficient
for its needs — hence neither far too much nor too little from the optimal level required.
If the firm has a large amount of the working capital, it probably has money lying idle
around. Due to the cost of money (finance), the corporation must pay significant interest
on the amount used to purchase surplus working capital. Another perspective is that
there is an opportunity cost because the corporation could have used the extra money to
make long-term investments and get a return.
We are aware that a finance manager's primary responsibility is to raise money and use it
wisely. The maximization of wealth is an important goal of financial management.
Therefore, the finance manager must choose a capital structure where investor’s
expectations are low and shareholders' wealth is high. He must first determine the costs
associated with various sources of funding for that objective. To properly understand the
working capital management , we should also understand the cost of capital concept and
capital structure. The return that investors, lenders, and debt holders expect to receive
from the business in exchange for their capital contributions is known as the cost of
capital.
When an entity (corporate or others) obtains funds from either of the aforementioned
sources, then in addition to the principal amount, it is required to pay another sum of
money. The extra cash given to these financiers may be a one-time payment or a
recurring payment made at predetermined intervals. The cost of capital refers to the
increased cash outlay that is allegedly incurred as a result of utilizing capital. The cash
flow or stream of cash flows is compounded or discounted using this cost of capital
stated as a - rate. Other names for cost of capital include "cut-off" rate, "hurdle rate,"
"minimum rate of return," etc. It serves as a standard for setting a company's capital
structure or debt policy.

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2. Factors affecting working Capital

Business needs to estimate the requirement of working capital in advance for
proper control and management. The factors influence the quantum of working
capital in the business. The assessment of working capital requirement is made
keeping these factors in view. Each constituent of working capital retains its form
for a certain period and that holding period is determined by the factors
discussed above. So for correct assessment of the working capital requirement,
the duration at various stages of the working capital cycle is estimated.
Thereafter, proper value is assigned to the respective current assets, depending
on its level of completion.

These are discussed here in detail-

1. The proportion of the cost of materials to total cost - In those industries where
cost of materials is a large proportion of the total cost of the goods produced or
where costly material will have to be used, requirements of working capital will be
rather large sums are required for this purpose. But if the importance of materials
is small, as for example, in an oxygen company, the requirements of working
capital will naturally be small.

2. Importance of labor- This factor operates like the one mentioned above. If goods
are manufactured with the help of labor, large sums of money will have to be kept
invested as working capital. Industries where there is a great degree of
mechanization, the working capital requirements are correspondingly small. It may
be remembered, however, that to some extent the decision to use manual labor or
machinery lies with the management. Therefore, it is possible in most cases to
reduce the requirements of working capital and increase investment in fixed assets
and vice versa.

3. Length of period of manufacture. The time which elapses between the

commencement and the end of the manufacturing process has an important bearing
upon the requirements of working capital. If it takes long to manufacture the
finished product, a large sum of money will have to be kept invested in the from of
work-in progress at all stages. Hence, working capital will be required in large
amounts. To give an example a baker requires a night’s time to bake his daily
quota of bread. His working capital is, therefore, much less than that of a ship-
building concern which takes three to five years to build a ship.

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4. Stocks - Manufacturing concerns generally have to carry stocks of raw materials

and other stores and also finished goods. In certain cases, manufacture is carried
out only against a definite order from a customer and as soon as production in
completed the gods are delivered to him. In this case, there will be no finished
stocks, and to this extent, the requirements, of working capital will be reduced.
The larger the stocks, whether of raw materials or finished goods, the larger will
be the requirement of working capital. To some extent, the size of stocks to be
carried will depend upon the decisions of management. Besides, the stocks to be
carried are generally proportionate to the volume of sales.

5. Rapidity of turnover- Turnover represents the speed with which the working
capital is recovered by the sale of goods. In certain businesses, sales are made
quickly so that stocks are soon exhausted and new purchases have to be made. In
this manner, a small sum of money invested in stocks will result in sales of a much
larger amount. Considering the volume of sales the amount of working capital
requirements will be rather small in such types of businesses. There are other
business where sales are made infrequently. For instance, in case of jewelers, a
piece of jewelry may stay in the show-window for a long time before it catches the
fancy of a rich lady. In such cases large sums o money have to be kept invested in
stocks. But a baker or a new-hawker may be able to dispose of his socks quickly,
and may, therefore, need much smaller amounts by way of working capital.

6. Terms of Credit- It goes without saying that if credit is allowed by suppliers,

payment can be postponed for some time and can be made out of the sale proceeds
of the goods produced. In such a case, the requirements of working capital will be
reduced. The requirements will obviously be increased if credit has to be allowed
to customer. The period of credit also determined the working capital requirements
of a concern. If, for example, a retailer is allowed credit for a longer period than is
allowed by him to his own customers, he would not need much working capital
because he can pay the supplier after he has collected debts from his debtors.

3. Cost of Capital
To understand the working capital management properly, we must understand first
the cost of capital .The cost of capital is crucial to calculating the right amount and helps
management or investors in making the right choice. Making the following decisions is
aided by knowing the appropriate cost of capital:

Investment option evaluation: The projected benefits (future cash flows) from potential
investment possibilities (businesses or projects) are discounted with the appropriate cost
of capital to arrive at the present value of benefits.

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It is crucial to select the cost of capital that is appropriate for the options available
because different investment opportunities may have varying costs of capital.

The estimated and calculated benefits (future cash-flows) from available

investment opportunities (business or project) are then converted into the
present value of benefits by discounting them with appropriate and relevant
cost of capital. Here it is pertinent to mention that every and each
investment option may be having different cost of capital hence it is very
important to use cost of capital which is thus relevant to the options
available.

A finance manager can simply analyze the costs of the two sources of funding and select
the one with a lower cost when required to choose between them. He takes into account
management and financial risk in addition to cost.

Creating the best credit policy: When determining the credit duration that should be
granted to consumers, the cost of doing so is contrasted with the advantage or profit
obtained from giving credit to a certain group of customers. The present value of the
costs and benefits is determined in this case using the cost of capital.

Figure 1 : Working Capital Management in Balanced Way

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4. Factors Affecting cost of Capital

The minimal expected rate of return for investors or fund suppliers to the company is
known as the cost of capital. The expected rate of return is influenced by a variety of
factors, including the firm's risk profile, investors' perceptions of risk, and many more.
The following are a few of the elements that affect a company's cost of capital
determination.

4.1. Risk-free Interest Rate:

The interest rate on risk-free and default-free assets, if any, is known as the "risk
free interest rate." For instance, the Government of India's securities are regarded
as risk-free and default-free in terms of the payment of periodic interest as well as
the return of principal at maturity. Theoretically, the risk-free interest rate, If, is
based on the financial market's supply and demand for long-term funds. The If,
which has two parts and is determined by the market's sources of supply and
demand

4.1.1. Real Interest Rate:

The interest rate due to the lender for providing the money, or in other words, for
surrendering the funds for a specific term, is known as the real interest rate.

4.1.2. Purchasing Power Risk Premium:

When a lender lends money, he actually lends the borrower his current purchasing power.
The lender occasionally receives the same amount of cash back when he receives
repayment. However, if prices rose at the same time, he would not be receiving the same
level of purchasing power in return. In general, investors prefer to keep their purchasing
power intact and as a result, they prefer to be reimbursed for the purchasing power they
lose over the course of a loan or supply of money. In order to calculate the risk-free
interest rate, the purchasing power risk premium is therefore included in addition to the
real interest rate. The buying power risk premium would be higher the higher the
anticipated rate of inflation, and as a result, the risk free interest rate, or IRF, would also
be higher.

4.2. Business Risk:

The risk connected with the firm's promise to pay interest and dividends to its investors is
another element that influences the cost of capital. The company's earnings before

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interest and taxes, or EBIT, and how they change in reaction to changes in sales revenue
are tied to the business risk. Every project has an impact on the company's business risk.
The investor will likely increase the cost of financing to account for the higher risk if a
firm accepts a proposal that is riskier than the average current risk. The term "business
risk premium" refers to the additional premium that is added to the business risk
compensation. There will always come a time when the investor will no longer want to
provide the funds, regardless of the return that the company is willing to provide.

4.3. Financial Risk:

The firm's cost of capital may be impacted by this additional form of risk. The
capital structure, sometimes referred to as the financial plan or capital structure,
and its specific composition can have an impact on the return that investors can
expect. The probability that the company will be unable to pay its fixed financial
charges is a common definition of financial risk. It has to do with how the firm's
earnings per share react to changes in EBIT. The capital structure or the firm's
financial plan have an impact on the financial risk. Financial risk would increase
as the percentage of fixed-cost assets in the overall capital structure increased. In
this situation, the investor has to be paid for the additional risk. In addition to the
business risk premium, they also include the financial risk premium.

4.4. Other Considerations:

The investors might also want to add a premium in light of further variables. The
investment's liquidity or marketability may be one of these factors. Less premium would
be requested by the investor the more liquidity is offered with an investment. Investors
may add a premium for this as well and consequently demand a greater rate of return if
the investment is difficult to sell.

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Figure 2 : Working Capital Management to Increase Wealth

5. Determination of cost of capital

Cost is not the sum that the corporation anticipates or actually pays; rather, it is
what stakeholders expect. Stakeholders in this case include intermediaries (brokers,
underwriters, merchant bankers, etc.), capital providers (shareholders, debenture holders,
money lenders, etc.), and the government (for taxes).

5.1. Debt Capital Cost:

Term loans, bonds, and debentures are all considered debt in general. A
firm is willing to pay the set rate of interest that is always attached to debts in
order to increase its profitability and wealth. The rate adjacent to the debt, which is
typically displayed (as a 10% or 12% Debenture), is the rate of interest to be paid
over the Debenture/debt, but this is not the only cost associated with the issuance
of debt; the actual cost may be different from this rate. Knowing the relationship
between interest and the actual amount realised is necessary to determine the
actual charge (real cost of debt) (Net Proceed).The amount actually recovered after
adjusting the discount or premium on the face value of the loan or debentures and
deducting floating charges is known as the net proceeds.
As following will be used to determine Net Proceeds:

Net Proceeds=Net Face value of Debenture + Premium onissue ( if any ) – discount onissue (if any ) – floatat

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The term "floatation costs" refers to all fees or costs incurred in order to
secure a loan, such as advertising costs, postage, stationery, printing costs,
stamp duty, brokerage underwriting commission, etc.
Debt capital can be categorised into one of two categories:

5.2. Cost of Debt :-

This is the cost associated with the Debt Capital mentioned above. This is
mainly of two type, discussed below

5.2.1. Cost of Perpetual or irredeemable debt-

These Debt capital are not redeemed and remains always.
These are the debts that cannot be repaid for the duration of the
business. Only upon the company's insolvency are they repayable.
The amount of interest due on this kind of debt capital is divided by
the net revenues from its issuance to determine the cost of the debt
capital.
Cost of these irredeemable debt is calculated as below:

I ( 1−t )
C d (after Tax)= x 100
NP

Where
I = interest rate
NP = Net Proceeds

5.2.2. Cost of Redeemable Debt

MV −NV
I ( 1−t ) +
n
C d (after Tax)= x 100
MV + NV
2

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Where,
Cd ( after Tax ) = Cost of debt capital after tax
I= interest rate
MV = Maturity Value
N = Number of years to Maturity
Debentures typically have a time limit for repayment. The length of time
until such debts are redeemed is crucial in determining the cost of those
loans.

5.3. Cost of Preferred Share Capital

Like debentures, preference shares are fixed cost bearing securities. On

these shares, the dividend rate is fixed. Contrary to debentures, where the
cost of capital is considered to be "after tax," the cost of preference shares is
considered to be "before tax," and this can be changed by using the
following formula:

5.3.1. Types of Preference Share:

There are two types of preference shares , these are –

1. Perpetual or irredeemable Preference share

2. Redeemable Preference Shares

5.3.1.1 Perpetual or irredeemable Preference share

The cost of these preference shares is calculated as the annual dividend
burden divided by the share's net proceeds.

Using the formula:

PD
C p ( ¿ K p )= x 100
NP

Where,
C p= Cost of Preference Capital
PD= Preference Dividend amount per share
NP= Net proceeds per Share

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Following formula is used if dividend tax is paid:

C p ( ¿ K p )=PD ¿ ¿

Here, Dt = Dividend Tax

Note:

The only distinction between the cost of debt and preference shares is that,
since dividends were paid on preference shares, we will take preference
dividends instead of interest when calculating the cost of preference shares.
We will first calculate the after-tax cost of preference shares before
converting it to the before-tax cost.
5.3.1.2 Cost of Capital for Redeemable Preference Shares:

After a predetermined time, these shares are redeemed. Similar to how

redeemable debentures are addressed, the cost of such shares is calculated.
Periods of issue, terms of redemption, and floating costs will all require
modifications.

For this, the formula shown below may be used:

MV −NP
PD +
n
C p= x 100
MV + NP
2

Where,
PD = Preference dividend
MV= Maturity Value
NP=Net Proceeds
N= Number of years after which the preference Shares will be repaid

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5.4. Cost of Equity Share Capital

Because there is no predefined rate of dividend due on these shares, unlike

preference share capital, and no legal requirement to pay dividend on them,
calculating the cost of equity share capital is a challenging undertaking. It
does not, however, imply that equity share capital is free.
The price of such capital is equal to the expectation of equity shareholders,
who count on the management to keep their business running.

The three methods for calculating the cost of equity share capital are as
follows:

5.4.1. Dividend Yield Method

The Dividend/Price Ratio Method, or D/P Ratio Method, is another name

for this. This method is predicated on the idea that an investor anticipates a
dividend at least equal to the current rate of return when he puts his savings
in a company. As a result, the cost of equity capital is determined based on
the expected future dividend payments from a company to its shareholders.

The equation is:

DPS
C e ( after Tax ) = x 100
MP

Where,
C e ¿ Cost of Capital
DPS= Current Cash Dividend per share
MP= Market price peer share

5.4.2. Earnings Yield Method

This is often referred to as the E/P Ratio Method or the Earnings/Price

Ratio Method. According to this strategy, shareholders capitalization
predicted future earnings (as opposed to dividends) in order to assess their
shareholders because the market price of the shares is dependent on
earnings per share.

In order to determine the cost of equity capital, one must relate earnings per
share to its market price.

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The equation reads as follows:

EPS
C e ( after Tax ) = x 100
MP

Where,
C e ¿ Cost of Equity Share Capital
EPS= Earnings per share
MP= Market price per share

5.4.3. Dividend Yield plus Dividend Growth Method:

The Dividend/Price + Growth in Dividend Method, or D/P + G Method, is

another name for this approach. This approach is predicated on the idea that
each equity shareholder expects the company's future earnings to improve,
thus instead of being content with the current dividend rate alone, he or she
wants it to rise annually.

By calculating the necessary modifications to the existing dividend rate in

accordance with the anticipated rate of growth in the company's future
earnings, this method determines the cost of equity share capital.

This rate of growth is known as the growth rate:

5.4.4. When dividends are anticipated to increase consistently throughout

time:

In this instance, the cost of equity capital determined in accordance with the
D/P ratio technique is increased by the dividend growth rate per year.

The equation is:

DPS
C e ( after Tax ) =[ x 100]+G
MP (¿ NP)

Where,
C e ¿ Cost of Equity Share Capital

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DPS= Expected Dividend per share

MP= Current Market price per share
NP= Net proceeds per share
G= Growth Rate in Expected Dividend ( or expected annual percentage rate of increase in
future dividends

5.5. Retained Earnings Cost:

Retained earnings are the portion of a company's earnings that are still in its
possession after dividends have been distributed to shareholders. They are
frequently referred to as the concern's internal equity. Since the business is
neither explicitly or implicitly obligated to provide a return on these gains,
there is no explicit cost associated with this type of profit. However,
treating them as though they are free is incorrect.

The opportunity cost of this source of funding is actually its cost. If retained
earnings had not been kept, they would have been distributed as a dividend
to the shareholders, who should have used the money to make returns on
alternative assets.

The stockholders are compelled to forgo such return when earnings are
maintained. As a result, the expected return on dividends forgone by
shareholders may be considered the cost of retained earnings.

The cost of retained earnings will be determined using the following

formula:

DPS ( 1−T i ) (1−B)

C r (¿ K r)=
MP(1−T c )

Where,
C r ¿ Cost of retained earning
DPS= Dividend per share
T i ¿ Marginal tax rate applicable ¿ individual shaareholder
B= Brokerage Cost
MP= Present Market price per share
T c ¿ Capital Gain Tax
G= Growth Rate of Dividends

Notes:

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By using the calculation above, the cost of retained earnings is the after-tax
cost.

However, by using the following formula, it may be changed into a

before-tax cost:

After Tax Cost

Before Tax Cost=
1−Tax rate

5.6. Weighted Average Cost of Capital

We must determine the total cost of capital, which will act as the discount rate for
investment decisions, after calculating the cost of capital of various sources of funding.
The total cost of capital for the entire project would be the weighted average cost of
capital since throughout a project we have to employ a range of sources to cover our full
capital demand (WACC).

The cost of capital of each individual source and the proportion of each source to the total
are the two variables that determine the WACC. A high individual source's cost of capital
will have minimal effect on the total if its percentage of the total is small, but a high share
will significantly raise the WACC.

WACC =[ ( weig h tage of Equity X Cost of Equity ) + ( weig htage of Debt x Cost of Debt ) ] x (1−Tax Rate )

6. The Management of Working Capital

Working capital is referred to in accounting as the difference between current assets and
current liabilities. Working capital is made up of the following elements, which can be
broken down as follows:

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 Chapter 1
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Figure 3 :Working Capital Calculation

6.1. Current Assets :

Current assets of an entity can be divided into the following groups for working capital
management purposes:

 INVENTORY (RAW MATERIALS, FINISHED GOODS, AND WORK-

IN-PROGRESS );
 RECEIVABLES (TRADE RECEIVABLES AND BILLS RECEIVABLES)
 CASH OR CASH EQUIVALENTS (INCLUDING SHORT-TERM
MARKETABLE SECURITIES )
 PREPAID EXPENSES
 OTHER CURRENT ASSETS COULD ALSO INCLUDE ANY OTHER
ACCRUED INCOME, SHORT-TERM LOANS OR ADVANCES, ETC.

6.2. Current Liabilities :

If it is anticipated to be paid within the entity's normal operating cycle or within twelve
months following the reporting period, whichever comes first, a liability is considered
current. Additionally, it is considered current if either current assets are used to pay it or
new current liabilities are created. For working capital management purposes, current
liabilities of an entity can be divided into the following categories: Payable (trade
payables and bills payables) and Remaining balances (wages, salary, overheads, and
other expenses, etc.).Other current liabilities could include short-term loans, the current
portion of long-term obligations, and short-term provisions that are due in the next year,
including tax provisions.

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 Chapter 1
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Working Capital Management is a procedure that makes sure an organisation runs

smoothly by keeping track of and effectively using both its current assets and current
liabilities. The primary goal is to ensure that a firm has enough cash flow to cover its
short-term obligations and daily operational costs.

7. Working Capital - A Theoretical Discussion

Working capital is the lifeline and line blood to the entities. Various experts and authors
has given the suitable definition on it. Some of the prominent definition are –

“Working Capital is the excess of current assets over current liabilities.” - H.G,
Guthmann1

“Working Capital is descriptive of that capital which is not fixed. But the more common
use of the Working Capital is to consider it as the difference between the book value of
the C.A. and current liabilities.” - Hoglend. J. Bierman, and A. K. Mc Adams2

Mayer J.N. said that working capital is the amount of current assets that would remain in
a firm if all its current liabilities are paid.3

L. N. Chopde, D. H. Choudhri & Sandeep Chopde define “Working capital is descriptive

of that capital which is not fixed but, the more common use of working capital is to

1
H. G. Guthmann, analysis Of Financial Statements,(New Yourk: Prentice Hall) IV
Edition-1953
2
Hoglend. J. Bierman, and A. K. Mc Adams, Management Decisions for Cash and
Marketable Securities,( New York : Graduate School of Business, Cornell University),
1962
3
Myer, J.N., Financial Statement Analysis, Prentice Hall of India Ltd.,1974, p.99

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 Chapter 1
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common use of working capital is to consider it as the difference between the book value
of the current assets and current liabilities.”4

Arvind A. Dhond said that “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 receivables and receivables to cash.5

“Working Capital according to the time honored definition.” Say Professor Henry G.
Gethmann and Herbert E. Gaugall, “is the excess of current assets over current
liabilities.”6

“Gross Working Capital may be used to refer to total C.A. and net working capital refers
to the surplus of C.A. over current liabilities” - Prof. S.C. Kuchhal7

Thus ,
Working capital can be defined as excess of Total of the current assets over total of the
current liabilities.

That is to say, if we have Rs. 2,00,000 current assets and Rs. 1,50,000 current liabilities
the Rs. 50,000 will be the in working capital that is Rs. 200000- Rs. 150000. As a result,
working capital is the sum of current assets that are still held by the company after all
liabilities have been settled. It implies When a company still has working capital, it has
no further obligations to fulfill in short run with short fulfillment nature.

8. Working Capital Concept

4
Chopde, L.N., Choudhri, D.H., and Chopde Sandeep, Introduction to Financial
Management
5
Dhond, Arvind. A., Financial Management, Vipul Prakashan, Mumbai, 3rd Edn., p.11-1

6
Quoted by Sharma, N.K., Capital Management, Surabhi Publication, Jaipur, 1998,p. 39.
7
S.C. Kuchhal, Financial Management – An Analytical and Conceptual Approch,
(Allahabad: Chaitanya publishing House) – 1982

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 Chapter 1
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The amount of money needed for the regular operation of commercial activity is known
as working capital Brown and Howard likened it to a river, saying that whose water level
is always there yet fluctuates constantly.

Working capital is comprised of a wide range of current assets and current liabilities,
including the following:

8.1. Current Assets:

These assets are often realised quickly, within a year, in most cases. In other terms,
current asset is an asset that a company holds and can be easily sold or consumed and
further lead to the conversion of liquid cash. For a company, a current asset is an
important factor as it gives them a space to use the money on a day-to-day basis and clear
the current business expenses. In other words, the meaning of current assets can be
explained as an asset that is expected to last only for a year or less is considered as
current assets. The components of above are listed below-
8.1.1. Inventories or stocks,

8.1.2. raw materials,

8.1.3. work-in-progress,

8.1.4. finished goods,

8.1.5. consumable stores,

8.1.6. bills receivable,

8.1.7. short-term investments,

8.1.8. Prepayments,

8.1.9. accrued income,

8.1.10.Balances in Cash and Banks

8.2. Current liabilities:

Current liabilities are those that are typically settled within a year in the normal course of
business. These are an enterprise’s obligations or debts that are due within a year or
within the normal functioning cycle. Moreover, current liabilities are settled by the use of
a current asset, either by creating a new current liability or cash. Current liabilities appear
on an enterprise’s Balance Sheet and incorporate accounts payable, accrued liabilities,

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 Chapter 1
Introduction

short-term debt and other similar debts. The average amount of current liabilities is a vital
component of various measures of the short term liquidity of trading concern.
The following are examples of current liabilities:
8.2.1. sundry Creditors

8.2.2. Bills Payable

8.2.3. Accrued Expenses

8.2.4. Bank Overdrafts

8.2.5. Short-Term Bank Loans

8.2.6. Proposed Dividends

8.2.7. Short-Term Loans

8.2.8. Tax Payments Due

9. Working Capital Circulating Cycle

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 Chapter 1
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Figure 4 : Working capital Flow

In the context of working capital management, the phrases "working capital cycle" and
"operating cycle" are identical. Any company concerned, regardless of its industry—that
is financial, commerce, or manufacturing—needs time to see the results of its efforts.
For example, by making an investment of money and working hard for a while, you can
make money. However, after making a cash investment, it is unable to quickly recoup
that profit in cash. It needs time to complete. The period of time between investing
money in assets and then withdrawing it again is known as the operational or working
capital cycle. The cycle here refers to the duration.

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 Chapter 1
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Depending on the kind of company and its operations, the length of the working capital
cycle may vary from one to the next. It implies that the working capital cycle pattern
changes depending on its operations.

10. Gross Working Capital

The term Gross Working Capital or working capital. It refers to the firms investment in
current assets. The assets that may be turned into cash within an accounting year are
known as current assets. Items that fall under the category of current assets include raw
material inventories, work-in-progress, completed goods, debtors, cash and bank
balances, pre-paid costs, accumulated revenue, advance payments, short-term
investments, etc.
Gross working capital is a measure of working capital that places a greater focus on its
amount than its quality. From the perspective of a financial management, this idea is
crucial for planning the ideal amount of total working capital.

Figure 5 : Components of Gross Working capital

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 Chapter 1
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It includes Cash and cash equivalents , accounts receivables , stock or inventory,

marketable securities , prepaid expenses or prepaid liabilities and other liquid assets.
The gross notion makes sense from a commercial perspective. In the world of financial
management, this idea is more often used.

Gross working capital = total current assets

11. Net Working Capital

The term Net Working Capital refers to the difference between total current assets and
total current liabilities, or The gap between current assets and current liabilities is known
as net working capital.

The difference between current obligations and current assets. Creditors, bills that must
be paid, short-term bank overdrafts, pending costs, etc. are all included in total current
liabilities. A positive or negative net working capital is possible. Positive working capital
is achieved when current assets are greater than current liabilities. When the current
obligations exceed the current assets, working capital is negative. Crisis situations like
this one are uncommon in corporate organisations.
The net working capital provides the organisation with qualitative data. Accounting
professionals, investors, creditors, and other anyone with an interest in the firm's liquidity
and financial stability can all benefit from understanding the notion of net working
capital.

The following equation can be used to determine net working capital:

Net working capital = current assets – current liabilities

Figure 6 : Net Working capital

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 Chapter 1
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12. working capital types

There are two classifications that working capital can be categorised under:

12.1. Classification on the Basis of Financial Statement."

Classification on the Basis of Financial Statements

As working capital information is gathered from the profit and loss account or balance
sheet, this classification has been made based on financial statements.

12.1.1.Balance Sheet: Working capital is referred to as as based on balance

sheet , when information about it is gathered from the balance sheet,
namely from the items that appear there.
Might once more be categorised as;

Gross working capital

Net Working capital

Deficit working capital

12.1.2.Profit and Loss Account

 Cash working capital: When the working capital-related items, or the

items showing in the P&L Account, are collected from the profit and loss
account, cash working capital is created. Since it demonstrates the
sufficiency of cash flow in a business, it is thought to be a more realistic
method and to have tremendous significance for working capital
management in recent years. It displays the actual movement of money and
values at a specific time. It is based on the idea of an operational cycle.

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 Chapter 1
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The amount of time needed, in the case of a manufacturing company, to

complete various events, such as the conversion of cash into raw materials,
raw materials into works-in-progress into finished goods, finished goods to
debtors, bill 9 receivable through sales, and the conversion of bill
receivable to cash, etc.

12.2. Classification based on Variability

12.2.1.Permanent Working Money:

This is the minimal amount of capital that any business must have on hand to spend in
current assets throughout the course of a year in order to meet client needs even during
the off-season. With the expansion of the business, the amount of permanent working
capital will also rise.

Once more, we may break up permanent working capital into:

a. Initial working capital
b. regular working capital

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 Chapter 1
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Initial working capital is the sum of working capital needed when a business is first
established. In the beginning, it is challenging for the company to obtain credit from the
bank; yet, it can be necessary to extend credit to its clients. In a situation like this,
sufficient working capital is needed to get the money going and keep it moving until the
debtors are paid off in full.

Regular working capital is the bare minimum of liquid capital required to maintain the
flow of funds from cash to raw materials, work in progress to finished goods, finished
goods to debtors, and debtors back to cash. It is a necessary, everyday task. A constant
and regular flow of operating capital must be maintained. A minimum stock of raw
materials, finished commodities, and cash is included in regular working capital.

12.2.2.Variable working capital :

Variable working capital is an amount that is above the permanent working capital
needed to meet the firm's seasonal demand. It fluctuates depending on the business's
operational size and seasonal demands. Additionally, variable working capital may be
separated into;

12.2.2.1seasonal Working capital -

Working capital needed to meet seasonal demand is referred to as seasonal working
capital Working capital requirements vary according to the season, with off-season
requirements being lower.

12.2.2.2Special working capital:

Every firm must deal with ambiguous situations. A company needs specialised cash
above and above its seasonal requirements to handle such unforeseen occurrences. Such
capital is referred to as special working capital. The portion of the variable working
capital known as special working capital is needed to finance special operations.

Techniques or methods for Determining Working Capital

Establishing the necessary working capital is one of the most important short-term plans
that is essential to the successful operation of the firm. The Working capital needs to be

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determined carefully; otherwise, it can be overestimated or underestimated. The operating

capital amount should be adequate. The methods shown below can be used to calculate
the amount of working capital needed.

1. Percentage on Sales Method

2. Operating Cycle Approach
3. Regression Analysis Method
4. Percentage on Sales Method:

12.3. Percentage on Sales Method

It is a simple method of determining the level of working capital and its components.
This approach bases working capital on actual or anticipated sales. It is decided based on
historical data experience. If the relationship between sales and working capital proves to
be consistent over time, it may be used as a foundation for forecasting future working
capital. This approach is straightforward, simple, and effective for predicting working
capital. percentage based on sales: It is an easy approach for figuring out the components
and quantity of working capital. This approach bases working capital on actual or
anticipated sales. Based on prior knowledge, it is decided. If the relationship between
sales and working capital proves to be consistent over time, it may be used as a
foundation for forecasting future working capital. This approach is straightforward,
simple, and effective for predicting working capital.

12.3.1.Operating Cycle Method:

The period of time required to transform raw materials into completed items, those goods
into sales, and those things into receivables into cash is referred to as the operating cycle.
When calculating the amount of working capital needed, the operating cycle technique
takes into account the time needed to acquire various current asset categories as well as
the lag time needed to pay for purchases and costs. the following stages could be used to
categorise its Stages include:

1: Raw materials and storage

2: Work-in-Progress

3: Finished or completed goods inventory storage

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 Chapter 1
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4: Receivables

The sum of the durations of each of these stages, less the credit time permitted by
the company's suppliers, is the operating cycle duration for working capital estimation
purposes. Numerically

O=R+W+F+D–C

Where;

O = Duration of Operating Cycle period

R = Raw Material Period that is (Average Stock of Raw Material /

Average Raw Material and Storage Consumption per Day)

W =Work-in-Progress Period that is (Average Work-in-Progress

Inventory / average Cost of the Production per Day)

F =Finished Goods Inventory Storage Period that is (Average Finished

Stock Inventory / the Average Cost of Goods Sold Per Day)

D =Receivable Stage

C = Creditors Payment Period or duration

12.3.2.Regression Analysis Method:

The regression analysis method is a very useful statistical technique of forecasting
working capital requirement. After determining the typical link between sales and the
working capital and its components during the previous years, it aids in developing
projections in the field of working capital management. The analysis can be done using a
mathematical formula or a pictorial representation (Scatter Diagram).The relationship
between sales and working capital may be straightforward and completely linear,

33
 Chapter 1
Introduction

showing total linearity between the two, or it may be complex to varying degrees,
involving simple linear regression, simple curvilinear regression, and multiple regression
scenarios. Both basic and complicated situations can be solved using this technique.

A business's working capital serves as its heart and brain. Working capital is crucial to
the continued smooth operation of a firm, much as blood circulation is necessary for
preserving life in the human body. Without sufficient operating capital, no business can
operate successfully. The following are the key benefits of keeping sufficient operating
capital:

13. Advantages of sufficient working capital

1. Solvency of the business: Adequate working capital assists in keeping solvency

of the business by providing uninterrupted production flow.

2. Goodwill: Having enough working cash enables a company to make prompt

payments, which contributes to the development and maintenance of goodwill.

3. Easy loans: A concern ensuring sufficient working capital, high solvency and
strong credit standing can arrange loans from financial institutions and other on
easy and favourable terms.

4. Cash Discounts: A company with sufficient operating capital can also take
advantage of cash discounts on purchases, which lowers costs.

5. Consistent supply of raw materials: Consistent supply of raw materials and

continuous production are ensured by adequate working capital.

6. Regular payment of salaries, wages, and other day-to-day obligations: A

business with sufficient working capital can pay salaries, wages, and other day-to-
day obligations on time, which boosts employee morale, promotes productivity,
lowers costs, and increases production and profits.

7. Making use of advantageous market conditions: Only businesses with sufficient

working capital are able to take advantage of favorable market situations, such as
buying in bulk when prices are lower and holding onto inventory for higher prices.

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 Chapter 1
Introduction

8. Capacity to handle crises: Because working capital is typically under a lot of

strain at such times, having sufficient working capital helps a company handle
crises like depression.

9. Everyone who invests expects to see a quick and consistent return on their
money. When a company has enough working capital, there may not be much
pressure to reinvest profits, allowing it to pay dividends to investors quickly and
on a regular basis. This increases the trust of its investors and generates a good
market to raise more money in the future.

10. Good spirits and morale :

Adequate working capital fosters a culture of stability, confidence, and good

morale as well as overall business efficiency.

14. Disadvantages of Excess OR Inadequate Working Capital

Redundant or excessive working capital has the following drawbacks:

1. Excessive working capital refers to idle money that generates no earnings for the
company; as a result, the company is unable to obtain the correct rate of return on its
investments.

2. Excessive working capital can result or be construed as resulting from irrational

purchases and the buildup of inventories, which increases the likelihood of theft,
waste, and losses.

3. Excessive working capital suggests unbalanced borrowers and poor credit

practices, which may increase the likelihood of bad debts.

4. The organisation may become generally less efficient as a result.

5. Relationships with banks and other financial institutions may not be upheld when
there is an excessive amount of working capital.

6. The value of shares could decrease as a result of the low rate of return on
investments.

7. The surplus operating capital encourages speculative activities.

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 Chapter 1
Introduction

15. Factors Influencing Working Capital

Figure 7 : Factors Effecting Working capital

1. Nature of the Industry / Business : From industry to industry, working

capital management is handled entirely differently. The issue can be made
clearer by drawing a contrast between the service and industrial sectors.
Since there is no inventory in the service sector, a significant portion of
working capital has already been avoided. Therefore, a significant aspect in
determining the need for working capital is the type of the industry.

2. Seasonality of Industry and Production Policy: Businesses are based on

the seasons, such as the production of air conditioners, whose demand rises
in the summer and falls in the winter. If produced in the manner of their
demand, the need for working capital will be greater in the summer than the
winter. The necessity for working capital can fluctuate, but this can be
tempered by a production strategy that produces throughout the year.

3. Competition : In a competitive market, meeting client demands quickly is

required, necessitating the maintenance of a higher amount of inventory. To
survive in the market, generous credit conditions are also necessary with

36
 Chapter 1
Introduction

top-notch service. Thus, the need for working capital increases as

competition increases.

4. Production Cycle Time : The amount of time needed to transform raw

materials into completed items is referred to as the production cycle time.
The time of blocking funds in working capital would increase as the time
increased.
5. Credit and dividend policy : A loose credit policy calls for more working
capital, while a strict credit policy calls for less. The level of retained
profits within the company, which are also used for working capital, is
determined by the dividend policy. This shows how the need for working
capital is impacted by dividend policy.

6. Growth and Expansion : While some industries remain unchanged, others

are expanding. Of course, compared to a static sector, a rising industry has
a higher need for working capital.

7. Shortage of Raw Material Supply : Companies frequently keep more raw

materials than necessary if the raw material supply is unreliable for any
reason, which raises the need for working capital.

8. Taxes - Taxes are frequently paid in advance. Additionally, some of the

working capital is blocked. Working capital requirements are also impacted
by the tax climate of the sector.

9. Price Levels : The need for working capital rises as a result of rising
inventory prices and other costs like labour rates. This effect is lessened if
the corporation can also raise the price of its final items.

10. Other Factors : The following are additional elements that influence or
determine working capital in one way or another:

 Requirements for cash

 Quantity of Sales

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 Chapter 1
Introduction

 Purchase and Sales Agreement

 Inventory Turnover
 Existing Assets Requirements
 Operational Effectiveness
 Changes to the financing and dividend policies of a
technology company
 Attitude towards Risk
 Raw material extraction time.
 Work Being Done holding time
 Holding Period for Finished Goods.
 Average Time for Collection.
 Payment interval on average.
 Cycle of working capital.
 Safety Stock of Raw Material.
 Cash Balance to be retained.

16. Current Assets components:

We have discussed above about what current assets are. Now we will see in detail
about the major component of the current assets. The major and prominent
components of the current assets are -
1. Cash
2. Receivables &
3. Inventory

16.1. Cash

Since cash is what keeps a business operating, it is essential to working capital.

The common purchasing power exchange medium is cash. It contains the firm's holdings
of coins, money, claques, and bank account balance. Near monetary goods are
occasionally also included. Cash is a very liquid commodity that is crucial to the
continual operation of the organisation. Raw material purchases and payment of
obligations to the business both demand cash. In other words, money is the fundamental
input required to keep a business operating continuously.
The availability of cash has a major impact on a company's ability to pay.

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Introduction

As a result, money in a company might be compared to the blood that provides an

organism life and vigor. Similar to how money gives a corporate concern life, vitality,
profitability, and solvency.
In the case of credit sales, cash is transformed into raw materials, which are then
transformed into works-in-progress, works-in-progress, finished items, and debtors, who
are then transformed into cash. If a corporation doesn't have enough liquidity, it could
wind up paying a price that results in the company being liquidated. However, having too
much cash might be expensive because it doesn't provide any income. Therefore,
effective cash management is required to prevent both situations of excessive and
insufficient liquidity.
Intentions for Holding Cash:
Despite the fact that cash does not generate significant profits for the business, a
firm still keeps cash on hand. Three justifications have been put forth for why people
keep cash on hand. Transactional, speculative, and preventative are these motives. By
putting less focus on people, we may utilise these three categories to describe the reasons
why businesses hoard cash.

Figure 8 : Motive of Holding cash

1. Transaction motive: This refers to keeping cash on hand to cover both

daily expenses and payments for things like purchases. dividends, taxes, and
wages that come up naturally in business.
2. Speculative motive: To profit from fleeting possibilities, such as a sharp
drop in the cost of raw materials, and to speculate on changes in interest rates, etc.
3. Precautionary motive: A business must keep cash on hand for uses that
are unforeseen and irrational. For instance, flooding, strikes, paying bills before
they are due, a spike in the price of raw materials, an unanticipated slowdown in
the collection of receivables, etc.

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16.2. Debtors or Accounts receivables :

The second crucial element of the overall working capital is debtors and
receivables. Businesses have the option of selling their products or services for cash or on
credit. When products or services are sold for cash, payment is made right away, but
when they are sold on credit, a debtor situation occurs. The only kind of receivable is a
debtor. Risk and bad debts were engaged with debtors and receivables.

16.2.1.Debtors typically exhibit three key characteristics:

a. It entails risk- which needs to be carefully considered because cash sales

are risk-free whereas cash is still waiting to be received with credit sales.

a. Its foundation is present economic worth -

The economic worth of the items is transferred instantly at the time of sale,
but the seller anticipates receiving an equivalent benefit in the future.

b. suggests the future - The buyer will be responsible for paying back the
value of the products or services received at a later time.

16.2.2.Receivables are related with the following costs:

1. Opportunity cost: Due to the time lag between the sale of goods to
customers and the customers' payment, the company's financial resources
are stuck in receivables. if such a sum is not put against the accounts
receivable. It 24 may have been used for other ways to make money.
Opportunity cost refers to the income lost as a result of investing in
receivables.

2. Administrative expenses: In order to keep track of credit customers, a

business must pay a variety of expenses. These expenses include the wages
paid to the staff members responsible for keeping track of credit sales and
payments, as well as the cost of finding out a potential customer's
creditworthiness.

3. Collection expenses: These expenses come from consumers who owe

money on a credit basis. When a customer doesn't pay on time, we have to

40
 Chapter 1
Introduction

write a letter of reminder, send telegrams or fax messages, sometimes send

a person, and sometimes we have to spend money on legal fees if the debtor
disputes their obligation to pay.

4. Defaulting costs: In general, credit is issued following a careful

examination of the customers' financial situation and credit worthiness.
Even so, there are situations when clients are unable to pay and the
company may not be able to collect the past-due amounts from them. Since
the amounts owed will not be recovered in the future,

5. these obligations are considered bad debts and must be written off as such.
Even though the company has adequate insurance against bad debts, the
cost will rise if credit sales increase proportionately to cash sales.

16.3. Inventory

Inventory makes up the third part of working capital. The factory is like a very large
kitchen that needs hundreds or thousands of different ingredients to produce various
goods. The stock of raw materials, commodities in progress, finished goods, and other
consumable stores are some examples of such items.
The majority of a corporate organization's present assets are made up of inventory. A
delicate topic in working capital management is stock cost.

I. Various Inventory Types are-

1. Raw material: In a manufacturing company, raw materials are

consumable items that have not yet been committed to production. They
could include essential raw materials, supplies, and spare parts. Like iron
ore in the steel sector or groundnuts or oil seeds in the oil industry.

2. Work-in-process: Materials utilised in the production process but not yet

transformed into the finished goods are included in work-in-process
inventories.

3. Finished goods: Products that have been fully manufactured and are ready
for sale are included in finished goods inventories. It's necessary for
efficient marketing operations. As a result, inventories connect the
production and consumption of products.

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Introduction

A firm's amount of the three different types of inventories relies on the nature of its
operation. A manufacturing company will have far higher levels of all three types of
stocks than a retail or wholesale company, which will have much higher levels of
finished goods and inventories but no raw materials or work-in-progress inventories.
Large heavy engineering firms develop items with lengthy manufacturing cycles,
therefore they maintain enormous inventories. Contrarily, a company that sells consumer
goods won't have big inventories due to its quick turnover and short production cycle.
Companies also retain a fourth category of supplies in their inventory.
Supplies include things like oil, fuel, light bulbs, and cleaning supplies for offices and
factories (soap, brooms, etc.). These materials are not used right away in the
manufacturing process. Typically, these items make up a modest portion of the entire
inventory and don't require a big financial commitment. Consequently, it may not be
possible for them to maintain a sophisticated inventory control system.

II. Need to Keep inventories:

Only when the businesses keep inventories does the issue of inventory
management come up. The firm's capital is committed to storing a variety of inventory,
and it must pay for storage and transportation expenses as a result. In spite of this, every
business retains enough inventory. The following list of reasons for keeping inventory is
only a sample:

1) To guarantee output: Production would be hindered by a lack of sufficient raw

material supplies. An organisation cannot always obtain the raw materials it need.
An order must be planned ahead of time in order to be delivered on schedule.
Sometimes it is challenging to obtain raw materials because of strikes,
transportation problems, disruptions, and supply shortages. In order for a factory
to receive raw materials continuously and maintain production, a company must
keep enough of them on hand.

2) Getting a quantity discount: By placing large orders with suppliers, a business

can benefit from trade discounts. If a business orders twice as much as it normally
does, suppliers will typically offer a significantly lower price. The expense of
managing inventory will need to be kept in an appropriate relation to the discount
that is likely to be obtained.

3. Order cost reduction: Since forms must be typed, reviewed, and mailed, each
order incurs a fee. Upon arrival, products must be accepted, examined, and tallied.
The invoice must be compared against the delivered products before being
forwarded to the accounting department, which will subsequently pay the supplier.
If a company makes a few larger orders rather than many little ones, the expenses
that change with each order can be decreased.

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4) Complete utilisation of capacity: The company must also have an appropriate

supply of raw materials in stock to utilise its idle manufacturing capacity. Owing
to the fact that some 27 elements of cost are intended for production capacity, if
the production capacity is not being completely utilised due to a shortage of raw
materials, the cost of production will increase. Such expenses are not decreased by
partial capacity use. Holding an appropriate inventory is therefore necessary to
protect the company from such losses.

5) To continue to retain sales: Delivery on time is crucial for customer satisfaction,

yet it is impossible to create items as soon as an order is received. In order to
ensure on-time delivery of ordered goods and to satisfy consumers, it is crucial to
keep a sufficient stock of finished goods on hand. The drive to keep up with
production and sales is known as a transaction motive.

6) Precautionary motive: Precautionary motive calls for the keeping of inventories

to mitigate the risk of unforeseen changes in supply and demand pressures as well
as other factors. The opportunity cannot be taken advantage of if the demand for
finished goods and their prices are increasing while there is a shortage of finished
items in stock. for the purpose of utilising such a chance. A specific amount of
finished goods must be kept in stock.

7) Speculative motive: The intention to profit from favourable price movements is

referred to as a speculative motive. It seeks to benefit financially from changes in
pricing. The stock level also changes in response to changing price conditions. If
there is a chance that raw material prices will increase in the near future, a higher
quantity of stock may be kept on hand.

17. Current Liabilities

This includes the followings –

a. Accounts Payable: The money owing to the manufacturers is what accounts

payable are.

b. Accrued expenses are bills that are owed to a third party but not paid, such
as unpaid salaries.

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c. Accrued Interest: Accrued Interest is the total amount of interest that has
accrued since any prior payments.

d. Bank overdrafts - are the brief advances that the bank specifies for the
purpose of overdrafts

e. It is the current principle portion of a long-term loan, sometimes known as

notes payable or bank loans.

f. Dividends payable\These are the dividends that the company's board of

directors (BOD) has determined are owed to shareholders.

g. Income Taxes Owed: One type of tax that must be paid to the government
is income tax.

18. Working Capital Policy

Working capital can be calculated by subtracting current assets from current liabilities. A
liquidity issue occurs when a corporation is unable to manage its current liabilities
through its current assets. This may jeopardize the company's ability to continue
operating. However, when there is extra cash on hand, a business should invest it in
short-term securities to increase shareholder wealth. Three categories can be used to
classify working capital policies. They are conservative, combative, and defensive
strategy or policies.

18.1. Defensive Strategy

When a corporation adopts a defensive strategy, it finances its fixed assets and a
sizable portion of its current assets with long-term debt and equity. An accountant is
capable of making precise plans, such as financing large amounts of inventory with
debenture loans (1 year). The business can maintain a sizable inventory to satisfy
customer demand as it arises. Customers won't be dissatisfied or turn to competitors in
this situation because they may obtain the goods from the company's substantial
inventory. A trade creditor who offers the company to pay him/her in full within 60 days
or later may provide funding for inventory that is expected to be sold within that time
frame. A three-year debenture loan could be used to fund a delivery van. Due to the fact
that long-term funds have already been used to support this, the corporation does not
press for the conversion of 17 of its stock into cash or for debtors to make early payments

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as a result of its defensive stance. Profitability is consequently decreased. Profitability is

further decreased by the interest costs associated with debt. Businesses that are unsure
about the market demand for their products would like to be protected by the defensive
policy. A significant number of stock and trade debtors would be present under a
defensive strategy.
This policy's cash conversion cycle would be lengthy. A bank overdraft would hardly
ever be used to pay for stocks and debts, though. The business will be required to pay
interest to the lender on the lent sum. The corporation runs the danger of becoming
obsolete and racking up holding expenses by holding huge holdings. Because the existing
assets are already backed with long-term funding sources, this policy lessens the need to
handle working capital strategically. The disadvantage of this policy is that it will result
in higher costs and lower profitability

18.2. Aggressive Strategy

The company's objective is to finance its working capital using short-term debt as
part of its aggressive working capital programme. When compared to long-term debt,
when interest must be paid on the total lent amount for the year, this approach is regarded
to be more affordable because finances like overdrafts can be used as needed and interest
is only paid when an overdraft is taken. A corporation has less flexibility because short-
term debt must be repaid within a year. An aggressive working capital strategy would
fund all current assets using short-term debt. The non-current assets will also be partially
financed by short-term debt. This measure will increase financial

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Figure 9 :Financing of Current Assets

department must always be proactive in managing working capital since they must sell
stocks quickly and collect receivables on promptly. Pay off your short-term bills on
promptly in order to. This policy is therefore extremely dangerous.
If the company is expanding, increasing sales and profitability under an aggressive
programme will be challenging because the short-term debt won't be enough to fund the
rising inventories and receivables. As a result, such a policy carries risk. Firms that
operate in a stable economic climate should use this policy. The product must be well-
established and provide consistent cash flow because this will simplify cash forecasting
and, as a result, enhance working capital management. A business with an aggressive
working capital policy typically doesn't offer long credit terms. Normally, the credit term
lasts for around one month. On the other hand, the inventory level will be at its lowest
due to the low level of customer demand. These kinds of businesses will be able to
produce items as needed. But it should be mentioned that despite the strategy's
considerable risk, the corporation stands to gain significantly from it.

18.3. Conservative Strategy

A combination of a cautious working capital policy and an aggressive working capital
policy may be preferred by some businesses. They will try to incorporate the aggressive
working capital policy feature if they believe there is a compelling reason why debtors 18

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will pay on time to settle trade creditors. On the other hand, if a specific pricey sort of
stock has not yet generated interest from clients but shows potential in the future, the
company may choose to take a cautious approach by taking out a long-term loan to
purchase and stock this item in the hopes that the promise will come true. To determine
which strategy will work best for the present asset and category, it is crucial that certain
goods and subcategories be thoroughly investigated. The business could increase
profitability and boost liquidity by comprehending and controlling its current assets.
This strategy will include components from the two previously mentioned policies,
balancing risk and profitability for the company. A company with strong sales or growth
typically benefits from aggressive working capital since they can manage the cash flow
problems caused by the increase in sales. Contrarily, a business operating in an
unpredictable climate with erratic sales will need to implement a conservative strategy
because it is impossible to know for sure

about the funds coming in soon to cover the obligations. A confrontational policy will
strain the company's finances. Therefore, knowing the company's current assets and
liabilities will help it decide on the optimal working capital policy.

18.4. Techniques for Analysis of Working Capital

A thorough investigation of current assets, current liabilities, and trends in the terms that
are included in working capital, i.e., current assets and liabilities, are necessary for
effective working capital management.
Analyzing a commercial enterprise's working capital status may be necessary for a
variety of reasons. To predict what will be discovered when financial statements are
analysed is one reason to analyse the working capital. The ability for management to
recognise trends and implement corrective action when necessary is a secondary
argument. A third party will examine the changes that have occurred inside the
organisation over time in order to provide guidelines. There are four key methods for
examining a company's working capital position.

(a) Ratio Analysis

(b) Trend Analysis
(c) Common-size Statements
(d) Fund Flow Analysis
(e) Cash Flow Analysis
(f) Arithmetic Mean
(g) Co-efficient of Variation
(h) Simple Growth Rates

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(i) Trend Indices

(j) Correlation Co-efficient
(k) ANOVA (Single Factor) F-test

Here, a few approaches are covered, including ratio analysis, trend analysis, financial
statement analysis using common sizes, fund flow analysis, cash flow analysis, etc.

19. Ratio Analysis

A ratio is defined as indicated quotient of two mathematical expressions and as thus the
relationship between two or more things.

Here, the term "ratio" refers to a financial or accounting ratio, which is a formula that
represents the relationship between two accounting statistics.

Ratio analysis is founded on the idea that while a single accounting figure by itself might
not convey any significant information, when it is expressed relative to another figure, it
almost certainly does.
Ratio analysis involves more than merely comparing figures from the cash flow
statement, income statement, and balance sheet. For the purpose of financial analysis, it
involves comparing the figure to prior years, other firms (inter-firm comparison), the
industry, or even the overall economy.

Classification of Ratios according to its nature

The various ratios that will be discussed here are categorized in some common groups that are
as below-

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Figure 10 : Types Of Ratio Analysis

19.1. Current Ratio

The current or working capital ratio is the ratio of current assets to current liabilities. It
serves as a measure of the company's solvency. The current ratio formula is provided
below;

Figure 11 : Current ratio Formula

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Current Assets = Inventories + Sundry Debtors + Cash and Bank

Balances + Receivables/ Accruals + Loans and Disposable
Investments + Any other current assets.

Current Liabilities = Creditors for goods and services + Short term Loans
+ Bank Overdraft + Cash Credit + Outstanding
Expenses + Provision for Taxation + Proposed
Dividend + Unclaimed Dividend + Any other current
liabilities.

In order to compute the current ratio, current assets must be divided by current liabilities.
A current asset is any asset that can be converted into cash within a year. Common
examples of current assets are cash on hand, cash in the bank, cash in transit, short-term
investments or marketable securities, bills receivable, pre-paid expenses, raw material
inventory, goods in process, stock of stores and spare parts, finished goods inventory,
bills receivable, loans and advances, and various debtors. Current assets also include pre-
paid expenses, raw material inventory, goods in process, stock of stores and spare
Current liabilities are debts that mature within a year, such as debts to creditors, unpaid
invoices, unreimbursed expenses, bank overdrafts, and unpaid taxes. Thus, the current
ratio serves as a gauge of the company's short-term viability. For every rupee of current
liability, it shows the rupee availability of current assets. If the ratio is larger than 1, the
company has more current assets than it has in terms of its current liabilities.The normal
state idle current ratio is 2:1.

19.2. Quick ratio or Acid Test ratio

The quick ratio is used to determine whether a business has enough liquid assets that can
be turned into cash to pay its bills. Cash, marketable securities, and accounts receivable
are the three main components of current assets that are taken into account by the ratio.
Since inventory might be difficult to sell off quickly and may even result in a loss, it is
not included in the ratio. The quick ratio is a more accurate estimate of a company's
capacity to meet its immediate obligations than the current ratio because inventory is
excluded from the calculation. When a company is experiencing severe financial times
and must quickly pay off a sizable number of liabilities, this ratio is especially helpful.
Formula is –

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Figure 12 : Quick ratio Formula

Here quick assets excludes Prepaid expenses and inventories and Current liabilities
excludes

19.3. Absolute liquidity ratio/cash ratio:

The cash ratio gauges the company's overall liquidity. This ratio simply takes the firm's
absolute liquidity into account. Calculating this ratio is as follows:

Figure 13 : cash ratio Formula

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Here cash and cash equivalents includes marketable securities also.

19.4. Basic Defense Interval/ Interval Measure:

The Basic Defense Interval would help identify the number of days for which the
company can cover its cash expenses without the aid of extra funding if all of the
company's revenues were to abruptly stop.

Figure 14 : Basic Defence Interval Formula

19.5. Equity Ratio

This ratio shows how much of the business's overall funding is invested in the
owners' money. The conventional wisdom holds that the risk level decreases as the
percentage of owners' funds increases.
Formula for this is -

Shareh olders Equity

Equity Ratio¿
Capital Employedd

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19.6. Debt Ratio

Debt ratio is calculated as below-

Total outside liabilities

Debt Ratio=
Total Debt + Net worth

Total debt or total outside liabilities includes bank borrowings, public deposits,
short- and long-term borrowings from financial institutions, debentures, bonds,
deferred payment plans for the purchase of capital equipment, and any other
interest-bearing loan.

19.7. Debt to Equity Ratio:

Here, a high debt-to-equity ratio provides less protection for creditors,

whereas a low ratio shows a larger safety net (i.e., creditors believe the owner's
money can assist absorb any income and capital losses). This ratio shows how
much debt there is compared to equity. This percentage is frequently used both
in capital structure decisions and in the legislation governing such decisions
(i.e. issue of shares and debentures). Since this ratio demonstrates the relative
weights of debt and equity, lenders are also quite interested in knowing it. The
debt equity ratio serves as a measure of a company's financial leverage.

Total Outside Liabilities

Debt ¿ Equity Ratio= '
S h are h oldde r sEquity

19.8. Debt to Total Assets Ratio:

This ratio determines the amount of financial leverage by calculating the

percentage of total assets that are financed by debt.

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Total Outside Liabilities

Debt ¿ Total Assets Ratio=
Total Assets

19.9. Capital Gearing Ratio:

Capital gearing ratio, which measures the ratio of fixed interest (dividend)
bearing capital to funds belonging to equity shareholders, such as equity funds
or net worth, is sometimes measured in addition to the debt-equity ratio.

Capital Gearing Ratio=¿

( Preference ShareCapital + Debentures+OtherBorrowedfunds )

(Equity ShareCapital + Reserves∧Surplus−Losses)

19.10. Proprietary Ratio:

Proprietary fund consists - Equity Share Capital +Preference Share Capital +

Reserve and Surplus.
Total assets do not include losses or false assets.

Proprietary Fund
Proprietary Ratio=
Total Assets

19.11. Total Asset Turnover Ratio:

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This ratio measures how effectively a company uses all of its resources that is
assets. This ratio is calculated using:

Net Sales
Total Assets Turnover Ratio=
Total Assets

19.12. Fixed Asset Turnover Ratio:

This ratio measures how effectively a company uses all of resources that is
Fixed assets. This ratio is calculated using
Net Sales
¿ Assets Turnover Ratio=
¿ Assets

19.13. Capital Turnover Ratio/ Net Asset Turnover Ratio:

This ratio shows how well the company can produce sales or COGS ( cost of
goods sold ) per rupee of long-term investment. The owner's and long-term creditors'
cash are utilised more effectively the higher the ratio. Net Assets consists of Net
Current Assets and Net Fixed Assets (Current Assets – Current Liabilities). Net
Assets is sometimes referred to as the capital turnover ratio because it equals capital
employed.

Net Sales
Capital Turnover Ratio= Assets +(Total Current Asssets−Total Current Liabilities)¿
Net ¿

19.14. Current Assets Turnover Ratio:

Utilizing the company's current assets, it calculates efficiency.

Net Sales
Current Assets Turnover Ratio=
Current Assets

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19.15. Working Capital Turnover Ratio:

Working Capital Turnover formula is as below

Net Sales
Working Capital Turnover Ratio=
WorkingCapital

19.16. Inventory / Stock Turnover Ratio:

The average inventory maintained during the year and the cost of items sold
during the year are related by this ratio, also known as the stock turnover ratio. It
gauges how effectively a business uses or maintains its inventory.

Net Sales
Inventory Turnover Ratio=
Average Inventory

Opening Stock+Closing Stock

Average Inventory=
2

19.17. Raw Material Inventory Turnover Ratio –

The formula is as below

Raw Material Consumed

Raw Material Inventory Turnover Ratio=
Average Inventory

19.18. Receivables (Debtors) Turnover Ratio:

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When a business offers products on credit, sales revenue realisation is

postponed and receivables are created. Later, the cash is recovered from these
receivables.
The amount of liquidity in the company's balance sheet depends on how
quickly these receivables are collected. The debtor turnover ratio provides insight into
the company's credit and collection practises. It gauges how successfully management
manages its accounts receivable. The formula is as follows:

Credit Sales
Debtors Turnover Ratio=
Average Debtors

19.19. Receivables (Debtors’) Velocity:

The turnover ratio of debtors reveals the typical collecting time. However, the
following formula can be used to determine the typical collection period:

Average Accounts Receivables

Receivable Velocity / Average Collection Period=
Average Daily Credit Sales

12 months /52 weeks/360 days

¿=
ReceivableTurnoverRatio

Credit Sales
Average Daily Credit Sales=
No of Days∈a year

The average collection time calculates the typical number of days needed to
collect an outstanding account. The number of days of receivables and the number of
days' sales in receivables are other names for this ratio.

19.20. Payables Turnover Ratio:

This ratio is computed using the same formula as the receivables turnover ratio.
This ratio demonstrates the firm's payables payment velocity. The formula is as
follows:

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Annual Net Credit Purchase

Payable Turnover Ratio=
Average Accounts Payable

Suppliers' generous credit terms are reflected in a low creditor turnover ratio,
whereas a high ratio indicates that accounts are settled quickly.

19.21. Payable Velocity/ Average payment period can be calculated using:

The formula is -

Average Accounts Payable

Payable Velocity∨ Average payment period=
Average Daily Credit Purchases

Or alternatively,

12months /52 weeks /360 days

¿
PayablesTurnoverRatio

The average collection period and debtor turnover offer specific and unique
guidance or information when choosing the credit policy.

19.22. Gross Profit Ratio or Gross Profit Margin

It calculates the proportion of each sale's rupee proceeds left over after selling
price reimbursement. Gross profit margin depends on how price, sales, volume, and
costs are related. A positive indicator of effective management is a high gross profit
margin.

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Gross Profit
Gross Profit Ratio= X 100
Sales

19.23. Net Profit Ratio/ Net Profit Margin:

It measures the business's relationship between net profit and sales. Depending
on how net profit is defined, it can be calculated as follows:
Net Profit
Net Profit Ratio= X 100
Sales

¿ alternatively

Earning After tax( EAT )

¿ X 100
Sales

19.24. Operating Profit Ratio:

Operating profit ratio is often calculated to assess how well a business is running.

Operating Profit
Operating Profit Ratio= X 100
Sales

Or alternatively

Earningsbefore interest∧taxes(EBIT )
¿ X 100
Sales

Here

Operating Profit = Sales – Cost of Goods Sold (COGS) – Expenses

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Operating profit ratio measures the amount of each transaction in rupees that is left over
after all costs and expenses, except interest and taxes, have been paid. Analysts pay great
attention to this ratio since it concentrates on operating results.

Operating profit is also known as EBIT, or profits before interest and taxes.

19.25. Cost of Goods Sold (COGS) Ratio

Calculated as

Cost of Goods Sold

Cost of Goods Sold Ratio= X 100
Sales

19.26. Operating Expenses Ratio

The formula is -

Administrative exp .+Selling ∧Distribution OH

O perating Expenses Ratio= x 100
Sales

19.27. Operating Ratio

The formula is -

Cost of Goods Sold + operating exp .

Operating Ratio= X 100
Sales

19.28. Financial Expenses Ratio

The formula is -

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Financial exp .
Financial exp . ratio= X 100
Sales

19.29. ROI ( Return on Investment )

The most crucial ratio is the ROI. It measures the owner-invested capital's
return as a percentage. This ratio, in essence, informs the owner of whether or not
all of the work put into the business has been worthwhile. It contrasts earnings,
returns, and profit with the capital invested in the business. The ROI is computed
as follows:

Return/ Profit / Earning

Returnon Investment = X 100
Investment

19.30. Profitability Ratio

The formula is -

Return/ Profit / Earning

Profitability Ratio= X 100
Sales

19.31. Investment Turnover Ratio

Calculated as -
Sales
Calculated Investment Turnover Ratio=
Investment

19.32. Return on Assets (ROA):

The profitability ratio is calculated as the difference between net profits and
the assets used to generate those profits. This ratio calculates a company's
profitability based on the assets it uses.

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The ROA may be calculated in the following ways based on various

concepts of net profit (return) and assets:

Net Profit after taxes

Returnon Assets(ROA )=
Average total Assets

19.33. Return on Capital Employed (ROCE):

It is another variation of ROI. The ROCE is calculated as follows:

Earnings before interest∧taxes ( EBIT )

ROCE ( Pre−tax ) = X 100
Capital Employed

Or

Earnings before interest ∧taxes ( EBIT ) (1−t)

ROCE ( Post−tax )= X 100
Capital Employed

And here,

Capital Employed = Total Assets – Current Liabilities

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19.34. Return on Equity (ROE):

The profitability of equity money invested in the company is thus measured

by return on equity. This ratio shows how profitably the company has used the
owners' money. Additionally, it gauges the equity stockholders' percentage return
on investment. This ratio is calculated using:

Net Profit after taxes−Preferencedividend (if any)

ROE= X 100
Net Worth
'
Equity Share holde r s fund

One of the most crucial measures of a company's profitability and potential

for expansion is return on equity. Companies with a high return on equity and little
to no debt can expand without making significant capital investments, which frees
up resources for further investments by the business's owners. However, many
investors are unaware that two businesses can have the same return on equity
while one being a significantly better company. Net Profit after Taxes (Before
Preference Dividend) shall be divided by Total Shareholders' Fund, which
includes Preference Share Capital, if return on Total Shareholders is determined.

19.35. Profitability / Net Profit Margin:

The after-tax profit an organisation makes for every rupee of revenue is

what is known as the net profit margin. Because net profit margin differs
throughout industries, it's critical to evaluate a possible investment against its
rivals. Although it is generally accepted that a higher net profit margin is ideal,
management occasionally purposefully lowers the net profit margin in an effort to
boost sales.

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Profitability Profit Sales

= ÷
Net Profit Margin Net Income Revenue

19.36. Investment Turnover/Capital Turnover / asset Turnover :

A company's ability to turn its assets into sales is measured by its asset turnover ratio.
The formula is as follows:

Sales /Revenue
Investment Turnover /Capital Turnover /asset Turnover=
Investment / Assets /Capital

19.37. Return on Equity

Equity Multiplier:

A business with poor sales and margins has the potential to incur excessive debt and
falsely boost its return on equity. An investor can determine how much of the return on
equity comes from debt by using the equity multiplier, a measure of financial leverage.

Hence, This is how the equity multiplier is determined:

Equity Multiplier=Investment ∨ Assets÷ Shareholders ’ Equity

Returnon Equity=( Net profit margin ) x ( Investment Turnover∨ Asset Turnover∨Capital−Turnover ) x Equity Mul

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38. Earnings per Share (EPS):

Earnings per share are one way to quantify a company's profitability from
the perspective of common shareholders.
Earnings per share is the term for this. The formula is as follows:

Earnings per Share(EPS)=Net profit available¿ equity shareholders ¿

Number of equity shares outstanding

19.38. Dividend per Share (DPS):

The aforementioned earnings per share measure the profitability of a

company per share; it does not account for how much profit is distributed as
dividends and how much is kept by the company. The profit delivered to equity
shareholders is shown by the dividend per share ratio. It is determined by:

Dividend per Share (DPS)=Total Dividend paid ¿ equity shareholders ¿

Number of equityshare soutstanding

19.39. Dividend Payout Ratio (DP):

This ratio calculates how much of a dividend is paid in relation to net

income. It is determined how much of the company's earnings per share the
management has kept for itself. It's calculated as:

Dividend per equity share( DPS)

Dividend payout Ratio=
Earning perShare( EPS)

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19.40. Price- Earnings Ratio (P/E Ratio):

The price earnings ratio reveals what stock investors anticipate will happen to the
company's profits. It connects earnings to the market price and is typically used as a
summary indicator of an investment's growth potential, risk factors, shareholders'
orientation, company image, and level of liquidity. It is determined as

Market Price perShare( MPS)

Price−Earnings per Share(P /E Ratio)=
Earning perShare(EPS)

To investors or potential investors, it provides the payback period.

19.41. Dividend and Earning Yield:

Dividend Yield formula is as below

Dividend ±Change∈ share price

Dividend Yield= x 100
initial Share Price

Earning Yield formula is as below

Earning Per Share

Earning Yield= x 100
Market Price per Share(MPS)

This ratio represents the return on investment, which may be the average or final
investment. Dividend (%) is the share's return on paid-up value. However, the yield (%)
is a measure of genuine return in which the share capital is taken at face value.

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19.42. Market Value /Book Value per Share (MVBV):

It offers an analysis of how investors perceive the company's current and potential future
performance.

Market Value per share Averageshareprice

=
Book value per share Net worth ÷ No . of equityshares

This ratio shows how the shareholders' investment has fared in the market.

Unquestionably, the position of the shareholders in terms of return and capital gains is
improved by larger ratios.

19.43. Quick Ratio -

James Tobin has presented this ratio, and a ratio is defined as

Market Value of equity∧liabilities

Quick Ratio=
Estimated replacement cost of assets

Significance of ratio analysis:

The analysis of financial data to reveal operational effectiveness and the various facets of
the firm's financial status is of great interest to many people. These ratios are utilised to
ascertain certain financial details of the company that they are interested in. Ratio

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analysis is relevant for assessing a company's performance and identifying several key
aspects, including the following.

Short-term solvency: Liquidity ratio analysis can be used to make judgments about a
firm's liquidity condition. If a company can pay its present debts when they are due, its
liquidity condition is good. If a company has enough liquid money to cover interest and
short-term debts with maturities within a year, that company can be said to have the
ability to meet its short-term liabilities. For credit analysis, banks and other short-term
loan providers can use it.

Long-term solvency: A borrower's financial situation should worry long-term creditors,

security analysts, as well as any current or future customers of the business. Leverage,
capital structure, and profitability ratios, which put an emphasis on the earning power and
operational effectiveness of the company, are used to gauge long-term solvency. The
leverage ratios show if a company has a manageable amount of funding or is overly
indebted.

Operating efficiency: The ratio analysis is also beneficial in that it sheds information on
how effectively assets are managed and utilised. Different activity ratios gauge a
company's solvency in this case. Utilizing its assets as a whole as well as in parts, the
company depends on sales revenue.

Overall profitability: The firm's management is continuously worried about the

profitability overall. They are worried about the company's capacity to fulfil its short- and
long-term obligations to its creditors, to guarantee a fair return to its owners, and to make
the best possible use of the firm's resources. Only when all the ratios are taken into
account and an integrated view is established, is this made possible.

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Uses of ratio analysis

An essential technique for conducting financial analysis is ratio analysis. Accounting

ratios show the interrelationships that exist between various financial statement elements.
The true test of a company's earning potential, financial stability, and operational
effectiveness is ratio analysis. As a result, they can help internal management, potential
investors, creditors, and others make wise decisions. In the opinion of

The following points discuss the ratio analysis' significance:

(i) Simplifies Accounting Figures: Accounting figures frequently fall short of giving
information in the way that the user would like. Ratios structure, summarise, and simplify
accounting data so that it is understandable to individuals who do not speak the
accounting language.

(ii) Calculates liquidity position: Ratio analysis aids in calculating the firm's liquidity
situation. Applying a liquidity ratio makes it simple to determine the firm's short-term
liquidity condition, or if it can continue to meet its obligations with short maturities.

(iii) Measures long-term solvency: Ratio analysis is crucial for assessing the firm's long-
term solvency. It can also be calculated using profitability or leverage ratios. As a result,
the ratio is a crucial tool for those who utilise financial statements.

(iv) Measures operational efficiency: By comparing the present ratios to the historical
ratios, management can use ratios as important tools to assess the firm's performance over
time. The operational efficiency of the company is measured by a variety of activity or
turnover ratios. In general, bankers, investors, and other credit providers use these ratios.

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The management and shareholders of a company are primarily concerned with the overall
profitability of the company. (v) Measures profitability The profit and loss account for a
period does not accurately reflect the firm's ability to generate in terms of earnings per
rupee invested or per rupee of sales. Profitability rates aid in determining the firm's
earning potential. The best indicators of profitability are return on investment, return on
capital employed, net profit ratios, etc.

(vi) Trend analysis: Ratio analysis enables a company to take into consideration the
temporal dimension. Analyzing ratio trends can show whether a company's financial
situation is getting better or worse over time. Determine whether the trend is favourable
or detrimental with the aid of such. For instance, a specific ratio might be lower than the
average ratio, but the trend might be rising. On the other hand, the current situation can
be acceptable, but the tendency might be downward.

Ratio analysis is a helpful tool for management in carrying out its fundamental duties,
including planning, communication, control, and decision-making.

a. Aid in planning and forecasting: Ratios, derived after analysing the past results,
help the management to prepare budget and formulate future policies and plans of
action. Trend analysis is used to determine what has to be done right away. Ratios
are therefore incredibly helpful in forecasting and planning for businesses.

b. Assist in control: To gauge the level of deviation with the actual, trend ratios
and standard ratios are compared. If a comparison reveals a negative variance, the
management is informed so they can take corrective action. Analysis aids in the
efficient management of corporate activities.

c. Facilitate communication: Using ratios as a tool for communication is efficient.

They are crucial in alerting people about the company's success, the owners and
any other persons involved. The communication is easier to understand when it is
condensed and simplified.

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d. Assist with decision-making: Ratio analysis focuses on how effectively assets

are managed and used. Management of resources is used in decision-making.

Ratio analysis' drawback or limitations :

A common method for assessing a company's financial health and performance is

ratio analysis. However, there are certain issues with employing ratios. These
issues should be known to the analyst. The ratio analysis has some of the
following drawbacks.

1. Differences in the situations of two firms or one firm over time make
comparisons challenging.
2. It is challenging to analyse ratios since the definitions of items on the balance
sheet and the profit and loss account statement differ.
3. Because of short-term changes, ratios estimated at a given point in time are less
accurate and flawed.
Since the ratios are often calculated using historical financial statements, they
cannot predict the future.

20. Trend Analysis:

When trends in ratio throughout time are evaluated, the ratio analysis will more
accurately show the firm's financial state; ratios at any given point in time might be
deceptive. Trend percentage is another name for trend analysis. A strong current financial
situation can really be deteriorating over time, whilst a bad position might be rapidly
strengthening. Out of the study periods, one year is chosen as the base year, and each
item in this year is taken as 100. Trend analysis requires at least three financial years'
worth of data. The quantity of each item in the statement for each remaining year is
divided by the amount of the corresponding item in the base statement, and the results are
expressed as a percentage.

Amount of year under study

Trend Percentage= x 100
Amount of base year

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When the trend percentages are fewer than 100, there is a strong indication that the trend
is downward. If the trend percentages are greater than 100, there is an upward trend.
An effective comparison analysis of the financial performance of a business enterprise
over time is made possible by the trend percentages. As a result, the ratio's trend analysis
gives the events that happen over one or two periods a great deal more relevance. Trend
analysis is yet another crucial and practical method that can be used to examine the
direction of charges over a number of years. The ratio's time series or trend analysis
reveals the direction of change. The items and profit and loss account are particularly
appropriate for this form of study. Management occasionally employs ratio analysis to
identify the firm's financial strengths and weaknesses and takes appropriate action to
strengthen the firm's position. Management can do this because it has access to internal
data that credit analysts and security analysts do not.

21. Common Size Statement:

Financial statements may be difficult to comprehend and difficult to draw inferences

from when read with exact numbers. Therefore, absolute numbers are converted into
percentages to some common basis in order to get around these constraints and make it
easier to compare the quantities. "Total Net Assets" in the case of a balance sheet and
"Net Sales" in the case of an income statement
Common size statements are what are known as such "percentage" statements. The
percentage of these things in relation to the average size over a period of four to five
years clearly shows the trend, and we can use that information to compare financial
analyses and evaluate them.
The balance sheet's items are all expressed as a percentage of "Total Net Sales" and the
income statement's items are all expressed as a percentage of "Net Sales." A ratio of
different things to sales is calculated in terms of percentages in the case of a common size
income statement.
The relationship between each component and the total is shown via a Common Size
Statement analysis. When analysing income statements of a typical size In the event of a
standard size balance sheet analysis, Net Sales is taken to be 100%. Available Net Assets
as a whole are regarded as 100%. It is utilised for vertical financial analysis and
comparison of the financial data from two businesses or two years. Absolute numbers
from the financial statements are challenging to compare, but when they are transformed
and expressed as percentages of net sales in the case of the income statement and as
percentages of total net assets in the case of the balance sheet, it is easier to relate. It is a
sort of ratio analysis where all items are expressed as a relation to the denominator base,
which in the case of the income statement would be Net Sales and in the case of the

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balance sheet would be Total Net Assets. For the purpose of an intra- and inter-firm
analysis in a Common Size Statement study, the absolute data are transformed to
proportions.

22. Fund Flow Analysis:

The acquisition and use of funds for a business are revealed by a fund flow study. This
method aids in the analysis of variations in working capital elements between two dates.
The balance sheet's comparison of current assets and liabilities at the start and end of a
given period reveals changes in these current asset types as well as the sources from
which working capital has been obtained. It demonstrates how money was raised for a
company and how it was used. In terms of managing working capital, it is a beneficial
tool for internal management.
"The question of what happened to the net profit in such a situation is clearly answered
by the explanation of sources and use of funds. What happened to the money raised from
the other sources, as well?
However, we are unable to determine whether the working capital is being utilised as
effectively as possible with the aid of this technique. The importance of changes in the
working capital structure are not clarified.
The reduction of cash on hand is one goal of effective working capital management.
Knowing when money will be accessible and when money will be needed is essential for
reducing the amount of money needed. It is possible to control the flow of funds so that
the inflows and outflows are almost equal. It is insufficient for an enterprise's financial
health to be indicated by the balance sheet and final accounts showing a profit.
Everything will seem pointless unless the influx and outflow of money are controlled in
such a way that there is always enough money on hand to pay obligations as and when
they come due.

23. Cash Flow Analysis:

Because it is a type of liquid money, it is a crucial part of working capital. It is crucial for
everyday operations. It is a crucial current asset that has an impact on corporate

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operations. An essential tool for cash flow planning is cash flow analysis. The main focus
of working capital flows is cash.
The term "cash flow statement" refers to the document that must be created to reflect
changes in cash. It draws attention to the factors that affect how the cash position
fluctuates between two balance sheet dates. It shows an in-depth analysis of cash flow as
well as an operational cycle. It displays the flow of money over time. Thus, a cash flow
study is one that examines the inflow and outflow of cash. By identifying the sources of
cash receipts and the uses of cash, it demonstrates the flow of cash into and out of the
business. Maintaining a healthy cash balance is necessary for good working capital
management. Cash management is the first step in regulating the working capital
investment.

24. Arithmetic Mean:

The arithmetic mean provides one number to represent all of the data. By summing the
values of the observations and dividing it by the number of observations, the simple
arithmetic mean of each series of distinct ratios has been determined.

25. Co-efficient of Variation:

A relative indicator of dispersion is the coefficient of variation. The most widely used of
the several relative variation metrics is one created by "Karl Pearson." When comparing
the variability of two or more series, the coefficient of variation is employed to solve the
problem. A series or group is considered to be more variable if the coefficient of variation
is higher, or less consistent, uniform, steady, or homogenous if the coefficient of
variation is lower. On the other side, a series is said to be less variable or more consistent,
uniform, steady, or homogenous if the coefficient of variation is lower. In financial data
ratio analysis, a lower Coefficient of Variation in a ratio is seen as comparatively better
management of that ratio. "C.V." stands for the coefficient of variation, which is
calculated as follows:

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C . V .=S / X ̅

Here,

X = mean;

S = standard deviation

However, when calculating the coefficient of variation in this study, the standard
deviation (S) was based on (N-1) observations.

26. Simple Growth Rates:

Simple growth rates and average growth rates have been calculated to determine the rate
of growth in working capital and its various components in relation to sales during the
study period. Growth rates in this context simply refer to a variable's percent increase
over its previous year's value, as in

G = (Yt - Yt-1) / Yt-1 x 100

G is the growth rate.

Yt = Variable "Y" values in time "t" (the current year);

Yt = Variable "Y" values in time "t-1" (previous year)

The geometric mean of the various growth rates has been taken to be the average growth.

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27. Trend Indices:

The following formula was used to calculate the index of change in a variable:

Indices of Trend = (Yt / Yo) x 100

Where Yt = The variable's value in the year "t" for which the index is to be calculated

Yo = The variable's value in the base year,

These indices have been calculated to track changes in the relative proportion of the
working capital's various components to the overall amount.

28. Co-relation Co-efficient:

Co-relation The link between two variables, X and Y, is expressed numerically as a

coefficient. Its definition is;

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Figure 15 : Correlation Coefficient

here;

N = Number of pairs of score

ΣX = Sum of “X” scores

ΣY = Sum of “Y” scores

ΣXY = Sum of the products of paired scores

ΣX² = Sum of squared “X” scores

ΣY² = Sum of squared “Y” scores

The degree of relationship between the variables is determined by the co-relation

coefficient in this fashion, although it does not necessarily imply a functional
relationship. In small sample sizes, the significant correlation may be the result of chance,
or it may be affected by a third common component, and so on. Therefore, using "r2" is a
highly practical and useful way to interpret the value of "r."

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Additionally, the "t" test has been used to examine the significance of the correlation
between two variables. The population's co-relation coefficient being 0, or the
population's variables being uncorrelated, is the null hypothesis in this situation. The
value of "t" for "r" is;

Here;

r = Correlation Co-efficient and

t =Based on (N-2) degrees of freedom

if the calculated value of "t" at the 5% level of significance for (N-2) degrees of freedom
exceeds the value in the table. At a 5% level, we say that the value of "r" is significant.
The results are in line with the hypothesis of an uncorrelated population if the "t" value is
less than the table value at the 5% level of significance.

29. ANOVA (Single Factor) F test:

Analysis of variance (ANOVA) is an analytical technique used in statistics that splits an

observed aggregate variability found within a data set into two parts: systematic factors
and random factors.

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The presented data set is statistically affected by the systematic factors but not by the
random ones. The ANOVA test is used by analysts to evaluate the impact of independent
factors on the dependent variable in a regression analysis.

Up to 1918, when Ronald Fisher invented the analysis of variance method, statistical
analysis was conducted using the t- and z-test procedures produced in the 20th century.

The t- and z-tests are extended by the analysis of variance (ANOVA), often known as the
Fisher analysis of variance. After appearing in Fisher's book, Statistical Methods for
Research Workers, the phrase gained widespread recognition in 1925.

It was used in experimental psychology before being applied to more complicated topics.
We can assess the significance of differences between the means of more than two
sample sets using analysis of variance (ANOVA). Making assumptions about whether
our samples are taken from populations with the same mean is made easier with the help
of analysis of variance.

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