Financial Management Full Notes

SRM INSTITUTE OF HOTEL MANAGEMENT (Affiliated to National Council for Hotel Management & Catering Technology, Noida)

B.Sc. HOSPITALITY & HOTEL ADMINISTRATION

FIFTH SEMESTER

STUDY MATERIAL SUBJECT CODE: BHM307

SUBJECT NAME: FINANCIAL MANAGEMENT

1

BHM307 - FINANCIAL MANAGEMENT S.No. 1.

2.

3.

4.

5.

6.

7.

8.

9.

Topic FINANCIAL MANAGEMENT MEANING & SCOPE A. Meaning of business finance B. Meaning of financial management C. Objectives of financial management FINANCIAL STATEMENT ANALYSIS AND INTERPRETATION A. Meaning and types of financial statements B. Techniques of financial analysis C. Limitations of financial analysis D. Practical problems RATIO ANALYSIS A. Meaning of ratio B. Classification of ratios C. Profitability ratios D. Turnover ratios E. Financial ratios F. Du Pent Control Chart G. Practical Problems FUNDS FLOW ANALYSIS A. Meaning of funds flow statement B. Uses of funds flow statement C. Preparation of funds flow statement D. Treatment of provision for taxation and proposed dividends (as noncurrent liabilities) E. Practical problems CASH FLOW ANALYSIS A. Meaning of cash flow statement B. Preparation of cash flow statement C. Difference between cash flow and funds flow analysis D. Practical problems FINANCIAL PLANNING MEANING & SCOPE A. Meaning of Financial Planning B. Meaning of Financial Plan C. Capitalisation D. Practical problems CAPITAL EXPENDITURE A. Meaning of Capital Structure B. Factors determining capital structure C. Point of indifference D. Practical problems WORKING CAPITAL MANAGEMENT A. Concept of working capital B. Factors determining working capital needs C. Over trading and under trading BASICS OF CAPITAL BUDGETING A. Importance of Capital Budgeting B. Capital Budgeting appraising methods C. Payback period D. Average rate f return E. Net Present Value F. Profitability index G. Internal rate of return H. Practical problems

Page No

3

6

20

40

48

53

57

60

63

2

CHAPTER 1. FINANCIAL MANAGEMENT MEANING & SCOPE A. Meaning of business finance financial management

B. Meaning of financial management

C. Objectives of

MEANING OF FINANCE Finance may be defined as the art and science of managing money. It includes financial service and financial instruments. Finance also is referred as the provision of money at the time when it is needed. Finance function is the procurement of funds and their effective utilization in business concerns. The concept of finance includes capital, funds, money, and amount. But each word is having unique meaning. Studying and understanding the concept of finance become an important part of the business concern. DEFINITION OF FINANCE According to Khan and Jain, “Finance is the art and science of managing money”. DEFINITION OF BUSINESS FINANCE According to the Wheeler, “Business finance is that business activity which concerns with the acquisition and conversation of capital funds in meeting financial needs and overall objectives of a business enterprise”. TYPES OF FINANCE Finance is one of the important and integral part of business concerns, hence, it plays a major role in every part of the business activities. It is used in all the area of the activities under the different names. Finance can be classified into two major parts:

MEANING OF FINANCIAL MANAGEMENT Financial management refers to the efficient and effective management of money (funds) in such a manner as to accomplish the objectives of the organization. It is the specialized function directly associated with the top management. 3

Financial Management means planning, organizing, directing and controlling the financial activities such as procurement and utilization of funds of the enterprise. It means applying general management principles to financial resources of the enterprise. Scope/Elements of Financial Management 1. Investment decisions includes investment in fixed assets (called as capital budgeting). Investments in current assets are also a part of investment decisions called as working capital decisions. 2. Financial decisions - They relate to the raising of finance from various resources which will depend upon decision on type of source, period of financing, cost of financing and the returns thereby. 3. Dividend decision - The finance manager has to take decision with regards to the net profit distribution. Net profits are generally divided into two: a. Dividend for shareholders- Dividend and the rate of it has to be decided. b. Retained profits- Amount of retained profits has to be finalized which will depend upon expansion and diversification plans of the enterprise. Objectives of Financial Management The financial management is generally concerned with procurement, allocation and control of financial resources of a concern. Financial Management may be broadly divided into two parts such as: 1. Profit maximization 2. Wealth maximization.

Profit Maximization Main aim of any kind of economic activity is earning profit. A business concern is also functioning mainly for the purpose of earning profit. Profit is the measuring techniques to understand the business efficiency of the concern. Profit maximization is also the traditional and narrow approach, which aims at, maximizes the profit of the concern. Profit maximization consists of the following important features. 1. Profit maximization is also called as cashing per share maximization. It leads to maximize the business operation for profit maximization. 2. Ultimate aim of the business concern is earning profit, hence it considers all the possible ways to increase the profitability of the concern. Wealth Maximization Wealth maximization is one of the modern approaches, which involves latest innovations and improvements in the field of the business concern. The term wealth means 4

shareholder wealth or the wealth of the persons those who are involved in the business concern. Wealth maximization is also known as value maximization or net present worth maximization. This objective is universally accepted concept in the field of business. 1. To ensure regular and adequate supply of funds to the concern. 2. To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price of the share, expectations of the shareholders. 3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way at least cost. 4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that adequate rate of return can be achieved. 5. To plan a sound capital structure-There should be sound and fair composition of capital so that a balance is maintained between debt and equity capital. Functions of Financial Management 1. Estimation of capital requirements: A finance manager has to make estimation with regards to capital requirements of the company. This will depend upon expected costs and profits and future programmes and policies of a concern. Estimations have to be made in an adequate manner which increases earning capacity of enterprise. 2. Determination of capital composition: Once the estimation has been made, the capital structure have to be decided. This involves short- term and long- term debt equity analysis. This will depend upon the proportion of equity capital a company is possessing and additional funds which have to be raised from outside parties. 3. Choice of sources of funds: For additional funds to be procured, a company has many choices likea. Issue of shares and debentures b. Loans to be taken from banks and financial institutions c. Public deposits to be drawn like in form of bonds. Choice of factor will depend on relative merits and demerits of each source and period of financing. 4. Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so that there is safety on investment and regular returns is possible. 5. Disposal of surplus: The net profits decisions have to be made by the finance manager. This can be done in two ways: a. Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus. b. Retained profits - The volume has to be decided which will depend upon expansional, innovational, diversification plans of the company. 6. Management of cash: Finance manager has to make decisions with regards to cash management. Cash is required for many purposes like payment of wages and salaries, payment of electricity and water bills, payment to creditors, meeting current liabilities, maintenance of enough stock, purchase of raw materials, etc. 7. Financial controls: The finance manager has not only to plan, procure and utilize the funds but he also has to exercise control over finances. This can be done through many techniques like ratio analysis, financial forecasting, cost and profit control, etc. 5

CHAPTER: 2 FINANCIAL STATEMENT ANALYSIS AND INTERPRETATION A. Meaning and types of financial statements B. Techniques of financial analysis Limitations of financial analysis D. Practical problems

C.

Meaning of Financial Statements: Financial statements are the summary of the accounting process, which provides useful information to both internal and external parties. Definition of Financial Statements: John N. Nyer defined as “Financial statements provide a summary of the accounting of a business enterprise, the balance-sheet reflecting the assets, liabilities and capital as on a certain data and the income statement showing the results of operations during a certain period”. Financial statements generally consist of two important statements: (i) The income statement or profit and loss account. (ii) Balance sheet or the position statement. A part from that, the business concern also prepares some of the other parts of statements, which are very useful to the internal purpose such as: (i) Statement of changes in owner’s equity. (ii) Statement of changes in financial position.

Income Statement  Income statement is also called as profit and loss account, which reflects the operational position of the firm during a particular period. Normally it consists of one accounting year.  Income statement helps to ascertain the gross profit and net profit of the concern. Gross profit is determined by preparation of trading or manufacturing a/c and net profit is determined by preparation of profit and loss account. Balance Sheet Statement  Position statement is also called as balance sheet, which reflects the financial position of the firm at the end of the financial year. 6

 Position statement helps to ascertain and understand the total assets, liabilities and capital of the firm. One can understand the strength and weakness of the concern with the help of the position statement. Statement of Changes in Owner’s Equity  It is also called as statement of retained earnings. This statement provides information about the changes or position of owner’s equity in the company. How the retained earnings are employed in the business concern. Nowadays, preparation of this statement is not popular and nobody is going to prepare the separate statement of changes in owner’s equity. Statement of Changes in Financial Position  Income statement and position statement shows only about the position of the finance, hence it can’t measure the actual position of the financial statement.  Statement of changes in financial position helps to understand the changes in financial position from one period to another period.  Statement of changes in financial position involves two important areas such as fund flow statement which involves the changes in working capital position and cash flow statement which involves the changes in cash position. TYPES OF FINANCIAL STATEMENT ANALYSIS Analysis of financial statement may be broadly classified into two important types on the basis of material used and methods of operations.

1. Based on Material Used Based on the material used, financial statement analysis may be classified into two major types such as External analysis and internal analysis. A. External Analysis  Outsiders of the business concern do normally external analyses but they are indirectly involved in the business concern such as investors, creditors, government organizations and other credit agencies. 7

 External analysis is very much useful to understand the financial and operational position of the business concern.  External analysis mainly depends on the published financial statement of the concern. This analysis provides only limited information about the business concern.

B. Internal Analysis  The company itself does disclose some of the valuable information to the business concern in this type of analysis.  This analysis is used to understand the operational performances of each and every department and unit of the business concern.  Internal analysis helps to take decisions regarding achieving the goals of the business concern. 2. Based on Method of Operation Based on the methods of operation, financial statement analysis may be classified into two major types such as horizontal analysis and vertical analysis. A. Horizontal Analysis  Under the horizontal analysis, financial statements are compared with several years and based on that, a firm may take decisions.  Normally, the current year’s figures are compared with the base year (base year is consider as 100) and how the financial information are changed from one year to another.  This analysis is also called as dynamic analysis. B. Vertical Analysis  Under the vertical analysis, financial statements measure the quantities relationship of the various items in the financial statement on a particular period.  It is also called as static analysis, because, this analysis helps to determine the relationship with various items appeared in the financial statement. LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS: Analysis of financial statements helps to ascertain the strength and weakness of the business concern, but at the same time it suffers from the following limitations. 1. It analyses what has happened till date and does not reflect the future. 2. It ignores price level changes. 3. Financial analysis takes into consideration only monetary matters, qualitative aspects are ignored. 4. The conclusions of the analysis is based on the correctness of the financial statements. 5. Analysis is a means to an end and not the end itself. 6. As there is variation in accounting practices followed by different firms a valid comparison of their financial analysis is not possible. TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS: Financial statement analysis is interpreted mainly to determine the financial and operational performance of the business concern. A number of methods or techniques are 8

used to analyse the financial statement of the business concern. The following are the common methods or techniques, which are widely used by the business concern. 1. Comparative Statement Analysis A. Comparative Income Statement Analysis B. Comparative Balance Sheet Statement Analysis 2. Trend Analysis 3. Common Size Analysis 4. Fund Flow Statement 5. Cash Flow Statement 6. Ratio Analysis

COMPARATIVE STATEMENT ANALYSIS Comparative statement analysis is an analysis of financial statement at different period of time. This statement helps to understand the comparative position of financial and operational performance at different period of time. Comparative financial statements again classified into two major parts such as comparative balance sheet analysis and comparative profit and loss account analysis. 1. Comparative Balance Sheet Analysis  Comparative balance sheet analysis concentrates only the balance sheet of the concern at different period of time.  Under this analysis the balance sheets are compared with previous year’s figures or one-year balance sheet figures are compared with other years.  Comparative balance sheet analysis may be horizontal or vertical basis. This type of analysis helps to understand the real financial position of the concern as well as how the assets, liabilities and capitals are placed during a particular period. 2. Comparative Profit and Loss Account Analysis  Another comparative financial statement analysis is comparative profit and loss account analysis.  Under this analysis, only profit and loss account is taken to compare with previous year’s figure or compare within the statement.  This analysis helps to understand the operational performance of the business concern in a given period. It may be analyzed on horizontal basis or vertical basis. 9

Percentage of Increase or Decrease =

Current year – Base year X 100 Base year

Practical Problem: 1 From the following Profit and Loss Account and Balance Sheet of Ramco Ltd. For the year ended 1999 and 2000, you are required to prepare a comparative income statement and a comparative Balance Sheet. Profit and Loss Account Particulars To Cost of Goods sold To Operating Expenses: Administrative Selling To Net Profit

1999 Rs. 6,000

2000 Particulars Rs. 7,500 By Net Sales

1999 Rs. 8,000

2000 Rs. 10,000

8,000

10,000

1999 Rs. 1,000 2,000 2,000 1,000 3,000 3,000 1,000

2000 Rs. 1,400 3,000 3,000 1,000 2,700 2,700 1,400

13,000

15,200

200 200 300 400 1,500 1,900 8,000 10,000 Balance Sheet as on 31st December

Liabilities Bills Payable Sundry Creditors Tax Payable 6% Debentures 10% Preference Capital Equity Capital Reserves

1999 Rs. 500 1,500 1,000 1,000 3,000 4,000 2,000

2000 Rs. 750 2,000 1,500 1,500 3,000 4,000 2,450

Assets Cash Debtors Stock Land Buildings Plant Furniture

13,000 15,200 Solution:

RAMCO Limited Income Statement for the year ended 31st Dec. 1999 and 2000 Particulars Net Sales Less: Cost of goods sold Gross Profit (A) Less: Operating Expenses: Administrative Selling Total Operating Expenses (B) Operating Profit (A+B)

1999 Rs. 8,000 6,000 2,000 200 300 500 1,500

2000 Increase(+) or Decrease (-) Rs. Amount(Rs.) Percentage (%) 10,000 +2,000 +25 7,500 +1,500 +25 2,500 +500 +25 200 400 600 1,900

+100 +100 +400

+33.3 +20 +26.7

10

RAMCO Limited Income Statement for the year ended 31st Dec. 1999 and 2000 Particulars

1999 Rs.

ASSETS: Current Assets: Cash Debtors Stock Total Current Assets (A) Fixed Assets: Land Buildings Plant Furniture Total Fixed Assets (B) Total Assets (A+B) LIABILITIES AND CAPITAL: Current Liabilities: Bills Payable Sundry Creditors Taxes Payable Total Current Liabilities (A) Long-term Liabilities: 6% Debentures Total Liabilities (B) Capital and Reserves: 10% Preference Capital Equity Capital Reserves Total Shareholders’ Funds

(C)

Total Liabilities and Capital(A+B+C)

2000 Rs.

Increase(+) or Decrease (-) Amount(Rs.) Percentage (%)

1,000 2,000 2,000 5,000

1,400 3,000 3,000 7,400

+400 +1,000 +1,000 +2,400

+40 +50 +50 +48

1,000 3,000 3,000 1,000 8,000 13,000

1,000 2,700 2,700 1,400 7,800 15,200

-300 -300 +400 -200 +2,200

-10 -10 +40 -2.5 +17

750 2,000 1,500

+250 +500 +500

+50 +33.3 +50

4,250

+1,250

+41.7

1,000

1,500

+500

+50

4,000

5,750

+1,750

+43,75

3,000 4,000 2,000 9,000

3,000 4,000 2,450 9,450

+450 +450

+22.5 +5

13,000

15,200

+2,200

+17

500 1,500 1,000 3,000

11

Practical Problem: 2

The following is the Balance Sheets of MS Gupta for the years 2006 and 2007. Prepare the comparative Balance Sheet and study the financial position of the concern.

Balance Sheet as on 31st December Liabilities

2006 Rs

2007 Rs

Assets

2006 Rs

2007 Rs

Equity share capital

500,000

700,000 Land and Building

270,000

1,70,000

Reserves and surplus

330,000

222,000 Plant and Machinery

400,000

600,000

Debentures

200,000

300,000 Furniture

20,000

25,000

Long term loan on

100,000

150,000 Other fixed assets

25,000

30,000

20,000

40,000

120,000 Bill Receivables

100,000

80,000

10,000 Sundry debtors

200,000

250,000

Stock

250,000

350,000

—

2000

1285000

1547000

mortgage Bill Payables Sundry creditors Other current liabilities

50,000 100,000 5000

45,000 Cash in hand

Prepaid Expenses 1285000

1547000

12

Solution: Comparative Balance Sheet of MS Gupta for the year ending December 2006 and 2007

Particulars

ASSETS: Current Assets: Cash in hand Bill Receivable Sundry Debtors Stock Prepaid expenses Total Current Assets (A) Fixed Assets: Land &Buildings Plant & Machinery Furniture Other Fixed Assets Total Fixed Assets (B) Total Assets (A+B)

2006 Rs.

2007 Rs.

Increase(+) or Decrease (-) Amount(Rs.) Percentage (%)

20,000 1,00,000 2,00,000 2,50,000 5,70,000

40,000 80,000 2,50,000 3,50,000 2,000 7,22,000

+20,000 -20,000 +50,000 +1,00,000 +2,000 +1,52,000

+100 -20 +25 +40 +100 +26.67

2,70,000 1,70,000 4,00,000 6,00,000 20,000 25,000 25,000 30,000 7,15,000 8,25,000 12,85,000 15,47,000

-1,00,000 +2,00,000 +5,000 +5,000 +1,10,000 +2,62,000

-37.03 +50 +25 +20 +13.49 +20.39

LIABILITIES AND CAPITAL: Current Liabilities: Bills Payable Sundry Creditors Other current liabilities Total Current Liabilities (A)

50,000 1,00,000 5,000 1,55,000

45,000 1,20,000 10,000 1,75,000

-5,000 +20,000 +5,000 +20,000

-10 +20 +100 +12.9

Long-term Liabilities: Debentures Long term loan on mortgage Total long term liabilities (B)

2,00,000 1,00,000 3,00,000

3,00,000 1,50,000 4,50,000

+1,00,000 +50,000 1,50,000

+50 +50 +50

Capital and Reserves: Equity share capital Reserves & surplus Total Shareholders’ Funds

5,00,000 3,30,000 8,30,000

7,00,000 2,22,000 9,22,000

+2,00,000 -1,08,000 +92,000

+40 -32.73 +50

12,85,000 15,47,000

+2,62,000

+20.39

(C)

Total Liabilities and Capital(A+B+C)

13

Practical Problem: 3 The income statements of a concern are given for the year ending 31st December 2006 and 2007. Rearrange the figures in a comparative form and study the profitability of the concern Details

2006 Amount (Rs)

2007 Amount (Rs)

Net Sales

785,000

900,000

Cost of goods sold

450,000

500,000

General and administrative expenses

70,000

72,000

Selling expenses

80,000

90,000

Interest paid

25,000

30,000

Income tax

70,000

80,000

Operating expenses :

Non-operating expenses :

Solution: Comparative income statement for the year ended 31st Dec 2006 and 2007 Particulars

2006 Amount (Rs)

2007 Amount (Rs)

Increase (+) Decrease (–) (Rs)

Increase (+) Decrease (–) (Percentage)

Net sales

785,000

900,000

+115000

+14.65

Less cost of goods sold

450,000

500,000

+50000

+11.11

335,000

400,000

+65000

+19.40

General & Administrative

70,000

72,000

+2000

+2.8

Selling expenses

80,000

90,000

+10000

+12.5

150,000

162,000

+12000

+8.0

185,000

238,000

+53000

+28.65

25,000

30,000

+5000

+20

160,000

208,000

+48000

+30.0

70,000

80,000

+10000

+14.28

90,000

128,000

+38000

+42.22

Gross profit Less: Operating expenses :

Total operating expenses Operating profit Less: other deductions Interest paid Net profit before tax Less: income tax Net profit after tax

14

TREND ANALYSIS  Trend analysis is a statistical method used in analyzing financial statements to understand the trend in the components of the statements over a period of time.  The financial statements may be analysed by computing trends of series of information.  Trend analysis helps to understand the trend relationship with various items, which appear in the financial statements.  Each component of the base year is expressed as 100%

Practical Problem: 1 From the following information, you are required to prepare a trend analysis taking 1998 as the base year: Particulars Hotel premises Kitchen equipment Cash in hand Cash at bank Sundry debtors Closing stock

1998 Rs. 2,000 4,000 400 520 800 1,600

1999 Rs. 2,400 4,800 480 600 1,200 2,400

2000 Rs. 2,800 4,800 800 400 2,000 3,600

2001 Rs. 2,400 5,600 440 480 3,200 4,000

Solution: Particulars

1998 1999 2000 2001 1998 1999 2000 2001 Rs. Rs. Rs. Rs. % % % % Hotel premises 2,000 2,400 2,800 2,400 100 120 140 120 Kitchen equipment 4,000 4,800 4,800 5,600 100 120 120 140 Cash in hand 400 480 800 440 100 120 200 110 Cash at bank 520 600 400 480 100 115.4 77 92.3 Sundry debtors 800 1,200 2,000 3,200 100 150 250 400 Closing stock 1,600 2,400 3,600 4,000 100 150 225 250 The base year is assumed to be 1998, and hence the entire statement of 1998 is expressed as 100%. Therefore, the percentage of Hotel Premises for 1990 is: If Rs. 2,000 is 100% Therfore Rs. 2,400 is ? Percentage of Hotel Premises for 1999 = 2,400 X 100 = 120 % 2,000 Similarly, the percentage of Hotel Premises for 2000 is: If Rs. 2,000 is 100% Therfore Rs. 2,800 is ? Percentage of Hotel Premises for 1999 = 2,800 X 100 = 140 % 2,000 All other percentages can be calculated accordingly. 15

Practical Problem: 2 Calculate the Trend Analysis from the following information of Tamilnadu Mercantile Bank Ltd., taking 1999 as a base year and interpret them (in thousands). Year 1999 2000 2001 2002 2003 2004

Deposits 2,05,59,498 2,66,45,251 3,19,80,696 3,72,99,877 4,08,45,783 4,40,42,730

Advances 97,14,728 1,25,50,440 1,58,83,495 1,77,26,607 1,95,99,764 2,11,39,869

Profit 3,50,311 4,06,287 5,04,020 5,53,525 6,37,634 8,06,755

Solution Trend Analysis (Base year 1999=100) (Rs. in thousands) Year 1999 2000 2001 2002 2003 2004

Deposits Amount Trend

Advances Amount Trend

Profits Amount

Trend

Rs.

Percentage

Rs.

Percentage

Rs.

Percentage

2,05,59,498 2,66,45,251 3,19,80,696 3,72,99,877 4,08,45,783 4,40,42,730

100.0 129.6 155.5 181.4 198.7 214.2

97,14,728 1,25,50,440 1,58,83,495 1,77,26,607 1,95,99,764 2,11,39,869

100.0 129.2 163.5 182.5 201.8 217.6

3,50,311 4,06,287 5,04,020 5,53,525 6,37,634 8,06,755

100.0 115.9 143.9 150.0 182.0 230.3

COMMON SIZE ANALYSIS  The common size statement represents the relationship of different items of a financial statement with some common item by expressing each item as a percentage of the common item.  In the income statements, the sales figure is taken as basis and all other figures are expressed as percentage of sales.  Similarly, in the balance sheet the total assets and liabilities is taken as taken as base and all other figures are expressed as percentage of this total.

16

Practical Problem: 1

The balance sheet of Mr Anoop Private (Pvt) Limited (Ltd) and Bansal Private Limited are given below : Balance Sheet as on 31st December, 2007 Liabilities

Anoop Pvt Ltd Rs

Bansal Pvt Ltd Rs

Preference share capital

120,000

150,000

Equity share capital

140,000

410,000

24,000

28,000

110,000

120,000

7000

1000

Sundry creditors

12000

3000

Outstanding Expenses

15000

6000

Proposed Dividend

10000

90000

438,000

808,000

80,000

123,000

334,000

600,000

Temporary Investments

5000

40,000

Investment

6000

20,000

Sundry Debtors

4000

13,000

Prepaid expenses

1000

2000

Cash and Bank balance

8000

10,000

438,000

808,000

Reserves and surpluses Long-term loans Bill Payables

Land and Building Plant and Machinery

Compare the financial position of two companies with the help of common size balance sheet.

17

Solution : Common size Balance Sheet as on 31st December 2007 Anoop Pvt Ltd Amount Rs

%

Bansal Pvt Ltd Amount Rs

%

Fixed assets Land and Building

80,000

18.26

123,000

15.22

Plant and machinery

334,000

76.26

600,000

74.62

Total Fixed Assets

414,000

94.52

723,000

89.48

Temporary investment

5000

1.14

40,000

4.95

Investment

6000

1.37

20,000

2.48

Sundry Debtors

4000

0.91

13,000

1.61

Prepaid Expenses

1000

0.23

2,000

0.25

Cash and Bank

8000

1.83

10,000

1.25

24000

5.48

85,000

10.54

438,000

100.00

808,000

100.00

Preference share capital

120,000

27.39

150,000

19.80

Equity share capital

140,000

31.96

410,000

50.74

24,000

5.48

28,000

3.47

Total Capital and Reserves

284,000

64.83

588,000

74.01

Long term loans

110,000

25.11

120,000

14.85

7,000

1.60

1,000

0.12

Sundry creditor

12,000

2.74

3,000

0.37

Outstanding expenses

15,000

3.44

6,000

0.74

Proposed Dividend

10,000

2.28

90,000

11.15

39,000

10.06

109,000

12.38

438,000

100.00

808,000

100.00

Current asset

Total current assets Total Assets Share Capital and Reserves

Reserve and surpluses

Current liabilities Bill Payables

Total liabilities

18

Common size income statement The items in income statement can be shown as percentages of sales to show the relations of each item to sales. Practical Problems: 2 Following are the income statements of a company for the year ending 31st December 2006 and 2007 2006 Rs

2007 Rs

500,000

700,000

20,000

15,000

520,000

715,000

330,000

510,000

Office expenses

20,000

30,000

Interest

25000

30,000

Selling expenses

30,000

40,000

405,000

610,000

115,000

105,000

520,000

715,000

Sales Miscellaneous income

Expenses Cost of sales

Net profit

Solution : Common size Income Statement for the year ending 31st December 2006 and 2007. 2006

2007

Amount Rs

%

Amount Rs

Sales

500,000

100.00

700,000

100.00

Less : Cost of sales

330,000

66.00

510,000

72.86

Gross profit

170,000

34.00

190,000

27.14

Office expenses

20,000

4.00

30,000

4.29

Selling expenses

30,000

6.00

40,000

5.71

Total operating expenses (B)

50,000

10.00

70,000

10.00

Operating profit (A-B)

120,000

24.00

120,000

17.14

Miscellaneous income

20,000

4.00

15,000

2.14

140,000

28.00

135,000

19.28

25,000

5.00

30,000

4.28

115,000

23.00

105,000

15.00

(A)

%

Operating expenses

Total income Less : Non operating expenses Net profit

19

Interpretation – The sale and gross profit have increased in absolute figures in 2007 as compared to 2006. But the percentage of gross profit to sales has gone down in 2007. – The increase in cost of sales as a percentage of sales has brought the profitability from 34% to 27.14%. – Operating expenses have remained the same in both the years. – Net profit has decreased both in absolute figures and as a percentage in 2007 as compared to 2006.

CHAPTER: 3 RATIO ANALYSES A. Meaning of Ratio B. Classification of Ratios C. Profitability Ratios D. Turnover ratios E. Financial Ratios F. Du Pont Control Chart G. Practical problems MEANING: Ratio is an expression of one number in relation to another. Ratio analysis is the process of determining and interpreting the numerical relationship between figures of financial statements. DEFINITION: Kennedy and Mc Millan “the relationship of an item to another expressed in simple mathematical form is known as a ratio” OBJECTIVES: The objectives of using ratios are to test the profitability, financial position (liquidity and solvency) and the operating efficiency of a concern. ADVANTAGES OF RATIO ANALYSIS: Ratio analysis is an important technique in financial analysis. It is a means for judging the financial soundness of the concern. The advantages of accounting ratios are as follows: 1. It is a useful device for analysing the financial statements. 2. It simplifies, summarizes the accounting figures to make it understandable. 3. It helps in financial forecasting. 4. It facilitates interfirm and intrafirm comparisons. Ratio analysis is useful in finding the strength and weakness of a business concern. After identifying the weakness, the ratios are also helpful in determining the causes of the weakness.

20

CLASSIFICATION OF RATIOS The classification of ratios on the basis of purpose is as follows: Ratios

Liquidity

Solvency

Profitability

Activity (Turnover)

1. Current Ratio

1. Debt-Equity Ratio

1. Gross Profit Ratio

1. Capital Turnover Ratio

2. Liquid Ratio

2. Proprietory Ratio

2. Net Profit Ratio

2. Fixed Asset Turnover Ratio

3. Operating Profit Ratio

3. Stock Turnover Ratio

4.. Operating Ratio

4. Debtors Turnover Ratio 5. Creditors Turnover Ratio

3. Absolute Liquid Ratio

I. LIQUIDITY RATIOS Liquidity Ratios measure the firms’ ability to pay off current dues i.e.,repayable within a year. Liquidity ratios are otherwise called as Short Term Solvency Ratios. The important liquidity ratios are 1. Current Ratio 2. Liquid Ratio 3. Absolute Liquid Ratio 1. CURRENT RATIO This ratio is used to assess the firm’s ability to meet its current liabilities. The relationship of current assets to current liabilities is known as current ratio. The ratio is calculated as:

Current Ratio

=

Current Assests Current Liabilities

Current Assets are those assets, which are easily convertible into cash within one year. This includes cash in hand, cash at bank, sundry debtors, bills receivable, short term investment or marketable securities, stock and prepaid expenses. Current Liabilities are those liabilities which are payable within one year. This includes bank overdraft, sundry creditors, bills payable and outstanding expenses. 2. LIQUID RATIO This ratio is used to assess the firm’s short term liquidity. The relationship of liquid assets to current liabilities is known as liquid ratio. It is otherwise called as Quick ratio or 21

Acid Test ratio. The ratio is calculated as: Liquid Ratio

=

Liquid Assets Current Liabilities

Liquid assets means current assets less stock and prepaid expenses. 3. ABSOLUTE LIQUID RATIO It is a modified form of liquid ratio. The relationship of absolute liquid assets to liquid liabilities is known as absolute liquid ratio. This ratio is also called as ‘Super Quick Ratio’. The ratio is calculated as: Absolute Liquid Ratio

=

Absolute Liquid Assets Liquid Liabilities

Absolute liquid assets means cash, bank and short term investments. Liquid liabilities means current liabilities less bank overdraft.

II. SOLVENCY RATIOS Solvency refers to the firms ability to meet its long term indebtedness. Solvency ratio studies the firms ability to meet its long term obligations. The following are the important solvency ratios: 1. Debt-Equity Ratio 2. Proprietory Ratio 1. DEBT EQUITY RATIO This ratio helps to ascertain the soundness of the long term financial position of the concern. It indicates the proportion between total long term debt and shareholders funds. This also indicates the extent to which the firm depends upon outsiders for its existence. The ratio is calculated as: Debt-Equity Ratio

=

Total long term Dept Shareholders funds

Total long term debt includes Debentures, long term loans from banks and financial institutions. Shareholders funds includes Equity share capital, Preference share capital, Reserves and surplus. 2. PROPRIETORY RATIO This ratio shows the relationship between proprietors or shareholders funds and total tangible assets. The ratio is calculated as: Proprietory Ratio

=

Shere holders funds (Propreitors funds) Total tangible assets

Tangible assets will include all assets except goodwill, preliminary expenses etc. (Note : All solvency ratios are expressed as a proportion.) 22

III. PROFITABILITY RATIOS Efficiency of a business is measured by profitability. Profitability ratio measures the profit earning capacity of the business concern. The important profitability ratios are discussed below: 1. Gross Profit Ratio 2. Net Profit Ratio 3. Operating Profit Ratio 4. Operating Ratio 1. GROSS PROFIT RATIO This ratio indicates the efficiency of trading activities. The relationship of Gross profit to Sales is known as gross profit ratio. The ratio is calculated as: Gross Profit Ratio

=

Gross Profit

x 100

Sales Gross profit is taken from the Trading Account of a business concern. Otherwise Gross profit can be calculated by deducting cost of goods sold from sales. Sales means Net sales. Gross Profit = Sales –– Cost of goods sold Cost of goods sold = Opening Stock + Purchases –– Closing Stock (or) Sales –– Gross Profit 2. NET PROFIT RATIO This ratio determines the overall efficiency of the business. The relationship of Net profit to Sales is known as net profit ratio. The ratio is calculated as: Net Profit Ratio

=

Net Profit

x 100

Sales Net profit is taken from the Profit and Loss account of the business concern or the gross profit of the concern less administration expenses, selling and distribution expenses and financial expenses. 3. OPERATING PROFIT RATIO This ratio is an indicator of the operational efficiency of the management. It establishes the relationship between Operating profit and Sales. The ratio is calculated as: Operating Profit Ratio

=

Operating Profit

x 100

Sales Where operating profit is Net profit + Non-operating expenses – Non-operating income. Where, Non-operating expenses are interest on loan and loss on sale of assets. Non-operating income are dividend, interest received and profit on sale of asset. (or) 23

Operating profit = Gross profit – Operating expenses. Operating expenses include administration, selling and distribution expenses. Financial expenses like interest on loan are excluded for this purpose. 4. OPERATING RATIO This ratio determines the operating efficiency of the business concern. Operating ratio measures the amount of expenditure inurred in production, sales and distribution of output. The relationship between Operating cost to Sales is known as Operating Ratio. The ratio is calculated as: Operating Ratio

=

Cost of goods sold+ Operating expenses

x 100

sales (Note: All profitability ratios will be expressed in terms of percentage.)

IV. ACTIVITY RATIOS Activity ratios indicate the performance of the business. The performance of a business is judged with its sales (turnover) or cost of goods sold. These ratios arethus referred to as turnover ratios. A few important activity ratios are discussed below: 1. Capital turnover ratio 2. Fixed assets turnover ratio 3. Stock turnover ratio 4. Debtors turnover ratio 5. Creditors turnover ratio 1. CAPITAL TURNOVER RATIO This shows the number of times the capital has been rotated in the process of carrying on business. Efficient utilisation of capital would lead to higher profitability. The relationship between Sales and Capital employed is known as Capital Turnover Ratio. The ratio is calculated as: Capital Turnover Ratio

Sales

=

Capital Employed Where Sales means Sales less sales returns and Capital employed refers to total long term funds of the business concern i.e., Equity share capital, Preference share capital, Reserves and surplus and Long term borrowed funds. 2. FIXED ASSETS TURNOVER RATIO This shows how best the fixed assets are being utilised in the business concern. The relationship between Sales and Fixed assets is known as Fixed assets turnover ratio. The ratio is calculated as: Fixed assets turnover Ratio

=

Sales Fixed Assets

Fixed assets means Fixed assets less depreciation. 24

3. STOCK TURNOVER RATIO This ratio is otherwise called as inventory turnover ratio. It indicates whether stock has been efficiently used or not. It establishes a relationship between the cost of goods sold during a particular period and the average amount of stock in the concern. The ratio is calculated as: Stock turnover Ratio

=

Cost of goods sold Average stock

Average stock

Opening stock + closing stock

=

2 If information to calculate average stock is not given then closing stock may be taken as average stock. 4. DEBTORS TURNOVER RATIO This establishes the relationship between credit sales and average accounts receivable. Debtors turnover ratio indicates the efficiency of the business concern towards the collection of amount due from debtors. The ratio is calculated as: Debtors turnover Ratio

Credit Sales

=

Average Accounts Receivable Accounts receivable includes sundry debtors and bills receivable. Opening (debtors + bills receivable) Average Accounts Receivable = + Closing (debtors + bills receivable) 2 In case credit sales is not given, total sales can be taken as credit sales 5. CREDITORS TURNOVER RATIO: This establishes the relationship between credit purchases and average accounts payable. Creditors turnover ratio indicates the period in which the payments are made to creditors. The ratio is calculated as: Creditors turnover Ratio

=

Credit Purchases Average Accounts payable

Accounts payable include sundry creditors and bills payable. Average Accounts Receivable

=

Opening (creditors + bills payable) + Closing (creditors + bills payable) 2 25

In case credit purchases is not given total purchases can be taken as credit purchases. (Note: All turnover ratios will be expressed in terms of times.)

VI FINANCIAL RATIOS A company can finance its assets either with equity or debt. Financing through debt involves risk because debt legally obligates the company to pat interest and to repay the principal as promised. Equity financing does not obligate the company to any anything, but dividends are paid. 1. Debt to assets ratio 2. Long term debt to assets ratio 3. Debt to equity ratio 1. Debt to assets ratio: Debt to assets ratio indicates the proportion of assets that are financed with debt (both short – term and long- term debt): Total debt Total debt to assets ratio= __________ Total Assets 2. Long term debt to assets ratio Long term debt to assets ratio indicates the proportions of the company’s assets that are financed with long- term debt. Long term debt Long term debt to assets ratio = _______________ Total Assets

3. Debt to equity ratio Debt to equity indicates the relative uses of debt and equity as sources of capital to finance the company’s assets, evaluated using book values of the capital sources. Total debt Total debt to equity ratio = _____________________ Total shareholders equity

ABLE SHOWING SUMMARY OF ACCOUNTING RATIOS S.No 1.

Description of the ratio Current ratio

Formula

Notes

Current assets

Current assets include cash in hand, cash at bank, sundry debtors, bills receivable, marketable securities, stock and prepaid expenses.

Current liabilities

26

2.

Liquid Ratio

3.

Absolute Liquid Ratio

4.

5.

6.

Debt Equity Ratio

Long Term Debts Shareholders funds

Proprietory Ratio

Gross Ratio

Current liabilities include Bank overdraft, sundry creditors, bills payable and outstanding expenses. Liquid assets Liquid assets mean current assets less stock and prepaid Current liabilities expenses Absolute Liquid assets Absolute Liquid assets means cash, bank and short term Liquid liabilities investment.

Shareholders funds Total tangible assets

Profit

Gross Profit x 100

Sales

Liquid liabilities means current liabilities less bank overdraft. Long term debts include Debentures, long term loans from banks and financial institutions. Shareholders funds include Equity share capital, Preference share capital, Reserves and surplus. Tangible assets include all assets except goodwill, preliminary expenses etc. Gross profit = Sales – Cost of goods sold. Cost of goods sold = Opening stock + Purchases – Closing stock

7.

Net Profit Ratio

Net Profit x 100 Sales

8.

Operating Ratio

Profit Operating Profit x 100 Sales

Net sales = Total sales (cash & credit) – Sales returns Net profit = Gross profit – (Administration, Selling and distribution and financial expenses) Operating profit = Net profit + Non-operating expenses – Nonoperating income [OR] Gross

profit –

Operating 27

Expenses 9.

Operating Ratio

Cost of goods sold + Operating expenses x 100 Sales

10.

11. 12. 13.

14.

Capital Turnover Ratio

Fixed Assets Turnover Ratio Stock Turnover Ratio

Sales Capital Employed

Sales Fixed Assets Cost of goods sold Average stock

Capital employed = Equity share capital + Preference share capital + reserves and surplus + long term borrowed funds Fixed assets = Fixed assets – Depreciation Average stock = opening stock + closing stock divided by two.

Debtors

Average

Turnover Ratio

is calculated by dividing the opening balance of debtors

Creditors Turnover Ratio

Credit Purchases Average accounts payable (Creditors + Bills payable)

accounts

receivable

and bills receivable and closing balance of debtors and bills receivable by two. Average accounts payable is calculated by dividing the opening balance of creditors and bills payable and closing balance of creditors and bills payable by two.

28

DUPONT ANALYSIS DuPont Analysis (also known as the DuPont identity, Du Pont equation, DuPont Model or the DuPont method) is an expression which breaks ROE (return on equity) into three parts. The name comes from the DuPont Corporation that started using this formula in the 1920s. DuPont explosives salesman Donaldson Brown invented this formula in an internal efficiency report in 1912. DEFINITION DuPont analysis is a model widely used in financial ratio analysis to designate the ability of a company to increase its return on equity ratio (ROE). The model breaks down ROE ratio into three components: profit margin, asset turnover, and financial leverage. FORMULA The DuPont model is expressed as follows: ROE = Profit margin × Asset Turnover × Financial Leverage Or Net Income Net Sales Total Assets ROE = × × Net Sales Total Assets Total Shareholders’ Equity OBJECTIVE: The goal of DuPont analysis isn’t to calculate ROE but to identify factors affecting it. If investors are not satisfied with the current ROE ratio, management can analyze what problems caused its current value and attempt to solve them. DUPONT MODEL INTERPRETATION DuPont analysis breaks down return on equity into three major components to determine the impact of each of them.  Profit margin. This ratio reflects a company’s strength in generating profit from each dollar of sales.  Asset turnover. This ratio measures how efficiently a company uses its assets to generate sales.  Financial leverage or equity multiplier. This ratio shows the extent to which a company uses debt financing. The greater the value of a ratio, the greater the risk and uncertainly of expected ROE.

29

PRACTICAL PROBLEMS Practical Problem : 1 The following is the Trading & Profit and Loss Account of a firm for the year ended 31.3.04. Trading and Profit and Loss Account of Lilly & Co. for the year ended 31.3.2003 Particulars To Opening stock To Purchases To Wages To Gross profit

To Administration expenses To Interest To Loss on sale of machinery To Selling Expnes To Net Profit

Rs. Particulars 35,000 By Sales 2,25,000 By Closing stock 10,000 1,80,000

Rs. 4,00,000 50,000

4,50,000

4,50,000

10,000 By Gross profit 5,000 By Dividend 2,000 10,000 1,55,000

1,80,000 2,000

1,82,000

1,82,000

Calculate profitability ratios.

Solution: 1. Goss Profit Ratio

=

Gross Profit

x 100

Sales 1,80,000

=

x 100

4,00,000 =

45%

30

2. Net Profit Ratio

=

Net Profit

x 100

Sales 1,55,000

=

x 100

4,00,000 =

3. Operating Profit Ratio

=

38.75%

Operating Profit

x 100

Sales Operating profit

=

Net Profit + Non-operating expenses – Nonoperating income = Net Profit + Interest + Loss on sale of machinery – Dividend

= 1,55,000 + 2,000 + 5,000 – 2,000 = Operating Profit Ratio

=

Rs. 1,60,000 1,60,000

x 100

4,00,000 =

4. Operating

Ratio

=

40 %

Cost of goods + Operating Expenses Sales

Cost of goods sold

Operating Expenses

Operating Ratio

= Sales – Gross Profit =

4,00,000 - 1,80,000

=

Rs. 2,20,000

= Administration + Selling Expenses =

10,000 + 10,000

=

Rs. 20,000

=

2,20,000 + 20,000

x 100

4,00,000 =

60%

31

Practical Problem : 2 Following is the Profit & Loss Account for the period ending 31/3/10. Calculate (a) gross profit ratio (b) Net profit ratio (c) Operating ratio (d) Administrative expenses ratio. Trading account and Profit & Loss Account for the period ended on 31/03/10 Particulars

Amount (Rs.)

Particulars

Amount (Rs.)

To opening stock

1,00,000

By sales

5,60,000

To Purchases

3,50,000

By Closing stock

1,00,000

To Wages

9,000

To Gross Profit

2,01,000 6,60,000

6,60,000

To Administrative exp.

20,000

By Gross Profit

To Selling & Marketing

89,000

By interest

To Non-operating exp.

30,000

By Profit on sale of investment

To Net Profit

80,000 2,19,000

2,01,000 10,000 8,000

2,19,000

Solution: (a) Gross Profit Ratio = Gross Profit ÷ Sales × 100 = 2,01,000 ÷ 5,60,000 × 100 = 35.89% (b) Net Profit Ratio = Net Profit ÷ Sales × 100

= 80,000 ÷ 5,60,000 × 100 = 14.28% (c) Operating Ratio = Cost of sales + operating expenses ÷ sales × 100 (i) Cost of sales = Sales – Gross Profit Cost of sales = 5,60,000 – 2,01,000 = 3,59,000 So Operating Ratio = Cost of sale + operating expenses ÷ Sales × 100 = 3,59,000 + 1,09,000 ÷ 5,60,000 × 100 32

= 4,68,000 ÷ 5,60,000 × 100 = 83.57 % (Operating expenses = Administrative expenses and Selling & marketing exp.) (d) Administrative expenses = Administrative expenses ÷ Sales × 100 = 20,000 ÷ 5,60,000 × 100 = 3.57 % Practical Problem : 3 The following is Profit & Loss for the year ended 31st December 2010 and the Balance Sheet of the Company as on that date: Profit & Loss Account For the period ended on 31st December Particulars Amount (Rs.) Particulars Amount (Rs.) To opening stock

80,000

By Sales

9,50,000

To Direct Expenses

10,500

By Closing stock

1,19,000

To Purchases

3,40,000

To Gross Profit

6,38,500 10,69,000

To Administrative expenses

2,00,000

To Selling expenses

30,000

To interest on loan

17,000

To loss on sale of assets To Net Profit

10,69,000 By Gross Profit

6,38,500

2,000 3,89,500 6,38,500

6,38,500

Balance Sheet as on 31st December 2010 Liabilities Amount (Rs.) Assets Amount (Rs.) Equity Shares 2,80,000 Plant 1,00,000 Long term loan 70,000 Land & Building 2,50,000 Bank overdraft 15,000 Stock 76,000 Outstanding expenses 10,000 Debtors 50,000 Sundry creditors 80,000 Bills Receivables 9,000 Retained Earnings Cash at Bank 30,000 5,15,000 5,15,000 Calculate (a) Quick ratio (b) current ratio (c) Debt Equity ratio (d) Proprietary ratio (e) Stock Turnover ratio (f) Fixed Assets Turnover ratio (g) Net Profit ratio. 33

(a) Current ratio = Current Assets ÷ Current Liabilities = Cash at bank + Bills receivable + Debtors + Stock Bank overdraft + Sundry Creditors + Outstanding expenses

=

30,000 + 9,000 + 50,000 + 76,000 15,000 + 80,000 + 10,000

=

1,65,000 1,05,000

= 1.57

(b) Quick Ratio = Liquid Assets ÷ Current Liabilities =

=

Cash at bank + Bills Receivables + Debtors Bank overdraft + Sundry Creditors + Outstanding expenses 30,000 + 9,000 + 50,000 15,000 + 80,000 + 10,000

=

89,000 1,05,000

= 0.84

(c) Debt Equity Ratio = Debt ÷ Equity Debt = Long term Loan Equity = Equity Share (Shareholders fund) + Retained Earnings =

70,000 2,80,00 + 1,60,000

=

70,000 3,40,000

=

0.20

(d) Proprietary Ratio = Equity Share (Shareholders Fund) ÷ Total Assets Equity Share = 2,80,000, Retained earnings = 60,000. Total Equity = 3,40,000. =

3,40,000 5,15,000

=

0.66

34

(e) Stock Turnover Ratio = Cost of goods sold ÷ Average Stock Net Sales Less Gross Profit = Cost of sales = 9,50,000 – 6,38,500 = 3,11,500 Average Stock = Opening Stock + Closing stock ÷ 2 = 80,000 + 1,19,000 ÷ 2 = 99,500 Stock Turnover Ratio = Cost of sale ÷ Average Stock = 3,11,500 ÷ 99,500 = 3.14 (f) Fixed Assets Turnover Ratio = Cost of goods sold ÷ Fixed Assets = 3,11,500 ÷ 3,50,000 = 0.89 (g) Net Profit Ratio = Net Profit ÷ Net Sales x 100 = 3,89,000 ÷ 9,50,000 x 100 = 41% Practical Problem : 4 The following are the financial statements of Kamala Traders. You are required to calculate the ratios a) Current ratio. b) Quick ratio. c) Debtors turnover ratio d) Inventory turnover ratio. e) Total debts to shareholder’s equity. Profit & Loss Account Particulars To Opening stock

Amount (Rs.) 80,000

To Purchases

1,20,000

To Gross Profit

1,40,000

Particulars By sales

2,40,000

By closing stock

1,00,000

3,40,000 To selling expenses

30,000

Amount (Rs.)

3,40,000 By Gross Profit

1,40,000

35

To General expenses

40,000

To Interest paid

4,200

To Income tax

29,800

To Net Profit

36,000 1,40,000

1,40,000

Balance Sheet Liabilities Equity Share Capital 6% Preference Capital Profit & Loss A/C 5% Mortgage Loan Bills Payable Taxes Payable

Amount 50,000 20,000 44,000 80,000 30,000 20,000 2,44,000

Assets Plant & Equipment Inventory Debtors ) Short term Investments Cash

Amount) 40,000 1,00,000 60,000 24,000 20,000 2,44,000

Solution: (a) Current Ratio = Current Assets ÷ Current Liabilities Inventory + Debtors + Cash + Short term Investment = Bills Payable + Taxes Payable

=

1,00,000 + 60,000 + 20,000 + 24,000 30,000 + 20,000

=

2,04,000 = 4.08 50,000

(b) Acid Test / Quick Ratio = Quick Assets ÷ Current Liabilities Quick assets includes all current assets items except inventories and prepaid expenses =

Debtors + Short term investment + Cash = Bills payable + Taxes payable

=

1,04,000 50,000

60,000 + 24,000 + 20,000 30,000 + 20,000

= 2.08

36

(c) Debtors Turnover Ratio = Credit Sales ÷ Average Debtors Average Debtors = Opening value + Closing value ÷ 2 = 60,000 + 40,000 ÷ 2 = 1,00,000 ÷ 2 = 50,000 Credit sales = 2,40,000 Debtors Turnover Ratio =

2,40,000 50,000

= 4.08

(d) Inventory Turnover Ratio = Cost of goods sold ÷ Average Inventory Cost of goods sold = Opening stock + Purchases – Closing stock = 80,000 + 1,20,000 – 1,00,000 = 1,00,000 Average Inventory = Stock in beginning + Stock at end ÷ 2 = 80,000 + 1,00,000 ÷ 2 = 90,000 So Inventory Turnover Ratio = 1,00,000 ÷ 90,000

= 1.1 (e) Total debts to Shareholder’s equity =

=

=

Mortgage loan + Bills payable + Taxes payable Equity Share Capital + Preference Capital + Retained Earnings (Profit & Loss)

80,000 + 30,000 + 20,000 50,000 + 20,000 + 44,000

=

1,30,000 1,14,000

= 1.14

37

Practical Problem : 5 Calculate the following ratios from the Balance Sheet given here under: (a)Current ratio (b)Stock turnover ratio (c)Return on capital employed (d)Fixed assets turnover ratio Balance Sheet Amount 2,00,000 80,000

Liabilities Shares Reserves & Surplus

Assets Fixed Assets Current Assets (Stock 80,000)

Amount 2,30,000 2,40,000

Long-term loan Current Liabilities

70,000 1,20,000 4,70,000 Assumes sales 8,00,000 and profit for the year 60,000

4,70,000

Solution: (a) Current Ratio

=

Current Assets Current Liabilities

(b) Stock Turnover Ratio =

=

2,40,000 = 1,20,000

2

Sales Average Inventory Opening Stock +Closing Stock 2

Average Inventory =

=

8,00,000 = 10 80,000 (c) Return on Capital employed = Profit before interest & tax Capital employed Capital employed = 2,00,000 + 80,000 + 70,000 =3,50,000

=

=

60,000 X 100 3,50,000 17.14%

(d) Fixed Assets Turnover Ratio = Net Sales Fixed Assets (Net) 8,00,000 = --------------= 3.48 2,30,000

38

Practical Problem : 6 The following are the summarized Profit & Loss Account of Krishna Hotel for the year ending 31st Dec.2010 and the Balance Sheet as on that date: Trading and Profit & Loss Account Particulars To Opening stock To Purchases To Direct expenses To Gross Profit To operating expenses To loss on sale of assets

Amount 9,950 54,525 1,425 34,000 99,900 19,500 400

To Net Profit

15,000

Particulars By Sales By Closing Stock

Amount 85,000 14,900

99,900 34,000 600

By Gross Profit b/d By Profit on sale of shares By Interest

300

34,900

34,900

Balance Sheet of Krishna Hotel Amount 15,000 8,000 14,900 7,100 3,000 48,000 48,000 You are required to calculate: (a) Current ratio (b) Operating ratio (c) Stock turnover ratio (d) Return on total resource (e) Turnover of fixed assets Liabilities Share Equity Capital Reserves Current Liabilities Profit & Loss A/C

Amount 20,000 9,000 13,000 6,000

Assets Land & Building Plant & Machinery Stock Sundry Debtors Cash & Bank balances

Solution: Net Profit 15,000 (a) Return on total resources = ------------------- = ---------------- X 100 Total Assets 48,000

(b) Turnover of Fixed Assets

Net Sales = --------------------- = Fixed Assets

85,000 -----------23,000

= 31.25%

= 3.70: 1

***************

39

CHAPTER: 4 FUNDS FLOW STATEMENT A. Meaning of funds flow statement B. Uses of funds flow statement C. Preparation of funds flow statement D. Treatment of provision for taxation and proposed dividends (as non-current liabilities) E. Practical problems FUNDS FLOW STATEMENT Funds flow statement is one of the important tools, which is used in many ways. It helps to understand the changes in the financial position of a business enterprise between the beginning and ending financial statement dates. It is also called as statement of sources and uses of funds. Definition of Funds Flow Stataement: Smith and Brown defines as, "Funds Flow Statement is prepared to indicate in summary form, changes occurring in items of financial position between two different balance sheet dates." Institute of Cost and Works Accounts of India, funds flow statement is defined as “a statement prospective or retrospective, setting out the sources and application of the funds of an enterprise. The purpose of the statement is to indicate clearly the requirement of funds and how they are proposed to be raised and the efficient utilization and application of the same”. Uses / advantages of Fund Flow Statement : 1. Fund flow statement helps the management in the assessment of long range forecasts of a cash requirements and availability of liquid resources. The manager can judge the quality of management decisions. 2. With the help of Fund Flow Statement, the investors are able to measure as to how the company has utilized the funds supplied by them and its financial strength. Also, the investors can judge the company’s capacity to generate funds from operations. 3. It serves as effective tools to the Management for economic analysis as it supplies additional information which can not be provided by financial statement based on historical data. 4. Fund flow statement explains the relationship between changes in working capital and net profits. 5. Fund flow statement helps the management in making planning process of a company. It is also useful in assessing the resources available and the manner of utilization of the resources. 6. It explains the financial consequences of business activities. It also provides explicit and clean answer to questions regarding liquid and solvency position of the company. 7. Fund Flow Statement provides clues to the creditors and financial institutions as to the ability of a company to use funds effectively in the best interest of the investors, creditors and owners of the company. Limitations of Fund Flow Statements 1. It should not be overlooked that Fund Statements ignore non-cash transactions, therefore it is considered as cruder device than the financial statement. 2. Fund Flow Statements merely rearrange a part of the information contained in financial statements. They do not serve as original evidence of financial status. 3. Though changes in cash resources are more significant, they are not highlighted by Fund Statements except being shown by them as a part of working capital. 4. As Fund Flow Statements are prepared from information provided by financial statements, they are essentially historical in nature. 40

PROCEDURES FOR PREPARING FUNDS FLOW STATEMENT The preparation of a funds flow statement consists of three steps 1. Schedule of changes in working capital which shows whether there is increase in working capital or decrease in working capital. 2. Funds from operation or adjusted profit and loss account which exhibits funds from operation 3. Funds flow statement reveals the sources and uses of funds I. The preparation of Statement of Schedule of Changes in Working Capital is as follows.    

Effects of Fund Flow on Working Capital Increase in the current year current assets than previous year - Increase in Working Capital Decrease in the current year current assets than previous year -Decrease in Working Capital Increase in the current year current liabilities than previous year - Decrease in Working Capital Decrease in the current year current liabilities than previous year - Increase in Working Capital Schedule of changes in working capital Current Assets Cash in hand Cash at bank Bills receivable Debtors. Stock. investment Prepaid expense Current Liabilities Creditors Bill payable Bank overdraft Outstanding expenses Provision for Doubtful debts Increase / Decrease in working capital Total

Previous year xxx xxx xxx xxx xxx xxx

Current year xxx xxx xxx xxx xxx xxx

Working capital Increase Decrease xxx xxx xxx xxx xxx xxx -

xxx xxx xxx xxx

xxx xxx xxx xxx

xxx xxx

xxx xxx -

xxx

xxx

xxx

-

xxx xxx

xxx xxx

II. Funds from Operations- Adjusted P&L Account Calculation of Funds From Operation Particulars Rs. Rs. Net profit for the current year Add: Non-operating expenses General reserve xxxx Goodwill written off xxxx Preliminary expenses written off xxxx Patents written off xxxx Miscellaneous expenses xxxx 41

Provision for depreciation Depreciation Loss on sale of fixed asset Provision for tax Proposed dividend Interim dividend Premium on redemption of debenture Discount on issue of shares

xxxx xxxx xxxx xxxx xxxx xxxx xxxx xxxx

xxxx

Less: Non-operating income Profit on sale of fixed assets Refund of double taxation Dividend on investment Discount on redemption of debenture

xxxx xxxx xxxx xxxx

xxxx xxxx

Funds from operation III. Preparation of Fund Flow Statement A funds flow statement is prepared on the basis of information contained in the consecutive two years Balance Sheet and that is based on the Profit and Loss Account for the period concerned. This statement consists of two parts: – Sources of funds – Application of funds FORMAT – HORIZONTAL FUNDS FLOW STATEMENT (STATEMENT OF SOURCES AND APPLICATION OF FUNDS) Sources of Funds Issue of Equity Shares

Amount ----

Application of Funds Purchase of Fixed Assets

Amount ----

Issue of Preference shares

----

Purchase of Investments

----

Issue of Debentures

----

Redemption of shares

----

Loan borrowed

---

Redemption of debenture

----

Sale of Fixed Assets

----

Payment of loan

----

Sale of Investments

----

Payment of Tax

----

Non-trading incomes

----

Payment of Dividend

----

Fund from Operation (profit)

----

Non-trading losses

----

Decrease of working capital

----

Increase of working capital

----

Fund from operation (loss)

----

-------

-------

42

Practical Problem: 1 From the following balance sheet of A Company Ltd. you are required to prepare a schedule of changes in working capital and statement of flow of funds. Balance Sheet of A Company Ltd., as on 31st March Liabilities Share Capital Profit and Loss a/c Loans Creditors Bills payable

2004 1,00,000 20,000 — 15,000 5,000

2005 1,10,000 23,000 10,000 18,000 4,000

1,40,000

1,65,000

Assets Land and Building Plant and Machinery Stock Debtors Bills receivable Cash

2004 2005 60,000 60,000 35,000 45,000 20,000 25,000 18,000 28,000 2,000 1,000 5,000 6,000 1,40,000 1,65,000

Solution: Schedule of Changes in Working Capital Particulars Current Assets Stock Debtors Bills Receivable Cash Total Current Assets

2004 Rs.

A

Less: Current Liabilities Creditors Bills Payable Total Currents Liabilities B Increase in W.C.

2005 Rs.

20,000 18,000 2,000 5,000 45,000

25,000 28,000 1,000 6,000 60,000

15,000 5,000 20,000

18,000 4,000 22,000

Increase Rs. 5,000 10,000 — 1,000

Decrease Rs. — — 1,000

3,000 1,000 17,000 — 17,000

4,000 13,000 17,000

Fund Flow Statement Sources

Rs.

Issued Share Capital Loan Funds From Operations

10,000 10,000 3,000 23,000

Application Purchase of Plant and Machinery Increase in Working Capital

Rs. 10,000 13,000

23,000

43

Practical Problem: 2 Form the following Balance Sheets as on 31 December, 1996 and 31 December, 1997, you are required to prepare a Schedule of Changes in the Working Capital and a Funds flow Statement taking the provision for tax and proposed dividends as non-current liabilities. BALANCE SHEET as on 31 December Liabilities 1996 1997 Assets 1997 1998 Rs Rs Rs Rs Share Capital 10,000 15,000 Fixed Assets Profit and Loss A/c 4,000 6,000 Current Assets Provision for Tax 2,000 3,000 Proposed Dividends 1,000 1,500 Sundry Creditors 4,000 6,000 Outstanding Expenses 2,000 3,000 23,000 34,500 Additional Information (i) Tax paid during 1997 Rs (ii) Dividends paid during 1997 Rs

10,000 13,000

20,000 14,500

23,000

34,500

2,500 1,000

Solution: SCHEDULE OF CHANGES IN WORKING CAPITAL Increase Decrease Particulars 1996 1997 (+) (–) Rs. Rs. Rs Rs

Sundry Creditors

4,000

6,000

2,000

Outstanding Expenses Current Assets Decrease in Working Capital

2,000 13,000

3,000 14,500

1,000 1,500 1,500 3,000

3,000

FUNDS FROM OPERATIONS Particulars Rs. Rs. Net Profit (Rs. 6000- Rs. 4000) 2,000 Add: Provision for Tax (Rs 3,000 + Rs 2,500 – Rs 2,000) 3,500 Proposed Dividends (current year) 1,500 5,000 Funds from operations 7,000

44

FUNDS FLOW STATEMENT Source: Increase in Share Capital Funds from Operations Net Decrease in Working Capital Total Sources

Rs 5,,000 7,000 1,500 13,500

Applications: Fixed assets purchased Tax paid (during year) Dividends paid (during year)

10,000 2,500 1,000

Total Applications

13,500

Practical Problem:3 From the following balance sheets of X Ltd. on 31 December, 1995 and 1996, you are required to prepare: (a) A schedule of changes in working capital, (b) A funds flow statement. 1995 1996 1995 1996 Liabilities Rs Rs Assets Rs Rs Share Capital General Reserve Profit and Loss A/c Sundry Creditors Bills Payable Provision for Taxation Provision for Doubtful Debts

1,00,000 1,00,000 Goodwill 14,000 18,000 Building 6,000 3,000 Plant 8,000 5,400 Investments 1,200 800 Stock 16,000 18,000 Bills Receivable 400 600 Debtors Cash/Bank 1,55,600 1,55,800

12,000 12,000 40,000 36,000 37,000 36,000 10,000 11,000 30,000 23,400 2,000 3,200 18,000 19,000 6,600 15,200 1,55,600 1,55,800

The following additional information has also been given: (i) Depreciation charged on Plant was Rs 4,000 and on Building Rs 4,000. (ii) Provision for taxation of Rs 19,000 was made during the year 1996. (iii) Interim dividend of Rs 8,000 was paid during the year 1996.

45

Solution: SCHEDULE OF CHANGES IN WORKING CAPITAL Particular

Current Assets: Cash at Bank Debtors Bills receivable Stock Current Liabilities: Provision for doubtful debts Bills payable Sundry creditors Net Increase in working capital

Increase Decrease (+) (–) Rs Rs

1995 Rs

1996 Rs

6,600 18,000 2,000 30,000

15,200 19,000 3,200 23,400

8,600 1,000 1,200 -

6,600

400 1,200 8,000

600 800 5,400

400 2,600

200 –

13,800

7,000 13,800

FUNDS FLOW STATEMENT Particulars

Rs

Source: Funds from Operations (See Note 1) Total Sources Applications: Purchase of plant (See Note) Tax paid (See Note 3) Investments purchased (See Note 4) Interim dividend paid Total Applications Net Increase in Working Capital

36,000 36,000 3,000 17,000 1,000 8,000 29,000 7,000 36,000

46

Working Notes: 1. Funds from operations: Particulars

Rs

Profit and loss A/c balance on 31 December, 1996 Add: Items which do not decrease funds from operations Transfer to general reserve Provision for tax Depreciation: Plant Building Interim dividend paid Add:

Rs 13,000

4,000 19,000 4,000 4,000 8,000 52,000

Profit and Loss Account balance on 31 December, 1996 Funds from operations for the year

39,000 16,000 36,000

2. Purchase of Plant: This has been found out by preparing the Plant Account. PLANT ACCOUNT Particulars

Rs

To Balance b/d To Bank (Purchase of plant— balancing figure)

Particulars

Rs

37,000 By Depreciation 3,000 By Balance c/d

4,000 36,000

40,000

40,000

3. Tax paid during the year has been found out by preparing a provision for tax account. PROVISION FOR TAX ACCOUNT Particulars To Bank (being tax paid—Bal. figure) To Balance c/d

Rs

Particulars

17,000 By Balance b/d 18,000 By P. & L. A/c 35,000

Rs 16,000 19,000 35,000

******************** 47

CHAPTER: 5 CASH FLOW STATEMENT A. Meaning of cash flow statement B. Preparation of cash flow statement C. Difference between cash flow and funds flow analysis D. Practical problems CASH FLOW STATEMENT Cash flow statement is a statement which shows the sources of cash inflow and uses of cash outflow of the business concern during a particular period of time. It is the statement, which involves only short-term financial position of the business concern. Cash flow statement provides a summary of operating, investment and financing cash flows and reconciles them with changes in its cash and cash equivalents such as marketable securities. Institute of Chartered Accountants of India issued the Accounting Standard (AS-3) related to the preparation of cash flow statement in 1998.     

Objectives of Cash Flow Statement Cash flow statement aims at highlighting the cash generated from operating activities. Cash flow statement helps in planning the repayment of loan schedule and replacement of fixed assets, etc. Cash is the centre of all financial decisions. It is used as the basis for the projection of future investing and financing plans of the enterprise. Cash flow Statement helps in efficient and effective management of cash. It is very useful in the evaluation of cash position of a firm.

Classification of Cash Flows The statement of cash flows categorizes cash receipts and cash payments as operating, investing, and financing activities. 1. Operating activities include receiving cash from customers for the sale of goods and services, receiving interest and dividends on loans and investments, and making cash payments for wages, goods and services purchased, interest, and taxes. 2. Investing activities include purchasing and selling long-term assets and marketable securities (other than cash equivalents), as well as making and collecting on loans. 3. Financing activities include issuing and buying back capital stock, as well as borrowing and repaying loans on a short- or long-term basis (issuing bonds and notes). Dividends paid are also included in this category, but the repayment of accounts payable or accrued liabilities is not. Difference between Funds Flow and Cash Flow Statement Funds Flow Statement

Cash Flow Statement

1. Funds flow statement is the report on the Cash flow statement is the report movement of funds or working capital. showing sources and uses of cash. Funds flow statement explains how Cash flow statement explains the inflow 2. working capital is raised and used and out flow of cash during the during the particular particular period. 3. The main objective of fund flow The main objective of the cash flow statement is to show the how the statement is to show the causes of resources have been balanced mobilized changes in cash between two balance and used. sheet dates. 48

4. Funds flow statement indicates the Cash flow statement indicates the results of current financial management. factors contributing to the reduction of cash balance in spite of increase in profit and vice-versa. 5. In a funds flow statement increase or In a cash flow statement only cash decrease in working capital is recorded. receipt and payments are recorded. 6. In funds flow statement there is no Cash flow statement starts with opening opening and closing balances. cash balance and ends with closing cash balance.

Cash from Operations = Net Profit + (Increase in Current Liabilities & Decrease in Current Assets) – (Increase in Current Assets & Decrease in Current Liabilities) Practical Problem: 1 From the Balance Sheets of M/s. XYZ Hotel, you are required to prepare

cash flow statement:

21.11.2015

Solution:

Cash from operations Particulars Profit made during the year (6,15,000 – 7,39,000) Net Loss Add: Increase in C.L & Decrease in C.A Stocks Sundry Creditors Bills payable Less: Increase in C.A & Decrease in C.L Debtors

Rs.

Rs. 5,000

10,000 5,000 5,000

5,000 Cash from operations

20,000 25,000 5,000 20,000

49

Cash flow statement Particulars Cash Balance as on 31.3.2014 Add: Source of cash (Cash inflows) Cash from operations Share Capital

Rs.

Rs. 10,000 20,000 20,000 50,000

Less: Application of cash (Cash outflows) Debentures Purchase of Buildings Purchase of Furniture

10,000 15,000 20,000

Cash Balance as on 31.3.2014

5,000

Practical Problem: 2 From the following balances you are required to calculate cash from operations: 31 December

Debtors Bills Receivable Creditors Bills Payable Outstanding Expenses Prepaid Expenses Accrued Income Income received in advance Profit made during the year

1993 Rs.

1994 Rs.

50,000 10,000 20,000 8,000 1,000 800 600 300 —

47,000 12,500 25,000 6,000 1,200 700 750 250 1,30,000

Solution: CASH FROM OPERATIONS Particulars Profit made during the year Add: Decrease in Debtors Increase in Creditors Increase in Outstanding Expenses Decrease in Prepaid Expenses Less: Increase in Bills Receivable Decrease in Bills Payable Increase in Accrued Income Decrease in Income received in Advance Cash from Operations

Rs.

Rs. 1,30,000

3,000 5,000 200 100 2,500 2,000 150 50

8,300 1,38,300

4,700 1,33,600 50

Practical Problem: 3 Following information is available from the books of Standard Company Ltd:

Calculate cash flow from operations. Solution:

51

Practical Problem: 4 From the following calculate cash from operations:

Solution:

***************

52

CHAPTER: 6 FINANCIAL PLANNING MEANING & SCOPE A. Meaning of Financial Planning D. Practical problems

B. Meaning of Financial Plan C. Capitalization

Definition of Financial Planning Financial Planning is the process of estimating the capital required and determining it’s competition. It is the process of framing financial policies in relation to procurement, investment and administration of funds of an enterprise. Objectives and scope of Financial Planning a. Determining capital requirements- This will depend upon factors like cost of current and fixed assets, promotional expenses and long- range planning. Capital requirements have to be looked with both aspects: short- term and long- term requirements. b. Determining capital structure- The capital structure is the composition of capital, i.e., the relative kind and proportion of capital required in the business. This includes decisions of debtequity ratio- both short-term and long- term. c. Framing financial policies with regards to cash control, lending, borrowings, etc. d. A finance manager ensures that the scarce financial resources are maximally utilized in the best possible manner at least cost in order to get maximum returns on investment.

Importance of Financial Planning 1. Adequate funds have to be ensured. 2. Financial Planning helps in ensuring a reasonable balance between outflow and inflow of funds so that stability is maintained. 3. Financial Planning ensures that the suppliers of funds are easily investing in companies which exercise financial planning. 4. Financial Planning helps in making growth and expansion programmes which helps in long-run survival of the company. 5. Financial Planning reduces uncertainties with regards to changing market trends which can be faced easily through enough funds. 6. Financial Planning helps in reducing the uncertainties which can be a hindrance to growth of the company. This helps in ensuring stability an d profitability in concern. Process of Financial Planning     

Preparation of sales conjecture (assumption) . Decide the number of funds – fixed and working capital. Conclude the expected benefits and profile ts to decide the number of funds that can be provided through internal sources. This causes us to evaluate the requirement from external sources. Recognize the conceivable sources and set up the money spending plans consolidating these variables.

53

CAPITALIZATION MEANING OF CAPITAL The term capital refers to the total investment of the company in terms of money, and assets. It is also called as total wealth of the company. The capital requirements of the business concern may be classified into two categories: (a) Fixed capital (b) Working capital. Fixed Capital Fixed capital is the capital, which is needed for meeting the permanent or long-term purpose of the business concern. Fixed capital is required mainly for the purpose of meeting capital expenditure of the business concern and it is used over a long period. It is the amount invested in various fixed or permanent assets, which are necessary for a business concern. Definition of Fixed Capital According to the definition of Hoagland, “Fixed capital is comparatively easily defined to include land, building, machinery and other assets having a relatively permanent existence”. Character of Fixed Capital ● Fixed capital is used to acquire the fixed assets of the business concern. ● Fixed capital meets the capital expenditure of the business concern. ● Fixed capital normally consists of long period. ● Fixed capital expenditure is of nonrecurring nature. ● Fixed capital can be raised only with the help of long-term sources of finance. Working Capital Working capital is the capital which is needed to meet the day-to-day transaction of the business concern. It may cross working capital and net working capital. Normally working capital consists of various compositions of current assets such as inventories, bills, receivable, debtors, cash, and bank balance and prepaid expenses. According to the definition of Bonneville, “any acquisition of funds which increases the current assets increase the Working Capital also for they are one and the same”. Working capital is needed to meet the following purpose: ● Purchase of raw material ● Payment of wages to workers ● Payment of day-to-day expenses ● Maintenance expenditure etc.

54

CAPITALIZATION: Meaning Capitalization refers to the process of determining the quantum of funds that a firm needs to run its business. Capitalization is only the par value of share capital and debenture and it does not include reserve and surplus. Definition of Capitalization According to Guthman and Dougall, “capitalization is the sum of the par value of stocks and bonds outstanding”. According to Arhur. S. Dewing, “capitalization is the sum total of the par value of all shares”. TYPES OF CAPITALIZATION Capitalization may be classified into the following three important types based on its nature: • Over Capitalization • Under Capitalization • Water Capitalization 1. Over Capitalization Over capitalization refers to the company which possesses an excess of capital in relation to its activity level and requirements. In simple means, over capitalization is more capital than actually required and the funds are not properly used. According to Bonneville, Dewey and Kelly, over capitalization means, “when a business is unable to earn fair rate on its outstanding securities”. Example A company is earning a sum of Rs. 50,000 and the rate of return expected is 10%. This company will be said to be properly capitalized. Suppose the capital investment of the company is Rs. 60,000, it will be over capitalization to the extent of Rs. 1,00,000. The new rate of earning would be: 50,000/60,000×100=8.33% When the company has over capitalization, the rate of earnings will be reduced from 10% to 8.33%. Causes of Over Capitalization Over capitalization arise due to the following important causes: • Over issue of capital by the company. • Borrowing large amount of capital at a higher rate of interest. • Excessive payment for acquisition of goodwill. 2. High rate of taxation. 3. Under estimation of capitalization rate. Effects of Over Capitalization Over capitalization leads to the following important effects: • Reduce the rate of earning capacity of the shares. • Difficulties in obtaining necessary capital to the business concern. • It leads to fall in the market price of the shares. • It creates problems on re-organization. 55

•

It leads under or misutilisation of available resources.

Remedies for Over Capitalization Over capitalization can be reduced with the help of effective management and systematic design of the capital structure. The following are the major steps to reduce over capitalization. • Efficient management can reduce over capitalization. • Redemption of preference share capital which consists of high rate of dividend. • Reorganization of equity share capital. • Reduction of debt capital. 2. Under Capitalization Under capitalization is the opposite concept of over capitalization and it will occur when the company’s actual capitalization is lower than the capitalization as warranted by its earning capacity. Under capitalization is not the so called inadequate capital. Under capitalization can be defined by Gerstenberg, “a corporation may be under capitalized when the rate of profit is exceptionally high in the same industry”. Hoagland defined under capitalization as “an excess of true assets value over the aggregate of stocks and bonds outstanding”. Causes of Under Capitalization Under capitalization arises due to the following important causes: • Under estimation of capital requirements. • Under estimation of initial and future earnings. • Maintaining high standards of efficiency. Effects of Under Capitalization Under Capitalization leads certain effects in the company and its shareholders. • It leads to manipulate the market value of shares. • It increases the marketability of the shares. xi Consumers feel that they are exploited by the company. xii It leads to high competition. Remedies of Under Capitalization Under Capitalization may be corrected by taking the following remedial measures: = = = =

Under capitalization can be compensated with the help of fresh issue of shares. Increasing the par value of share may help to reduce under capitalization. Under capitalization may be corrected by the issue of bonus shares to the existing shareholders. Reducing the dividend per share by way of splitting up of shares.

3. Watered Capitalization If the stock or capital of the company is not mentioned by assets of equivalent value, it is called as watered stock. In simple words, watered capital means that the realizable value of assets of the company is less than its book value. According to Hoagland’s definition, “A stock is said to be watered when its true value is less than its book value.” 56

Causes of Watered Capital Generally watered capital arises at the time of incorporation of a company but it also arises during the life time of the business. The following are the main causes of watered capital: 1. Acquiring the assets of the company at high price. 2. Adopting ineffective depreciation policy. 3. Worthless intangible assets are purchased at higher price. *********************

CHAPTER: 7 CAPITAL EXPENDITURE A. Meaning of Capital Structure B. Factors determining capital structure indifference D. Practical problems

C. Point of

Meaning of Capital Structure Capital structure refers to the kinds of securities and the proportionate amounts that make up capitalization. It is the mix of different sources of long-term sources such as equity shares, preference shares, debentures, long-term loans and retained earnings. The term capital structure refers to the relationship between the various long-term source financing such as equity capital, preference share capital and debt capital. Definition of Capital Structure According to the definition of Presana Chandra, “The composition of a firm’s financing consists of equity, preference, and debt”. According to the definition of R.H. Wessel, “The long term sources of fund employed in a business enterprise”. FINANCIAL STRUCTURE The term financial structure is different from the capital structure. Financial structure shows the pattern total financing. It measures the extent to which total funds are available to finance the total assets of the business. Financial Structure = Total liabilities Or Financial Structure = Capital Structure + Current liabilities.

57

The following points indicate the difference between the financial structure and capital structure. Financial Structures

Capital Structures

1. It includes both long-term and short-term sources of funds 2. It means the entire liabilities side of the balance sheet.

1. It includes only the long-term sources

3. Financial structures consist of all sources of capital.

3. It consists of equity, preference and retained earning capital. 4. It is one of the major determinations of the value of the firm.

4. It will not be more important while determining the value of the firm.

2. It means only the long-term liabilities of the company.

POINT OF INDIFFERENCE: The cost indifference point analysis tool determines the point at which there is no difference in cost between two alternative methods. Used to compare two strategies, this analysis can be used to decide between different cost structures or selling prices. Example From the following information, calculate the capitalization, capital structure and financial structures. Balance Sheet

Liabilities Equity share capital Preference share capital Debentures Retained earnings Bills payable Creditors

Assets 50,000 5,000 6,000 4,000 2,000 3,000 70,000

Fixed assets Good will Stock Bills receivable Debtors Cash and bank

25,000 10,000 15,000 5,000 5,000 10,000 70,000

(i) Calculation of Capitalization S. No. 1. 2. 3.

Sources Equity share capital Preference share capital Debentures Capitalization

Amount 50,000 5,000 6,000 61,000

(ii) Calculation of Capital Structures S. No. 1. 2. 3. 4.

Sources Equity share capital Preference share capital Debentures Retained earnings

Amount 50,000 5,000 6,000 4,000 65,000

Proportion 76.92 7.69 9.23 6.16 100% 58

(iii) Calculation of Financial Structure S. No. 1. 2. 3. 4. 5. 6.

Sources Equity share capital Preference share capital Debentures Retained earnings Bills payable Creditors

Amount 50,000 5,000 6,000 4,000 2,000 3,000 70,000

Proportion 71.42 7.14 8.58 5.72 2.85 4.29 100%

OPTIMUM CAPITAL STRUCTURE Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and thereby the value of the firm is maximum. Optimum capital structure may be defined as the capital structure or combination of debt and equity, that leads to the maximum value of the firm. Objectives of Capital Structure Decision of capital structure aims at the following two important objectives: 1. Maximize the value of the firm. 2. Minimize the overall cost of capital. Forms of Capital Structure Capital structure pattern varies from company to company and the availability of finance. Normally the following forms of capital structure are popular in practice. • Equity shares only. • Equity and preference shares only. • Equity and Debentures only. • Equity shares, preference shares and debentures.

FACTORS DETERMINING CAPITAL STRUCTURE The following factors are considered while deciding the capital structure of the firm. 1. Leverage It is the basic and important factor, which affect the capital structure. It uses the fixed cost financing such as debt, equity and preference share capital. It is closely related to the overall cost of capital. 2. Cost of Capital Cost of capital constitutes the major part for deciding the capital structure of a firm. Normally long- term finance such as equity and debt consist of fixed cost while mobilization. When the cost of capital increases, value of the firm will also decrease. Hence the firm must take careful steps to reduce the cost of capital. 59

(a) Nature of the business: Use of fixed interest/dividend bearing finance depends upon the nature of the business. If the business consists of long period of operation, it will apply for equity than debt, and it will reduce the cost of capital. (b) Size of the company: It also affects the capital structure of a firm. If the firm belongs to large scale, it can manage the financial requirements with the help of internal sources. But if it is small size, they will go for external finance. It consists of high cost of capital. (c) Legal requirements: Legal requirements are also one of the considerations while dividing the capital structure of a firm. For example, banking companies are restricted to raise funds from some sources. (d) Requirement of investors: In order to collect funds from different type of investors, it will be appropriate for the companies to issue different sources of securities. 3. Government policy Promoter contribution is fixed by the company Act. It restricts to mobilize large, long-term funds from external sources. Hence the company must consider government policy regarding the capital structure. ********************* CHAPTER: 8 WORKING CAPITAL MANAGEMENT A. Concept of working capital and under trading

B. Factors determining working capital needs

C. Over trading

DEFINITION OF WORKING CAPITAL According to the definition of Shubin, “Working Capital is the amount of funds necessary to cover the cost of operating the enterprises”. According to Weston and Brigham, “Working capital generally stands for excess of current assets over current liabilities. Working capital management therefore refers to all aspects of the administration of both current assets and current liabilities”. CONCEPT OF WORKING CAPITAL Working capital can be classified or understood with the help of the following two important concepts.

60

1. Gross Working Capital Gross Working Capital is the general concept which determines the working capital concept. Thus, the gross working capital is the capital invested in total current assets of the business concern. Gross Working Capital is simply called as the total current assets of the concern. Gross Working Capital = Current Assets 2. Net Working Capital Net Working Capital is the specific concept, which, considers both current assets and current liability of the concern. Net Working Capital is the excess of current assets over the current liability of the concern during a particular period. If the current assets exceed the current liabilities it is said to be positive working capital; it is reverse, it is said to be Negative working capital. Net Working Capital = Current Asset – Current Liabilities COMPONENT OF WORKING CAPITAL Working capital constitutes various current assets and current liabilities. This can be illustrated by the following chart.

FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS 1) Nature of Business : The quantum of Working Capital required by a business organisation is related to the type and nature of its business activities. Public utilities (like railway companies) require less Working Capital as they sell services on cash basis only. But a trading organisation requires proportionately larger amount of Working Capital as it has to carry large inventories and allow credit to customers. 2) Size of Business : It is an important factor for determining the proportion of Working Capital. If the size of the business organisation in big, it require more Working Capital. On the other hand, small scale organisation requires less amount of Working Capital. 61

3) Production Policies : Production policies of a business organisation exert considerable influence on the requirement of Working Capital. But production policies depend on the nature of product. The level of production, decides the investment in current assets which in turn decides the quantum of working capital required. 4) Terms of Purchase and Sale : A business organisation making purchases of goods on credit and selling the goods on cash terms would require less Working Capital whereas an organisation selling the goods on credit basis would require more Working Capital. If the payment is to be made in advance to suppliers, then large amount of Working Capital would be required. 5) Dividend Policies : Dividend policies of a business organisation also influence the requirement of Working Capital. If a business is following a liberal dividend policy, it requires high Working Capital to pay cash dividends where as a firm following a conservative dividend policy will require less amount of Working Capital. 6) Seasonal Variations : In case of seasonal industries like Sugar, Oil mills etc. More Working Capital is required during peak seasons as compared to slack seasons. 8) Business Cycle : Business expands during the period of prosperity and declines during the period of depression. More Working Capital is required during the period of prosperity and less Working Capital is required during the period of depression. 9) Change in Technology : Changes in Technology as regards production have impact on the need of Working Capital. A firm using labour oriented technology will require more Working Capital to pay labour wages regularly. 10) Inflation : During inflation a business concern requires more Working Capital to pay for raw materials, labour and other expenses. This may be compensated to some extent later due to possible rise in the selling price. IMPORTANCE OF WORKING CAPITAL a) Enables a company to meet its obligations. b) Ensures the credit standing of a company. c) Facilitates obtaining Credit from banks without any difficulty. d) Ensures solvency of a company. e) Enables a company to make prompt payments to its creditors and thereby take advantage of cash and quantity discounts offered by them. f) Improves the prospects of prosperity and progress of a company. g) Enables an organisation to tide over difficult periods successfully. OVER TRADING : A company which is under-capitalized will try to do too much with the limited amount of capital which it has. For example it may not maintain proper stock of stock. Also it may not extend much credit to customers and may insist only on cash basis sales. It may also not pay the creditors on time. UNDER TRADING : Under-trading is the reverse of over-trading. It means keeping funds idle and not using them properly. This is due to the under employment of assets of the business, leading to the fall of sales and results in financial crises. This makes the business unable to meet its commitments and ultimately leads to forced liquidation. Under trading is an aspect of over-capitalization and leads to low profit. 62

CHAPTER: 9 BASICS OF CAPITAL BUDGETING A. Importance of Capital Budgeting B. Capital Budgeting appraising methods C. Payback period D. Average rate of return E. Net Present Value F. Profitability index G. Internal rate of return H. Practical problems Capital Budgeting The word Capital refers to be the total investment of a company of firm in money, tangible and intangible assets. Whereas budgeting defined by the “Rowland and William” it may be said to be the art of building budgets. Budgets are a blue print of a plan and action expressed in quantities and manners. The examples of capital expenditure: 1. Purchase of fixed assets such as land and building, plant and machinery, good will, etc. 2. The expenditure relating to addition, expansion, improvement and alteration to the fixed assets. 3. The replacement of fixed assets. 4. Research and development project. Definitions According to the definition of Charles T. Hrongreen, “capital budgeting is a long-term planning for making and financing proposed capital out lays. According to the definition of Richard and Green law, “capital budgeting is acquiring inputs with long-term return”. Need and Importance of Capital Budgeting 1. Huge investments: Capital budgeting requires huge investments of funds, but the available funds are limited, therefore the firm before investing projects, plan are control its capital expenditure. 2. Long-term: Capital expenditure is long-term in nature or permanent in nature. Therefore financial risks involved in the investment decision are more. If higher risks are involved, it needs careful planning of capital budgeting. 3. Irreversible: The capital investment decisions are irreversible, are not changed back. Once the decision is taken for purchasing a permanent asset, it is very difficult to dispose off those assets without involving huge losses. 4. Long-term effect: Capital budgeting not only reduces the cost but also increases the revenue in long-term and will bring significant changes in the profit of the company by avoiding over or more investment or under investment. Over investments leads to be unable to utilize assets or over utilization of fixed assets. Therefore before making the investment, it is required carefully planning and analysis of the project thoroughly. METHODS OF CAPITAL BUDGETING OF EVALUATION By matching the available resources and projects it can be invested. The funds available are always living funds. There are many considerations taken for investment decision process such as environment and economic conditions. 63

The methods of evaluations are classified as follows: (A) Traditional methods (or Non-discount methods) (i) Pay-back Period Methods (ii) Average (Accounts) Rate of Return (B) Modern methods (or Discount methods) (i) Net Present Value Method (ii) Internal Rate of Return Method (iii) Profitability Index Method 1. PAY-BACK PERIOD METHODS Pay-back period is the time required to recover the initial investment in a project. (It is one of the non-discounted cash flow methods of capital budgeting). Pay – back period = Initial investment Annual Cash inflows Annual Cash inflows is always before depreciation and after tax Merits of Pay-back method The following are the important merits of the pay-back method: 1. It is easy to calculate and simple to understand. 2. Pay-back method provides further improvement over the accounting rate return. 3. Pay-back method reduces the possibility of loss on account of obsolescence. Demerits 1. It ignores the time value of money. 2. It ignores all cash inflows after the pay-back period. 3. It is one of the misleading evaluations of capital budgeting. Accept /Reject criteria If the actual pay-back period is less than the predetermined pay-back period, the project would be accepted. If not, it would be rejected. Practical Problem: 1 Project cost is Rs. 30,000 and the cash inflows are Rs. 10,000, the life of the project is 5 years. Calculate the pay-back period. Pay – back period = Initial investment Annual Cash inflows Pay – back period =

Rs. 30,000

= 3 Years

Rs. 10,000

The actual pay-back period is (3 years) less than the predetermined pay-back period (5 year), the project would be accepted. 64

Practical Problem: 2 From the following particulars, compute Payback period. Cash outflow Annual cash inflow (After tax before depreciation) Estimate Life Pay – back period =

Rs. 1,00,000 Rs. 25,000 6 years Initial investment Annual Cash inflows

Pay – back period = Rs. 1,00,000 Rs. 25,000

= 4 Years

The actual pay-back period is (4 years) less than the predetermined pay-back period (6 year), the project would be accepted. Practical Problem: 3 Certain projects require an initial cash outflow of Rs. 25,000. The cash inflows for 6 years are Rs. 5,000, Rs. 8,000, Rs. 10,000, Rs. 12,000, Rs. 7,000 and Rs. 3,000. Solution Year 1 2 3 4 5 6

Cash Inflows (Rs.) 5,000 8,000 10,000 12,000 7,000 3,000

Cumulative Cash Inflows (Rs.) 5,000 13,000 23,000 35,000 42,000 45,000

The above calculation shows that in 3 years Rs. 23,000 has been recovered Rs. 2,000, is balance out of cash outflow. In the 4th year the cash inflow is Rs. 12,000. It means the pay-back period is three to four years, calculated as follows Pay-back period = 3 years+2000/12000×12 months = 3 years 2 months. The actual pay-back period is (3 years 2 months) less than the predetermined pay-back period (6 year), the project would be accepted. Practical Problem: 4 25.11.2013 There are two projects A & B. Each project require an investment of Rs. 2,00,000/-. Rank these projects according to the ‘Pay Back Period’ method on the basis of the following information:

65

Years 1 2 3 4 5

Project A 10,000 20,000 40,000 50,000 80,000

PROFIT/ INFLOWS OF CASH Project B 20,000 40,000 60,000 80,000 -

Years

Project A Cash Inflows (Rs.)

1 2 3 4 5

10,000 20,000 40,000 50,000 80,000

Cumulative Cash Inflows (Rs.) 10,000 30,000 70,000 1,20,000 2,00,000

Project B Cash Inflows (Rs.) 20,000 40,000 60,000 80,000 0

Cumulative Cash Inflows (Rs.) 20,000 60,000 1,20,000 2,00,000 2,00,000

Project A : The above calculation shows that in 5th years Rs. 2,00,000 has been recovered. Therefore Payback period for Project A is 5 years. Project B The above calculation shows that in 4th years Rs. 2,00,000 has been recovered. Therefore Payback period for Project B is 4 years. Hence the pay - back period of Project B is less than Project A. Therefore Project B would be accepted. Practical Problem: 5 21.11.2016 A project cost Rs.25,000/-. The net profits before depreciation and tax, and tax rate 20% for the five years. Following are the expected cash flows to be: Years Project A 1 5,000 2 6,000 3 7,000 4 8,000 5 10,000 You are required to calculate payback period. Years

Cash inflow

1 2 3 4 5

5,000 6,000 7,000 8,000 10,000

Cash inflow after tax 4,000 4,800 5,600 6,400 8,000

Cumulative Cash Inflows (Rs.) 4,000 8,800 14,400 20,800 28,800

The above calculation shows that in 4 years Rs. 20,800 has been recovered, Rs. 4,200 is balance out 66

of cash outflow. In the 5th year the cash inflow is Rs. 8,000. It means the pay-back period is four to five years, calculated as follows Pay-back period = 4 years+4,200/8000×12 months = 4 years 6 months.

2. ACCOUNTING RATE OF RETURN OR AVERAGE RATE OF RETURN (ARR) Average rate of return means the average rate of return or profit taken for considering the project evaluation. This method is one of the traditional methods for evaluating the project proposals: Merits 1. 2. 3. 4.

It is easy to calculate and simple to understand. It is based on the accounting information rather than cash inflow. It is not based on the time value of money. It considers the total benefits associated with the project.

Demerits 1. It ignores the time value of money. 2. It ignores the reinvestment potential of a project. 3. Different methods are used for accounting profit. So, it leads to some difficulties in the calculation of the project. Accept/Reject criteria If the actual accounting rate of return is more than the predetermined required rate of return, the project would be accepted. If not it would be rejected. ARR

=

Annual Average net earnings Original investment

X 100

Practical Problem: 6 A company is considering investment of Rs. 10,00,000 in a project. The following are the income forecasts, after depreciation and tax: 1st year loss Rs. 1,00,000 4th year profit Rs. 2,00,000 nd 2 year profit Rs.3,00,000 5th year profit Rs. 2,00,000 rd 3 year profit Rs.4,00,000 Calculate the Average rate of return. Solution: ARR

=

Annual Average net earnings Original investment

X 100

Annual Average net earnings = -1,00,000 + 3,00,000 + 4,00,000 + 2,00,000 + 2,00,000 5 67

ARR = 2,00,000 10,00,000

= 10,00,000 5 X 100 = 20 %

= Rs. 2,00,000

3. NET PRESENT VALUE Net present value method is one of the modern methods for evaluating the project proposals. In this method cash inflows are considered with the time value of the money. Net present value describes as the summation of the present value of cash inflow and present value of cash outflow. Net present value is the difference between the total present value of future cash inflows and the total present value of future cash outflows. Merits 1. 2. 3. 4.

It recognizes the time value of money. It considers the total benefits arising out of the proposal. It is the best method for the selection of mutually exclusive projects. It helps to achieve the maximization of shareholders’ wealth.

Demerits 1. It is difficult to understand and calculate. 2. It needs the discount factors for calculation of present values. 3. It is not suitable for the projects having different effective lives. Accept/Reject criteria If the present value of cash inflows is more than the present value of cash outflows, it would be accepted. If not, it would be rejected. Practical problem: 7 25.11.2013 Rank the following projects in the order of their desirability according to the Net Present Value Method: Year 1 Rs. 5,000 20,000

Project x Project y

Year 2 Rs. 10,000 10,000

Year 3 Rs. 10,000 5,000

Year 4 Rs. 3,000 3,000

Year 5 Rs. 2,000 2,000

Initial investment: Project A - `20000 Project B - `30000 Discount rate 10% Present value `1/- @10% (discount factor) using present value tables: Year Factor

1

2

0.909

0.826

3 0.751

4 0.683

5

6

0.621

0.564

68

Solution: Cash Inflows Year 1 2 3 4 5

Project X Rs. Project Y Rs. 5,000 20,000 10,000 10,000 10,000 5,000 3,000 3,000 2,000 2,000

Present Value of Rs. 1 @ 10% 0.909 0.826 0.751 0.683 0.621

Present Value of Net Cash Inflow Project X Rs. Project Y Rs. 4,545 18,180 8,260 8,260 7,510 3,755 2,049 2,049 1,242 1,242

Total present value Initial investments Net present value

23,606 20,000 3,606

33,486 30,000 3,486

Project Y should be selected as net present value of project Y is higher than project X.

Practical problem: 8 21.11.2015 From the following data, calculate the „Net Present Value‟ of two projects viz. X&Y and suggest which of the two projects should be accepted assuming a discount rate of 10%: Sl. Particulars Project X (Rs.) Project Y (Rs.) No. 1 Initial Investment 50,000/60,000/2 Estimated Life 5 years 5 years 3 Scrap Value 1,000/1,000/The profits before depreciation and after taxes (cash flows) are as follows: Year 1 Year 2 Year 3 Year 4 Rs. Rs. Rs. Rs. Project x 10,000 15,000 10,000 15,000 Project y 10,000 15,000 15,000 15,000 Present value at 10% of Re.1/- is as under: Year 1 2 3 Factor 0.909 0.826 0.751

4 0.683

5 0.621

Year 5 Rs. 10,000 15,000

6 0.564

69

Solution: Cash Inflows Year Project X Rs. Project Y Rs. 1 10,000 10,000 2 15,000 15,000 3 10,000 15,000 4 15,000 20,000 5 10,000 15,000 Scrap Value 1,000 2,000 Total present value Initial investments Net present value

Present Value of Rs. 1 @ 10% 0.909 0.826 0.751 0.683 0.621 0.621

Present Value of Net Cash Inflow Project X Rs. Project Y Rs. 9,090 9,090 12,390 12,390 7,510 11,265 10,245 13,660 6210 9,315 621 1,242 46,066 56,962 50,000 60,000 3,934 3,038

Project X should be selected as net present value of project X is higher than project Y.

4. INTERNAL RATE OF RETURN Internal rate of return is time adjusted technique and covers the disadvantages of the traditional techniques. In other words it is a rate at which discount cash flows to zero. It is expected by the following ratio: Factor to be located =

Investment initial Cash inflow

Merits 1. 2. 3. 4.

It consider the time value of money. It takes into account the total cash inflow and outflow. It does not use the concept of the required rate of return. It gives the approximate/nearest rate of return.

Demerits 1. It involves complicated computational method. 2. It produces multiple rates which may be confusing for taking decisions. 3. It is assume that all intermediate cash flows are reinvested at the internal rate of return. Accept/Reject criteria If the present value of the sum total of the compounded reinvested cash flows is greater than the present value of the outflows, the proposed project is accepted. If not it would be rejected. Practical problem: 8 A project costs Rs. 80,000 and is estimated to generate cash inflow of Rs. 20,000 for a period of 5 years. Ascertain the internal rate of return (IRR). Factor to be located =

Investment initial Cash inflow 70

F

= I C

F = 80,000 20,000 = 4 Factor of 4 should be located in annuity table II in the line of 5 years. The discounting percentage is somewhere between 8 % and 6 %. 3.993 present value of annuity of Re. 1 8 %. 4.212 present value of annuity of Re. 1 6 %. Since 3.993 is very near to 4. IRR may be taken as 8 %.

5. PROBABILITY INDEX (P.I) Probability technique refers to the each event of future happenings are assigned with relative frequency probability. Probability means the likelihood of future event. The cash inflows of the future years further discounted with the probability. The higher present value may be accepted. Capital Rationing In the rationing the company has only limited investment the projects are selected according to the profitability. The project has selected the combination of proposal that will yield the greatest portability. Probability index

= Present Value (present value of cash Inflows) Initial Investment (present value of cash outflows)

Practical problem: 9 Rank the following projects in the order of their desirability according to the Net Present Value Method: Year 1 Rs. 5,000 20,000

Project x Project y

Year 2 Rs. 10,000 10,000

Year 3 Rs. 10,000 5,000

Year 4 Rs. 3,000 3,000

Year 5 Rs. 2,000 2,000

Initial investment: Project A - `20000 Project B - `30000 Discount rate 10% Present value `1/- @10% (discount factor) using present value tables: Year Factor

1

2

0.909

0.826

3 0.751

4 0.683

5

6

0.621

0.564

71

Solution: Cash Inflows Year 1 2 3 4 5

Project X Rs. Project Y Rs. 5,000 20,000 10,000 10,000 10,000 5,000 3,000 3,000 2,000 2,000

Present Value of Rs. 1 @ 10% 0.909 0.826 0.751 0.683 0.621

Present Value of Net Cash Inflow Project X Rs. Project Y Rs. 4,545 18,180 8,260 8,260 7,510 3,755 2,049 2,049 1,242 1,242

Total present value Initial investments Net present value

23,606 20,000 3,606

33,486 30,000 3,486

Project X Probability index = 23,606 20,000

=

1.18

Project Y Probability index = 33,486 30,000

= 1.12

Project X should be selected, as P.I project X is higher than project Y.

**********************

72