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Unit 1 : Business Finance c

Learning Objective

 Grasp Nature & Scope of Finance Function

 Understand Significance of Finance Function

 Know Significance of Agency Cost

 Understand role of Finance Manger

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1.1 Introduction

Finance is backbone of every business No activity in the business can be carried out
as per expectations of management without proper support of finance function.
This unit makes you to understand meaning, significance, objective & role of
finance function in any organization.

1.2 Nature & Scope of Finance Function

(A) Nature
i) Business is exchange of goods & services for profit. Profit is a function of
revenue & expenses. Business earns revenue only when goods & services are
delivered to customer where, when & how he wants. Thus unless expenses
are incurred first by business it cannot earn profits. Finance function deals
with organizing funds required for these expenses.

ii) Finance function permeates throughout the organization. No activity in

business can be effectively & efficiently carried out without proper support of
finance function.

iii) Even for non profit making organizations it is a necessary function.

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iv) Thus finance function is fundamental to every business & is foundation of any
commercial activity. It is necessary for survival & success of any business.

v) Finance is a service function & it must give proper support to all functions in a
organization in terms of M.I.S. which is useful for decision making & control
throughout the organization.

(B) Scope
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Scope of finance function extends to following three areas.

(a) Procurement of funds (Financing decisions)
(i) Prime responsibility of finance management is to ensure that sufficient
amount of funds are made available to all business activities all the times.
(ii) The quantum of funds required by business depends upon goal of business
& plans of management to achieve this goal.
(iii) Finance management has to assess volume of funds required, when they are
required & locate sources from which these funds can be procured.
(iv) Company has following sources available for procuring funds
- Share Capital
- Debenture Capital
- Loan Capital
(v) Funds are required for two main purposes. Long term funds are required for
creating infrastructure & building production capacity as well as for
developing sales network required to achieve the desired goal. Short term
funds are required for meeting day to day fund requirements of
the organization.
(vi) Long term requirements are met by issuing share capital, debenture capital
or by taking long term loan. Short term requirements can be met by taking
short term loans known as working capital loans from banks or financial
institutions.
(vii) While deciding a particular source of finance following factors need
consideration
- Cost of funds i.e. interest & other costs
- Convenience of organization
- Risks involved
(viii) Interest charged by banks depends on % of C.R.R. & S.L.R. to be
maintained by banks. Banks have been given powers to negotiate interest
rates within certain limits. Finance manager must keep in mind changes in
C.R.R. & S.L.R. & try to negotiate with banks for lower rate of interest.
(ix) Funds are also available at cheaper rates from many foreign sources.
Finance manager must take advantage of these opportunities so that interest
cost would come down & it would be useful for reducing product cost
which is very much essential for competitive advantage of the firm.

(b) Utilization of funds(Investment decisions)

Funds procured are to be properly deployed in the business & finance
manager has to ensure that funds deployed in various areas of business are
properly utilized. For this he should initiate following actions:
(i) Assess exact finance requirements of various divisions.
(ii) Deploy funds only which are required & only when they are required.
(iii) Ensure that funds are utilized for the purposes as desired by B.O.D.
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(iv) Employ various techniques such as budgets, standards, plans, MIS, cost
reduction etc. to ensure that funds are efficiently used by all divisions of
company.
(v) Analyze financial performance of organization & periodically perform top
management regarding utility of funds & profitability of various divisions
& organization on a whole.
(vi) Initiate various actions to correct the situations wherever there is deviation
from predetermined level of fund utilization & analyze its effect.
(vii) Finance manager has to ensure top management that required Returns on
Investment (R.O.I) would be available to shareholders of company.

(c) Distribution of Funds (Dividend Decisions)

Providers of equity funds expect returns on their investments & providers of

loan funds expect repayment of their interest & Principal. Following points
are therefore worth noting
(i) Earning Before Interest & Tax (EBIT) should be sufficient enough to pay
interest burden of organization. This can be achieved by better operational
profits through improved operational efficiency & better fund management.
(ii) Earnings After Tax (EAT) should be sufficient enough to pay dividend to
preference share holders.
(iii) Amount remaining after payment of preference dividend is available to
equity shareholders & this decides Earning Per Share (EPS)
(iv) Of the total amount available to equity shareholders certain percentage is
retained by management as retained earnings. Remaining amount is
distributed as divided on equity shares
(v) Finance manager has to assist Board of Directors for taking decision on
dividend percentage & percentage of earnings to be retained.

For this following factors need consideration

 Future growth & expansion plan of organization
 Future financial needs of organization
 Expectations of equity Shareholders
 Goodwill & image of organization
 Stability of dividend
 Attitude of management
 Legal requirements
 Effect on market value of Company’s Shares
 Effect on liquidity of firm
 Cash dividends versus bonus shares.
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1.3 Goal of Finance Function

A) Goal of Wealth Maximization :
Financial management has principal goal as maximizing wealth of current
shareholders. This goal has been defended on following grounds
(i) In a market based economy social responsibility of business is to create value.
(ii) Increasing company’s value is a concern of everyone who has a stake in
company including shareholders of company
(iii) It calls for more effective deployment & most productive use of scarce
resources available with organization
(v) It ensures faster economic growth & improvement in standard of living of
society
(vi) It reflects financial power of organization
This goal has been criticized on following grounds
(i) Many times stock markets do not reflect correct prices of securities as they are
dominated by many other forces
(ii) Shareholders can also be rewarded in following ways
a) Maximizing Company’s market share
b) Enhancing customer satisfaction by offering products at competitive price,
giving desired Quality products & maintaining delivery schedule desired
by customer.
c) Giving products with zero defects.
(iii) There are interests of various groups in organization who are having their
stakes in company, & these interests must be properly dealt with e.g.
 Customers require products of desired quality at reasonable price.
 Employees expect reasonable returns for the services rendered by them.
 Shareholders require maximum R.O.I. on their investment
 Suppliers require reasonable price & continued business for the goods
supplies by them.
 Society at large expect goods & services which will enhance their
standard of living
Firm should not concentrate on maximization of wealth of shareholders but
try to achieve balance between the interests of these groups.
(iv) Firm must consider itself as a socially responsible entity & should try to
discharge its responsibilities towards society because firm operates with the
franchise given to it by the society.

B) Goal of Profit Maximization :

Besides the goal of wealth maximization other suggested goals of financial

management in terms of profit maximization are :
 Maximization of profits
 Maximization of Earning Per Share (E.P.S.)
 Maximization of return on equity
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Maximization of profit is not as inclusive a goal as maximization of wealth of

shareholders. It suffers from following limitations
a) Profit in absolute terms is not a proper guide to decision making. It should
be expressed either on per share basis or in relation to investment
b) Moreover which profits are to be maximized remains a problem i.e. P.B.T.
or P.A.T. This limitation does not apply to maximization of E.P.S. or return
on equity.
c) All the above 3 goals suffer from following limitations
 They do not consider time value of money. Profits earned at different
points of time cannot be compared because their present values are
different.
 They ignore risk factor e.g. there is no discrimination between
investment project which generates a certain profit of Rs.50,000 & one
which has a variable profit outcome with an expected value of
Rs.50,000.

C) Conclusion :
 Thus maximization of wealth of equity share holders which is reflected
in market value of equity appears to be most appropriate goal for
financial decision making.

 Business often pursue several goals such as

- High rate of growth
- Increased market share
- Attain market leadership
- Attain technological superiority
- Promote employee welfare
- Increased customer satisfaction & so on.

Some of these goals are in line with goal of wealth maximization & some are
conflicting with it. It is important to know cost of pursuing these goals & trade off
must be understood.
 Maximization of wealth of equity shareholders constitute the principal
guarantee for efficient allocation of resources in economy & hence is to
be regarded as the normative goal from financial point of view.
 Many Indian companies have started according greater importance to
the goal of wealth maximization. Some of the reasons for this are:

i) Many business families take higher education abroad & hence they have
realized importance of shareholder value more.

ii) With liberalization companies require more funds & their dependence of
capital markets have increased. This has induced companies to become
more shareholder friendly.
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iii) Companies are relying more on mutual funds, financial institutions &
foreign institutional investors for raising equity capital. They compel
companies to pursue shareholder friendly policies.

iv) With abolition of wealth tax on equity shares & other financial assets
there is now an incentive to enhance share prices.

1.4 Significance of Finance Function

Finance is backbone of every business. Every activity requires interaction &
support of finance department.
(A) General
In general it is useful to organization as a whole on the following aspects
(i) To know utilization of funds employed in business
(ii) To assess fund requirements for future growth & expansion
(iii) Providing periodical information on profitability of firm.
(iv) To highlight areas of financial inefficiency.
(v) To judge efficacy of management efforts
(vi) To understand operational efficiency of organization
(vii) Assessing liquidity & Solvency of firm
(viii) Economic Value Added reporting is now-a-days part of financial reporting
for many blue chips cos. Like Coca-Cola
(ix)To evaluate interest burden of organization
(x) To design appropriate capital structure of company.

(B) Top management

There is constant interaction of top management with finance department of
organization. In particular it is useful to top management on following aspects
(i) To assess effect of various strategies on financial position of company.
(ii) To express goals of organization in financial terms.
(iii) Formulating financial policies of company
(iv) Making financial plans of company
(v) Finance manager gives periodical profitability reports to top management
which show division wise profits, overall profits & R.O.I. of company
(vi) Top management takes many vital decisions such as finalizing capital
budgeting proposals, designing capital structure of company or restructuring
of organization through mergers & acquisitions. Finance manager provides
useful information for taking these decisions.
(vii) B.O.D. declares dividend only after consulting finance manager

(C) Research & Development ( R&D )

(i) Formulating R&D budgets of company
(ii) Project wise allocation of funds
(iii) Controlling utilization of funds allocated to various projects
(iv) Comparing R&D budgets of company with R&D budgets of competitors.
(v) Cost-benefit analysis of various R&D projects.
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(D) Materials Management

(i) Formulating vendor development budget of company.
(ii) Participate in negotiations with suppliers along with purchase executives.
(iii) Preparing purchase budget of company
(iv) Designing inventory policy of Co. with reference to funds requirement
(v) Set inventory valuation norms.
(E) Production management
(i) Formulating production budget
(ii) Monitor & control production costs through these budgets with close
interaction with production management
(iii) Preparing material & labour expense budgets
(iv) Make the required funds available for day to production activities
(v) Appraisal of capital expenditure proposals forwarded by production
management.

(F) Sales & marketing

(i) Preparing sales budget
(ii) Preparing budget for advertisement
(iii) Monitor expenses on Sales & marketing activities
(iv) Decide credit & collection policy of company
(G) Human Resource Management
(i) Prepare Employee cost budget for entire organization through close
interaction with personnel manager
(ii) Making funds available for V.R.S. scheme
(iii) Prepare training & development budget
(iv) Involve in mass bargaining negotiations with employee representatives.

1.5 Role of Modern Finance Manager

 In modern enterprise finance manager occupies key position

a) He is one of the members of top management team.
b) His role day-by-day is becoming more pervasive, intensive & significant
in solving complex managerial problems.
c) He is no more a score keeper maintaining records, preparing reports &
raising funds as & which needed or a staff officer acting in a passive role
of an advisor.
d) His job is vastly changed. Earlier finance was a supporting function. now
it is a mainline function.
e) In many organizations finance itself is considered as profit centre
f) In his new role he needs to have a broader & far sighted outlook & must
ensure that funds of organization are utilized in most efficient manner.

 In last few years Indian economic & financial environment has undergone sea
changes, important ones being
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(a) Industrial licensing considerably relaxed

(b) MRTP Act has been virtually abolished
(c) Foreign Exchange Regulation Act (FERA) has been liberalized and
replaced by Foreign Exchange Management Act (FEMA)
(d) Considerable freedom given to companies in pricing their equity shares.
(e) Foreign investment is liberalized
(f) Interest rates have been considerably brought down
(g) Rupee is made fully convertible on current account
(h) Dependence on capital market has increased.

These changes have made job of finance manager more important, complex &
demanding.

 The key challenges for finance manager in new competitive environment are :

(i) Locate the sources of funds nationally & internationally which are cost
effective & convenient to the firm
(ii) Invest funds in projects which would add value to company so that effective
& efficient utilization of funds is ensured.
(iii) In his new role of using funds wisely he must address following
three Questions
(a) What should be size of an enterprise & how far should it grow?
(b) In what form should it hold its assets?
(c) How the required funds be raised?
These questions relate to three broad decision areas viz. investment,
financing & dividend decisions. Modern finance manager has to help
management making these decisions in most rational way.

(iv) Profit planning which refers to operating decisions in the areas of pricing,
costs, volume of output & firm’s selection of product lines
(v) Develop M.I.S. such that every business decision maker & managers at
operating level gets information at the earliest so that decision making
becomes qualitative & fast & also proper control is ensured throughout the
organization
(vi) Continuously update management with risk-return analysis of various
projects.
(vii) Implement effective cost reduction programme on continuous basis.
(viii) Evaluate financial impact of proposed corporate restructuring
(ix) Design capital structure which will give minimum overall cost of capital &
help improving wealth of shareholders through increased market value of
shares.
(x) Implement most effective foreign exchange management so that company’s
expenses on this account are kept at minimum
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1.6 Summary

 Finance function deals with organizing funds required for various expenditures
in organization. It is a backbone of any organization & for achieving desired
results proper support of finance function is required .

 Scope of finance function extendens to financing, investment & dividend

decisions

 Principal goal of finance function is not the profit but wealth maximization.

 Conflict between personal goals of managers & maximizing shareholders

wealth & its effects & remedies have been explained by agency cost theory.

 In modern organization finance manager occupies key position . Key

challengers in competitive environment is to locate right sources of funds &
invest these funds in projects which will create value to equity shareholders.
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Unit 2 : Techniques of Financial Statement Analysis

Learning Objectives

After learning this unit you will be able to :

 Grasp various tools of financial analysis

 Understand managerial reporting of such analysis

 Draw conclusions for managerial decision making & control.

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2.1 Introduction
 Financial statements exhibit income earned by company during specific period &
give assets & liabilities available with company at a particular point of time.

 Financial analysis gives trend pattern of revenues, expenses, assets & liabilities.
Many conclusions can be drawn from financial analysis which can be used by
management for improving their performance & control the business.

 This unit takes you through five types of analysis.

Comparative statements analysis is useful for year to year comparison of financial
performance of same company.
Common size statements analysis is useful for comparing competitor’s
performance with our company.
Trend Analysis is useful for knowing trend of various financial parameters.
Ratio analysis is useful to know liquidity, Profitability, solvency & efficiency of
company. Finally cash flow analysis is useful to know the sources of cash in
business & how this cash has been utilized.

2.2 Comparative Statements Analysis

 It is also known as horizontal analysis or dynamic analysis.
 In this analysis figures of two or more periods are shown side by side to facilitate
comparison.
 This analysis shows
i) Absolute figures in terms of money for each period
ii) Changes ( + / - ) in absolute figures
iii) Changes (+ / - ) in terms of percentage
iv) Percentage of totals
v) Comparison of period to period percentages.
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 Comparative financial statements are prepared both for income statement &
balance sheet
 Presenting comparative financial statements in annual report increases usefulness
of the report. & brings out trend of current changes which affect the enterprise.
 Analysis gives considerable insight into strengths & weakness of various areas.

Illustration 1 :
Comparative Income Statement for year 2006 & 2007 [Rs. In lakhs.]
Particulars 2006 2007 ( +/- ) Rs. ( + / - )%
Net Sales 2,000 2,100 (+) 100 5 [ 100 x 100]
2,000
(-) C.O.G.S. 1,300 1,200 (-) 100 (-) 7.7 [ 100 x 100]
1,300
= Gross Profit 700 900 (+) 200 28.6 [ 200 x 100]
700
(-) Admin. Expenses 100 130 (+) 30 30 [ 30 x 100]
100
Selling Expenses 150 220 (+) 70 46.7 [ 70 x 100]
150
Depreciation 100 150 (+) 50 50 [ 50 x 100]
100
(+)Other income 10 15 (+) 5 50 [ 5 x 100]
10
= E.B.I.T. 360 415 (+) 55 15.3 [ 55 x 100 ]
360
(-) Interest 60 95 (+) 35 58.3 [ 35 x
100 ]
60
= E.B.T. 300 320 (+) 20 6.7 [ 20 x 100 ]
300
(-) Tax [ 35% ] 105 112 (+) 7 6.7 [ 7 x 100 ]
100
= E.A.T. 195 208 (+) 13 6.7 [ 13 x 100 ]
195
(-) Dividend 95 108 (+) 13 13.7
= Reserves 100 100 - -
Comparative Balance Sheet as on 31/3/2006 & 31/3/2007 [Rs. In lakhs.]
Particulars 2006 2007 ( + / - )Rs. (+/-)%
Equity Capital 80 250 (+) 200 (+) 250 [ 200 x 100]
80
Reserves 100 200 (+) 100 (+) 100 [ 100 x 100]
100
Preference Capital 20 50 (+) 30 (+) 150 [ 30 x 100]
20
Shareholders’ 200 500 (+) 300 (+) 150 [ 300 x 100]
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Equity (A) 200

Particulars 2006 2007 ( + / - )Rs. ( + / - )%
Debentures 250 250 - - -
Secured Loans 200 100 (-) 100 (-) 50 [ 100 x 100 ]
200
Unsecured Loans 50 50 - -
Loan Funds (B) 500 400 (-) 100 (-) 20 [ 100 x 100 ]
500

Total Sources (A+B)=C 700 900 (+) 200 28.6 [ 200 x 100 ]
700
Gross Fixed Assets 400 750
(-) Depreciation 100 250

= Net Fixed Assets (D) 300 500 (+) 200 66.7 [ 200 x 100]
300
Investment (E) 20 20 - -

Current Assets 480 780 (+) 300 62.5 [ 300 x 100]

480
(-) Current Liabilities 200 400 (+) 200 100 [ 200 x 100]
200

= Net Current Assets(F) 280 380 (+) 100 35.7 [ 100 x 100]
280

Total Applications 700 900 (+) 200 28.6 [ 200 x 100]

[D+E+F] = G 700

Report to Management :
 There is an increase in sales by 5%
 Gross profit has increased by 28.6% which indicates that direct expenses are under
control.
 There is sharp rise in administrative expenses by 30%, in selling expenses by
46.7% & in depreciation by 50%. This has resulted in operating expenses to go up
which means operating efficiency of the business has gone down.
 There is rise in interest payment by 35% where as loan funds have gone down by
20%. This means the interest rate on loans has considerably increased.
 All above changes have resulted in increasing E.A.T. only by 6.7% despite of
increase in G/P by 28.6%
 Company has policy of transferring same amount to reserves every year that is why
dividend payout is not constant
 Shareholders equity has increased by 150% . This is mainly due to new issue of
equity & transfer to reserve. Former has increased by 250% & latter by 100%.
Company has also issued preference capital.
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 Capital has increased by 150%

 Company has repaid Rs. 100 lakhs. of secured loans.
 In 2006 company was more dependent on loan funds. In 2007 there is more
dependence on own funds & less on external debt.
 Net fixed assets have increased by 66.7% which means company has made new
investments in fixed assets- a sign of growth.
 The working capital of company has also increased by 35.7%
2.3 Common Size Statements Analysis
 Also termed as vertical analysis
 It is useful to study quantitative relationship of items of financial statement on a
particular date
 In this analysis comparison is made between
- Different division of same company or
- Same division of different companies.
e.g. comparison of soap division & furniture division of Godrej
or comparison of soap division of Godrej & soap division of Hindustan Lever
 This analysis can be done on monthly or yearly basis
 In common size income statement net sales figure is assumed to be 100 & all other
items are expressed as a percentage of net sales. This statement is useful to assess
operating efficiency of the business.
 Common size balance sheet is prepared by assuming total assets to be 100 & total
sources to be 100 & all other items are expressed as percentage of these two
variables.

Illustration 2 : [Amt. Rs. Crores]

Particulars 2006 % 2007 %
Net Sales 40 100 50 100
(-) C.O.G.S. 20 50 30 60
= G/P 20 50 20 40
(-) Admin. Expenses 1 2.5 1.5 3
Selling Expenses 3 7.5 4.0 8
Depreciation 3 7.5 3.5 7
(+) Other Income 2 5 2 4
= E.B.I.T. 15 37.5 13 26
(-) Interest 2 5 3 6
= E.B.T. 13 32.5 10 20
(-) Tax 4 - 3 -
= E.A.T. 9 22.5 7 14
(-) Dividend 5 - 4 -
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= Retained Earnings 4 - 3 -

Solution [Amt. Rs. Crores]

Sources 2006 % 2007 %

Equity Capital 11 55 13 56.5

Reserves 4 20 7 30.5

Shareholders Equity (I) 15 75 20 87

Debentures 3 15 2 8.7
Secured Loans 1.8 9 0.8 3.5
Unsecured Loans 0.2 1 0.2 0.8

Loans Funds ( II ) 5 25 3 13

Total Sources [ I + II ] 20 100 23 100

Applications 2006 % 2007 %

Gross Fixed Assets 13.0 14.50

(-) Depreciation 3.0 6.50

= Net Fixed Assets (III) 10.0 50 8.0 34.80

Investments (IV) 0.50 2.5 0.50 2.20

Current Assets 16 23
(-) Current Liabilities 6.50 8.50

= Net Current Assets(V) 9.50 47.5 14.50 63

Total Applications 20 100 23 100

[ III + IV + V ]

Report to Management.

 Sales have increased by 12.5% in 2007. Satisfactory performance of marketing

division.

 In 2006 gross profit was 50% which has come down to 40% in 2007. Purchase &
Manufacturing departments are accountable for increase in. C.O.G.S.
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 Operating expenses i.e. administration, selling & depreciation have by & large
remained same. This means operating efficiency remains same in 2007 as in 2007.

 E.B.I.T. was 37.5% in 2006 which has come down to 26% in 2007. This is mainly
due to drop in G/P. Same drop is observed in E.B.T. & E.A.T
.
 Dividend payout by & large remains constant
[ For 2006 . 5/9 = 56% & for 2007: 4/7 = 57%]
This means company is following constant dividend policy.

 In 2006 shareholders funds are 75% & loan funds are 25% which has become 87%
& 13% respectively in 2007. This means company is more dependent on internal
funds in 2007 as compared to 2006.

 Company has invested 50% of funds in fixed assets & 47.5% funds in working
capital, in 2006. This has charged to around 35% & 63% respectively i.e.
company’s investment policy has charged in 2007.

 In conclusion we can say that top line i.e. net sales is improving where as bottom
line i.e. E.A.T. is decreasing. This may affect market price of company’s shares.

 Company investing equal funds in fixed assets and working capital in 2006 . This
policy has changed in 2007 with more investment in working capital & less in fixed
assets .

2.4 Trend Analysis

 This involves calculating index ratios of various items in financial statements for a
number of accounting periods.

 Following steps are involved

i) Select a base year

ii) Every item of financial statements for base year is taken as 100

 Figure for subsequent years is calculated as :

Absolute figure of year x 100

Absolute figure of base year

 This analysis is useful to know the trend of various financial parameters & from
this trend company’s progress can be assessed.
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Illustration 3 : Income Statement

[ Rs. In Lakhs. ]
2005 2006 2007 2005 2006 2007
Net Sales 50 75 100 100 150 200
(-)C.O.G.S. 40 60 72 100 150 180
= G/P 10 15 28 100 150 280
(-) Admin. Exp. 2 3 4 100 150 200
Selling Exp. 2 3 8 100 150 400
Depreciation 1 2 3 100 200 300
(+)Other income 1 1 2 100 100 200
= E.B.I.T. 6 8 15 100 133 250
(-) Interest 2 3 5 100 150
250
= E.B.T. 4 5 10 100 125 250
(-) Tax 1.5 2 4 100 133 267
= E.A.T. 2.5 3 6 100 120 240
(-) Dividend 1.0 1.5 2 100 150 200
= Retained Earnings 1.5 1.5 4 100 100 267
Solution : Balance Sheet
2005 2006 2007 2005 2006 2007
Equity Capital 5.5 6 6 100 109 109
Reserves 1.5 3 7 100 200 467
Shareholder’s Equity (I)7.0 9 13 100 129 186
Debentures 1.5 3 3.5 100 200 233
Secured Loans 1 1.5 2 100 150 200
Unsecured Loans 0.5 0.5 0.5 100 100 100
Loan Funds (II) 3 5 6 100 167 200
Total Sources (I + II) 10 14 19 100 140 190
Gross Fixed Assets 7 12 18 100 171 257
(-) Depreciation 1 3 6 100 300 600
= Net Fixed Assets (III) 6 9 12 100 150 200
Investment (IV) 1 1 1 100 100 100
Current Assets 6 9 13 100 150 217
(-)Current Liabilities 3 4 5 100 133 167
= Net Current Assets (V) 3 5 8 100 167 267
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Total Applications 10 15 20 100 150 200

[III+IV+V]
Report to Management :

 There is continuous growth in net sales of company which has doubled in last three
years.
 G/P has increased by 180%, E.B.I.T. has increased by 150%, E.B.I. has increased
by 150% & E.A.T. by 140%. These are the indicators of improving operational
efficiency
 Dividend distributed has doubled in three years & retained earnings by 167% .
Both these would result in company’s share price to go up.
 Shareholders equity has increased by 86% in last three years. This means
management is crating value to shareholders.
 Loan funds have doubled in last three years which means company is also taking
loan for expansion & growth.
 Company’s investment in fixed assets has doubled & in working capital by 167%
in last three years which is required for supporting similar growth in sales.

2.5 Ratio Analysis

a) Meaning:

 Ratio is a relationship expressed in mathematical terms between two figures

or group of figures connected with each other in some logical manner.
Ratios are expressed as pure ratio i.e. say 4:1 or as no. of times e.g.3 times
or as % say 25%

 Ratio analysis is 3 step process:

-- Calculate ratio
-- Compare it with standard ratio
-- Find conclusion which is useful for decision making & control

 Ratio analysis can take any of the following forms:

A) Cross sectional analysis:

-- Comparison of ratios of our company with other company of same
industry (generally competitors)
-- Comparison of ratios of our company & of leader in the industry
This is useful for bench marking

B) Time series analysis:

-- Comparing performance of our company over a period of time
-- Trends are studied
-- Useful for future planning
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-- Company can assess whether it is achieving long term goals or not

C) Combined analysis :
-- Both A& B are combined
-- Trend of ratio is compared with some standard over a period of time

 Ratio analysis should be undertaken only after following precautions:

-- Period for comparison must be same
-- Accounting policies must be same of companies whose ratio are being
compared
-- Group of ratios is preferred to single ratio
-- Figures used to calculate ratios must be related to each other

b) Significance:

 Liquidity
It is the ability of company to pay its current obligations & is reflected by
liquidity ratios such as current ratio & liquid ratio. These two ratio give amount of
inventory, debtors &cash balance with company. High level of ratio indicate that
funds of company are blocked in its current assets which may reduce profits as
company may have to pay interest on these funds. Low level of ratios indicate
excess current liabilities & it indicates that company is unable to pay its short term
liabilities

 Long term solvency

It is the ability of co to pay its long term liabilities & is of concern to long term
creditors & present & potential investors of company. This aspect is reflected by
capital structure or leverage ratios. Debt-Equity is the main ratio in this group.
High ratio means more debt & this may endanger long term solvency of the
business & low ratio means less dependence on external funds, but dilution of
control as firm has employed more equity capital as compared to debt capital.

 Management Efficiency
Ratio analysis throws light on degree of management efficiency & utilization of its
assets. Various activity ratios measure operational efficiency by reflecting use of
assets of company to generate sales revenue.

 overall profitability of concern.

Ratios such as N/P ratio or ROCE reflect ability of the firm to provide reasonable
returns to its owners & ensure optimum utilization of assets of company.

 Intra firm & inter firm comparison

 19

Intra firm & inter firm comparison is possible with ratios. Company ratios are
compared with those of competitors. Ratios of two or more divisions of same
company can be compared to assess their performance.
 Trend analysis
Ratio analysis shows whether financial position of company is improving or
deteriorating over the years. Treads can be compared with respect to industry
standards.

c) Classification of ratios

I ) Liquidity Ratios
 Liquidity refers to the maintenance of cash, bank balances & those assets
which are easily convertible into cash in order to meet liabilities as & when
they arise.
 Liquidity ratios provide a quick measure of liquidity of the firm by
establishing relationship between its current assets & current liabilities. If
firm does not have sufficient liquidity, it may not be in a position to meet its
commitments & thereby may loose its creditworthiness.
 Liquidity ratios are also called as balance sheet ratios because information
required for the calculation of these ratios is available in balance sheet only.

1) Current Ratio

Formula: _Current assets__

Current liabilities

Current Assets = Inventory + Debtors + B/R+ Pre-paid exp. + Marketable

Securities + Cash + Bank

Current Liabilities = Creditors + B/P + Short Term Loans + Bank o/d

+ outstanding expenses + Provision for tax + Proposed
dividend
Significance:
(i) Throws light on the firm’s ability to pay its current assets
(ii) Generally ratio 2:1 is considered to be satisfactory
(iii) Standard Current Ratio may vary from one industry to other
(iv) Gives margin by which the value of current assets may go down without
creating any payment problems.

2) Quick Ratio
 Also called as acid test or liquid ratio.
 Establishes relationship between quick or liquid assets & liquid liabilities.
 A current asset is considered liquid if it is convertible into cash without loss of
time & value .
 20

 Inventory is kept out because it may become obsolete, unstable or out of fashion
& always inventories have tendency to fluctuate in value .
 Another item which is generally kept out is pre-paid expenses because by nature
they are not realized into cash.
Formula:
Quick Ratio = Quick or liquid assets
Quick liabilities

= C.A.- (Inventory & prepaid expenses)

C.L. – (Bank Overdraft)

Significance:
(i) Better test of liquid than the current ratio
(ii) Ratio 1:1 is considered satisfactory
(iii) Quick ratio is itself not a conclusive test of liquidity because-
 Inventories which have been ignored may not always be so illiquid
 Receivables & marketable securities which are considered to be liquid may
not be so liquid.

Therefore firm having quick ratio 1:1 or even higher may still face problems in
meeting its commitments if the liquid assets consist of slow paying or defaulting
customers.

Absolute Liquid Ratio = Absolute Liquid Assets (Cash in hand + Cash at Bank + M Secu)
CL - BoD

II ) Solvency or Leverage or Capital Structure Ratios

These ratios decide long term solvency of the company. Their value is decided
by debt-equity mix in the capital structure. When debt component is more there
is excess dependence on external funds and compulsory commitment of
interest payment. Long term survival & success of organization is reflected by
these ratios.

1. Debt-Equity Ratio
Formula:
D/E Ratio = Long term debts
Shareholders Equity
OR
D/E Ratio = _Total debts__
Shareholders Equity

Total debts = Long term debts + Current Liabilities

Shareholders Equity = Equity Capital + Preference Capital + Reserves & Surplus

The use of particular formula depends on requirements of user
 21

Significance:
i) Ratio, indicates proportion of owners’ stake in the business
ii) Excess debts tend to cause insolvency.
iii) Ratio indicates the extent to which firm depends upon outsiders for its existence.
iv) It tells the owners, the extent to which they can gain benefits or maintain control
with limited investment.

2 Proprietary Ratio
Formula:
Proprietary Ratio = Shareholders’ funds
Total Tangible Assets

= Equity & Preference capital + Reserve & Surplus

Total Tangible Assets
Significance:
i) It focuses attention on the general financial strength of business.
ii) High ratio means more portion of business assets is financed by shareholders.
This situation is preferred by creditors of company e.g. If ratio= 0.70 & assets =
100 crs. This means assets worth Rs.70 crs are financed by shareholders .In case of
winding up of Co. more money would be available for creditors.
iii) Low ratio indicates greater risk to creditors e.g. if in above case ratio is 0.3 then
only 30crs. would be available to creditors on winding up of Co.

2 Capital Gearing Ratio: ( Fixed Rate Commitment of Interest & Pref Dividend)
Formula:
Capital gearing Ratio = Long term debts + Preference Capital
Equity Capital + Reserves & surplus
Significance:
(i) Business is highly geared when ratio is more than 1.
This situation is preferred when business is having boom & profits
are stable or increasing.
(ii) Business is low geared when ratio is less than 1.This situation is
preferred when business is having slack & profits are decreasing.
 22

Sales
( - ) COGS (Op Stock + Purchases + All Direct Exps – Closing Stock)
Gross Profit / Factory Level Profit
(- ) Admn O/h
( - ) S&D O/h
( - ) Fin O/h
EBDIT
( - ) Depreciation
EBIT / Operating Profit 600
( - ) Interest 150
EBT / Taxable Profit 0
( - ) Tax 0
EAT / PAT ( Net Profit / Profit available for owners)
( - ) Preference Dividend
EATAPD (Earnings available to Equity Shareholder)
( - ) Equity Dividend
Reserve & Surplus (Retained Earnings/ Undistributed Profits)

4 Interest Coverage Ratio:

Formula:
I.C.R. = Profit before depreciation, interest & tax (PBDIT or EBIT)
Interest payment
Significance:
(i) Shows capabilities of the firm to pay interest
(ii) Banks & financial institutes look for this ratio
(iii) Higher the ratio more is the assurance to banks & F.Is for interest recovery

5 Debt Service Coverage Ratio:

Formula:
D.S.C.R = Profit After Tax (PAT) +Interest + Depreciation
Interest on term loan + periodic repayment
Significance:
(i) Financial Institutions calculate average D.S.C.R. for period during which term
loan is repayable.
(ii) Normally they consider D.S.C.R. 1.5 to 2 to be satisfactory

III Activity Ratios

 Also called turnover or performance ratios
 Measure of movement & thus indicates as to how frequently an account has
 23

moved/ turned over during a period

 Shows how effectively and efficiently assets of the firm are being utilized.
 Measure effectiveness with which the firm uses its resources
 Calculated with reference to sales/ cost of goods sold
 Expressed in terms of rate or times
 Following are activity ratios:

1 Inventory Turnover Ratio:

Ratio= Sales or cost of goods sold
Average Inventory

= Sales or (sales – G/P)

(Op. stock+Cl. Stock)
2

Higher the ratio better is the efficiency with which the inventory is used.
It also indicates that inventory level for given sales level is low.

2 Receivables or debtors turnover ratio:

Ratio = Annual Net credit sales
Average Receivables

i) More ratio means less receivables (Quick turnaround)

Lower ratio mean high receivables
ii) Ratio reflects efficiency of credit & collection department & also indicates
credit policy of the firm.

3. Payables or creditors turnover ratio:

Ratio = Annual net credit purchases
Av. Payables

i) More ratio means less payables

Lower ratio means more payables
ii) Ratio indicates credit period availed by company from suppliers.

4. Working capital turnover ratio:

Ratio = Annual Net Sales_
Av. Working Capital
Higher ratio means lower investment in working capital i.e. better working
capital management.

5. Total asset turnover ratio:

 24

Ratio = Net Sales __

Av. tangible assets

i) Indicates how efficiently assets have been used by company for generating
sale.
ii) Higher the ratio better is the efficiency.

6 Fixed Assets Turnover Ratio:

Ratio = Net Sales__

Av. fixed assets

It indicates efficiency of management of using fixed assets. Higher the ratio more
is efficiency.

7 Capital Turnover Ratio:

Ratio = Net Sales__

capital employed

Ratio indicates greater sales made for each rupee of capital employed &hence
higher profits. It shows efficiency of using capital.

IV Profitability Ratios

1 Gross Profit Ratio (G/P Ratio):

Ratio = Gross Profit x 100

Sales

= (Sales- Cost of goods sold) x100

Sales

Ratio reflects efficiency of purchase & production departments

2 Operating Profit Ratio:

Ratio = Operating profits x 100 = E.B.I.T. x 100

Sales Sales

i) Ratio measures the efficiency with which the firm not only manufactures/
purchases goods but also sells goods
ii) It shows operating efficiency of the firm.
 25

3. Net Profit Ratio (N/P Ratio):

Ratio = P.A.T. x 100 or = P.B.T. x 100

Sales Sales

i) Ratio indicates overall efficiency in manufacturing, administration, selling &

distribution .
ii) Shows proportion of sales revenue available to the owners of company

4. Operating Ratio / Operating Cost Ratio:

Ratio = Total operating cost x 100

Net Sales

Operating ratio & operating profit ratio are complementary to each other.
If operating ratio is 85% then operating profit ratio is 15%.

5. Return on investment (ROI) or return on capital employed (ROCE):

ROI or ROCE = Profit After Tax (PAT) x 100 or = EBIT x 100

Capital employed Capital employed

i) It shows whether amount of capital employed has been effectively used or not.
ii) It is an index to the operational efficiency of the business as well as an indicator
of profitability. Higher the ratio better it is.
iii)Factors which affect ROI can be represented by a chart known as Du Pont Chart.

This chart was first introduced by Du Pont company of U.S.A. in annual report.

Du Pont Chart

ROI = Net Profit

Capital

= Net Profit x Sales

Sales x Capital

= N/P Ratio x Capital Turnover Ratio

N/P = [Sales] - [C.O.G.S. + Admin. Exp. + Selling Exp. + Income Tax ]

 26

Capital = Shareholders Equity + Long Term Funds or

= Fixed Assets + Current Assets – Current Liabilities

6 Return On Equity

Ratio = [Profit After Tax (PAT)- preference dividend] x 100

Equity

Equity = Equity Capital + Reserves

Significance:
i) This is the single most ratio to judge whether firm has earned satisfactory
returns for its equity holders or not.
ii) This ratio is compared with that of competitors or with industry average.

V. Invisibility Ratio

 Investors who are interested to invest in the shares of a Co. would be keen
to know the investment potential of a company before taking final decision.
 Analysis of Invisibility ratio help the investors to know the Invisibility of a Co.
 Following are the ratios:

1. Earning per share (E.P.S)

E.P.S = PAT – PREF dividend

No. of equity shares

Cash E.P.S = PBT + Depreciation

No. of equity shares
Ratio indicates:
i) Earning Capacity of Co.
ii) Amount available to shareholders
iii) Efficiency of management
iv) Market value of share
v) Amount of cash generated from equity share employed in business.

2. Price Earning Ratio (P/E):

P/E = Market Price

E.P.S

i) Ratio indicates market price fluctuations of Co’s share

ii) Capitalization Rate = 1 = __E. P . S___
P/E Market Price
 27

e.g. If P/E = 10 then capitalization rate = 1/10 = 10%

3. Dividend per share ( D.P.S ):

D.P.S = Total profit distributed
No. of equity shares

This reflects dividend policy of the firm

E.P.S – D.P.S = Reserve created per share

e.g. E.P.S = Rs. 5 & D.P.S = Rs.3

No. of shares = 1 lakh

Reserves created by Co. = 1 lakh (5-3) = 2 lakhs

4. Dividend payout ratio (D/P ratio)

D/P = D.P.S x 100

E.P.S

(1 – D/P ) = Retention ratio

ROE x (1 – D/P) = rate of growth of shareholders’ funds

ROE = PAT - Preference Dividend x 100

Equity shareholders funds

5. Dividend Yield:
Ratio = D.P.S. x 100 _
Mkt. Price Per Share

Ratio is useful for investor to find returns on shares when purchased from market.

Illustration 1 :
Particulars Amt. ( Rs. )
Stock 40,000
Sundry debtors 50,000
Prepaid expenses 10,000
Bank balance 20,000
Cash Balance 15,000
Sundry Creditors 50,000
Bank Overdraft 30,000
Proposed Dividend 5,000
 28

Provision for tax 15,000

Calculate : (a) Current Ratio (b) Liquid Ratio.

Solution :
(a) Current Ratio = __Current Assets__
Current Liabilities

= Stock + Sundry debtors + P.P. Expenses + Bank + Cash

S/Crs + Bank overdraft + Proposed dividend + Prov. For tax

= 40,000 + 50,000 + 10,000 + 20,000 + 15,000

50,000 + 30,000 + 5,000 + 15,000

= 1,35,000
1,00,000

= 1.35

(b) Liquid Ratio = _Liquid Assets_

Liquid Liabilities

= ( Current Assets ) - [ Stock & Prepaid expenses ]

( Current Liabilities ) - [ Bank overdraft ]

= ( 1,35,000 ) - ( 40,000 + 10,000)

( 1,00,000 ) - ( 30,000 )

= 85,000
70,000

= 1.21

Illustration 2 :
Current Ratio is 2
Liquid Ratio is 1.2
Working Capital is Rs. 2,40,000 ( WC = CA – CL )
There is no overdraft & prepaid expenses
Decide (a) Current Assets (b) Current Liabilities (c) Stock

Solution :
Working Capital = 2,40,000
WC = CA – CL i.e. 240000 = CA - CL
CA / CL = 2
CA are double of CL
WC = CA – CL
 29

WC = 2 CL – CL
240000 = 1 CL ie. CA= 2 CL = 480000

Liquid Ratio (1.2 ) = CA – (Stock & Pre Paid Expenses) / CL – Bank Overdraft
Liquid Ratio (1.2) = CA – Stock / CL i.e. 1.2 = 480000 – Stock / 240000

STOCK = 192000

i.e. [Current Assets ] (-) [Current liabilities ] = 2,40,000----------(1)

Current Ratio = 2 = Current Assets

Current Liabilities.

i..e. Current Assets = 2 x Current Liabilities --------------------------(2)

From (1) & (2)
2 [ Current Liabilities ] - [ Current Liabilities ] = Rs. 2,40,000

i.e. Current Liabilities = Rs. 2,40,000

Putting this value in equation (2)
Current Assets = 2 x 2,40,000 = Rs. 4,80,000

Now, Liquid Ratio = ( Current Assets ) - ( Stock & prepaid Expenses)

( Current Liabilities ) - ( Bank Overdraft)

i.e. 1.2 = (4,80,000) – (Stock) [Since There are no prepaid Exp.

2,40,000 & Bank overdraft ]

Stock = (4,80,000) - 1.2 ( 2,40,000)

= Rs. 1,92,000

Ans. : Current Assets Rs. 4,80,000

Current Liabilities Rs. 2,40,000
Stock Rs. 1,92,000

Illustration 3 :
Total capital of company is Rs. 400 Crs. Collected from following sources :
Equity Capital Rs. 220 Crores.
Preference Capital Rs. 10 Crores.
Reserves Rs. 40 Crores.
Debentures ( 12% ) Rs. 100 Crores.
Secured Loans ( 13% ) Rs. 30 Crores.
 30

Decide : (a) Debt Equity Ratio (b) Capital Gearing Ratio

Solution :

(a) Debt – Equity = Long Term Debt

Shareholders equity

= Debentures + Secured Loans

Equity + Reserves + Pref. Capital

= __100 + 30___
220 + 40 + 10

= 130
270
= 0.48
(b)Capital Gearing Ratio = Debenture + Secured Loan + Pref. Capital
Equity + Reserves.

= 100 + 30 + 10
220 + 40

= 140
260
= 0.54
Illustration 4 :
Capital Structure of company has following sources :
Equity Capital Rs. 100 Crores.
Reserves Rs. 50 Crores.
Debentures (10 % ) Rs. 200 Crores
Secured Loans ( 12 % ) Rs . 50 Crores.
Net Sales are Rs. 800 Crores.
Operating expenses are Rs. 600 Crores.
Which includes depreciation Rs. 100 Crores.
Tax rate is 35%.
Secured loan & debentures are to be repaid in 5 equal installments
Decide:(a)Interest Coverage Ratio (I.C.R.) (b) Debt Service Coverage Ratio (D.S.C.R.)

Solution :
E.B.I.T. = (Net Sales ) - (Operating Expenses )
= ( 800 ) - ( 600 )
= Rs. 200 Crores.

E.B.T. = (EBIT) - ( Interest )

 31

Interest = (Interest on debentures) + ( Interest on loans )

= (10% of 200 ) + ( 12% on 50 )

= 20 + 6
= 26
E.B.T. = 200 - 26
= 174
E.A.T. = (E.B.T.) - Tax
= 174 - 35% of 174
= 174 - 60.9
= 113.10
(a) Interest Coverage Ratio (I.C.R.) = __E.B.I.T.___
Interest Payable

= 200
26

= 7.7

(b) Debt Service Coverage Ratio (D.S.C.R.) = E.A.T. + Interest + Depreciation

Principal + Interest

= 113.10 + 26 + 100
50 + 26

[Total Loan = Rs. 250 Cr. Principal repayment = 250 x 1 = Rs. 50 Crores. ]
5
Debt. Service Coverage Ratio (D.S.C.R.) = 239.10
76
= 3.15
Illustration 5 :
You have been given following income statement
Particulars Rs. ( in Crores.)
Net Sales 3,000
(-) C.O.G.S. 2,000

= G/P 1,000

(-) Admin. Exp. 50

Selling Exp. 150
 32

Depreciation 80

= E.B.I.T. 720

(-) Interest 120

= E.B.T. 600
= Tax 210
= E.A.T 390
(-) Pref. Dividend 40
(-) Equity Dividend [ 20% on 150 Crores. Capital) 30

= Retained Earnings. 320

Accumulated Reserves are Rs. 480 Crores.
Required :
a) Gross Profit Ratio
b) Operating Profit Ratio
c) Operating Ratio
d) Net Profit Ratio
e) Returns on Equity
f) Earning Per share.
Solution :
(a) G / P Ratio = G / P x 100 = 1,000 x 100 = 33.33%
Sales 3,000

(b) Operating Profit Ratio = E.B.I.T. x 100 = 720 x 100 = 24%

Sales 3,000

(c) Operating Ratio = C.O.G.S + Admin. + Selling + Depreciation x 100

Sales

= 2,000 + 50 + 150 + 80 x 100

3,000
= 2,280 x 100
3,000

= 76%

(d) N / P Ratio = E.A.T. x 100 = 390 x 100 = 13%

Sales 3,000

(e) Returns on Equity = E.A.T - Pref. Dividend

Equity + Reserve
 33

= 390 - 40
150 + 480

= 350 x 100
630
= 55.6%
(f) E.P.S. = E.A.T - Pref. Dividend
No. of Equity Shares.

= (350 - 40 ) cr
15 cr.

= Rs. 23.33
Note : Equity Capital is Rs. 150 Crores Each Equity Share is of Rs. 10 hence no. of
Equity Shares are 150/ 10 = 15 Crores.

Illustration 6 :
Amt. ( Rs. Lakhs. )
Annual Sales 2,100
Equity 200
Reserves 100
Debentures ( 10% ) 100
Loans (12 %) 100
Represented by :
Net Fixed Assets 300
Current Assets 300
Current Liabilities 100

Note: Current assets include: 150 (Inventory), 100 (Debtors), 50 (Other current assets)
Decide : (a) Current Ratio
(b) Inventory Turnover
(c) Working Capital Turnover
(d) Fixed Assets Turnover.
(e) Capital Turnover

Solution :

(a) Current Ratio = Current Assets_ = 300 = 3

Current Liabilities 100

(b) Inventory Turnover = Net Sales = 2,100 = 14

Inventory 150

(c) W.C. Turnover = __Net Sales_ _ = __2,100 _ = 10.5

 34

Working Capital (300 – 100)

(d) Fixed Assets Turnover = Net Sales = 2,100 = 7.0
Net Fixed Assets 300

(e) Capital Turnover = ___Net Sales _ _

Capital Employed

= Net Sales = 2,100 = 4.2

Equity + Reserves 500
+ Debentures + Loans

Illustration 7 :
Company is capitalized as follows :
7% Preference Shares ( Re. 1 each ) 6,00,000
Equity shares ( Re. 1 each ) 16,00,000
Market Price Per Equity Share 4
Dividend 20 %
P.A.T. 5,42,000

Calculate :
a) Dividend yield
b) Dividend payout
c) P/E Ratio
d) Earnings Yield.

Solution :
(a) Dividend Yield = _ Dividend x 100__ = 0.20 x 100 = 5%
Market Price Per Share 4

(b) Dividend Payout = D.P.S. = 0.20 x 100 = 64%

E.P.S. 0.3125

E.P.S. = P.A.T. - Pref. Dividend = 5,42,000 - 42,000 = Rs. 0.3125

No. of Equity Shares. 16,00,000

(c) P/E = Market Price Per Share = 4 = 12.80

E.P.S. 0.3125

(d) Earnings Yield = E.PS. x 100 = 0.3125 x 100 = 7.8%

Market Price 4

Illustration 8 :
 35

Financial statement are provided to you for year 2005 & 2006.Caluclate following
ratios & write report to management based on these ratios
(i) G / P (ii) Operating Profit (iii) Operating
Expenses
(iv) N / P (v) Return On Equity (vi) R.O.I.
(vii) Current (viii) Liquid (ix) Debt Equity
(x) Capital Gearing. (xi) I.C.R. (xii) D.S.C.R.
(xiii) Inventory Turnover (xiv) Debtors Turnover (xv) Fixed Assets Turnover
(xvi) Working Capital Turnover (xvii) Total Assets Turnover (xviii)Capital Turnover
(xix)E.P.S. (xx) D.P.S. (xxi) D / P
(xxii) P / E (xxiii) Dividend Yield (xiv) Earning Yield
(xv) Return on Net Worth.
[ Amt. in Rs. Crores. ]

Particulars 2005 2006

Net Sales ( All Credit ) 1,385 1,580

(-) C.O.G.S. 950 1,100

= G/P 435 480

(-) Admin. Exp. 35 40

Selling Exp. 60 65
Depreciation 30 40

= E.B.I.T. 310 335

(-) Interest 32 38

= E.B.T. 278 297

(-) Tax 94 100

= E.A.T. 184 197

(-) Dividend ( Pref.) 4 4

Dividend ( Equity ) 90 163

= Retained Earnings. 90 30

Equity Capital 60 80
Reserves 90 120
Pref. Capital ( 8% ) 50 50
Debentures (10% ) 200 200
Term Loans (12%) 100 150
 36

Total Sources (A) 500 600

Net Fixed Assets (I) 250 300

Inventory 330 460

Sundry Debtors 220 240
Advances Pre- Paid 35 15
Marketable Securities 15 5
Bank 30 70
Cash 20 10

Total Current Assets (i) 650 800

Less :
Sundry Creditors 180 230
Outstanding Expenses 20 40
Advances Received 30 20
Bank Overdraft 40 20
Proposed dividend 90 163
Provision for tax 40 27

Total Current Liabilities ( ii ) 400 500

= Net Current Assets ( II ) 250 300

Total Applications ( I + II ) 500 600

Market Price Per Share ( Rs. ) 55 60

Debentures & Term loans are to be repaid in 5 equal installment

Solution :
2005 2006
i) G / P Ratio = G / P x 100 435 x 100 = 31.41% 480 x 100 = 30.38%
Sales 1,385 1,580

 Ratio has slightly come down. Direct Manufacturing expenses are under control.
2005 2006
ii) Operating = EBIT x 100 310 x 100 = 22.38% 335 x 100 = 21.20%
Profit Ratio Sales 1385 1580

 Ratio show slight downward trend. Operating expenses are under control.

iii) Operating Exp. Ratio = C.O.G.S. + Adm. Exp. + Selling Exp. + Deprn. x 100
Sales.
 37

2005 2006
950 + 35 + 60 + 30 x 100 = 77.62% 1100 + 40 + 65 40 x 100 = 78.8%
1,385 1,580

 Ratio by & large remains at same level operating expenses are under control.

iv) N / P Ratio = PAT x 100 2005 2006

Sales 184 x 100 = 13.3% 197 x 100 = 12.47%
1,385 1,580

 Overall profitability has slightly come down. Management should try to maintain
this ratio in line with industry average or with competitor’s ratio
v) Return on Equity = E.A.T. - Preference Dividend x 100
Equity + Reserves

2005 2006
( 184 - 4 ) x 100 = 120 % (197 - 4 ) x 100 = 96.5 %
150 200

 Ratio has come down which indicates that returns to shareholders have gone down.
Actions are required to improve this ratio. However very good returns to
shareholders.

vi) R.O.I. = E.A.T. _____ 2005 2006

Capital Employed 184 x 100 = 36.8% 197 x 100 =
32.83%
500 600

 ROI has dropped down by nearly 4%. Management should try to regain position of
year 2005. Also study ROI of competitors & realign target ROI accordingly.

vii) Current Ratio = _Current Assets_ 2005 2006

Current Liabilities 650 = 1.63 800 = 1.60
400 500

 No change in ratio. Working capital is managed properly. Ratio. 1.6 can be

considered as reasonably good one.

viii) Liquid Ratio = [ C.A. ] - [ Prepaid expenses & Inventory ]

[ C.L. ] - [ Bank overdraft ]

2005 2006
650 - 330 - 35 = 0.80 800 - 460 - 15 = 0.68
400 - 40 500 - 20
 38

 Ideal ratio is 1:1 . As ratio in 2005 is 0.80 & it has further gone down in 2006 to
0.68 This means company has liquidity problems.

ix) Debt – Equity Ratio = Long Term loan + Debts_

Equity + Reserves + Pref.

2005 2006
200 + 100_ = 1.5 200 + 150 _ = 1.4
60 + 90 + 50 80 + 120 + 50

 Ratio remains by & large same. This means equity & debt slightly increased to
maintain same ratio.

x) Capital Gearing Ratio = Long term debts + Preference

Equity + Reserves
2005 2006
300 + 50 = 2.33 350 + 50 = 2.0
150 200
 As ratio is more than 1 company is highly geared.

xi) Interest Coverage Ratio (I.C.R.) = E.B.I.T.

Interest
2005 2006
Interest 200 (10%) + 100( 12%) = 32 20(10%) + 150(12%) = 38

I.C.R. 310 = 9.69 335 = 8.82

32 38

 I.C.R. is very high in both years. Banks & FIs would give preference to company
for extending loan.

xii) Debt Service Coverage Ratio ( D.S.C.R.) = PAT + Interest + Depreciation

Principal + Interest
2005 2006
Interest 32 38
Principal 60(300/5) 70 (350 / 5)

D.S.C.R. 184 + 32 + 30 = 2.67 197 + 38 + 40 = 2.55

60 + 32 70 + 38

 Generally 1.5 to 2 D.S.C.R. is considered satisfactory.

Hence D.S.C.R. very good in both the years.

xiii) Inventory Turnover = Sales 2005 2006

Closing stock 1,385 = 4.20 1,580 = 3.43
 39

330 460

 Higher the ratio lower is the inventory level. This means company is maintain
higher stocks in 2006 as compared to 2005.

xiv) Debtors Turnover = Credit Sales 2005 2006

Debtors 1,385 = 6.3 1,580 = 6.5
220 240

Debtors in months = 12 12 = 1.90 12 = 1.82

D.T.R. 6.3 6.58

 Company is having credit policy of around 2 months.

xv) Fixed Asset Turnover = ____Sales______ 2005 2006
Net Fixed Assets 1,385 = 5.5 1,580 = 5.25
250 300
 Efficiency of using fixed assets is constant and is very high.

xvi) Working capital Turnover = _Sales _ 2005 2006

Working Capital1,385 = 5.5 1,580 = 5.25
250 300
( Note : Working Capital means net current assets )

 Efficiency of using working capital is constant & is quite satisfactory

xvii) Total Asses Turnover = __ ___ Sales __
Fixed Assets + Current Assets
2005 2006
__1,385 = 1.54 1,580 = 1.44
250 + 650 300 + 800
 Ratio seems to be inadequate & more efficiency is required in using fixed & current
assets.

xviii)Capital Turnover = Sales 2005 2006

F.A. + C.A. – C.L. 1,385 = 2.77 1,580 = 2.6
500 600

xix) E.P.S. = EAT - Pref. dividend 2005 2006

No. of Eq. Shares 184 - 4 = 30 197 - 4 = 24.12
6 8
 E.P.S. has come down in 2006. This may affect share price.

xx) D.P.S. = Total Amt. Distributed 2005 2006

No. of equity shares 90 = 15 163 = 20.37
6 8
 40

xxi) D / P = D.P.S. x 100 2005 2006

E.P.S. 15 x 100 = 50% 20.37 x 100 = 84.5%
30 24.12

 Company has changed its dividend policy. In 2006 more dividends have been
distributed. Company should try to follow constant dividend policy

xxii) P / E = M.V.P.S. 2005 2006

E.P.S. 55 = 1.83 60 = 2.49
30 24.12
 P / E ratio increase means market price of shares is going up.
xxiii) Dividend Yield = D.P.S. x 100 2005 2006
M.V.P.S. 15 x 100 = 27.3 20.37 x 100 = 34%
55 60
 Ratio is increasing investors can get good returns on investment good share to
invest.

xxiv) Earning Yield = E.P.S. 2005 2006

M.V.P.S. 30 x 100 = 54.5% 24.12 x 100 = 40.2
55 60
 Ratio is decreasing as EPS has come down & market price has increased.

xxv) Return on Net Worth = E.AT._____

Equity + Reserves
2005 2006
184 x 100 = 123% 197 x 100 = 98.5%
150 200
 Returns are decreasing less returns to shareholders

2.6 Cash Flow Analysis

 Every limited company listed on recognized stock exchange must incorporate cash
flow statement in Annual Report of company
 Cash flow statement must be prepared as per Accounting Standard no. 3 issued by
Institute of chartered Accountants of India.
 Cash flow statement indicates cash flows during a particular period under following
three heads :
i) Cash generated form operating activities.
ii) Cash generated from investing activities.
iii) Cash generated from financing activities.
 41

 Amount of cash flows arising from operating activities gives idea whether
organization has generated sufficient cash flows:
- To maintain operating capability of organization.
- To pay dividends
- To repay loans
- To make new investments
Without external sources of finance.
 Separate disclosure of cash generated from investing activities indicates the
investments made by business to generate future cash flows.
 Disclosure of cash flows from financing activities is useful to predict claims on
future cash flows by providers of funds to the business.

Format of cash flow statement.

(A) Cash flows from operating activities:
(i) Net profit before tax 3,350
(ii) +depreciation 450
(iii) +interest ( To be taken under financing activity) 400
(iv) +foreign exchange loss 40
(v) - interest income [To be taken under investment activities] 300
(vi) - dividend income [To be taken under investment activities] 200

= Operating profit before working capital changes 3,740

- Increase in Current assets 500

+ Decrease in Current assets 1,050
- Decrease in Current liabilities 2,340
+ Increase in Current liabilities 600

= Cash before Tax 2,550

- Tax 860

= Cash flow before Extraordinary items 1,690

+ Extraordinary item 180

= CASH FROM OPERATING ACTIVITIES (A) 1,870

(B) Cash flows from investment activities:

Purchase of plant (350)
Sale of plant 20
 42

Interest Received 300

Dividend Received 200
CASH FROM INVESTMENT ACTIVITIES (B) 170

( C) Cash flows from financing activities:

Issue of share capital 250
Issue of Debentures 250
Dividend paid (1,320)
Interest paid ( 400)

CASH FROM FINANCING ACTIVITIES ( C) (1,220)

Increase in cash during year (A+B+C) 820

Opening balance 160
Cash balance at end 980
Illustration 1 :
From following particulars prepare cash flow statement for year 2006 – 2007 & write
report to management .
Particulars Amt. ( Rs. Lakhs. )
E.B.T. (OA) 2,520
Tax Paid (OA) 820
Interest Paid (OA) add-(FA) 600
Depreciation (OA) add 350
Loss due to exchange rate fluctuation (OA) add 80
Interest received (OA) minus (IA) 150
Dividend received (OA) minus (IA) 230
Extraordinary gain (OA) add 50
Plant purchased (IA) 230
Investment sold (IA) 85
Plant sold (IA) 105
Investment Purchased (IA) 70
Dividend Paid (FA) 280
Share Capital issued (FA) 300
8% Debentures redeemed (FA) 50
10% Pref. Capital issued (FA) 50
Openings balance of cash & near cash items. 360

Opening Balance Closing Balance

Inventory 380 270
Debtors 148 268
Creditors 386 126
Outstanding Expenses 88 108

Solution : Amt. ( Rs. Lakhs. )

 43

(A) Cash Flow From Operating activities :

E.B.T. 2,520
+ Depreciation 350
+ Interest paid (to be considered under financing activities ) 600
+ Loss on foreign ( None operating loss ) 80
- Interest paid (to be considered under financing activities ) 150
- Dividend Recd.( To be considered under investing activities ) 230
= Operating profit before working capital changes 3,170
+ Decrease in inventory 110
+ Increase in outstanding expenses 20
- Increase in debtors 120
- Decrease in creditors 260

= Cash before extraordinary item 2,920

+ Extraordinary gain 50

= Cash before tax 2,970

- Tax paid
820

= Cash From Operating Activities ( A ) 2,150

(B) Cash From Investment Activities :

Investment Sold + 85
Plant Sold + 105
Plant Purchased - 230
Investment Purchased - 70
Interest Received + 150
Dividend Received + 230

= Cash From Investment Activities ( B ) 270

(C) Cash From Financing Activities :

Issue of Equity Capital 300
Issue of (10%) Preference Capital + 50
Redemption of ( 8%)Debentures - 50
Interest Paid - 600
Dividend Paid -
280

= Cash From Financing Activities ( C ) (-) 580

 44

Increase in cash & near cash items during year ( A+B+C) 1,840
+ Opening cash & near cash items 360

= Cash & near cash items balance in end 2,200

Report to Management :

 Total cash generated during is Rs. 1,840 lakhs.

 Major cash is generated from operating activities which indicates good operating
efficiency
 Company ahs sold plant for Rs. 105 lakhs. & purchased plant worth Rs. 70 lakhs.
This means asset base of company is reduced No. growth plans.
 Company has received dividend Rs. 230 lakhs. & interest Rs. 150 lakhs, which
shows that company is investing excess funds in good companies.
 Company has issued equity capital of Rs. 300 lakhs. This means equity base is
enlarged. This would be useful for raising loans for expansion & growth
 Company has issued (8%) Preference capital to redeem (10%) Debentures. This
would release the charge on assets created for debentures issued.
Illustration 2 :

You have been given following cash flow statement. Study this statement & give report
to management. ( Rs. In Crores.)
E.B.T. 135
+ Depreciation 35
+ Interest paid 20
+ Loss on sale of assets 30
- Interest Received 10
- Dividend Received 20

= Operating Profit Before Working Capital Changes 190

+ Decrease in Debtors 20
+ Increase in Creditors 10
- Increase in Inventory 15
- Decrease in Bills Payable 5

= Cash before tax 200

- Tax paid 40

= Cash Flow From Operating Activities (A) 160

Investment Sold + 20
Plant Sold + 80
Interest Received + 10
 45

Dividend Received + 20

= Cash Flow From Investment Activities ( B ) 130

Issue of ( 10 % ) Debenture + 20
Receipt of ( 13%) Loans + 90
Interest Paid - 20
Dividend Paid - 15

= Cash Flow From Financing Activities (C) 75

Increase in cash & near cash items 365

During year ( A + B + C )
+ Opening Cash & near cash items 85

= Closing cash & near cash items 450

Solution :

Report to Management :

 Company is having huge cash balance. No new investments have been made. This
means management is conservative & do not want to grow business .

 Plant has been sold for Rs. 80 Crores but not replaced. This has reduced asset base
a good sign for long term survival.

 Company has unnecessarily taken huge loans as this amount has not been utilized
for making any new investments.

 Company has generated Rs. 160 Crores from operation. This indicates operational
efficiency. Management should make use of this strength by investing funds in new
plants & other assets & achieve good growth in business.

 Company has E.B.T. of Rs. 135 crores & Rs. 40 crores taxes paid. This leaves Rs.
95 crores available to equity shareholders. However dividend paid is only Rs. 15
crores. This shows conservative approach of management.

3.7 Summary :

 Many conclusions can be drawn from financial analysis which can be used by
management for improving business performance & for SWOT analysis of
business. It is also useful for managerial control.
 46

 Comparative statements are prepared to get insight into strengths & weakness of
various areas.

 Common size statements are useful for assessing efficiency of different divisions of
same company or same divisions of different companies. This analysis is useful for
competitive analysis.

 Trend analysis gives idea about trends on company performance over no. of years.

 Ratio analysis a powerful tool used for assessing liquidity, solvency, profitability &
for knowing efficiency of using available resources & highlights various ratios
useful to investor for deciding whether to invert funds in a company or not.

 Cash flow analysis highlights cash generated from operations, investments & from
financing activities.
 47

Unit 3 : Working Capital Management

Learning Objective

After studying this unit you should be able to :

 Understand meaning of working capital

 Know factors on which working capital of company depends

 Estimate working capital requirements of company

 Know how to control working capital

 Understand various sources of working capital.

______________________________________________________________

3.1 Introduction

 Every company requires capital for infrastructure and for carrying out day to
day activities. Capital required for running the business smoothly and
efficiently on day to day basis is known as working capital of company.

 Understanding meaning, significance, factors, and methods of estimation of

working capital is essential for managing working capital efficiently

 For controlling working capital various ratios can be calculated to know the
effect of working capital management on liquidity & profitability of company.

 There are various sources working capital finance. It is important to know these
sources so that cost of working capital finance can be kept to minimum.
 48

3.2 Meaning of Working Capital

WORKING CAPITAL

CURRENT ASSETS (Less) CURRENT LIABILITIES

Converted into cash Payable
within one year within one year

1) Stock 1) Sundry creditors

 Raw material 2) Bills payable (B/P)
 W.I.P. 3) Short term loans
 Finished goods 4) Bank overdraft
 Stores / spares 5) Advances received
2) Sundry debtors 6) I/Tax payable
3) Advances paid 7) Proposed dividend
4) Temporary investment
5) Cash – Bank
6) Cash – Hand
7) Bills Receivables
8) (B/R)

Gross Net Temporary Permanent

Total of all Total of all Required Minimum level of

current assets current over & current assets
held by assets less above which must be
company at all current permanent maintained by
any given liabilities working company all times
point of time held by capital to also called as fixed
company at support working capital
a point of increased
time activities of
any business

3.3 Significance of Working Capital

 49

 For every business capital is required to build up productive capacity & basic
infrastructure. This capital is used for purchase of fixed assets such as land,
building, machinery, furniture, fixtures & other facilities required for long term.
This is called fixed capital of company.

 In addition company needs capital for purchase of raw materials, payment of

wages & salaries & payment of various services & other materials purchased by
company for producing & selling the goods. This capital is required for a short
period of time – generally for a period less than a year. This is called as
working capital required by company.
 If sufficient working capital is not available then business activities are either
disturbed or come to halt. Thus adequate working capital is required by every
business for day-to-day functioning.
 Further if working capital is in shortage then plant efficiency is affected due to
less use of machinery, as raw material, labour & other services would not be
available in time & in required quantity.
 Shortage of working capital results in
- Loss of production
- Late distribution of goods
- Loss of sale & loss of market share
- Loss of company’s goodwill.
 It is thus important for management to allocate funds for working capital or
make proper arrangements so that funds are available for working capital.

3.4Determinants of Working Capital

For estimating working capital following factors must be considered
1) Volume of business
When the volume of business is small working capital requirements are less,
whereas for the business having large volume of activities require higher level of
working capital e.g. company like Tata Steel or Tata Motors would require higher
level of working capital.

2) Type of business
Working capital depends on the type of business activities.
There can be three types of businesses
Manufacturing business requires maximum working capital
Trading business requires moderate working capital
Service industries require minimum working capital
3) Nature of business
 50

For a seasonal business such as sugar, ice-cream, or cold drink requires more
working capital during season and less working capital during off season.
For non- seasonal businesses such as FMCG. companies require by and large same
working capital throughout the year.

4) Raw material requirements

Companies manufacturing the products containing more raw materials have to
stock these materials in large quantities which increases working capital
requirements of company.
If raw material is imported then lead time is more and quantity to be purchased is
also more. This makes raw material stocks to go up and increase working capital
requirements.

5) Production activities
If production cycle time is more WIP stocks go up & working capital increases.
Due to peculiar features of production process such as in case of chemical
companies and liquor manufacturing units production cycle time is more which
makes these companies to carry higher WIP stocks.
If the production efficiency is low production cycle time increases and so also
working capital requirements.

6) Sales & distribution activities

 Company with more distribution time requires more working capital because
working capital cycle becomes longer.

 When company spends more on sales commission, advertising, sales promotion

& on after sales service working capital requirements go up.

7) Sale & Purchase Pattern :

Working capital requirements go up when :

- Cash sales are less
- Credit period given to customers is more
- Cash purchases are more
- Credit period given by suppliers is less

Working capital requirements go down when :

- Cash sales are more
- Credit period given to customers is more
- Cash purchases are less
- Credit period given by suppliers is more.

8) Other Factors.
 More labour requirements, more working capital
 51

 Higher machinery means higher level of : repairs, maintenance , spares,

consumables & more are requirements of working capital .
 When payments of Excise Duty, Sales Tax, Income Tax & Octroi are to be
made working capital requirements would go up .
 Working capital depends on volume of capital budgeting. More capital
expenditure means expansion of production which requires higher level of
working capital.

3.5Working Capital Cycle [ Operating Cycle ]

Operating cycle of a firm is time required to convert cash available with firm into
raw material, W.I.P. finished goods, debtors & back to cash.
Operating cycle can be shown as :

Cash Raw Work

material in process

Debtors Finished goods

Thus operating cycle consists of following stages :

i) Procurement of raw materials & services

ii) Conversion of raw materials into W.I.P.
iii) Conversion of W.I.P. into finished goods.
iv) Sale of finished goods on credit.
v) Conversion of receivables into cash

Operating cycle period is calculated by using following formula :

O.C. (days) = R + W + F + D – C

R = Average Raw material stocks / raw material consumption per day

W = Average W.I. P. stocks / cost of production per day
F = Average Finished goods stocks / cost of sales per day
D = Average Debtors / credit sale per day
C = Average Creditors / credit purchase per day

Illustration 1.
 52

Following information is available for ABC ltd. Compute operating cycle in days
Period covered 365 days
Av. Debtors outstanding 4,80,000 Rs.
Raw material consumed 44,00,000 Rs.
Total production cost 100,00,000 Rs.
Total cost of sales 105,00,000 Rs.
Sales of year 160,00,000 Rs.
Credit allowed by supplier 16 days

Value of av. Stocks :

Raw material 3,20,000 Rs.
W.I.P. 3,50,000 Rs.
Finished goods 2,60,000 Rs.

Solution :

Av.R.M. Stocks 3,20,000

R= Consumption / day = 44,00,000 / 365 = 27 days

Av. W.I.P. stocks 3,50,000

W= Cost of prodn. / day = 100,00,000 / 365 = 13 days

Av. F. G. stocks 2,60,000

F= Cost of sales / day = 105,00,000/365 = 9 days

Av. Debtors 4,80,000

D= Credit sale / day = 160,00,000/365 = 11 days

C= Credit allowed by suppliers = 16 days

O.C. = R + W + F + D – C

= 27 + 13+ 9 + 11 – 16

= 44 days

Now annual cost of sales is 105,00,000

W.C. reqd. = 105,00,000 / 365 x 44 = Rs. 12,65,753 i.e. 12.66 lacs

Illustration 2.
 53

Calculate the operating cycle of a company which gives the following details relating
to its operations:
Rs.
Raw materials consumption per annum 8,42,000
Annual cost of production 14,25,000
Annual cost of sales 15,30,000
Annual sales 19,50,000

Average value of current assets held :

Raw materials 1,24,000
Work-in-progress 72,000
Finished goods 1,22,000
Debtors 2,60,000

The company gets 30 days credit from its suppliers. All sales made by the firm are on
credit only. You may take one year as equal to 365 days.

Solution :
Calculation of operating cycle
a) Raw Material Conversion Period

Average stock of raw materials x 365 = Rs. 1,24,000 x 365 = 54 days.

Raw material consumption p.a. Rs. 8,42,000

b) Work-in-progress conversion period

Average stock of WIP x 365 = Rs. 72,000 x 365 = 18 days.

Annual cost of production Rs. 14,25,000

c) Finished Goods Conversion Period

Average stock of finished goods x 365 = Rs. 1,22,000 x 365 = 29 days.

Annual cost of sales Rs.15,30,000

d) Debtors collection period

Average value of debtors x 365 = Rs. 2,60,000 x 365 = 49 days.

Annual sales Rs.19,50,000

e) Payment Deferral Period = 30 days(given)

Operating cycle = ( 54 + 18 + 29 + 49 ) – 30 = 120 days.

3.6Estimation of Working Capital

 54

1) Percentage of sales method :

 traditional & simple method
 determined on basis of past experience
 based on relationship between sales and working capital requirements
 past figures are adjusted to suit future sales figures & price structure of
inventories & expenses expected

Illustration 1 .
Firm is having following details for 2006
Current assets Rs
Inventories 10,00,000
Receivables 11,00,000
Cash & bank 1,00,000
Current liabilities :
Sundry creditors 6,00,000
Provision for taxation 3,00,000
Turnover 60,00,000
Following changes are expected in year 2007
i) Raw material prices would go up by 5 %
ii) Inventories would be 10% more in quantity & included only raw material
iii) Selling price would increase by 10 %
iv) Sales volume would be 1.5 times that of this year
v) Receivables would be 10 % less in qty
vi) Cash balance would be 1.3 times of present level
vii) Creditors would be 20 % more in quantity
viii) Tax rates are expected to come-down to 35 % & profits are 10 % on sales
Estimate requirements of working capital of company for year 2007

Solution :
Year 2006 2007
Turnover 60,00,000 99,00,000 (60,00,000 x 1.5 x 1.1 )
Current asset
Inventories 10,00,000 11,55,000 (10,00,000 x 1.1 x 1.05 )
Receivables 11,00,000 14,85,000 (11,00,000 x 0.9 x 1.5 )
Cash & bank 1,00,000 1,30,000
Total Current Assets (A) 22,00,000 27,70,000
Current liabilities
Sundry creditors 6,00,000 7,56,000 (6,00,000 x 1.2 x 1.05 )
Prov. For tax 3,00,000 3,46,500 (99,00,000 x 0.1 x 0.35 )
Total Current liabilities (B) 9,00,000 11,02,000
Working capital (A–B) 13,00,000 16,68,000
From above it is clear that even though turnover has increased by 1.5 times working capital
requirements have increased by 1.28 times only. This means management is envisaging
aggressive policy of working capital.
2) Operating cycle method :
 55

Working capital is estimated by following formula :

Estimated Working Capital

= Estimated C.O.G.S. x Days of operating cycle + Desired cash balance

365

Illustration :

ABC Ltd. Expects its cost of goods for year 2007 to be Rs. 600 lacs. The expected
operating cycle is 90 days. It wants to maintain cash balance of Rs. 20 Lacs what is
expected working capital requirement if no. of days in a year are 360.

Solution :

Estimated Working Capital.

= [ Estimated C.O.G.S. x Days of operating cycle ] + Desired cash balance
360

= [ 600 x 90 / 360 ] + 20

= Rs. 170 Lacs

3) Regression analysis method :

 Statistical technique
 It helps is making working capital requirement projections after establishing
average relationship between sales & working capital & its various components
in past years. Method of least square is used

 Relationship between sales(X) & working capital (Y) is given by equation :

Y = a + bX

 Value of a & b is found from following simultaneous equations

∑Y = na + b∑X

∑XY = a ∑X + b∑X2

a = fixed component

b = variable component

n = No of observations

Illustration :
 56

Following are figures for ABC Ltd. Estimate working capital for year 2007
Year Sales ( Rs. Lacs ) C. A. (Rs. Lacs)
2002 320 220
2003 440 270
2004 520 315
2005 570 435
2006 690 450
2007 870 ?

Solution :
Year Sales (x) C.A. (y) xy x2
94 320 220 70,400 1,02,400
95 40 270 1,18,800 1,93,600
96 520 315 1,63,800 2,70,400
97 570 435 2,47,950 3,42,900
98 690 450 3,10,500 4,76,100
2
N=5 ∑x=2540 ∑y=1690 ∑xy=9,11,450 ∑x =13,85,400

y = na + b ∑x

1690 = 5a + 2540b ------------------(1)

xy = a∑x + b ∑x2

9,11,450 = 2540a + 13,85,400 b-------(2)

solving (1) & (2)

a = (-)2.36 & b= 0.67

y = a + bx , x = 870

y = (-)2.36 + 0.67 x 870

= 580.54 lacs
thus working capital required by company for year 2007 is Rs. 580.54 Lakhs

4. Individual component approach :

 note all items of C.A. & C.L.
 add all items of C.A. let it = A
 add all items of C.L. let it = B
 Working Capital = (A–B)
 Add amount for contingencies as required
 57

 Raw material stock is valued at raw material purchase price

 For valuing W.I.P. take
Raw material (100 %) + labour ( % as per stage of completion ) + overhead
(% as per stage of completion)
 In problems it is stated that production is carried out evenly throughout the
year in such case take. Raw Material = 100 % Over head =50 %
Labour = 50 %
 when items are required in days then annual figures /365
 when items are required in weeks then annual figures /52
 when items are required in months then annual figures /12
 when items are required in quarterly then annual figures /4

Illustration 1.

The board of XYX Ltd wants to now working capital requirements for activity level of
1,56,000 units production p.a. Other information is :

Raw material = Rs. 90 per unit

Dir. Labour = Rs. 40 per unit
Overheads = Rs. 75 per unit
Profit = Rs. 60 per unit
Sale 20 % cash & 80% credit
Cash at bank Rs 60,000
Raw material in stock 1 week
WIP in stock 2 weeks
Finished goods st. 1 weeks
Credit by suppliers 1 weeks
Credit to debtors 8 weeks [Debtors to be valued at selling price]
Lag in payment of wages 1.5 weeks
Lag in payment of overhead 4 weeks
Add 10 % for contingencies

Solution :
 58

Weekly production = 156,000 / 52 = 3000 units

Current assets :
Current assets
Raw material stock = 10,80,000
W.I.P. stock = 8,85,000
Finished goods stock = 24,60,000
Sundry debtors = 50,88,000
Cash at bank = 60,000
Total Current Assets (A) = 95,73,000

Current liabilities:
Sundry creditors = 10,80,000
Outstanding wages = 1,80,000
Outstanding overheads = 9,00,000
Total Current Liabilities. (B) 21,60,000

Working Capital (A - B) 74,13,000

+ contingencies 10 % 17,41,300
= Working Capital required 81,54,300

Notes :
1) Value of Raw material stock :
Value = Units per week x no. of weeks stock x Raw Material cost per unit
= 3,000 x 4 x 90
= Rs. 10,80,000

2) Value of WIP. Stock :

When stage of completion is not mentioned, wages & overheads are to be taken at
50% & raw material at 100%.
Thus one unit of WIP will value as :
Raw material (100%) + Labour (50%) + Overheads (50%)
Rs. 90 + 20 + 37.5 = Rs. 147.5
Value = Units per week x no. of weeks stock x cost per unit
= 3,000 x 2 x 147.5 = Rs. 8,85,000

3) Value of finished goods stock :

When finished goods is ready material, labour & overheads are to be taken at 100%
Value = Units per week x No. of weeks stock x Cost per unit
= 3,000 x 4 x [ 90 + 40 + 75 ]
= Rs. 24,60,000
For valuation of finished goods stock profit is not to be added since goods are still
not sold & are lying in company only.
4) Value of sundry debtors :
 59

Debtors are to be taken only for credit sale. When nothing is mentioned, valuation is
to be done at total cost i.e. Rs. 205 per unit.
In the given problem it is mentioned that debtors are to be valued at selling price i.e.
Rs. 265 per unit.
Value = [ Units per weeks x No. of week credit x Cost per unit ] x 80%.

= [ 3,000 x 8 x 265 ]

= Rs. 50,88,000
(Since 20% sale is against cash & 80% is on credit. )

5) Value of sundry creditors :

Value = Units per week x No. of week credit x Cost per unit.

= 3,000 x 4 x 90

= Rs. 10,80,000

6) Outstanding Wages :
Value = Units per week x Outstanding week x Labour rate per unit

= 3,000 x 1.5 x 40

= Rs. 1,80,000

7) Outstanding overheads :
Value = Units per week x No. of outstanding weeks x Cost per unit

= 3,000 x 4 x 75

= Rs. 9,00,000

Illustration 2 .
Estalla Garment Co. Ltd. is a famous manufacturer and exporter of garments to the
European countries. The Finance Manager of the company is preparing its working
capital forecast for the next year. After carefully screening all the document, and
collected the following information:
Production during the previous year was 15,00,000 units. The same level of activity
is intended to be maintained during the current year. The expected ratios of cost to
selling price are:
Raw materials 40%
Direct wages 20%
Overheads 20%
 60

The raw materials ordinarily remain in stores for 3 months before production. Every
unit of production remains in the process for 2 months and is assumed to be
consisting of 100% raw material, wages and overheads. Finished goods remain in
warehouse for 3 months. Credit allowed by the creditors is 4 months from the date of
the delivery of raw material and credit given to debtors is 3 months from the date of
dispatch.

Estimated balance of cash to be held Rs. 2,00,000

Lag in payment of wages ½ month
Lag in payment of expenses ½ month

Selling price is Rs. 10 per unit. Both production and sales are in a regular cycle. You
are required to make a provision of 10% for contingency (except cash )

Solution :
Calculation of Profit Margin
Particulars %
Rs.
Raw materials 40 4
Direct wages 20 2
Overheads 20 2
Total Cost 80 8
Add: Profit 20 2
Selling price 100 10

Estimation of Working Capital (Rs.)

Current Assets:
Raw materials stock (15,00,000 x 4 x 3/12) 15,00,000
Work-in-process (15,00,000 x 8 x 2/12) 20,00,000
Finished goods stock (15,00,000 x 8 x 3/12) 30,00,000
Debtors (15,00,000 x 8 x 3/12) 30,00,000
(a) 95,00,000

Current Liabilities :
Creditors for raw-material (15,00,000 x 4 x 4/12) 20,00,000
Wages outstanding (15,00,000 x 2 x 1/24) 1,25,000
Outstanding expenses (15,00,000 x 2 x 1/24) 1,25,000
(b) 22,50,000

Current Assets less Current Liabilities (a – b) 72,50,000

Add: Contingency (10% of 72,50,000) 7,25,000 79,75,000
Add: Desired Cash Balance 2,00,000
________
Estimated Working Capital 81,75,000
 61

3.7Controlling Working Capital

1) Various ratios can be used to judge whether working capital is managed efficiently
or not

2) These ratios reflect the impact of working capital management on liquidity &
profitability of firm

3) Ratios can be compared with standard ratios set for a particular industry or a
company or can be compared for one period to another period

4) While making comparison it should be ensured that accounting policy of firm does
not change & composition of CA & CL remains same

Ratio Formula Significance

WC turnover Sales / wc  Shows how efficiently wc has been used

by management

 More ratio – better efficiency

 Lower ratio – less efficiency

Inventory Sales or COGS/  Shows how efficiently has inventory

turnover (av or closing been turned
stocks)
 More the ratio better it is

C.A. turnover Sales / CA  Shows efficiency of CA

 More ratio means less investment in CA
 Reduction in ratio calls for investigation
into stocks & debtors mgt & also into
cash levels

Debtors Sales(cr.) / debtors  More ratio means less debtors indicating

turnover (av or closing) efficiency of debtors collection vice-a-
versa in case of more ratio

Bad debts to Bad debts  Lesser the ratio better it is

sales Sales
 Efficiency of credit & collection deptt

Creditors Credit purchases /  More ratio means less creditors

turnover creditors (av. or indicating that co is unable to obtain
closing) more credit from suppliers vice-a-versa
 62

if it is less
Current CA/CL  Higher ratio means larger amount of
rupee available per rupee of CL &
greater is the safety to short term
creditors

 Ratio 2:1 is generally preferred

 Banks accept minimum ratio of 1.33:1

for WC finance

Quick(or) C.A.- stock  Ratio 1:1 is considered satisfactory

liquid C.L-bank o/d
 It is a test of liquidity

 Ratio > 1 means high liquidity

 Ratio < 1 indicates liquidity problems

3.8Sources of Working Capital (Short Term Sources of Finance )

i) Trade Credit :

 It is spontaneous source of finance i.e. source arising in normal course of

business
 Trade credit is extended to business depending upon custom of trade,
competition in industry & relationship with suppliers
 Trade credit is generated when company acquires materials & do not pay
for them immediately.
 When bill of exchange is accepted by company it is called bills payable
 Trade credit is extended on following terms :
- Maximum credit limit
- Credit period
- Cash discount
- Starting date

ii) Bills discounting :

Bills drawn by company & accepted by customers are purchased by bankers

of company at say 80% of bill value. On maturity remaining amount less
bank charges are credited to company’s account
iii) Cash credit or Bank Overdraft:
 63

It is an arrangement under which bank sanctions limit up to which cash or

chaques can be drawn by company even if there is no balance in account.
When arrangement is temporary it is called overdraft & when it is
permanent it is called cash credit.

iv) Inter corporate deposits or loans :

Business can take loan from other business for short period of time. It is
Generally for 60 to 180 days.

v) Commercial Paper :

It is a short term debt instrument issued at discount for a period 3 months up

to one year.
Commercial paper can be issued by companies fulfilling requirements
issued by R.B.I.

vi) Public Deposits :

Important source for well established companies with huge capital base. For
issuing public deposits company must follow provisions of sections 58A,
58AA, & 58B of Companies Act. 1956 & rules there under.

vii) Factoring :

 Company sells its debtors to bank or financial institution called as factor

 Company sells goods to debtors & sends one copy of invoice to factor
 On receiving invoice factor immediately makes 80% payment to
company
 On due date factor collects bill amount from debtors and after deducting
his charges & interest remits remaining amount to company

 Factors performs following functions

- Debtors accounting
- Debtors collection
- Bears risk of non payment by debtors.

 Depending upon functions performed by factors his charges are

negotiated by company.
 64

3.9Summary

 There are four types of working capital.

Gross working capital is total of current assets
Net working capital is excess of current assets . Over current liabilities
Temporary working capital is additional current assets required to support
seasonal fluctuations.
Permanent working capital is amount of current assets required to be
maintained at all times.

 Adequate working capital is required for smooth & efficient day to day working
of business.

 Working capital required by business depends upon type, nature & volume of
business, raw material & labour requirements, production & distribution
efficiency, selling & after sales costs, credit period of suppliers & customers &
other factors.

 Operating cycle is the time required to convert cash of business into raw
materials, W.I.P., finished goods, debtors & back to cash. Longer the operating
cycle more are the requirements of working capital.

 There are 4 methods to estimate working capital

- Percentage of sales
- Relationship between sales & working capital
- Operating cycle period
- Estimation of individual working capital component

 For controlling working capital various ratios are used.

 Sources of working capital includes : Trade credit, discounting of bills raised on

customers, bank overdraft, cash credit, inter corporate loans, commercial paper
public deposits & factoring.
 65

Unit 4 : Cost Of Capital & Capital Structure

Learning Objective :

After studying this you will be able to :

 Understand meaning of cost of capital

 Grasp significance of cost of capital


Calculate cost of equity preference debenture loan capital & weighted average cost
of capital. (WACC).
_________________________________________________________________________

4.1 Introduction

 Business procuress funds from different sources. Every source has different
cost either in the form of dividend or in the form of interest.

 Business must earn returns which are sufficient to pay the cost of the funds.

 Cost of capital is the minimum returns which must be earned by business from
funds invested in business, which is weighted average cost of capital (WACC)
of various sources of funds used in business.

4.2Meaning of Cost of Capital

 It is the minimum rate of return that company must try to earn on the funds
invested in various projects of the company.

 Minimum rate consists of : Risk free rate of return + premium for risk
associated with particular business.

 Risk free rate of return is available on government securities where there is no

risk of default.

 Premium is added for two types of risks associated with business viz. Business
Risk which arises when there is volatility in earnings of a company due to
changes in demand, supply, economic environment, business conditions etc.
Financial risk arises when firm depends on debt funds, since payment of
principal & interest must be made as per loan obligation.
 66

4.3Significance of Cost of Capital

 Management must invest funds in those projects which would bring returns
more than cost of capital, then only share holders are benefited

 Cost of capital is the weighted average cost of capital (WACC) of various

sources of funds used in capital structure . Thus returns from the project
must be more than WACC

 In capital budgeting decision methods used for evaluation of project are

based on WACC of project

 While locating various sources of finance & designing capital structure

management must ensure that WACC is kept at minimum.

4.4 Cost of Equity Shares

Cost of Equity Capital (Ke)
(1) Dividend-Yield Method
 Formula : Ke = D/ P

D = Dividend per share

P = Market price per share

 Features :
(i) Future expected dividend is assumed to be constant
(ii) Does not allow for any growth rate
(iii) In reality shareholders expect growth

Illustration 1 :
ABC Ltd. has declared dividend of 15% on share of Rs. 10 . Which will remain
constant. What is cost of equity if market price of share is Rs. 30 .

Solution :
Ke = D x 100
P

Ke = 1.5 x 100
30

= 5%
 67

D = 15% = Rs. 1.50

P = Rs. 30
(2) Dividend-Growth Method
 Formula : Ke = (D1/ P) + g

D1 = Do (1+g)

g = Growth rate of dividend

 Features :
(i) Based on assumption that shareholders expect dividend to grow year after year
(ii) Allowance for future growth in dividend is added to current dividend yield
(iii) It is recognized that current market price of a share reflects expected future
dividends

Illustration 2 :
Company has declared dividend of 20% last year which is expected to increase at a
constant rate of 6% what is cost of equity if market price share is Rs. 18.

Solution :
Ke = Do (1 + g ) + g
P

Do = Rs. 2

g = 6%

P = Rs. 18

Ke = 2 (1 + 6% ) + 6%
18

= 2 ( 1.06 ) + 6%
18

= 17.78 %.

(3) Price-Earning Method

 Formula : Ke = E/ M

E = Current E.P.S.

M = EX-Dividend Market price Per share

 Features :
 68

(i) Based on assumption that investors capitalize the stream of future earnings of
the share
(ii) Even if earnings are not distributed & kept as retained earnings it causes
further growth in earnings of company & market price of share
Illustration 3 :
Aditya Ind. Ltd. has just paid dividend of 35%. Which is expected to grow at a constant
rate of 5%. What is cost of equity if market price of share is Rs. 30.
Solution :
Ke = D1 + g D1 = Rs. 3.50
P P = Rs. 30
g = 5%
= 3.5 + 5%
30
= 11.67% + 5%
= 16.67%.

Illustration 4:
EBIT of company is Rs. 28 Crores. Interest paid by company is Rs. 3 crores. Tax rate
is 40%. Preference capital (10%) is Rs. 10 crores & equity capital (Rs. 5)is Rs. 30
Crores. Debentures (10%) Rs. 50 Crores. Loan (12%) Rs. 25 Crores.
Decide cost of equity if market price of share is Rs. 20 .

Solution :
Ke = ___________E.P.S.______________
Market Value Per Share (M.V.P.S.)

Now EPS = EBIT - Int. – Tax – Pref. Dividend

No. of Equity Shares.

EBIT = Rs. 28 crores.

Int. = Rs. 3 crores.
Tax. = 40% [ 28 – 3] = Rs. 10 crores.

Pref. Div. = 10% [ 10 ] = Rs. 1 crores

No. of equity shares = Equity Capital = 30 Cr. = 6 Cr. Shares.

Price per share 5
Hence,
E.P.S. = 28 - 3 - 10 - 1
6
= 14
6
 69

& Ke = 2.33 x 100

20

= 11.65%
(4) Capital Asset Pricing Model (CAPM) Method

 Formula : Ke = Rf +β (Rm - Rf )

Rf = Risk free rate of return Risk free rate

Rm = Market return

Β = Beta of investment
 Features :

(i) CAPM divides cost of capital in 2 components Risk free rate of return& risk
premium for a particular investment which depends on market returns &
risk factor β

Illustration 5 :
Returns available on Govt. T-bills is 3%. Returns available in market are 18%. Beta for
the share is 1.2. Decide cost of equity using C.A.P.M. method.

Solution :
Ke = Rs + β [ R m - R f ]

Rf = 3% Rm = 18% β = 1.2
Hence ,
Ke = 3% + 1.2 [ 18% - 3% ]

= 3% + 18%

= 21%

4.5 Cost of Preference Shares

Cost of Redeemable Pref. Shares (Kp)

Company is not allowed to issue irredeemable pref. shares :

D + (Rv - Sv)
N
Kp = ------------------
(Rv + Sv )
2
 70

D = Annual fix dividend

Rv = Redemption value per share
Sv = Net sale value per share
Illustration 1 :
Company issued preference shares of Rs. 20 lakhs. (Rs. 100) at premium of 8%.
Dividend is 8% & redemption will be after 8 years at par what is cost of preference
shares.

Solution :
Ke = D + ( Rv - Sv )
N
x 100
(Rv + Sv)
2

D = Rs. 8 [ 8% of 100]

SV = Sale Value = Rs. 108

RV = Redemption value = Rs. 100

N = 8 Years.

Hence,

KP = 8 + [ 100 - 108 ]
8
x 100
[ 100 + 108 ]
2

= 8 - 1 x 100
104

= 6.73%.

4.6 Cost of Debenture

Cost of Redeemable Debentures (Kd)

I + (Rv - Sv) (1-t)

N
Kd = -------------------
(Rv+Sv)
2
N = Years to redemption
t = Tax rate
 71

Illustration 1 :
Debentures of Rs. 100 each issued at par. Coupon rate is 12% & redemption is after 5
years at 5% premium . What is cost of debentures if tax rate is 35%
Solution :

Kd = [ I + RV - SV ] ( 1 –t )
N
___________
RV + S V
2

I = 12% of Rs. 100 = Rs. 12

Sv = 100 Rv = 105 t = 35% N = 5

Hence ,
Kd = 12 + [ 105 - 100 ]
5
( 1 - 0.35 ) x 100
105 + 100
2

= 12 + 1 x 0.65 x 100
102.5

= 13 x 65
102 .5

= 8.24%

4.6 Cost of Long Term Loans (KL )

KL = Interest (1-t)
Loan
Illustration 1.:

Company took loan = 100 processing charges = 2% . Rate of interest 13%. Tax rate
35%
What is cost by Loan.

Solution :
KL = Interest ( 1 – t ) x 100
Net loan proceed
 72

= 13 Cr. ( 1 – 0.35) x 100

4 ( 100 - 2 ) Cr.

= 8.2 % .

4.7Weighted Average Cost of Capital ( W.A.C.C.)

Weighted Average Cost of Capital (WACC):

 WACC is the weighted average of cost of various sources of finance,
weight being book value or market value of each source.
 Capital available for any project of company is coming from various
sources. Hence cost of capital is WACC
 For proper evaluation of project WACC is considered as minimum rate of
return required from project. The relative worth of a project is determined
using this rate as discounting rate

W.A.C.C. Ke x Equity Kp x Pref. cap Kd x Debenture KL x Loan

= ---------------- + ---------------- + ------------------- + -------------
Total capital Total capital Total capital Total capital
Kd & KL are post tax costs

Total capital = Equity +Pref. + Debentures + Loan taken

Illu4stration 1 :
Total capital of Co. = Rs. 150 crores.
Composition is as under
Source Amount ( Rs. crores.) Cost
Equity 20 18%
Preference shares 10 8%
Debentures 100 7% (Post – Tax )
Loan 20 8.5% (Post – Tax )
What is W.A.C.C.

Solution :

WACC = __E x Ke + P x Kp + __D Kd__ + L x Kl__

E+P+D+L E+P+D+L E + P + D +L E+P+D+L

Given : E = 20, P = 10, D = 100, L = 20

Ke = 18% Kp = 8% Kd = 7% KL = 8.5%

Hence WACC = 20 x 18% + 10 x 8% + 100 x 7% + 20 x 8.5%

 73

150 150 150 150

= 1 [ 20 x 18 + 10 x 8 + 100 x 7 + 20 x 8.5 ] %
150

= 8.73%
Illustration 2 :

Company has total capital Rs. 100 Cr. With following composition ( tax rate = 40%)
Source Amt. ( Rs. Crores.). Cost
Equity 10 20%
Preference 20 8%
Debentures 60 12% ( Pre - tax )
Loan 10 14% ( Pre - tax )

Solution :

WACC = E Ke + P Kp + D Kd_(1-E)_ + L x KL ( 1- t)
E+P+D+L E+P+D+L E + P + D +L E+P+D+L

E = 10, P = 20, D = 60, L = 10

Ke = 20% Kp = 8% Kd = 12% KL = 14%

Hence WACC = 10 x 20% + 20 x 8% + 60 x 12%(1-0.4) + 10 x 14% (1-0.4)

100 100 100 100

= 1 [10 x 20 + 20 x 8 + 60 x 12 x 0.6 + 10 x 14 x 0.6 ] %

100

= 8.76%

4.8Summary
 Cost of capital is the minimum rate of return that must be earned by business on the
funds invested in business.

 Shareholders are benefited when management invest funds in projects which bring
returns more than cost of capita.

 There are different formulae & methods to find out cost of equity shares, preference
shares, debentures & loans.
 74

 WACC is the weighted average of cost of various sources of finance. Generally

cost of capital of company is WACC.

Capital Structure

Learning Objective

After studying this you will be able to :

 Understand meaning of capital structure

 Understand significance of capital structure

 Know importance & factors of optimum capital structure.

 Understand effect of capital structure on profitability & liquidity of firm.

_________________________________________________________________________

4.2.1 Introduction

Every company collect funds from different sources. Right mix of various sources
of long term funds is necessary to keep cost of funds to minimum & at the same
time company should be able to make maximum use of funds. Capital structure is
the mix of long term sources of funds. This unit deals with various aspects of
capital structure .

4.2.2 Meaning of Capital Structure

 It refers to the mix of long term finances used by company

 Capital structure may be the combination of equity & one or more of the
following in different proportion

-- Debentures
-- Preference shares
-- Long term loans
 75

 Capital structure is different from financial structure of company. While former

is mix of long funds later is mix of long term funds & current liabilities of
company.

 Company should plan its capital structure to maximize use of funds & to be
able to adapt more quickly to changing business conditions

4.2.3 Significance of Capital Structure

Having proper capital structure is important for following reasons
 Optimum capital structure is useful for maximizing Earning Per Share
(E.P.S.) & Market Value Per Share (M.V.P.S.)
 Liquidity & profitability of company is affected by capital structure decision
 Control over the company is defined by its capital structure
 Capital budgeting & capital structure decision are closely related to each other
 Capital structure decision is taken at the time of formation of company or at
the time of expansion & diversification of business.

4.2.4 Optimum Capital Structure

Company always likes to have optimum capital structure because at this point.
- E.P.S. is maximum
- Cost of capital is minimum
Following factors are to be considered while designing optimum capital structure
for company.
(1) Maximization of profitability
 Capital structure should be most profitable for equity share holders.
 Within given constraints maximum debt financing should be adopted to
increase the returns available to equity share holders
 E.P.S. should be maximized.

(2) Minimization of risk

 Capital structure must be consistent with business risk & financial risk
 Business Risk :
a) It is the relationship between revenue & E.B.I.T. of company.
b) Business risk is high when :
- E.B.I.T. changes (up or down ) as compared to sales of company
- Company has more fixed costs
- Costs & revenues are not stable.
 Financial Risk
a) This risk arises when company uses debt capital & preference capital in
capital structure.
 Capital structure may be called as sound if it keeps the total risk of the
company [i.e. Business Risk + Financial Risk] to minimum level.
 76

 Excessive use of debt affects long term solvency & financial risk & this
must be assessed for a given capital structure.

(3) Flexibility
 It refers to ability of company to raise additional capital funds whenever
needed to finance profitable & viable investment opportunities
 Flexibility implies that a capital structure should always have an
untapped borrowing capacity which can be used any time in future
(4) Capacity
 The capital structure should be determined within debt raising capacity
of the company
 The debt capacity of company depends on its ability to generate future
cash flows
 Company should have enough cash to pay fixed charges & principal
sum of creditors

(5) Control
 Control is the most important aspect of corporate management. Ultimate
control of company affairs is in the hands of equity share holders. For
dealing with controlling aspects while deciding capital structure
following points must be kept in mind:
 Capital structure should reflect the philosophy of control of
management.
 While redeemable debentures do not result in dilution of control,
convertible debentures result in dilution of control when
converted in equity shares
 Convertible preference shares & convertible loans from banks or
financial institutions result in dilution of control
 Preference capital & debt financing do not dilute controlling
powers of management.

(6) Simplicity
 Capital structure must be simple to operate & easy to understand.
 Administrative convenience must be maximum
 Rights attached with each type of security must be clearly spelt

(7) Economy
Capital structure should be economical from point of view of:
 Flotation cost i.e. cost of floating capital
 Operation cost i.e. servicing equity, preference & debenture holders, to
be paid to underwriters & brokers.
 Commissions & brokerage

4.2.5 Various Aspects of Capital Structure

 77

A] Profitability & Capital Structure : [ EBIT-EPS analysis. ]

 Finance manager must study various alternative financial leverages & find their
effect on E.P.S. of Co.
 When rate of return on assets employed in business is more than cost of their
financing EPS increases & it is favorable financial leverage.
 When rate of return on assets employed in business is less than cost of their
financing EPS decreases & it is unfavorable financial leverage.
 Fixed financial charge financing must be analyzed with reference to choice
between debt and preference shares.
 Generally rate of interest payable to debt instruments or loans is lower than
dividend payable on preference shares.
 Interest payable on debt is tax deductible whereas dividend on preference shares is
paid from P.A.T.
 When various options are available to company the action which gives maxm.
E.P.S. should be selected.
 Risk attached with leverage may be incorporated in analysis. Find indifferent level
of EBIT. i.e. level of EBIT for which EPS is same for different capital structure by
formula :
( EBIT - I1 ) ( 1 – T ) = (EBIT - I2 ) ( 1 – T )
E1 E2

EBIT = Earnings before interest & tax

I1 = Interest charges in alternative 1
I2 = Interest charges in alternative 2
E1 = No. of Equity shares in alternative 1
E2 = No. of Equity shares in alternative 2
Compare expected EBIT with indifference level.
a) When expected EBIT is more than indifferent EBIT debt financing is
advantageous.
b) When expected EBIT is less than indifferent EBIT debt financing is risky
Greater the difference between the two more the advantageous or risky is the
debt. Financing.
 In EBIT –EPS analysis debt capacity of the firm for debt service & interest service
& effect on liquidity of company must be incorporated.

B] Liquidity & Capital Structure ( Cash flow analysis. )

 Company though earning sufficient profits may not be generating large enough
cash surplus perhaps due to needs to reinvest heavily in working capital. Such a
firm finds it difficult to service fixed interest & preference dividend. In such case
company may resort to equity finance where dividends can be paid based on cash
position.
 78

 Companies which can generate large cash surplus from their operations will tend to
opt, for large debt financing.
Finance manager while evaluating different capital structures, should ensure
liquidity for :
i) Interest on debt
ii) Repayment of debt
iii) Dividend on Preference capital
iv) Redemption of Preference capital.
Liquidity can be ascertained from :
I) Debt service coverage ratio (DSCR)

DSCR = P.A.T. + DEP. + Interest + Non Cash Expenses __

Preference dividend + Interest + Repayment obligation.

This ratio helps in assessing the extent to which cash profits of the firm covers
the cash payments of revenue & capital nature. Higher DSCR better is the
liquidity of company

II) From projected cash flow analysis.:

If cash inflows are comfortably higher than cash outflows then company can
proceed with debt financing. Cash inflows and outflows should be assessed
under varying operating conditions along with their probabilities.

Illustration 1 :
Company is in the process of undertaking new project worth Rs. 2,000 crores. Four
alternatives are available to company. [Amt. Rs. Crores.]

Alternative Equity Preference (8%) Debenture (10%) Loan (12%)

I 300 100 800 800
II 400 200 700 700
III 600 300 600 500
IV 800 400 500 300

Company expects E.B.I.T. of 15% on capital employed. Tax applicable to company is

40%. Which alternative should be selected on basis of E.P.S.

Solution :
E.B.I.T. expected = 15% of Rs. 2,000 crores. = Rs. 300 crores.
Company should select the alternative which gives maximum E.P.S. It is therefore
necessary to calculate E.P.S. under all 4 alternatives.
[Amt. Rs. Crores.]
Alternative I II III IV
Equity Capital 300 400 600 800
Preference Capital (8%) 100 200 300 400
Debentures (10%) 800 700 600 500
 79

Loan (12%) 800 700 500

300

Total 2,000 2,000 2,000 2,000

E.B.IT. 300 300 300 300

(-) Interest on debentures 80 70 60 50
Interest on loan 96 84 60 36
= E.B.T. 124 146 180 214
(-) Tax (40%) 49.60 58.40 72 85.60

= E.A.T. 74.40 87.60 108 128.40

(-) Pref. Dividend 8 16 24 32

= Amount available
to equity shareholders(a) 66.40 71.60 84 96.40

No. of equity shares (b) 30 40 60 80

(in crores.)

E.P.S. = a 2.21 1.79 1.40 1.21

b

Note:

 When nothing is mentioned it is to be assumed that each equity share is of Rs. 10

 Interest is paid by company on debentures & loan before tax is paid.
 Dividend is paid on preference capital after tax is paid.

Since E.P.S. is maximum for alternative no. I company should select this alternative.
Equity capital Rs. 300 Crores.
Preference Capital (8%) Rs. 100 Crores.
Debentures (10%) Rs. 800 crores.
Loan (12%) Rs. 800 crores.

Illustration 2 .

Company has 2 alternatives of capital structure for its expansion plan which require Rs.
200 crores.
AlternativeA:Rs.60 crores Equity, Rs. 40 crores. Debentures (12%) & remaing by loan.
Alternative B:Rs.80 crores Equity, Rs. 50 crores. Debentures (12%) remaining by loan.
Interest on loan is as under :
 80

Up to Rs. 5 crores. - 10%

5 crores. To 20 crores. - 11%
More than 20 crores. - 13%

Expected E.B.I.T. is Rs. 35 crores. Tax is 40% . Company has corporate objective of
maximizing company’s wealth. P/E ratio expected is 8 for alternative A,9 for
alternative B.
Advice company on appropriate capital structure.

Solution :
[Amt. Rs. in Crores.]
Alternative A B
Equity Capital 60 80
Debentures (12%) 40 50
Loan 100 70
Total 200 200
E.B.I.T. 35 35
(-) Interest (Loan) 12.55 8.65
Interest (Deb.) 4.80 6.00
= E.B.T. 17.65 20.35

(-) Tax (40%) 7.06 8.14

= E.A.T. 10.59 12.21

(-) Pref. Dividend NIL NIL

= Amt. to Equity shareholders 10.59 12.21

(a)
No. of equity shares (b) 6 8
(in crores.)
E.P.S. = [a/b] 1.77 1.53

P/E 8 9

M.V.P.S. = E.P.S. x P/E 14.16 13.77

Market capitalization 84.96 123.93

= M.V.P.S. x No. of equity shares.

Notes. :
1) Calculation of Interest on loan
For alternative A :
First – Rs. 5 Crs. @ 10% = Rs. 0.5 Crs.
 81

Next Rs. 15 Crs. @ 11% = Rs. 1.65 Crs.

Next Rs. 80 Crs. @ 13% = Rs. 10.40 Crs.
Total Rs. 12.55 Crs.

For alternative B :
First Rs. 5 Crs. @ 10%
Next Rs. 15 Crs. @ 11%
Next Rs. 50 Crs. @ 13%
Total
= Rs. 0.5 Crs.
= Rs. 1.65 Crs.
= Rs. 6.50 Crs.
= Rs. 8.65 Crs.

2) Market Value Per Share (M.V.P.S.) = (P/E) x (E.P.S.)

3) Wealth of company is nothing but market capitalization.

Hence alternative which maximizes market capitalization should be selected.

4) Each equity share is of Rs. 10 unless otherwise stated.

5) If wealth of shareholders is to be maximized then select alternative with maximum

M.V.P.S.

Ans.: Management should select alternative B since market capitalization is maximum

Management should select alternative A if wealth of company is to be
maximized.

4.2.6 Summary
 Capital structure is composition of company’s long term capital .

 Optimum capital structure ensures maximum profitability, minimizing risk,

flexibility, control & at the same time keeps capital structure to be simple &
debt raising capacity to be in tact.

 Profitability & liquidity of company is affected by capital structure

decision.
 82

Leverage Analysis

Learning Objective

After studying this unit you should be able to:

 Understand meaning of different leverages

 Calculate various leverages

 Understand effect of these leverages

_____________________________________________________________

4.3.1 Introduction

Management is faced with two problems relating to procurement of capital & its
use in business. Operating leverage deals with use of funds in business & financial
leverage deals with borrowing of funds . This unit deals with borrowing of funds,
use of funds & their combined effect on profitability of the business.

4.3.2 Meaning of Leverage

 The term leverage refers to relationship between two inter related variables.
These variables may be cost, output, sales, EBIT, EPS

 Leverage = % change in dependent variable_

% change in independent variable

 Example: Firm increase sales promotion expenses from Rs. 5,000 to 6,000
This has resulted in no. of units sold to increase from 200 to 300

Leverage = % change in units sold_______

% change in sales promotion expenses

= 50%
20%
 83

= 2.5

This means if sales promotion expenses increase by 20% units sold will
increase by 50%

4.3.2 Types of Leverage

a) Operating Leverage (O.L.)
 It is the % change in EBIT as a result of % change in sales

 O.L. = % change in EBIT

% change in Sales
Or.
= Contribution
EBIT
Or.
= Contribution_ ___
Contribution (-) Fixed cost
 High O.L. means:
 High fixed cost by way of depreciation & other costs
 Higher risk to company
 EBIT increases faster in response to increase in sales

b) Financial Leverage (F.L.)

 It is % change in EPS as a result of % change in EBIT
 F.L. = % change in EPS
% change in EBIT
Or.
= EBIT
EBT
Or.
= E.B.I.T. ( 1 – t )___
(EBIT. – I ) ( 1 – t ) – Dp
Where t = Tax Rate
I = Interest
Dp = Preference Dividend
 High F.L. means:
 Higher level of borrowings & high interest cost
 Higher risk to company
 EPS increases faster in response to increase in EBIT
 84

c) Combined Leverage (C.L.)

 It is a % change in EPS as a result of % change in sales
 C.L. = O.L. x F.L.
a) Calculating Leverages

Sales
(-) Variable Cost

= Contribution (A)

(-) Fixed Cost

= EBIT (B)

(-) Interest

= EBT (C)

O.L. = A / B
F.L. = B / C
C.L. = O.L. x F.L.

4.3.4 Effect of Leverage

O.L. F.L. Comments

High High (i) High fixed cost & high borrowings

(ii) Highest risk
(iii) Expansion on external borrowings
(iv) High interest outflow

High Low (i) High fixed cost & less borrowings

(ii) Risk is reduced due to low borrowings
(iii) Company is expanding but less dependent
on external funds
(iv) Low interest outflow

Low High (i) Low fixed cost & high borrowings

(ii) Borrowings are used mainly for variable costs which
are in line with increase in sales
(iii) Risk is further reduced due to low fixed cost
(iv) Ideal situation for profit maximization
 85

Low Low (i) Low fixed cost & low borrowings

(ii) Management is over cautious
(iii) No expansion plans
(iv) Minimum interest outflow
Illustration 1 :
Sales = Rs. 20,000
Variable cost = Rs. 14,000
Fixed cost = Rs. 4,000
What is operating leverage of company. How you will interpret it.
Solution :
Sales = Rs. 20,000
- Variable cost = Rs. 14,000
= Contribution = Rs. 6,000 (a)
- Fixed cost = Rs. 4,000
= E.B.I.T. = Rs. 2,000 (b)
Operating Leverage = a/b
= 6,000
2,000
= 3
Interpretation : If sales of company ↑ 100% EBIT will ↑ 300%
If sales of company ↓ 100% EBIT will ↓ 300%

Illustration 2 :
Sales Rs. 8,00,000
P/V 20%
Fixed cost Rs. 40,000
Interest Rs. 20,000
Decide : (i) Operating leverage (ii) Financial leverage
(iii) Combined leverage
Give your interpretation.
Solution : Amt. ( Rs. )
Sales 8,00,000
P/V 20%
Contribution 1,60,000(a)[P/V = C i.e. sales x P/V = Contribution]
S
(-) Fixed cost 40,000
= E.B.I.T. 1,20,000 (b)
(-) Interest 20,000
= EBT 1,00,000 (c)
 86

O.L. (a/b) 1.33

F.L. (b/c) 1.20
C.L. = O.L. x F.L. 1.60
Interpretation :
1. When sales ↑ or ↓ by 100% E.B.I.T. ↑ or ↓ by 133.3%
2. When EBIT ↑ or ↓ by 100% E.P.S. ↑ or ↓ by 120%
3. When sales ↑ or ↓ by 100% E.P.S. ↑ or ↓ by 160%

Illustration 3 :
Operating leverage is 2 & financial leverage is 1.5. Interest paid by company is
Rs. 2 lakhs. & fixed cost is Rs. 3 lakhs. prepare income statement of company if tax
rate is 40% P/V ratio for company is 30%.

Solution :
F.L. = E.B.I.T.
E.B.T.

1.5 = _E.B.I.T. __
E.B.I.T. – Interest

1.5 = E.B.I.T.__
E.B.I.T. – 2

1.5 (EBIT) – 3 = E.B.I.T.

1.5 (E.B.I.T.) – E.B.I.T. = 3

0.5 (EBIT) = 3

E.B.I.T. = 3 = 6
0.5
O.L. = __C__
E.B.I.T.

C = O.L. x EBIT
= 2 x 6
= 12
Now C = P/V
S
Hence C = S
 87

P/V
_12_ = 40
30%
Income Statement Rs. in Lakhs.
Sales 40
P/V 30%

= Contribution 12

(-) Fixed Cost 6

= E.B.I.T. 6

(-) Interest 2

= E.B.T. 4

(-) Tax ( 40%) 1.60

= E.A.T. 2.40

Illustration : 4:
Net Sales = 10 Crores.
EBIT = 20% of sales
Tax rate = 40%
Equity capital Rs. 2 crores.
Preference capital (10%) Rs. 3 crores.
Debentures (12%) Rs. 5 crores.

Calculate : (a) E.P.S. (b) Percentage change in EPS. If E.B.I.T. increases by 10%
(c) Calculate financial leverage.

Solution :
a) E.P.S. = (E.B.I.T. – Interest) ( 1 – t) – Dp
N

t = Tax rate = 40%

Dp = Preference dividend = 10% of Rs. 3 Crs. = Rs. 0.3 Crs.

Interest = 12% of Rs. 5 Crs. = Rs. 0.6 Cr.

 88

N = No. of equity shares in Crs. = 0.2 Cr.

EBIT = 20% of 10 = 2 Crore.

Hence,
a) (E.P.S.)1 = [ 2 – 0.6 ] ( 1-0.4) - 0.3
0.2
= (1.4) (0.6) - 0.3
0.2
= 0.84 - 0.30
0.2
= 0.54
0.2
= Rs. 2.70

b) (E.P.S.)2 = (New E.B.I.T. - Interest ) ( 1 – t) – Dp

N
New E.B.I.T. = 1.1 x E.B.I.T.
= 1.1 x 2 Cr.
= 2.2 Crs.

(EPS)2 = (2.2 – 0.6) ( 1 – 0.4) – 0.3

0.2
= (1.6) ( 0.6) - 0.3
0.2
= 0.96 - 0.3
0.2
= 0.66
2
= Rs. 3.3

c) F.L. = % Change in E.P.S.

% Change in EBIT.

% Change in E.P.S. = [(EPS)2 - (EPS.)1] x 100

(E.P.S.)1

= [(3.3) - ( 2.70)] x 100

2.70
= 22.22%
 89

Hence F.L. = 22.22%

10%
= 2.22
Illustration No. 5.
The following figures relate to two companies : [Rs. lakhs.]
Particulars P Ltd. Q Ltd.
Sales 500 1,000
Variable costs 200 300
Contribution (A) 300 700
Fixed Cost 150 400
EBIT (B) 150 300
Interest 50 100
Profit Before Tax (PBT) (C) 100 200
You are required to calculate –
(a) Operating financial and combined leverages of the two companies, and
(b) Comment on the relative position of the companies in respect of the risk.

Solution :
[Rs. in lakhs.]
Particulars P Ltd Q Ltd.
Operating leverage Contribution 300 = 2 700 = 2.33
EBIT 150 300

Financial leverage EBIT 150 = 1.5 300 = 1.5

EBT 100 200

Combined leverage Contribution 300 = 3 700 = 3.5

EBT 100 200
Comment :
 The operating leverage is higher for Q Ltd. and therefore it is subject to greater
degree of business risk than P Ltd. The EBIT will tend to vary more with sales in Q
Ltd.
 The financial leverage of both the companies stand at 1.5 times. It conveys that
interest burden is proportionately same, and also financial risk is similar both the
companies.
The combined leverage of Q Ltd. is higher and its overall risk is more as compared to P
Ltd.
 90

Unit 5 : Capital Budgeting

Learning Objective

After learning this unit you should be able to :

 Understand meaning of capital budgeting

 Know significance of capital budgeting

 Understand steps involved in capital budgeting process.

_________________________________________________________________________

5.1 Introduction

Every company requires long term assets for creating infrastructure & capacity &
for long term survival & success of business. Capital budgeting is one of the
important managerial decisions. It is there fore important to know factors &
dimensions involved in this decision. Decision should increase profits & in turn
value of the firm .

5.2Meaning of Capital Budgeting

 Decision to invest current funds most efficiently in long term assets in

anticipation of an expected flow of benefits over a series of years.

 Long term assets are those which affect operations of the firm beyond one
year.

 Capital budgeting decision affects value of a firm. Value of a firm will

increase if investments are profitable & shareholders wealth is enhanced.
 91

Significance of Capital Budgeting

Capital budgeting is important for the following reasons:

 Cost today benefits tomorrow

When company purchases a plant , machinery or any other asset, payment is to be
made immediately but benefits are available in future.
When management wants to decide whether asset should be purchased or not it is
essential to know costs & benefits today. If benefits are more than costs asset is
purchased . To bring benefits to their present value, technique of time value of
money is used.

 Lumpy outflow of funds

When asset is purchased huge amount of funds are spent at one time. Management
therefore carefully considers all dimensions of capital budgeting decision including
long term effect & risks involved.

 Irreversible decision
Decision of buying a particular asset cannot be reversed easily. Once asset is owned
by organization & if it is not fulfilling desired expectations of management
replacing the same is not possible without huge losses.

 Decides future growth & direction

When company purchase new assets it means there is growth. Higher the volume of
capital budget more is the growth in sales & profits expected by management e.g.
when Tata Motor decided to undertake Indica project it was obvious that company
wanted to grow in new product line i.e. passenger cars which was diversion from
its truck manufacturing.

 Strategic importance
In order to have competitive advantage company increases its asset base & adopts
new technology . This increases size of capital expenditure budget.

 Related to image & goodwill of company.

When company expands its asset base, new opportunities open for suppliers,
employers, & others connected to business. Also market value of share goes up
with expectation of higher company profits. Many new jobs are likely to be
created. All this enhances image & goodwill of company.

 Capital structure decision depends on capital budgeting decision

Company requires huge funds for purchasing new assets. These funds are procured
from different sources viz. Equity shares, preference shares, debentures & loans. It
 92

Should be ensured by management that capital structure designed gives maximum

E.P.S. minimum cost of capital & increases market price of company’s shares .

 Financial planning depends on this decision

Company prepares its financial plan based on the assets it plans to purchase. Good
financial plan ensures that sufficient funds are available as & when new assets are
to be purchased.

 It is related to corporate restructuring decision

Corporate restructuring means internal restructuring i.e. combining two or more
divisions of company or splitting one division into two or more divisions and
external restructuring i.e. merger & acquisition of company with other company. In
both the cases restructuring of asset base is involved.
 Productivity/ quality/ delivery improves
With new plant & machinery production rate increases, defectives & wastages
reduced & quality improves. With new vehicles & equipments delivery
performance improvers. All this results into increasing market share of company.

5.3Steps in Capital Budgeting Process

Step 1:
To identify investment opportunities. potential sources of opportunities are:
 Study of supply/ demand conditions of different industries
Study of end & by-products
 Analysis of input requirements
 Important substitutes
 Social & economic trends
 Sick unit to be turned into profitable unit
 Backward & forward integration
 Government policy

Step 2 :
Available opportunities should be screened with reference to:
 Compatibility with promoters
 Compatibility with government
 Availability of raw materials & utilities
 Size of potential market
 Costs & risks involved

Step 3:
Appraisal of screened opportunities
i) Market appraisal
 93

 Market size
 Company’s share expected
 Composition
 Demand & supply analysis
 Consumer requirements
 Production constraints

ii) Technical appraisal

 Proposed Vs available technology
 Availability of raw material & other inputs
 Optimization
 Plant layout & design

iii) Economic appraisal

 Impact on savings & investment in society
 Job potential
 Contribution to social objectives
 Impact on foreign exchange reserves.
iv) Financial appraisal
This involves two steps
Step 1 : Assessing cash flows during life of a project
Step 2 : Evaluating different proposals based on cash flows generated
in step no. 1.

5.4 Cash Flows In Capital Budgeting

Three cash flows are involved

INITIAL CASH FLOWS (AT THE TIME OF BUYING NEW ASSET)

= Cost of new asset

(+) Installation Expenses
(+) Other capital expenditure
(+) Additional working capital
(+) Tax burden on sale of old asset
(- ) Salvage value of old asset
These are cash outflows at the time of buying an asset

SUBSEQUENT CASH FLOWS (EVERY YEAR DURING LIFE OF ASSET)

= EBIT ( 1-t) + Depreciation – Additional capital expenditure

 94

Where t = Tax Rate

TERMINAL CASH FLOWS (IN THE LAST YEAR OF LIFE OF ASSET)

Yearly cash flows

i.e. EBIT ( 1 – t) + Depreciation
(+) Working capital released
(+) Scrap value of new asset

 While ascertaining cash flows of a proposal financial cash inflows and

outflows such as issue of capital or debt or repayment of debt, interest &
dividend are ignored because interest & dividend are considered in
calculating W.A.C.C. which is used to discount future cash inflows.
5.5Evaluation of Capital Expenditure Proposals.
Expected cash flows estimated as above are used for deciding whether proposal /s
under consideration should be accepted or not Following methods are used

1 Payback Period (PB) Method

(i) Payback period (PB) is the no. of years required to cover initial
investment
(ii) PB less than PB expected by management then project is accepted
PB more than PB expected by management then project is rejected
(iii) When two or more projects are having accepted payback period then
project with minimum payback gets top priority.
(iv) Yearly cash flows are considered & not the profits
(v) Merits :
 Easy to understand &compute
 Inexpensive
 Uses cash flow information
 Easy but crude way to cope with risk
(vi) Demerits :
 Ignores time value of money
 Ignores cash flows after payback period
 Standard payback period cannot be determined
 Not in line with wealth maximization principle

2 Accounting Rate of Return (ARR) Method

(i) ARR is calculated by following formula:

ARR = AV. EBIT (! -t) x 100 [ or ] Av. P.A.T. x 100
AV. INVESTMENT Av. Investment

AV. EBIT (1– t) = (EBIT)1 (1- t) + (EBIT)2 (1 – t ) + -----(EBIT)n (1- t)

 95

N
n = No. of years.
t = Corporate tax rate

AV. Investment = Original Investment + Scrap Value

2
(ii) If ARR more than expected by management Project is accepted
If ARR less than expected by management Project is rejected
(iii) If two or more projects are having accepted ARR then project with
highest ARR gets top priority.
(iv) Yearly profits are considered & not the cash flows
(v) Merits:

 Uses accounting data

 Gives more weight age to future receipts

(vi) Demerits:

 Ignores the time value of money

 Do not use cash flows
 Minimum ARR required cannot be decided

3 NPV method

(i) Net Present Value (NPV) = ( ∑ P.V. of all cash flow) – ( ∑P.V. of all
cash outflow)

(ii) If N.P.V. > 0 (accepted project) or PI >1

N.P.V < 0 ( reject project ) or PI < 1

(iii) When two or more projects are having positive NPV then project with
maximum NPV gets priority.

(iv) Features of Net Present Value (NPV) Method :

 NPV of an investment proposal may be defined as sum of present
values of cash inflow-less sum of present values of all cash outflows
associated with a proposal.

 A rate of discount must be specified and applied to both inflows &

outflows in order to find out their present values (PVs)
 96

 When present value of all inflows & outflows are added, the
resultant figure is denoted as net present value (NPV). NPV is
positive or negative.

 When NPV is positive project is acceptable because cash inflows are

more than cash outflows on the other hand if cash outflows are more
than cash inflows then NPV is negative & project is rejected.

 From economic point of view rate of discount is the overall cost of

capital which takes into account expectations of shareholders,
business risk & leverage used.

 In case of mutually exclusive proposals with highest NPV ranks first

& that with lowest NPV ranks last.
(v) Merits:
 It recognizes time value of money
 Considers the entire cash flow streams during life of project
 Based on cash flow & thus helps in analyzing the effect of the
proposal on the wealth on shareholders in a better way
 Discount rate can be adjusted to take care of risk involved in the
project
 NPV represents the net contribution on a proposal towards wealth of
the firm & is therefore is in full conformity with the objective of
wealth maximization of shareholders.
 NPVs of different projects can be added
 Cash flows accruing between initial & end of project get reinvested
at discount rate.

(vi) Demerits:
 Calculations are difficult
 There may be uncertainty with cash flow occurring or there may be
errors in cash flow estimates.
 In practical life deciding correct rate of discounting is not easy
 Does not provide a measure of project’s own rate of return. It
evaluates proposal on minimum required rate of return.
 It ignores difference in initial outflows, size of different proposals
while evaluating mutually exclusive proposals.

4) Profitability Index Method. ( P.I. Method)

i) PI = [ ∑P.V. of all cash inflows ]
[∑ P.V. of all cash outflows]

ii) If PI > 1 Project Accepted

 97

PI < 1 Project Rejected.

iii) When two or more projects are having PI > 1 then project with highest
PI gets priority.

iv) Merits & Demerits : Same as for N.P.V. method.

5) Internal Rate Of Return (IRR) Method .

i) IRR of a proposal is the discount rate which produces zero NPV

ii) Also know as marginal or break even rate or return
iii) Future cash inflows are discounted in such a way the their PV is just
equal to PV cash outflows
iv) Discounting rate is arrived at by trial & error method.
v) Decision rule:
First firm has to decide its own required rate or return this is known as
“cut off rate” (k)

If IRR > k – Accept proposal

If IRR < k – Reject proposal

In case of mutually exclusive proposals

Proposal with highest IRR ranks first
Proposal with lowest IRR ranks last

vi) Method of calculating IRR :

Step I :
Decide factor ‘F’ to be located in PV annuity tables

F = Original investment ( I )
AV. Cash inflow per year (c)

This factor is located in PV table on line representing no. of years

corresponding to estimated useful life of the asset. This gives expected
rate of return to be applied for discounting cash inflows or IRR.

Step II:
Find NPV of project using IRR as decided in Step I

If NPV = 0 Then selected rate is correct IRR

 98

If NPV is + Ve then try higher rate for discounting

If NPV is - Ve then try lower rate for discounting.

(Generally choose next higher rate by 2% )

Step III :
To find IRR
Let, b = NPV at lower rate

c = NPV at higher rate

Actual IRR = [ Lower rate of discount ] + [ (b) x Diff. in rate ]

(b-c)

Example :
A company has to select one of the following two projects using IRR method
cash flow .
Year A B
0 (11,000) (10,000)
1 6,000 1,000
2 2,000 1,000
3 1,000 2,000
4 5,000 10,000
Solution :
F = 11,000 10,000
3,500 3,500

= 3.14 2.86
Discount Rate
(From Tables ) 10% 15%
Project A :
Year Cash inflow Discounting Factor (10%) P.V.
0 (11,000) 1.000 (11,000)
1 6,000 0.909 5,454
2 2,000 0.826 1,652
3 1,000 0.751 751
4 5,000 0.683 3,415

Total P.V. = 11,272 & NPV = + 272

As PV is more than required PV of Rs. 11,000 or NPV. is + ve
Choose next higher rate i.e. 12% then
Year Cash flow Discount factor (12%) PV.
0 (11,000) 1.000 (11,000)
 99

1 6,000 0.893 5,358

2 2,000 0.797 1,594
3 1,000 0.712 712
4 5,000 0.636 3,180
As NPV for 10% = + 272 (b)
& NPV for 12% = - 156 (c)
For some rate between 10% & 12% NPV must be zero
Required IRR = 10 + [ b ] x [ 2 ]
[b–c]

= 10 + [ 272 ] x 2_
272- (- 156 )

= 11.27%
Project B :
Year Cash flow Discount factor (15%) PV.
0 (10,000) 1.000 (10,000)
1 1,000 0.870 870
2 1,000 0.756 756
3 2,000 0.658 1,316
4 10,000 0.572 5,720
NPV. = (-)1.338

Since NPV. is – VE we try next lower level of rate i.e. 13%

Year Cash flow PVF. (13%) PV.
0 (10,000) 1.000 (10,000)
1 1,000 0.885 885
2 1,000 0.783 783
3 2,000 0.693 1,386
4 10,000 0.613 6,130
NPV. = (-) 816

Since NPV, is – VE we try next lower level of rate i.e. 11%

Year Cash flow PVF. (11%) PV.
0 (10,000) 1.000 (10,000)
1 1,000 0.900 900
2 1,000 0.812 812
3 2,000 0.731 1,462
4 10,000 0.659 6,590
NPV. = (-) 236

Since NPV. is – VE we try next lower level of rate i.e. 9%

Year Cash flow PVF (9%) PV.
0 (10,000) 1.000 (10,000)
 100

1 1,000 0.917 917

2 1,000 0.842 842
3 2,000 0.772 1,542
4 10,000 0.708 7,080
NPV. = (+) 381

As NPV is now + VE. IRR. Must be between 9% & 11% .

Actual IRR = 9 + 381 x 2
381 – (-236)

= 9 + 381 x 2
617

= 9 + 1.24
= 10.24%
IRR of project B = 10.24%

IRR of project A = 11.27%

as IRR of project A is more project A should be accepted by management

Superiority of NPV over IRR :

i) NPV shows expected increase in wealth of shareholders

ii) NPV gives clear-cut accept – reject decision rule while
IRR may give multiple results
iii) NPV of different projects can be added but IRR cannot be so added
iv) NPV gives better ranking as compared to IRR.

Illustration 1 .
Company wants to purchase new machine details of which are as under :
Cost of machine is Rs. 65 lakhs.
Installation charges are Rs. 3 lakhs.
Additional machine to support smooth functioning of this machine would cost Rs. 7
lakhs. New machine will increase production by 25% & to support the production
activities additional working capital of Rs. 8 lakhs would be required. Old machine
will be sold for Rs. 13 lakhs. & will be replaced by this machine.
Decide initial cash outflow (ignore tax effects )

Solution : Amt. (Rs. lakhs)

Cost of new machine 65
+ Installation charges 3
+ Additional machine cost 7
+ Additional working capital required 8
- Sale of old machine 14
 101

__
= Initial Cash Outflow 70

Illustration 2.
Cost of new plant is Rs. 120 lakhs. Additional working capital required is Rs. 10
lakhs. Installation charges Rs. 2 lakhs old plant is sold for Rs. 30 lakhs on which
tax burden is Rs. 6 lakhs. What is initial cash outflow.

Solution : Amt.(Rs.lakhs.)
Cost of new plant 120
+ Installation charges 2
+ Addition working capital 10
+ Tax burden 6
- Sale of old plant 30
= Initial cash outflow 108
Illustration 3 .
Cost of plant is Rs. 10,00,000 . Life of plant is 5 years & scrap value is nil. EBDIT
expected for 5 years is as :
Year : 1 2 3 4 5
EBDIT (Rs.) : 2,20,000 2,50,000 3,00,000 4,00,000 3,00,000

Corporate tax rate is 35%. Decide cash flows.

Company uses S.L.M. for depreciation

Solution :
Amt. (in Rs.)
Year EBDIT DEPREN. EBIT EBIT(1-t) Cash flow
(a) (b) (a-b) = c (d) (b + d)
0 - - - - (-) 10,00,000
1 2,20,000 2,00,000 20,000 13,000 2,13,000
2 2,50,000 2,00,000 50,000 32,500 2,32,500
3 3,00,000 2,00,000 1,00,000 65,000 2,65,000
4 4,00,000 2,00,000 2,00,000 1,30,000 3,30,000
5 3,00,000 2,00,000 1,00,000 65,000 2,65,000

Note : t = tax rate = 35% , Hence ( 1- t ) = 0.65 ,

EBIT (1- t) = 20,000 x 0.65

= 13,000 & so on
Illustration 4.
Company is planning to replace its old plant.
Old plant will be sold for Rs. 3 crores. & no income tax burden on this sale. New
plant will cost company Rs. 20 crores. Installation cost would be Rs. one Crores. &
additional working capital of Rs. 5 crores. Would be required. Estimated life of
 102

plant is 5 years with scrap value of Rs. 5 crores. Company follows straight line
method (SLM) of depreciation & tax rate applicable to company is 35% . Decide
cash flows for 5 years.
Expected EBIT for 5 years is :
Year : 1 2 3 4 5
EBIT (Rs.) : 2.5 3.2 4 5.5 5

Solution :
Initial cash outflow : (year 0) Rs. Crs.)
Purchase price of new plant 19
+ Installation cost 1
+ Additional working capital required 5
- Scrap value of old plant 3
= Initial cash outflow. 22

Subsequent cash inflows (year 1 to 4 ) :

[ Amt. Rs. Crores.]
Year EBIT EBIT(1-t) Depreciation Cash flow = EBIT (1-t) + Depre.
1 2.5 1.625 3.00 4.625
2 3.2 2.080 3.00 5.080
3 4 2.600 3.00 5.600
4 5.5 3.575 3.00 6.575
Terminal cash flow ( year 5 )
Cash flow = [EBIT(1-t) + Depreciation] + [working capital released]
+ [Scrap value of new asset]

= [ 5 ( 1 – 0.35 ) + 3 ] + [ 5 ] + [ 5 ]
= 6.25 + 5 + 5
= 16. 25
Cash flow statement (Amt. Rs. Crores.)
Year Cash Flow
0 ( - ) 22
2 4.625
2 5.080
3 5.600
4 6.575
5 16.250
Note: 1) Depreciation = Initial cost of plant - Scrap value
Life of plant
= ( 19 + 1) - 5
5
= Rs 3 crores.
2) While calculating depreciation installation charges are to be added
to cost of plant to get initial cost of plant.
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Illustration 5.
Ram Engineering works want to replace their old plant. Following details are
available
Cost of new plant is Rs. 70 Crores.
Old plant would be sold for Rs. 18 crores. on which tax burden is Rs. 2 crores.
Additional working capital required is Rs. 12 crores.
Installation of new plant would cost Rs. 2 crores
Expected life of new plant is 6 years.
Corporate tax rate is 40%.
Depreciation is to be charged on S.L.M.
New plant would fetch Rs. 12 crores. at the end of 6 years as scrap value.
Expected EBIT is Rs. 2 crores in year one, Rs. 8 crores in year 2 & 3 Rs. 18 crores
year 4 & 5 Rs. 25 crores & in year 6 Rs. 15 crores.
Decide cash flows during life of asset.
Solution :

Initial cash outflow (Year zero) (Amt. Rs. Crores)

Cost of new plant 70

+ Installation cost 2
+ Additional working capital 12
+ Tax burden 2
- Sale of old plant 8
__
= Initial Cash outflow 78

Subsequent cash flow : [ year 1 to 5 ] [Amt. Rs. Crores.]

Year EBIT (a) EBIT (1-t)(b) Depreciation(c) Cash flow (b+c)

1 2 1.20 10 11.20
2 8 4.80 10 14.80
3 8 4.80 10 14.80
4 18 10.80 10 20.80
5 18 10.80 10 20.80

Depreciation = ( 70 + 2 ) - 12 = 10
6

Terminal cash flows ( year 6 )

Cash flow = [EBIT(1-t) + Deprn.] + [Scrap value] + [Working capital

released]
 104

= [ 25 ( 1 – 0.4 ) + 10 ] + [ 12 Crores ] + [ 12 ]

= 25 + 12 + 12

= 49
Cash Flow Statement
Year Cash flow (Amt. Rs. Crores.)
0 (-) 78
1 11.20
2 14.80
3 14.80
4 20.80
5 20.80
6 49.00
Illustration 6.

Following cash flows are expected from two machines calculate payback period for
both machines. Maximum payback expected by management is 4 years.
Which machine should be purchased by company .
(Rs. lakhs.)
Year Machine I Machine II
0 (-) 70 80
1 10 15
2 20 20
3 20 35
4 30 25
5 20 20

Solution :
Payback period of machine I :

In first 3 years cash flow = 10 + 20 + 20 = Rs. 50 lakhs.

Amount to be recovered in year 4 = Rs. 20 lakhs.

Total cash flow in 4th year = Rs. 30 lakhs.

Hence no. of months required to cover 20 lakhs = 20 x 12 = 8 months.

30
Payback period = 3 years & 8 months.

Payback period of machine II :

 105

In first 3 years cash flow = 5 + 20 + 35 = Rs. 70 lakhs.

Amount to be recovered in 4th year = Rs. 10 lakhs.

Total cash flow in 4th year = Rs. 25 lakhs.

Hence no. of months required to cover Rs. 10 lakhs. = 10 x 12 = 4.8 months

25

Payback period = 3 years. & 4.8 months.

Decision : Both machines are having payback period less than target payback
period of 4 years. Both machines can be purchased. Priority
should be given to machine II because it has lower payback
period.

Illustration 7 .
Following details are available for a two machines [ Rs. in lakhs]
Machine 1 Machine 2
Initial investment 140 160
Scrap value 20 30
EBIT expected :
Year : 1 30 30
2 40 50
3 40 50
4 30 40
5 20 25
Tax rate of company is 40%
Management expects A.R.R. to be minimum 20%.
Decide A.R.R. of both machines & suggest management on selection of machine.
Solution :
A.R.R. = A.V. EBIT ( 1 – t ) x 100
Av. Investment.

Av. Investment = Initial Investment + Scrap Value

2
Av. EBIT (Machine I) = 30 + 40 + 40 + 30 + 20
5
= Rs. 32 lakhs.

Av. Investment (Machine I) = 140 + 20

2
= Rs. 80 lakhs.
 106

A.R.R. (Machine I ) = 32 ( 1 – 0.4 ) x 100

80
= 24%
Av. EBIT (Machine II ) = 30 + 50 + 50 + 40 + 25
5
= Rs. 39 lakhs.
Av. Investment (Machine II) = 160 + 30
2
= Rs. 95 lakhs.
A.R.R. ( Machine II ) = 39 ( 1 – 0.4 ) x 100
95
= 24.63%
Decision :
Both machines are acceptable as both are having A.R.R. more than 20% which is
an expection of management machine II is having slightly more A.R.R. hence this
machine can be given priority.
Illustration 8.
Two projects are under consideration of management
Their cash flows & discounting rate applicable are : [ Amt. Rs. Crores.]
Year Machine A Machine B
0 (-) 100 (-) 120
1 20 25
2 25 30
3 25 35
4 30 40
5 20 20
Discounting rate 12% 12%
Calculate : (i) NPV of both machines.
(ii) P.I. of both machines.
(iii) I.R.R. of both machines.
Solution :
Year Cash flow (A) Cash Flow(B) Pvf. (12%) PV (A) PV (B)

(1) (2) (3) (1 x 3) (2 x 3)

0 (-) 100 (-) 120 1.000 (-)100 (-)
120
1 20 25 0.893 17.86 22.33
2 35 40 0.797 27.90 31.88
3 35 45 0.712 24.92 32.04
4 30 40 0.636 19.08 25.44
5 20 20 0.567 11.34 11.34
____ ____
i) NPV = [∑P.V. of cash inflow] - [∑P.V of cash outflow] 1.1 3.03
 107

ii) P.I. = [∑P.V. of cash flow ] 1.01 1.03

∑ P.V. of cash outflow

iii) I.R.R.
Machine A : & Machine B
Since N.P.V. is positive try next discounting rate with difference of 2 %

Year Cash flow (A) Cash Flow(B) Pvf. (12%) PV (A) PV (B)

(1) (2) (3) (1 x 3) (2 x 3)

0 (-) 100 (-) 120 1.000 (-) 100 (-)120
1 20 25 0.877 17.54 21.93
2 35 40 0.769 26.92 30.76
3 35 45 0.675 23.63 30.38
4 30 40 0.592 17.76 23.68
5 20 20 0.519 10.38 10.38
= (-) 3.77 (-) 2.87
I.R.R. = [ Lower discount rate ] + b x difference in rates.
b-c

for machine A b = 1.1 ( NPV of lower discounting rate )

B b = 3.03 ( NPV of lower discounting rate )

For machine A c = (-) 3.77 ( NPV of higher discounting rate )

B c = (-) 2.87 ( NPV of higher discounting rate )

(IRR)A = 12% + ( 1.1___) x 2

(1.1) – ( -3.77)

= 12% + ( 1.1_ x 2 ) %
( 4.87 )

= 12.45%

(I.R.R.)B = 12% + ( 3.03____ ) x 2

(3.03) - (- 2.87)

= 12% + ( 3.03 x 2 ) %
 108

( 5.90 )

= 13.3 %

Answer :
Machine A B Priority
NPV (Rs. Crores.) 1.1 3.03 B
P.I. 1.01 1.03 B
I.R.R.(%) 12.45 13.3 B

Note :

When priority difference among different methods, Priority given by N.P.V. is

given first choice .

Illustration 9.
ITC Ltd. have decided to purchases a machine to augment the company’s installed
capacity to meet the growing demand for its products. There are three machines
under consideration of the management. The relevant details including estimated
yearly expenditure and sales are given below: All sales are on cash. Corporate
income-tax rate is 40%. Interest on capital may be assumed to be 10% . ( Rs. )
Particulars Machine 1 Machine2 Machine 3
Initial investment required 3,00,000 3,00,000 3,00,000
Estimated annual sales 5,00,000 4,00,000 4,50,000
Cost of production (estimated)
Direct Materials 40,000 50,000 48,000
Direct Labour 50,000 30,000 36,000
Factory overheads 60,000 50,000 58,000
Administration costs 20,000 10,000 15,000
Selling and distribution costs 10,000 10,000 10,000
The economic life of Machine 1 is 2 years, while it is 3 years for the other two. The
scrap values are Rs. 40,000, Rs. 25,000, and Rs. 30,000 respectively. You are
required to find out the most profitable investment based on ‘Pay Back Method’.

Solution : Calculation of Pay Back Period of Machines (Rs.)

___________________________________________________________________
Machine 1 Machine 2 Machine 3
Initial Investment (i) 3,00,000 3,00,000 3,00,0
___________________________________________________________________
Sales (a) 5,00,000 4,00,000 4,50,000
Cost :
Direct Material 40,000 50,000 48,000
Direct Labour 50,000 30,000 36,000
Factory overhead 60,000 50,000 58,000
Depreciation 1,30,000 91,667 90,000
 109

Administration cost 20,000 10,000 15,000

Selling and distribution 10,000 10,000 10,000
Interest on capital 30,000 30,000 30,000
Total cost (b) 3,40,000 2,71,667 2,87,000
Profit before tax (a)-(b) 1,60,000 1,28,333 1,63,000
Less: Tax @ 40% 64,000 51,333 65,200
Profit after tax 96,000 77,000 97,800
Add: Depreciation 1,30,000 91,667 90,000
Net cash flow (ii) 2,26,000 1,68,667 1,87,800
Pay Back Period (years) (i)/(ii) 1.33 1.78 1.60
___________________________________________________________________
Analysis – Machine I having low Pay Back Period hence it is preferred to the other
two machines.
Illustration 10.
National Electronics Ltd. an electronic goods manufacturing company, is producing
a large range of electronic goods. It has under consideration two projects X and Y,
each costing Rs. 120 lakhs.
The projects are mutually exclusive and the company is considering the question of
selecting one of the two. EBDIT have been worked out for both the projects and the
details are given below. X has life of 8 years and Y has a life of 6 years. Both will
have zero salvage value at the end of their operational lives. The company is
already making profits and its tax rate is 50%. The cost of capital of the company is
15%. (Rs. lakhs.)

At the end of EBDIT Present value of

the year Project X Project Y rupee at 15%

1 25 40 0.870
2 35 60 0.756
3 45 80 0.685
4 65 50 0.572
5 65 30 0.497
6 55 20 0.432
7 35 - 0.376
8 15 - 0.327
The company follows straight line method of depreciating assets. Advise the
company regarding the selection of the project.
Solution : Calculation of Net Present Value of the Project X and Project Y

Project X . ( Rs. in lakhs)

___________________________________________________________________
End of EBDIT Depn. EBIT EBIT(1-t) Net C.F. Discount P.V.
Year (a) (b) (c) (d) e = b + d factor(f) g = e x f
 110

___________________________________________________________________

1 25 15 10 5 20 0.870 17.40
2 35 15 20 10 25 0.756 18.90
3 45 15 30 15 30 0.658 19.74
4 65 15 50 25 40 0.572 22.88
5 65 15 50 25 40 0.497 19.88
6 55 15 40 20 35 0.432 15.12
7 35 15 20 10 25 0.376 9.40
8 15 15 - - 15 0.327 491
___________________________________________________________________
PV of Cash Inflows 128.23
Less: Initial Investment 120.00
Net Present Value 8.23
___________________________________________________________________
Project Y ( Rs. in lakhs)
___________________________________________________________________
End of EBDIT Depn. EBIT EBIT(1-t) Net C.F. Discount P.V.
Year (a) (b) (c) (d) e = b + d factor (f) g = e x f
___________________________________________________________________
1 40 20 20 10 30 0.870 26.10
2 60 20 40 20 40 0.756 30.24
3 80 20 60 30 50 0.658 32.90
4 50 20 30 15 35 0.572 20.02
5 30 21 10 5 25 0.497 12.43
6 20 20 0 0 20 0.432 8.64
___________________________________________________________________
PV of Cash Inflows 130.33
Less: Initial Investment 120.00
Net Present Value 10.33
___________________________________________________________________
Analysis – As project Y has a higher net present value, hence it is suggested to
take up project Y.

5.6Summary

 Capital budgeting is the process of investing funds of company in fixed assets

to get benefits over long period of time.

 Capital budgeting decision affects value of firm as it brings more profits to

company.

 Capital budgeting process involves three important steps

I Locating opportunities
 111

II Screening opportunities which are beneficial & convenient to

III Appraisal of screened opportunities to decide whether project/s should
be undertaken or not.

 Important methods used for appraisal of capital expenditure proposals are :

Payback Period Accounting Rate of Return, NPV . Profitability Index Internal
Rate of Return. Before selecting a particular method it is essential to study
merits & demerits of the method & its utility to business.

 Financial appraisal is the most important aspect of capital budgeting decision

which involves
a) Estimating cash flows from project
b) Applying different methods for evaluation of project on basis of
estimated cash flow.