Financial Management

FINANCIAL MANAGEMENT

PROF. SATISH INAMDAR M.Com., L.L.B., F.C.A., Gr.C.W.A., A.C.S.

(FOR PRIVATE CIRCULATION ONLY)

Published by

Symbiosis Center for Distance Learning, Pune.

© Symbiosis Center for Distance Learning (SCDL) No part of this book may be reproduced or copied or transmitted in any form without prior permission of the publishers.

2005 Batch

PREFACE Finance is the most basic and the most significant function in virtually every business activity. The success of business activity depends upon the success of its finance function. From academic point of view, finance is the subject which is considered to be one of the most technical ones, having a very wide scope and having constantly changing rules & regulations. This is the reason why a normal student attempts to keep himself away from the subject of finance. This aggravates the problems for the students. One cannot afford to ignore the function of finance. The ultimate evaluation of any business activity is profit-based evaluation and the term profit itself is the financial phenomenon. As such, one needs to get acquainted with the basics of finance, despite the hardships involved in the process. My objective of writing this book is to introduce the basic principles of finance to a nontechnical student in the simplest possible language. As such, I have deliberately avoided too much of quantitative or mathematical elaboration or explanation to any of the basic concepts or principles. I have attempted to explain the basic concepts with the help of examples and illustrations. Good numbers of problems have been incorporated for self-study. I am thankful to Symbiosis Center for Distance Learning and Ms. Swati Chaudhary, Director, SCDL, in particular for providing me this opportunity to reach out to a very wide spectrum of readership. Maximum efforts have been made to incorporate the latest status of the subject. Maximum care has been taken to make the text free of errors. Still, I don’t rule out the possibility of some omissions. I will be obliged if such omissions can be pointed out and intimated so that necessary modifications can be done in the subsequent editions.

Prof. Satish Inamdar 5, Brahma Residency, Bhusari Colony, Kothrud, Pune 411 038 Tel.: (020) 528 2058 / 528 5749 Email : [email protected]

ABOUT THE AUTHOR Prof. Satish Inamdar is holding a Master’s Degree in Commerce and Bachelor’s Degree in Law. He is fellow Member of the Institute of Chartered Accountants of India, Graduate Member of The Institute of Cost & Works Accountants of India and Associate Member of The Institute of Company Secretaries of India. He is associated with the industry for the last two decades in various senior capacities. For the past fifteen years, he is associated with Symbiosis Institute of Business Management as a Faculty of Finance. He has conducted Management Development Programmes and Executive Development Programmes for various private sector and public sector organisations. He has authored three books on the subjects like Cost & Management Accounting and Financial Management. He is the Charter Member of Rotary Club of Pune, Kothrud.

Mrs. Swati Chaudhari Director – SCDL

CONTENTS Chapter No.

TITLE

Page No.

1

Finance Function – Approaches to the term Finance – Scope of Finance Function – Goals/Objects of Finance Function – Organisation of Finance Function – The Fields of Finance – Finance Function in Relation with Other Functions

2

Forms of Business Organisation – Proprietory Firms, Partnership Firms, Joint Stock Companies – Advantages and Disadvantages

15

3

Financial Statements – Nature of Financial Statements – Basic Concepts in Accounting – Structure of Financial Statements – Role played by Financial Statements – Limitation of Financial Statements – Analysis and Interpretation of Financial Statements

25

4

Interpretation of Financial Statements (Ratio Analysis) – Role of Ratio Analysis – Classification of Ratios – Illustrative problems with solutions – Problems for students to solve

45

5

Interpretation of Financial Statements (Funds Flow / Cash Flow Statements) – Concept of Funds, Uses, Limitations – Construction of Funds Flow Statement – Cash Flow Statement

1

145

Chapter No.

TITLE

– –

Page No.

Illustrative Problems with Solutions Problems for Students to Solve

6

Capitalisation – Importance – Theories of Capitalisation – Overcapitalisation - Causes, Effects, Remedies – Undercapitalisation - Causes, Effects, Remedies

211

7

Sources of Long Term and Medium Term Finance – Shares - Advantages, Disadvantages – Debentures - Advantages, Disadvantages – Term Loans, Features of Term Loans – Public Deposits – Lease Financing, Advantages, Types of Leases – Retained Earnings

225

8

Capital Structure Part - I - Capital Structure – Goals/Principles of Capital Structure Management – Factors affecting Capital Structure - Internal, External and General Part - II - Cost of Capital – Concepts of Cost of Capital – Composite Cost of Capital – Illustration with Solutions Part - III - Leverages – Operating Costs - Variable, Fixed, Semi-Variable – Leverages - Operating, Financial, Combined Part - IV - Theories of Capital Structure – Capital Structure and Cost of Capital – Illustrative Problems with Solutions – Problems for Students to Solve

249

Chapter No.

TITLE

Page No.

9

Capital Market – Capital Market in General – Intermediaries in Capital Market – Credit Rating, Methodology, Limitations – Venture Capital

297

10

Capital Budgeting – Importance of Capital Budgeting, – Process of Capital Budgeting - Evaluations, Selection, Execution – Cash Flows, Time Value of Money – Illustration with Solutions – Relevance in Capital Budgeting Decisions – Techniques of Evaluation of Capital Expenditure Proposals - Advantages, Disadvantages – Limitations of Capital Budgeting – Planning, Organisation and Control of Capital Expenditure – Capital Rationing – Capital Budgeting and Risk – Illustrations with Solutions Pay Back Period, NPV, ARR, IRR – Problems for Students to Solve

319

11

Working Capital Management – Working Capital - The Term – Principles of Working Capital Management – Factors affecting Working Capital Requirement – Financing of Working Capital Requirement – Control over Working Capital - Dahejia Committee, Tandon Committee, Chhore Committee, Marathe Committee, Nayak Committee and Vaz Committee

373

Chapter No.

TITLE

– –

Page No.

Illustrative Problems with Solutions Problems for Students to Solve

12

Management of Cash – Motives of Holding Cash – Estimation of Cash Requirement – Principles of Cash Management – Illustrative Problems with Solutions – Problems for Students to Solve

415

13

Management of Receivables – Object – Areas Covered - Credit Analysis, Credit Terms, Financing Receivables, Credit Collection, Monitoring of Receivables – Techniques available on Macro and Micro basis – Factoring, Bill Discounting, Advantages, Disadvantages – Illustrative Problems with Solutions – Problems for Students to Solve

437

14

Management of Inventory – Catagories of Inventory – Motives of Holding Inventory – Objects of Inventory Management – Techniques of Inventory Management – Inventory Levels, Calculation of Levels – Illustrations with Solutions – ABC Analysis – Problems for Students to Solve

463

Chapter No.

15

TITLE

Page No.

Dividend Policy – Factors determining the Dividend Policy External and Internal – Choosing of Dividend Policy – Forms of Dividend Payment – Bonus Shares - Advantages, Disadvantages

495

Reference Books

509

Chapter 1 FINANCE FUNCTION

A business is an activity which is carried on with the intention of earning the profits. If the operations of a typical manufacturing organisation are considered, it involves the purchasing of raw material, processing the same with the help of various factors of production like labour and machinery, manufacturing the final product and selling the finished product in the market to earn the profits. Thus, production, marketing and finance are the key operational areas in case are of a manufacturing organisation, out of which finance, is the most crucial one. This is so, as the functions of production and marketing are related with the function of finance. If the decisions relating to money or funds fail, it may result into the failure of the business organisation as a whole. Hence, it is utmost important to take the proper financial decisions and that too at a proper point of time. In practical situations, in order to overcome temporary financial problems, the organisations tend to take the hasty decisions which may prove to be fatal over a longer span of time. APPROACHES TO THE TERM FINANCE The concept of finance has changed markedly with the change in times and circumstances. The various views on the finance can be categorised as stated below. (1)

According to the first approach, the term finance was interpreted to mean the procurement of funds by corporate enterprises to meet their financing needs. The term ‘procurement’ was used in a broad sense to include the whole gamut of raising the funds externally. This approach towards finance was criticised on various grounds. a.

It is too narrow and restrictive in nature. Procurement of the funds is only one of the functions of finance and other functions are ignored by this approach.

b.

It considers the financial problems only of corporate enterprises. In that sense, it ignores the financial problems of non-corporate entities like proprietary concerns, partnership firms etc.

Finance Function

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c.

It considers only the basic and non-recurring problems relating to the business. Day-to-day financial problems of a normal company do not receive any attention.

d.

It concentrates only on long term financing. It means that the working capital management is out of the purview of finance function.

(2)

The second approach holds that finance is concerned with cash. As all the transactions are ultimately expressed in terms of cash, the term finance will be concerned with every activity of the enterprise. Thus, according to this approach, the finance function is concerned with all the functional areas of the business e.g., Production, Marketing, Purchasing, Personnel Administration, Research and Development and so on. Obviously this approach is too broad to be meaningful.

(3)

The third approach, which is more balanced one and hence the acceptable one to the modern scholars, interprets the term finance as being concerned with procurement of funds and wise application of funds. This approach is supposed to be more acceptable as it gives equal weightage to both procurement of funds as well as utilisation of the funds. This approach is called the managerial approach to the term finance.

In the light of the above discussions, it will be worthwhile to note some of the definitions of the finance function given by some modern scholars. R.C. Osborn : The finance function is the process of acquiring and utilising funds of a business. Bonneville and Dewey : Financing consists of the raising, providing, managing of all the money, capital or funds of any kind to be used in connection with the business. Prather and Wert : Business finance deals primarily with raising, administering and disbursing funds by privately owned business units operating in non-financial fields of industry. SCOPE OF FINANCE FUNCTION According to the modern approach, the function of finance is concerned with the following three types of decisions – a.

Financing Decisions

b.

Investment Decisions

c.

Dividend Policy Decisions

FINANCING DECISIONS Financing decisions are the decisions regarding the process of raising the funds. This function of finance is concerned with providing the answers to the various questions like –

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a.

What should be the amount of funds to be raised? In simple words, the amount of funds to be raised by the organisation should not be more or less than what is required as both the situations involve the adverse consequences.

b.

What are the various sources available to the organisation for raising the required amount of funds? For the purpose of raising the funds, the organisation can go for internal sources as well as external sources.

c.

What should be the proportion in which the internal and external sources should be used by the organisation?

d.

If the organisation, particularly the corporate form of organisation, wants to raise the funds from different sources, it is required to comply with various legal and procedural formalities. Earlier, these legal and procedural formalities were prescribed and regulated by Controller of Capital Issues (CCI). Since 1992, after the abolition of the office of CCI, these formalities are prescribed and regulated by Securities and Exchange Board of India (SEBI). Though the intention of this subject is not to consider the SEBI regulations and guidelines in details, relevant SEBI guidelines are discussed at the appropriate places.

e.

During the last decade of the twentieth century, lot of changes have taken place in the capital market, which refers to the market available to the companies to raise the long term requirement of funds. The question arises what is the nature of capital market operations? What kinds of changes have taken place recently affecting the capital market in the country?

INVESTMENT DECISIONS Investment Decisions are the decisions regarding the application of funds raised by the organisation. The investment decisions relate to the selection of the assets in which the funds should be invested. The assets in which the funds can be invested are basically of two types – a.

Fixed Assets – Fixed Assets indicate the infrastructural facilities and properties required by the organisation. Fixed Assets are the assets which bring the returns to the organisation over a longer span of time. The investment decisions in these types of assets are technically referred to as “Capital Budgeting Decisions.” Capital Budgeting decisions are concerned with the answers to the questions like – 1.

How the fixed assets or proposals or projects should be selected to make the investment in? What are the various methods available to evaluate the investment proposals in the fixed assets?

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2.

b.

How the decisions regarding the investment in fixed assets or proposals or projects should be made in the situations of risk and uncertainty?

Current Assets – Current Assets are the assets which get generated during the course of operations and are capable of getting converted in the form of cash or getting utilized within a short span of time of one year. Current Assets keep on changing the form and shape very frequently. The investment decisions in these types of assets are technically referred to as “Working Capital Management.” Working Capital Management decisions are concerned with the answers to the questions like – 1.

What is the meaning of working capital management? What are the objectives of working capital management?

2.

Why the need for working capital arises?

3.

What are the factors affecting the requirement of working capital?

4.

How to quantify the requirement of working capital?

5.

What are the sources available for financing the requirement of working capital?

6.

Working capital management is concerned with the management of current assets on overall basis as well as on individual basis. In practical situations, current assets may be found in the form of cash and bank balances, receivables and inventory. Working capital management is concerned with the management of these individual components of current assets as well.

DIVIDEND POLICY DECISIONS Profits earned by the organisation belong to the owners of the organisation. In case of the corporate form of organisation, shareholders are the owners and they are entitled to receive the profits in the form of dividend. However, there is no specific law or statute which specifies as to how much amount of profits should be distributed by way of dividend and how much amount of profits should be retained in the business. The alternatives available to the organisation to distribute the profits in the form of dividend on one hand and retention of profits in the business, have reciprocal relationship with each other. If the dividends paid are higher, retained profits are less and vice versa. If the organisation pays higher dividends, shareholders are very happy as they get more recurring income and the company may be able to gain the confidence of the shareholders. However, the organisation can be in financial problems as payment of dividend results into the withdrawal of profits from the business. On the other hand, if the organisation pays less dividends, the organisation may be in a favourable situation. However, the shareholders are likely to be offended. As such, the organisation is required to take the decisions regarding the payment of dividend in such a way that neither the shareholders are offended nor the organization is in financial problems. As such, dividend policy decisions are

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Financial Management

the strategic financial decisions and are concerned with the answers to the questions like – 1.

What are the forms in which the dividends can be paid to the shareholders?

2.

What are the legal and procedural formalities to be completed while paying the dividend in different forms.

GOALS/OBJECTS OF FINANCE FUNCTION : Profit Maximization : As a basic principle, any business activity aims at earning the profits. According to this principle, all the functions of the business will have the profit as the main objective. Similarly, the finance function will also have the profits as the main objective. But this was only a traditional belief. Now, profit cannot be the sole and only goal or objective of the finance function, due to the following problems connected with this objective. (1)

The term profit is a ambiguous concept which isn’t having precise connotation. E.g. Profits can be long term or short term. Profits can be before tax or after tax and so on. If profit maximization is accepted as the goal of finance function, the next question that arises is “Which types of profits should be maximized?”

(2)

The profits always go hand in hand with risks. The more profitable ventures necessarily involve more amount of risk. The owners of the business will not like to earn more and more profits by accepting more risk. If the profit maximization is accepted as the goal of finance function, it totally ignores the risk factor.

(3)

Profit maximization as the goal of financial function ignores the time pattern of returns. Consider the following two proposals A and B which involve the same amount of returns. A (Rs.)

B (Rs.)

Year I

70,000

–

Year II

20,000

–

Year III

10,000

1,00,000

1,00,000

1,00,000

Both the proposals A and B involve same amount of profits and hence ideally should be treated on par. But it will not be proper as proposal A involves higher amount returns in the earlier years, while proposal B involves the returns in the later years. It makes proposal A more profitable ultimately, as the returns received earlier are more valuable than the returns received later. The objective of profit maximization doesn’t differentiate between the returns received earlier and the returns received later.

Finance Function

5

(4)

Profit maximization as the objective doesn’t take into consideration the social considerations as well as the obligations to various interests of workers, consumers, society etc., and the ethical trade practices. If these factors are ignored, the organisation can’t survive for long. Profit maximization at the cost of social and moral obligations is a short-sighted policy. As such, profit maximization can’t be a prime objective of the finance function. The objective has to be one having more broad a base, which is more precise, which considers risk factor and time value of money and which give consideration to social and ethical elements also. The alternative is in the form of wealth maximization as the objective of the finance function.

Wealth Maximization : Due to the limitations attached with the profit maximization as an objective of the finance function, it is no more accepted as the basic objective. As against it, it is now accepted that the objective of the business should be to maximize its wealth and value of the shares of the company. This object can also be stated as maximization of value. The value of an asset is judged not in terms of its cost but in terms of the benefit it produces. Similarly the value of a course of action is judged in terms of the benefits it produces less the cost of undertaking it. The benefits can be measured in terms of stream of future expected cash flows, but they must take into consideration not only their magnitude but also the extent of uncertainty. Thus, wealth maximization goal as a decision criteria suggests that, any financial action which creates wealth or which has discounted stream of future benefits exceeding its cost, is desirable and should be accepted and that which does not satisfy this test should be rejected. The goal of wealth maximization is supposed to be superior to the goal of profit maximization due to following reasons : (1)

It uses the concept of future expected cash flows rather than the ambiguous term of profits. As such, measurement of benefits in terms of cash flows avoids ambiguity.

(2)

It considers time value of money. It recognises that the cash flows generated earlier are more valuable than those generated later. That is why while computing value of total benefits, the cash flows are discounted at a certain discounting rate. At the same time, it recognises the concept of risk also, by making necessary adjustments in discounting rate. As such, cash flows of a project involving higher risk are discounted at a higher discounting rate and vice versa. Thus, the discounting rate used to discount future cash flows reflects the concepts of both time and risk.

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Financial Management

Due to the above reasons, the wealth maximization is considered to be superior to profit maximization as an objective or goal of finance function. However, it should be noted that wealth maximization goal is only an extension of profit maximization goal. If the time period is too short and risk element is minimum, both wealth maximization and profit maximization will mean the same thing. Organization of Finance Function : At the outset, it must be cleared that there is no standard pattern for the organization of finance function. It varies from the enterprise to enterprise and its characteristics also vary in terms of nature, size, convention etc. In smaller concerns, where the operations are relatively less complicated and simple, there may not be separate executive to look after finance function. In fact, the proprietor or partners only will be looking after all the functional areas like production, marketing, finance etc. In bigger concerns, the execution of finance function becomes a specialised task and may be handled by an executive who may be in the form of Treasurer, Finance Controller, Finance Manager, Vice-President (Finance) and so on. He is generally given the charge of credit and collection accounting, investment and audit departments. He is responsible for preparing annual financial reports. He reports directly to the President and Board of Directors. Secondly, it should be noted that generally the organization of finance function is centralised one, unlike other business functions. Board of Directors takes the main financial decisions. Board of Directors may delegate the powers to the executive committee, comprising of managing director, other one or two directors and finance officer of the company. This executive committee takes all the financial decisions. Routine financial matters may be delegated to lower level officers. The reasons for finance function being a highly centralised function are very obvious. (1)

Financial decisions are the most crucial ones on which survival or failure of the organisation depends.

(2)

Financial decisions affect the solvency position of the organisation and a wrong decision in this area may land the organisation into crisis.

(3)

The organisation may gain economies of centralization in the form of reduced cost of raising the funds, acquisition of fixed assets at the competitive prices etc.

Though there is no standard pattern for organization of finance function, in general terms, the organization of finance function takes the following form.

Finance Function

7

Board of Directors Executive Committee Vice President (Production)

Vice President (Finance)

Finance Controller

Vice President (Marketing) Treasurer

(1)

Accounting and Costing

(1) Receivables management

(2)

Annual Reporting

(2) Taxes and Insurance

(3)

Internal Auditing

(3) Cost management

(4)

Budgeting

(4) Securities

(5)

Statistics and Finance

(5) Banking Relations

(6)

Record Keeping

(6) Real Estates (7) Dividend Distribution

DUTIES AND RESPONSIBILITIES OF FINANCE EXECUTIVE : On the basis of the scope of the finance function, which has already been discussed, the various duties and responsibilities which a finance executive has to fulfil can be classified as below : (1)

Recurring Duties :

(2)

Non-recurring Duties :

Recurring Duties :

8

(a)

Deciding the Financial Needs : In case of a newly started or growing concern, the basic duty of the finance executive is to prepare the financial plan for the company. Financial plan decides in advance the quantum of funds required, their duration, etc. The funds may be needed by the company for initial promotional expenditure, fixed capital, working capital or for dividend distribution. The finance executive should assess this need of funds properly.

(b)

Raising the Funds Required : The finance executive has to choose the sources of funds to fulfil financial needs. The sources may be in the form of issue of shares, debentures, borrowing from financial institutions or general public, lease financing etc. The finance executive has also to decide the proportion in which the various sources should be raised. For this, he may have to keep in mind basic three principles of cost, risk and control. If the company decides to go in for issue of securities say in the form of shares

Financial Management

or debentures, he has to arrange for the underwriting or listing of the same. If the company decides to go in for borrowed capital, he has to negotiate with the lenders of the funds. (c)

Allocation of funds : The financial executive has to ensure proper allocation of funds. He can allocate the funds basically for two purposes. (i)

Fixed Assets Management : He has to decide in which fixed assets the company should invest the funds. He has to ensure that the fixed assets acquired or to be acquired satisfy the present as well as future needs of the company. He has to ensure that the funds invested in the fixed assets justify the investments in terms of the expected cash flows generated by them in future. If there are more than one proposals for making the investments in fixed assets, the finance executive has to decide in which proposal, the company should invest the funds. For this purpose, he may be required to take the help of various techniques of capital budgeting to evaluate the various proposals, e.g. Pay Back Period, Net Present Value, Internal Rate of Return, Profitability Index etc. If the outright purchases of fixed assets is not useful, the finance executive has to ensure that in order to facilitate the replacement of fixed assets after their economic life is over, proper depreciation policies are formulated. The wrong policies in the area of providing for the depreciation may result into over-capitalisation or under-capitalisation.

(ii)

Working Capital Management : The finance executive has to ensure that sufficient funds are made available for investing in current assets as it is the life-blood of the business activity. Non-availability of funds to invest in current assets in the form of say cash, receivable, inventory etc. may halt the business operations. At the same time he has to ensure that there is no blocking of funds in the current assets, as it may prove to be costly in terms of cost of these funds and also in terms of opportunity cost of their use. Thus, the finance manager has to ensure that investments in the current assets is minimum without affecting the operations of the company.

(d)

Allocation of Income : Allocation of the income of the company is the exclusive responsibility of the finance executive. For this purpose, basically the income may be distributed among the shareholders by way of dividend or it may be retained in the business for future purpose like expansion. Decision in this regard may be taken in the light of financial position, present and future cash requirements, preferences of the shareholders etc.

(e)

Control of Funds : The finance executive is responsible to control the use of funds committed in the business so as to ensure that cash is flowing as per the plan and if there is any deviation between estimates and plans, proper corrective action may be taken in the light of financial position of the company. For this purpose, he may be required to supervise the cash receipts and disbursements, ensure the safety of cash balances, expediate receipts and delay the payments wherever possible etc.

Finance Function

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(f)

Evaluation of Performance : The financial executive may be required to evaluate and interpret the financial statements, financial position and operations of the company. For this purpose, he may be required to ensure that proper books and records are maintained in proper way so that whatever data is required of this purpose is available in time. For the evaluation and interpretation of the financial statements, financial executive may use the techniques like ratio analysis, funds flow statement etc.

(g)

Corporate Taxation : As the company is a separate legal entity, it is subjected to the various direct and indirect taxes like income tax, wealth tax, excise and customs duty, sales tax etc. The finance executive may be expected to deal with the various tax planning and tax saving devices in order to minimize the tax liability.

(h)

Other Duties : In addition to all the above duties the financial executive may be required to prepare annual accounts, prepare and present financial reports to top management, carrying out internal audit, get done statutory and tax audit, safeguarding securities and assets of company by properly insuring them etc.

Non-recurring Duties : The non-recurring duties of the finance executive may involve preparation of financial plan at the time of company promotion, financial readjustments in times of liquidity crisis, valuation of the enterprise at the time of acquisition and merger thereof etc. THE FIELDS OF FINANCE There can be various fields in which the finance function may operate. In each field, finance executive deals with the management of money and claims against money. The distinctions arise due to variety of problems and variety of objects. The various fields of finance can be stated as below.

10

(1)

Business Finance : The term business and hence business finance is a very broad term. It covers all the activities carried on with the intention of earning profits. Thus, business finance covers the study of finance function in the area of business which includes both trade as well as industry.

(2)

Corporation Finance : Corporation finance is a part of business finance and deals with the financial practices, policies and problems of corporate enterprises or companies to describe in simple words. The corporation finance studies the financial operations carried on by a corporate enterprise from the stage of its inception to the stage of its growth and expansion.

Financial Management

(3)

International Finance : International finance is the study of flow of funds between individuals and organisations beyond national boundaries and developing the methods to handle these funds more effectively. This study may become crucial as it involves exchange of currencies and also as the governments of either of the nations may have close watch and control on these transactions involving foreign currencies.

(4)

Public Finance : It deals with the financial matters of the Governments. It becomes crucial as the Governments deal with huge sums of money which can be raised through the sources like taxes or other methods and are required to be utilised within the statutory and other limitations. Further, the Government does not operate with objectives similar to that of the private organisations i.e. earning the profits is not the intention with which the Governments operate, but they operate with the intention of accomplishing social or economic objectives.

(5)

Private Finance : It deals with the financial matters of non-government organisations.

FINANCE FUNCTION IN RELATION WITH OTHER FUNCTIONS Other than finance, every business generally operates in three main functional areas viz. Production, Marketing and Personnel. All these functions are closely related to finance function due to the simplest reason that for executing these functions, funds are required which is the area covered by finance function. E.g. To produce good quality of finished goods, the business needs good infrastructural facilities like building, machineries etc., a regular flow of production facilities like quality, raw material, work in progress, consumable stores, quality control equipments, good maintenance facilities etc. All these activities need the investment to be made either in terms of fixed capital and/or working capital, which is the area of finance function. To market the finished goods properly in market, the business has to have proper investment in the finished goods to guarantee regular flow of goods in the market. It may be required to have good distribution systems which may call for investment in terms of fixed assets or labour force. All these activities need the investments to be made either in terms of fixed capital and/or working capital which is the area of finance function. The personnel function deals with the availability of proper kinds of labourers at proper time, training them properly and fixing their job responsibilities. All these activities need funds e.g. to pay salaries, wages and other facilities to workers, funds are needed, to provide training facilities to workers, it may be necessary to invest in some fixed assets like building or equipments etc. To conclude, it may be stated that all the functions or activities of the business are ultimately related to finance. The success of the business depends on how best all these functions can be coordinated.

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QUESTIONS 1.

Describe the scope and importance of the finance function in the management of a corporation.

2.

Explain the meaning, nature and scope of Business Finance.

3.

Explain the organizational frame work of finance function. State the relation of finance function to other functions of a business enterprise.

4.

What are the duties discharged by the financial executives in a large business organization?

5.

(a)

Explain the traditional and modern concept of finance function.

(b)

State the relation of finance function to other functions of a business enterprise.

6.

Describe the organizational structure of finance department of a large business concern.

7.

How is finance function organized in business firms? Explain the internal structure of finance department in medium and large business enterprises with suitable chart.

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NOTES

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13

NOTES

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Chapter 2 FORMS OF BUSINESS ORGANISATION

The finance function of the organisation is greatly affected by the forms of organisation. In practical circumstances, we come across basically three forms of business organisations. a.

Proprietary Firms

b.

Partnership Firms

c.

Joint Stock Companies

PROPRIETARY FIRMS In this case, only one person is the owner of the business who is called as the “Proprietor” and the same person is the manager. All the profits earned by the business belong to the proprietor and he is liable for the losses and liabilities of the business. Advantages : a.

Proprietary Firm is the easiest and most economical form of business organisation to form and operate. Not many of the government regulations are applicable to the Proprietary Firms.

b.

This form of organisation is very suitable where the size of the business is small and the complexities involved in the business are comparatively less. However, if the size of the business increases or the complexities in the business operations grow, this form may prove to be insufficient.

Disadvantages : a.

This form of organisation does not have any legal status. The proprietary firms exist due to the existence of the proprietor. If the proprietor ceases to be in existence, the firm ceases to be in existence.

b.

As only one person is the owner and the manager, the capacity of the business to raise the funds and to cope up with the complex business operations is comparatively limited.

Forms of Business Organisation

15

c.

Proprietary firm is always an unlimited liability organisation. In the sense, if the assets of the firm are insufficient to meet its liabilities, personal property of the proprietor is always at stake.

d.

The income of the proprietary firm is clubbed with the individual income of the proprietor. As such, effective rate of income tax which the proprietor may be required to pay is likely to be higher.

e.

It is not possible to transfer the ownership of the business to somebody else without affecting the basic constitution of the business.

PARTNERSHIP FIRMS In this case, more than two persons but less than twenty persons come together and form a partnership firm. Each of these partners is the owner of the business in the proportion decided among themselves. Partnership is a contract among the partners and the relationship among the partners is governed on the basis of terms and conditions laid down in an official and written document called as “partnership deed” or “partnership agreement”. Advantages

16

a.

This form of organisation is also reasonably easy and economical to form and operate.

b.

As resources of more than one person are pooled together, capacity of the business to handle more complex business operations or operations requiring more amount of funds is better as compared to the proprietary firms.

c.

The tax structure applicable to the partnership firms is fairly reasonable. At present, profit of the partnership firm is taxed at a flat rate of 35%. While calculating the profit of the partnership firm, following amounts can be claimed by the firm as the allowable expenditure. i.

The firm can pay interest on capital to the partners on the amount of capital introduced by them in the business but the rate of interest can not exceed 12% per annum. This interest on capital can be paid by the firm to all the partners.

ii.

The firm can remunerate the partners in the form of salary, bonus, commission etc. provided that the partners are “working partners”. A working partner is a partner who is capable of participating in the day-to-day affairs of the firm by virtue of experience or qualifications. However, the firm cannot remunerate the partners to any extent it wants. The maximum amount of remuneration which the firm can pay to all the working partners taken together is prescribed in Income Tax Act, 1961. Section 44AA of the said Act provides that the maximum amount of remuneration which the firm can pay to its working partners gets decided on the basis of its “book profits” which means the amount of profits as per its profitability statement after calculating Financial Management

the interest on capital paid to the partners. After deciding the amount of book profit, the remuneration is decided as below : If the firm is carrying on a profession : a.

On the first Rs. 1,00,000 of the book profit or in case of a loss, Rs. 50,000 or 90% of the book profit whichever is more.

b.

On the next Rs. 1,00,000 of the book profit, at the rate of 60%.

c.

On the balance amount of book profit, at the rate of 40%.

In case of any other firm : a.

On the first Rs. 75,000 of the book profit or in case of a loss, Rs. 50,000 or 90% of the book profit whichever is more.

b.

On the next Rs. 75,000 of the book profit, at the rate of 60%.

c.

On the balance amount of book profit, at the rate of 40%.

However, it should be remembered that the amount of interest on capital paid by the firm and the remuneration paid to the partners is taxable in the hands of individual partners. After charging the above amounts, the balance amount of profits are transferred to the capital account of the partners which is referred to as “share of profit” and this share of profit is not taxable in the hands of individual partners. d.

Not many of the government regulations are applicable to the partnership firms.

Disadvantages a.

This form of organisation also does not have any legal status. The partnership firms exist due to the existence of the partners. If the partners cease to be in existence, the firm ceases to be in existence. The retirement or death of a partner leads to the dissolution of the partnership firm.

b.

The capacity of the business to raise the funds and to cope up with the complex business operations is comparatively limited though it is more than that of the proprietary firms.

c.

Partnership firm is also an unlimited liability organisation. In the sense, if the assets of the firm are insufficient to meet its liabilities, personal property of the partners is always at stake.

d.

It is not possible to transfer the ownership of the business to somebody else without affecting the basic constitution of the business.

Forms of Business Organisation

17

JOINT STOCK COMPANIES Joint stock companies has become a major form of organisation in the recent past. This form of organisation can raise large amount of funds as the resources of larger number of people can be pooled together. In this case, the total requirement of funds of the organisation is split into smaller units, each of such units being called as a ‘share’. Each such share carries a denomination value which is called as ‘face value’ or ‘nominal value’. An individual can participate in the capital requirement of an organisation by purchasing the shares of the company and he becomes the part owner of the company to the extent of his shareholding in the overall amount of capital of the company. Such shareholder can exercise his ownership rights through the voting rights offered to him. The joint stock companies have the following characteristic features.

18

1.

All the joint stock companies have a legal entity separate from their owner viz. shareholders. They gain the legal status by being registered under Companies Act, 1956, which governs and regulates the operations of all joint stock companies in India. As legal entities, the joint stock companies can own assets, incur liabilities, enter into contracts, sue and be sued. The shareholders of the company cannot be held liable for the actions of the company.

2.

Generally all joint stock companies are limited liability organisations and the liability of the members i.e. shareholders is limited to the extent of amount of shares they undertake to purchase. E.g. If Mr. A undertakes to purchase 100 shares of a company of Rs. 100 each, his liability ceases once he pays Rs. 10,000 to the company. His personal property is never in danger despite the losses and liabilities incurred by the company.

3.

Segregation of ownership and management is a typical feature of joint stock companies. In case of the companies, shareholders are the owners. However, due to large number of shareholders and their wide geographical spread, it may not be possible for the shareholders to exercise their ownership rights by participating in the day-to-day affairs of the company. As such, the shareholders appoint their representatives (viz. directors) to manage the day-to-day affairs of the company. In case of joint stock companies, shareholders are the owners while directors/board of directors are the managers.

4.

Transferability of shares is a feature of a joint stock company. A shareholder can transfer his ownership rights in the company by transferring his shares to some other person. In case of public limited companies, shares are freely transferable and such transfer can be greatly facilitated if the shares are listed on the stock exchange. In case of private limited companies, there may be some restrictions on the transfer of shares.

5.

Being an artificial legal person, the company enjoys a perpetual existence. The company can die only a legal death, after complying with the prescribed legal formalities. There is a very famous case under the Companies Act, where during the war, all the members of a private company, while in meeting, were killed by a bomb. But the company survived.

Financial Management

6.

A company is an artificial legal person which does not have a body like a natural person and hence it cannot sign any documents. However, being a legal personality, it is bound only by those documents which bear its signature. Hence, as a substitute to the signature, the law provides for the use of common seal. Any document having the common seal and witnessed by at least two directors is binding on the company legally.

Advantages : 1.

The capacity of the corporate organisations to raise the funds is comparatively high. As the number of persons contributing to the requirement of funds is large, it is possible to raise large amount of funds.

2.

As the company has a separate legal entity, apart from its owners viz. shareholders, the personal property of the shareholders is generally not in danger.

3.

Transferability of shares is a facility available to the shareholders. If the shareholders want to release their investment in shares, they can transfer their shares to any other person. However, it should be remembered that in case of private limited companies, the shares are not freely transferable.

Disadvantages : 1.

The company form of organisation are subjected to elaborate legal and procedural formalities to be completed not only for the purpose of formation but also for the regular operation. The basic applicable law in this connection is in the form of Companies Act, 1956. However, it should be noted that in case of private limited companies, these formalities are less rigorous in nature.

2.

Double Taxation is a typical characteristic feature of a company form of organization. The profits earned by the company are taxed in the hands of company first and when the same profits are distributed to the shareholders in the form of dividend, the same are taxed in the hands of shareholders again. This amounts to the payment of tax by both the company as well as the shareholders on the same amount of profits.

As the company form of organisation is the most frequently found form of organisation, for the future discussion in the following chapters, we will refer the business organisation to be a “company”. In practical situations, we come across basically two types of limited liability companies : a.

Private Limited Company

b.

Public Limited Company

Forms of Business Organisation

19

PRIVATE LIMITED COMPANY In non-technical language, operations of a private limited company affect the fate of smaller number of people. As such, Companies Act, 1956 is very liberal towards the private limited companies. Private Limited Company is entitled to many privileges/exemptions from the various provisions of the Companies Act, 1956. A private limited company is characterised by the following features. a.

Minimum number of shareholders is 2 and the maximum number is 50.

b.

A private limited company cannot approach public in general for subscribing to the shares/ debentures of the company. Similarly, a private limited company cannot invite or accept deposits from public in general other than its shareholders, directors or their relatives. The funds required by the company are required to be collected through the private circulation only.

c.

In case of a private limited company, right of the shareholders to transfer the shares is restricted. These restrictions are usually in two forms :

d.

i.

that the shares to be transferred should be offered to the existing members on priority basis and if the existing members do not want to take up those share, they can be transferred to anybody else.

ii.

that the directors will have the power to refuse to register the transfer of shares provided that such power should be exercised by the directors in good faith and in the interest of the company.

A private limited company needs to have a minimum paid-up share capital of Rs. 1 Lakhs or any higher amount as may be prescribed.

PUBLIC LIMITED COMPANY In non-technical language, a public limited company affects the fate of larger number of people. As such, operations of a public limited companies are subjected to a close control in the form of compliance to the various provisions of Companies Act, 1956. A public limited company is characterised by the following features :

20

a.

Minimum number of shareholders is 7 and there is no restriction on the maximum number of shareholders.

b.

Public limited company can freely approach public in general for subscribing to the shares and/or debentures of the company.

c.

The shareholders of a public limited company can freely transfer their shares to any other person. As such, shares of only a public limited company can be listed on the stock exchange.

d.

A public limited company needs to have a minimum paid-up share capital of Rs. 5 Lakhs or any higher amount as may be prescribed. Financial Management

QUESTIONS 1.

2.

Critically evaluate the following forms of business organisations. (a)

Proprietory Firms

(b)

Partnership Firms

(c)

Joint Stock Companies

Write short notes on the following (a)

Taxation of Partnership Firms

(b)

Types of Companies

Forms of Business Organisation

21

NOTES

22

Financial Management

NOTES

Forms of Business Organisation

23

NOTES

24

Financial Management

Chapter 3 FINANCIAL STATEMENTS

Financial statements of an organisation is the basis of data required for financial decision making. As such, correct understanding of the structure of financial statements and also of the tools available for the interpretation of financial statements is a must before one talks of any of the further discussions on financial management. NATURE OF FINANCIAL STATEMENTS Any organisation doing the business, whether it is manufacturing activity or trading activity or service activity, is interested in knowing basically two facts about the business. a.

Where the business stands at any given point of time in financial terms.

b.

What is the result of operations carried out by the business organisation during a specific period.

In order to answer these two questions, the organisation carries out the process of recording various transactions in a defined set of records, technically referred to as “accounting”, which effectively result into the preparation of what are called as financial statements. These financial statements are basically in two forms. a.

First financial statement is Balance Sheet. This is the answer to the first question viz. Where the business stands in financial terms. Balance Sheet informs about the various sources used by the organisation to raise the funds which technically result into what are referred to as “liabilities” and the way these sources are used which technically result into the creation of “assets”. Sometimes, Balance Sheet is also referred to as “Statement of Sources and Application of funds”. Effectively, Balance Sheet is a listing of various assets and liabilities of the organisation at any given point of time. Technically, Balance Sheet is a position statement in the sense it refers to a particular date. As such, Balance Sheet is referred to as “Balance Sheet as on ——— or “Balance Sheet as at ———.

Financial Statements

25

b.

Second financial statement is Profitability Statement. In technical language, it is referred to as “Profit & Loss Account”. This is the answer to the second question viz. What is the result of operations of the business during the specific period i.e. whether the operations have resulted into a profit or loss and by what amount. Technically, Profitability Statement is a period statement in the sense it refers to a particular period . This may be a month, a quarter, a half year or a year depending upon the organisation and the purpose for which it is prepared. As such, Profitability Statement is referred to as “Profit and Loss Account for the year ending on ———. Basic principles behind the preparation of Financial Statements

BASIC CONCEPTS IN ACCOUNTING The theory and practice of accounting is based upon certain basic assumptions which are referred to variously as concepts, principles, conventions and rules. For the convenience purpose, we will term them as ‘concepts’. The various concepts which form the basic of theory and practice of accounting can be discussed as below. (1)

Business Entity Concept : According to this concept, the business is assumed to be a distinct entity from the persons who own the business E.g. If there is a partnership concern carrying the name of M/s. X, where Mr. A and Mr. B are partners, from accounting point of view, M/s. X is supposed to be a separate entity from Mr. A or Mr. B. The financial statements prepared on the basis of accounting records relate to the business i.e. M/s. X and not to Mr. A or Mr. B individually. It should be noted in this connection that the business entity concept has nothing to do with the legal entity of the business. It applies to both corporate organisation (which by itself is a legal entity separate from the owners) as well as noncorporate organisation. (which is not a legal entity separate from the owners.)

(2)

Money Measurement Concept : According to this concept, only those transactions and facts find the place in the process of accounting and hence on financial statements which can be expressed in terms of money. As such, all those transactions and facts which cannot be expressed in terms of money (e.g. Morale and motivation of the workers, goodwill of the organisation in the market etc.) are not within the purview of accounting though they may be having direct or indirect bearing on the business. This principle imposes severe restrictions on the kind of information available from the financial statements. In fact, it is one of the major drawbacks of financial statements.

26

Financial Management

(3)

Cost Concept : According to this concept, the assets acquired by a business are recorded at their cost of acquisition and this cost is considered for all the subsequent accounting purposes say charging of depreciation. This concept does not take into consideration the current market prices of the various assets.

(4)

Going Concern Concept : According to this concept it is assumed that the business entity is going to be in business for an indefinitely long period of time and is not likely to close down its business in a shorter period of time. This concept affects the valuation of assets and liabilities. As such, the assets are shown on the Balance Sheet at cost less depreciation and not at the current market price or realisable value. If the assets are to be disclosed at the correct value in the Balance Sheet, the current market price will be most suitable. However, as the business is likely to be a going concern in future and as the assets are not likely to be sold in the market in the near future, they are disclosed at cost less depreciation.

(5)

Conservation Concept : This concept is usually expressed as – “Anticipate all the future losses and expenses, however do not anticipate the future incomes and profits.” This principle is applicable to current assets generally and hence the current assets are valued at cost or market price whichever is lower. The valuation of non-current assets is made at cost (as per the cost concept.)

(6)

Dual Aspect Concept : According to this concept, every business transaction has two aspects, however the basic relationship between assets and liabilities i.e. assets are equal to liabilities, remains the same e.g. If Mr. A starts the business by introducing the capital of Rs. 50,000 the assets and liabilities structure will be as below : Liabilities Capital

Rs. 50,000

Assets Cash

Rs. 50,000

Now, if Mr. A uses the cash to purchase the material worth Rs. 40,000, the assets and liabilities structure will change as below : Liabilities Capital

Rs. 50,000

50,000

Financial Statements

Assets

Rs.

Stock in trade

40,000

Cash

10,000 50,000

27

If Mr. A sells the above material worth Rs. 40,000 for Rs. 45,000, on credit basis, the assets and liabilities structure will change as below : Liabilities Capital

Rs. 55,000

55,000 (7)

Assets

Rs.

Receivables

45,000

Cash

10,000 55,000

Accounting Period Concept : According to this concept, eventhough a business is likely to be a going concern over a longer period of time, in order to facilitate the preparation of financial statements periodically, the future time is divided into shorter segment, each one of them being in the form of Accounting Period. Income is computed according to this accounting period (by preparing profitability statement) and financial position is assessed at the end of such accounting period (by preparing Balance Sheet). It may be noted that the length of accounting period may depend upon various factors like characteristics of the business, tax considerations, statutory requirements and so on.

(8)

Matching Concept : According to this concept, in order to calculate the profit for the accounting period in a correct manner, the expenses and costs incurred during that period, whether paid or not, should be matched with the revenues generated during that period.

(9)

Materiality Concept : According to this concept, while accounting for the various transactions, only those which are having material impact on profitability or financial position of the organisation will be considered, ignoring the insignificant ones. E.g. If an organisation purchases some postage stamps some of which remain non-used at the end of the accounting period, according to matching concept, the cost of such non-used stamps should not be treated as an item of expenditure. However, as its impact on profitability is likely to be negligible, the cost of non-used stamps may be ignored treating the cost of purchase of stamps as an expenditure. Now which transactions should be treated as material ones is a subjective concept and depends upon the judgement and knowledge of the accountant.

(10) Consistency Concept : According to this concept, whatever accounting policies and procedures are adopted, they should be adopted consistently from one period to another to enable the comparison between two different sets of financial statements. If there is any change in the accounting policies and procedures, this fact coupled with its effect on profitability should be disclosed specifically. 28

Financial Management

STRUCTURE OF FINANCIAL STATEMENTS As there is no specific law applicable to the preparation of financial statements of a noncorporate organisations like proprietary firms or partnership firms, these organisations can prepare their financial statements in whatever structure they want. However, in case of a corporate organisation, in simple language a company form of organisation, there is a uniform law applicable to these types of organisations viz. Companies Act, 1956. As such, a company form of organisation is required to prepare and present its financial statements in accordance with the provisions of Companies Act, 1956, to be more specific as per the provisions of Schedule VI of the Companies Act, 1956. The underlying presumption of the Schedule VI provisions is that it is through the financial statements that the companies communicate with the various outsiders. As such, it is required that the financial statements should be as transparent and as informative as possible. Hence, Schedule VI lays down various disclosure requirements which the companies are required to follow while preparing their financial statements. Schedule VI of the Companies Act, 1956 is subdivided into four parts : Part I deals with the format of the Balance Sheet. Part II deals with the Profit and Loss Account. Part III deals with notes forming part of the Profit and Loss Account and the Balance Sheet. The last reporting requirement to Part IV was inserted recently with effect from 15th May 1995 which deals with Balance Sheet abstract and the company’s general business profile. Part I : Structure of Balance Sheet : As stated above, Part I of Schedule VI deals with Balance Sheet. It lays down both the vertical as well as horizontal form of preparing the Balance Sheet, though in normal circumstances we come across vertical form of Balance Sheet. Following items appear in the Balance Sheet. Liabilities

Assets

a.

Share Capital

a.

Fixed Assets

b.

Reserves & Surplus

b.

Investments

c.

Secured Loans

c.

Current Assets, Loans & Advances

d.

Unsecured Loans

d.

e.

Current Liabilities & Provisions

e.

Miscellaneous Expenditure to the extent not written off or adjusted. Profit & Loss Account debit Balance.

Financial Statements

29

In addition to the above items of assets and liabilities, the various contingent liabilities are required to be disclosed by way of a foot-note. LIABILITIES SIDE Share Capital : The share capital is required to be disclosed under the following headings a.

Authorised : ....... shares of Rs......... each

b.

Issued : ........ Shares of Rs. ........each

c.

Subscribed : ....... shares of Rs. .......... each

d.

Called up : ........ shares of Rs. .............. each

e.

Less : Calls Unpaid

f.

Add : Forfeited Shares (Amount originally paid up)

Notes : a.

The details of issued and subscribed capital should be given after distinguishing between the different classes of shares. It should be noted that in the Indian circumstances, the company can issue only two types of shares i.e. Equity Shares and Preference Shares. In case of preference shares, details of different classes of preference shares should be given. Similarly, in case of redeemable or convertible preference shares, the terms of redemption on conversion should be given.

b.

If the shares are allotted as fully paid shares pursuant to a contract without payments being received in cash, the details of the same should be given.

c.

If the shares are allotted as fully paid bonus shares, details of the same should be given alongwith the sources from which the bonus shares are issued i.e. capitalisation of profits or reserves, share premium etc. Similarly, the details of bonus shares held by i) directors and ii) others should be given.

d.

It is provided that any profit on the reissue of forfeited shares should be transferred to capital reserve.

Reserves and Surplus : Reserves indicate that portion of the earnings, receipt or other surplus of the company (whether capital or revenue) appropriated by the management for a general or specific purpose other than provisions for depreciation or for a known liability. The reserves can be primarily of two types. i) Capital Reserve and ii) Revenue Reserve. Capital Reserve is that reserve which can not be distributed by way of dividend. Revenue Reserve is any other reserve than the capital reserve. 30

Financial Management

The reserves are required to be classified as below : a.

Capital Reserve

b.

Capital Redemption Reserve (As per the provisions of Section 80 of the Companies Act, 1956, this reserve is created for the redemption of redeemable preference shares).

c.

Share Premium Account

d.

Other reserves specifying the nature of each reserve and the amount in respect thereof.

Less : Debit balance in Profit & Loss Account, if any. e.

Surplus i.e. balance in Profit & Loss Account after providing for proposed allocations viz. dividend, bonus shares or reserves.

f.

Proposed additions to reserves.

g.

Sinking fund

Notes : a.

Additions and deductions since the last balance sheet is required to be given under each head of reserves and surplus.

b.

In case of the share premium account, the details of the utilisation of the balance in share premium account should be given. It should be noted that as per the provisions of Section 78 of the Companies Act, 1956, the amount lying to the credit of share premium account can be used for : 1.

For issuing fully paid bonus shares.

2.

To write off preliminary expenses.

3.

To write off the balance of commission/discount allowed/paid while issuing shares/ debentures.

4.

To provide for premium payable on the redemption of preference shares.

c.

The word “fund” is generally used interchangeably with the word “reserve fund”. The word fund indicates that there is a specific investment against such reserves.

d.

Debit balance in Profit and Loss Account should be deducted from the unspecified reserves. If there are no unspecified reserves, such debit balance should be shown on assets side.

Secured Loans : Loans borrowed by the company, secured wholly or partly, against the assets of the company are stated as secured loans.

Financial Statements

31

Secured Loans are classified as below : a.

Debentures

b.

Loans and Advances from Banks

c.

Loans and Advances from Subsidiaries

d.

Other Loans and Advances

Notes : a.

In case of debentures, the terms of redemption or conversion, if any, should be specified together with the earliest date of redemption or conversion.

b.

Nature of security should be specified.

c.

Interest accrued and due on secured loans should be included under the appropriate sub-head under secured loans.

d.

Loans taken from directors and managers should be shown separately.

e.

If the loans are guaranteed by director or manager, it is required to mention the guarantee and the amount of loan under each head.

Unsecured Loans Unsecured Loans are those loans which are not secured against the security of any of the assets of the company. Unsecured portion of the partly secured loans should be shown under unsecured loans. Unsecured Loans are classified as below : a.

Fixed Deposits

b.

Loans and Advances from Subsidiaries

c.

Short Term Loans and Advances

d.

32

i)

from Subsidiaries

ii)

from others

Other Loans and Advances i)

from subsidiaries

ii)

from others

Financial Management

Notes : a.

Interest accrued and due on secured loans should be included under the appropriate sub-head under unsecured loans.

b.

Loans taken from directors and managers should be shown separately.

c.

If the loans are guaranteed by director or manager, it is required to mention the guarantee and the amount of loan under each head.

d.

Short term loans and advances are those which are due for repayment within one year from the date of balance sheet.

e.

Inter-corporate unsecured deposits and Commercial Papers fall under this head.

Current Liabilities and Provisions : The Guidance Note issued by The Institute of Chartered Accountants of India on Terms used in Financial Statements defines “Current Liability” as liability including loans, deposits and bank overdraft which falls due for payment in a relatively short time, normally not more than 12 months. Current Liabilities and Provisions are classified as below : A.

B.

Current Liabilities : a.

Acceptance : This includes the bills payable including the promissory notes issued by the Company.

b.

Sundry Creditors for goods purchased or services received

c.

Subsidiary Companies

d.

Advance received and unexpired discount

e.

Unclaimed dividend

f.

Other liabilities, if any.

g.

Interest accrued but not due on loans

Provisions : a.

Provision for Taxation

b.

Proposed Dividend

c.

Provision for contingencies

d.

Provision for Provident Fund Scheme

e.

Provision for insurance, pension and other similar staff benefit schemes

f.

Other provisions

Financial Statements

33

ASSETS SIDE Fixed Assets : Schedule VI requires the company to classify the fixed assets as far as possible under the following heads a.

Goodwill

b.

Land

c.

Buildings

d.

Leaseholds

e.

Railway sidings

f.

Plant and Machinery

g.

Furniture and Fittings

h.

Development of Property

i.

Patents, Trade Marks and Designs

j.

Livestock

k.

Vehicles etc.

Under each of the above heads, original cost and the additions thereto or the deductions therefrom during the year and the total depreciation written off or provided upto the end of the year should be stated. In the practical circumstances, in the vertical form of balance sheet, the fixed assets are presented as below : a.

Gross Block (which indicates accumulated original cost)

b.

Less : Depreciation (which indicates accumulated depreciation)

c.

Net Block (which indicates Gross Block less Depreciation)

d.

Capital Work-in-Progress.

Note : Capital work-in-progress indicates the fixed assets under construction or under installation. After the construction of fixed assets is complete or the fixed assets are installed, they are capitalised under the suitable head. No depreciation will be provided by the company on capital work-in-progress. Usually details of original cost, additions, deductions, depreciation etc. are shown in a separate schedule.

34

Financial Management

Investments : Investments indicate the assets held by a company for earning income by way of dividend, interest etc. or for capital appreciation or for other benefits to the investing company. Investments are required to be distinguished as below : a.

Investments in Government or Trust securities.

b.

Investments in shares, debentures or bonds showing separately shares fully paid up and partly paid up and also distinguishing different classes of shares. Similar details should be given in case of investment in subsidiary companies.

c.

Immovable Properties

d.

Investment in capital of Partnership Firm.

e.

Balance of unutilised monies raised by issue.

Notes : a.

It is necessary to indicate the nature of investment and mode of valuation, for example cost or market value.

b.

It is required to disclose – i)

Aggregate amount of company’s quoted investments and the market value thereof

ii)

Aggregate amount of company’s unquoted investments. Quoted investments means an investment which is traded on a recognised stock exchange and unquoted investment means otherwise.

Current Assets, Loans and Advances : A.

Current Assets Cash and other assets which are expected to be converted into cash or consumed in the production of goods or rendering the services in the normal course of business are defined as current assets. Current Assets are required to be classified as : a.

Interest accrued on investments

b.

Stores and spare parts

c.

Loose tools

d.

Stock-in-Trade (This in turn may consist of stock of raw materials and stock of finished goods)

Financial Statements

35

e.

Work-in-Progress

f.

Sundry Debtors i)

Debts outstanding for a period exceeding six months

ii)

Other Debts

Less : Provision g.

Cash balance on hand

h.

Bank Balances i)

With Scheduled Bank

ii)

With others

Notes : a.

Mode of valuation of stock-in-trade and work-in-progress should be specified.

b.

Sundry debtors are required to be disclosed based on security in the following manner. i)

Debts considered good and in respect of which the company is fully secured.

ii)

Debts considered good for which the company holds no security other than the debtor’s personal security.

iii)

Debts considered bad or doubtful.

Further following details are also required to be disclosed in case of debtors :

c.

i)

Debts due by directors or other officers of the company or any of them either jointly or severally with any other person.

ii)

Debts due by firms in which any director is a partner or debts due by a private company in which a director is a director or member.

iii)

Maximum amount due by directors or other officers of the company at any time during the year is required to be shown by way of a note.

iv)

Debts due from the companies under the same management as defined in Section 370(1B) of the Companies Act, 1956 are required to be shown separately along with the names of these companies.

In case of bank balances, following details are required to be given : i)

36

Balance lying with Scheduled Bank in current account, call account or deposit account. It should be noted here that a Scheduled Bank is defined in Section 2(e) of the Reserve Bank Act, 1934.

Financial Management

B.

ii)

Balances lying with banks other than Scheduled Banks in current account, call account or deposit account. It is further required to state the names of all such banks and the maximum amount outstanding at any time during the year from each such bank.

iii)

Nature of interest of the directors or the relatives of the directors in the nonscheduled bank is also required to be stated.

Loans and Advances : The Loans and Advances may not always be in the form of current assets. However, for the purpose of Schedule VI they are clubbed with current assets. The Loans and Advances are classified as : a.

Advances and loans to subsidiaries.

b.

Advances and loans to partnership firms in which the company or any of its subsidiaries is a partner.

c.

Bills of exchange.

d.

Advances recoverable in cash or in kind or for value to be received e.g. Rates, Taxes, Insurance etc.

e.

Balances with customs, port trust etc. (where payable on demand)

Disclosure requirements applicable to sundry debtors equally apply to Loans and Advances. a.

Loans and advances are required to be classified as i)

Outstanding for a period exceeding six months

ii)

Other Loans and Advances

b.

Provision for bad and doubtful advances is required to be reduced from the balance of loans and advances.

c.

Advances due by directors or other officers of the company or any of them either jointly or severally with any other person are required to be disclosed separately.

d.

Advances due by firms in which any director is a partner or debts due by a private company in which a director is a director or member is required to be disclosed separately.

e.

Maximum amount due by directors or other officers of the company at any time during the year is required to be shown by way of a note.

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37

f.

Advances due from the companies under the same management as defined in Section 370(1B) of the Companies Act, 1956 are required to be shown separately alongwith the names of these companies.

MISCELLANEOUS EXPENDITURE (to the extent not written off or adjusted) In accounting language, this amount arises due to the deferred revenue expenditure incurred by the company. Deferred revenue expenditure is that expenditure which is neither capital expenditure nor revenue expenditure. It is not a capital expenditure as no fixed asset is created due to this expenditure. It is not a revenue expenditure also as the benefits received from such expenditure are staggered benefits. Such expenditure should not be transferred to Profit & Loss Account in the year of incurrance. In practical circumstances, following expenditure may appear under this head. a.

Expenditure incurred in connection with drafting and printing of Memorandum of Association and Articles of Association of the Company, legal charges, stamp duty and filing fees paid for getting the company registered as per the provisions of Companies Act, 1956 etc.

b.

Expenditure incurred in connection with the preparation of feasibility report, conducting the market survey etc.

c.

Expenditure incurred in connection with the public issue of shares and debentures like underwriting commission, brokerage, drafting & printing of prospectus, advertisement & legal charges etc.

As per the provisions of Section 35D of the Income Tax Act, 1961, such expenditure can be written off to Profit and Loss Account over the period of five years. Contingent Liabilities : Contingent liabilities may be defined as the liabilities the crystalisation of which depends upon the happening or non-happening of certain events. Contingent Liabilities are never a part of main Balance Sheet. They are to be disclosed below the Balance Sheet by way of “Foot Note.” In practical circumstances, contingent liabilities are disclosed in the Annexure to the Balance Sheet in the form of “Notes on Accounts.” The contingent liabilities referred to in Schedule VI are as below : a.

38

Claims against the company not acknowledged as debts. (In simple language they are the disputed claims. They are likely to become final liability only if the company looses the suit.)

Financial Management

b.

Uncalled liability on shares partly paid. (This liability may arise if the company has invested some amount in the shares of another company the entire amount of which is not called.)

c.

Arrears of dividend on cumulative preference shares.

d.

Estimated amount of contracts remaining to be executed on capital accounts and not provided for.

e.

Other money for which the company is contingently liable. (In practical circumstances, it may include the amounts like bills discounted by the company with banks, the amount of guarantees given by the company on behalf of directors or other officers of the company etc.)

Part II : Structure of Profitability Statement : The profitability statement of a company may be split into the following components. a.

First component discloses profits earned by the company after the manufacturing function is over. This profit is technically referred to as “Gross Profit” and is calculated as Sales less Cost of Goods Manufactured (also called as Factory Cost).

b.

Second component discloses profits earned by the company after all the operating activities are over. This profit is technically referred to as “Operating Profit” and is calculated as Sales less Operating Cost.

c.

Third component discloses final profit earned by the Company after all the activities are over. This profit is technically referred to as “Profit After Tax” and is calculated as – Operating Profit Add : Non-operating incomes Less : Non-operating expenses Less : Taxation

d.

Forth component indicates the profits retained in the business after the Profit After Tax is distributed among the owners by way of dividend. Based upon the above discussion, the structure of the profitability statement can be drafted as below : Sales Less : Factory Cost Gross Profit Less : Administrative and Selling Overheads

Financial Statements

39

Operating Profits Less : Non-Operating Expenses Add : Non-Operating Incomes Profit Before Tax Less : Taxes Profit After Tax Less : Dividend Paid Retained Profit ROLE PLAYED BY FINANCIAL STATEMENTS In the present circumstances the process of financial accounting and hence the preparation of financial statements has been made a mandatory legal requirement, either directly or atleast indirectly. As such, the preparation of financial statements indicates the compliance with the various legal requirements. Moreover, it is through the financial statements that a host of persons dealing with an organisation get the information to enable them to take proper decisions eg. on the basis of financial statements, the shareholders may decide whether to retain the investment in the company or not or the prospective shareholders may decide whether to invest in the shares of the company or not. On basis of financial statements, the creditors of an organisation may decide whether to continue extending the credit or not, and if yes to what extent. On the basis of financial statements, the employees may base their demands for additional wages or various benefits i.e. the employees’ demands will definitely carry weight if the organisation is having good profitability. It is on the basis of financial statements that the banks and/or financial institutions appraise the applications made by the organisations for the grant of or renewal of or continuance of credit facilities, as the financial statements give a good indication about the performance and financial condition of an organisation. The financial statements may be used by the various agencies like Government or Reserve Bank of India, to formulate certain policy decisions. The financial statements may be used by the various tax authorities to ascertain the tax liability of the organisation in various areas like Income Tax, Sales Tax etc. Last but not least, on the basis of financial statements the management may review the progress of the organisation and decide about the course of action to be taken in future. However, it may be stated that the financial statements may not be really available to the management as a tool for decision making due to the various limitations attached to the same. Nevertheless, their basic role in the decision making process is undeniable. Thus, it is by way of the financial statements that an organisation speaks to the various persons dealing with it and gives the report to them about the performance and financial position of itself. It may not be out of place to mention here that if the accounts are required to be audited as per any of the statutory requirements (like provisions of Companies Act, 1956 or Income Tax Act, 1961) the financial statements prepared therefrom may be treated as more credible by the readers.

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Financial Management

Limitations of Financial Statements : (1)

Financial statements are available only after the specific period of time is over e.g. the Balance Sheet as on 31st March, 1990 is available only after 31st March, 1990 is over. The various legal provisions also provide for sufficient time lag for the preparation of financial statements. Thus, the financial statements give the information about the historic facts which may not be sufficient from decision making point of view for the management.

(2)

Financial statements are necessarily interim reports and cannot be final ones. E.g. to understand the correct profitability and to understand the correct position of various assets and liabilities, it will be necessary to stop the business operations and dispose off all the assets and liquidate all the liabilities which may not be practicable and feasible. In order to prepare the financial statements for a specific period, it may be necessary to cut off various transactions involving costs and incomes at the date of closing the accounts which may involve the personal judgements. Various policies and principles are required to be formulated and followed consistently for such cutting off of incomes and costs.

(3)

As ‘going concern principle’ is followed while preparing the Balance Sheet, the various assets and liabilities are shown at historical prices and do not necessarily represent the current market prices or the liquidation prices. This may affect the profitability statement as well in the form of incorrect provision for depreciation. This problem may be more critical during the periods of extreme inflation or depression. As such, any conclusions drawn on the basis of such financial statements may be misleading ones.

(4)

Financial statements consider only those transactions which can be expressed in monetary terms. All other transactions or factors which cannot be expressed in terms of money are ignored by the financial statements. E.g. Assuming that the business of a company is such that it is likely to be injurious to the health of local community. As such, there is a strong opposition from the local community for the company’s carring on of business at that location. This opposition is something which cannot be expressed in terms of money and hence finds no place in the financial statements though it is affecting the business operations of the company to a very great extent.

(5)

The financial statements prepared may be useful for the use of normal users under normal circumstances. If a user wants to use the financial statements for some special purposes, the necessary information or details may not be available from the financial statements. E.g. If a user, on the basis of financial statements available wants to value the equity shares of the company with the methods considering earnings capacity of the company, the required details may not be available from the financial statements. Similarly, the financial statements may not give correct indications about the profitability or the financial conditions of the business under abnormal circumstances. E.g. Suppose that the production and sales of a company in a particular year are abnormally high due to

Financial Statements

41

the prolonged strike in one of the major competitor companies, and hence profits in that particular year are abnormally high. Now when both the sales and profits are at normal level, the performance of that year may be treated as bad as compared to abnormal year. (6)

Financial statements, howsoever carefully and correctly prepared, do not mean anything all by themselves unless the information stated therein is properly studied, analysed and interpreted. As such, merely the preparation of financial statements is not sufficient, equally important is the task of their analysis and interpretation.

ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS As stated earlier the financial statements are not useful unless they are properly analysed and interpreted. The process of analysis of financial statements involves the arrangement and rearrangement, grouping and regrouping of the financial and operational data appearing on the financial statements, and the calculations of ratios and trends therefrom. The process of interpretation follows that of analysis and involves the attempts to arrive at logical conclusions regarding the performance and financial position of the business organisation. Types of Analysis : There can be basically two ways in which the analysis of financial statements can be carried out. (1)

Internal Analysis : This indicates the analysis carried out by those parties who have the access to the books and records of the company. Naturally, it indicates basically the analysis carried out by the management of the company to enable the decision making process. This may also indicate the analysis carried out in the legal or statutory matters where the parties who are not a part of the management of the company may have the access to the books and records of the company.

(2)

External Analysis : This indicates the analysis carried out by those parties who do not have the access to the books and records of the company. This may involve the analysis carried out by creditors, prospective investors and other outsiders. Naturally, those outsiders are required to depend upon the published financial statements. As such, the depth and correctness of the external analysis is restricted, though some of the recent amendments to the statutes like Companies Act, 1956 have made it mandatory for the companies to reveal maximum information relating to the operations and financial position, in order to facilitate the correct and proper analysis and interpretation of the financial statements by the readers.

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Financial Management

Techniques of Analysis and Interpretation : Though there may be numerous techniques available for the analysis and interpretation of financial statements, we will consider the following two techniques in details. (a)

Ratio Analysis

(b)

Funds Flow/Cash Flow Analysis.

Financial Statements

43

NOTES

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Financial Management

Chapter 4 INTERPRETATION OF FINANCIAL STATEMENTS (RATIO ANALYSIS)

INTRODUCTION Generally, an absolute figure conveys no meaning. A figure may become meaningful if it is compared with some other information. Similarly, the absolute figures appearing on the financial statements, either the profitability statement or the balance sheet, may not give the qualitative indication regarding the financial position or performance of an organisation which may be available if the accounting figures appearing in the financial statements can be compared with each other. E.g., If the profitabilty statement discloses the amount of Rs. 1 Lakh as the net profit, it appears to be a good performance. But if this information is supported by the fact that the sales turnover during the corresponding period was Rs. 10 crores. It can be immediately concluded that the performance of the organisation is not all that fabulous, as the net profit as a percentage of sales turnover is only 0.1%. The comparison of profit on one hand and sales turnover on the other hand, gives a qualitative indication about the performance of the organisation. Here comes into the picture the technique of ‘Ratio Analysis’. The term ‘ratio’ implies arithmetical relationship between two related figures. The technique of ‘Ratio Analysis’ as technique for interpretation of financial statements deals with computation of various ratios, by grouping or regrouping the various figures and/or informations appearing on the financial statments (either profitablity statement or Balance sheet or both) with the intention to draw the fruitful conclusions therefrom. It should be remembered that ratios, depending on the nature of ratio, may be expressed in either of the following ways : (a)

Percentage e.g., Net Profit as 10% of Sales.

(b)

Fractions e.g., Retained Earnings as 1/3rd of Share Capital.

(c)

Stated comparison between numbers e.g., Current Assets as twice the Current Liabilities.

Interpretation of Financial Statements (Ratio Analysis)

45

INTERPRETATION OF RATIOS The ratios calculated on the basis of grouping and regrouping of the figures appearing on either profitability statement or Balance Sheet or both, may not all by themselves mean anything, unless they can be compared with some yardstick. The yardstick with which the ratios can be compared may be in following three forms : 1)

The ratios of one organisation may be compared with the ratios of the same organisation for the various years, either the previous years or the future years. This may be in the form of “intra-firm comparison.”

2)

The ratios of one organisation may be compared with the ratios of other organisations in the same industry and such comparison will be meaningful as the various organisations in the same industry may be facing similar kinds of financial problems. This may be in the form of “inter-firm comparison.”

3)

The ratios of an organisation may be compared with some standards which may be supposed to be thumb rule for the evaluation of the performance e.g., If the comparison of current assets and current liabilities of an organisation is to be made, the resutl of 2 : 1 i.e., two rupees of current assets for one rupee of current liabilities is supposed to be ideal. The position as reflected by the actual current assests and actual current liabilities may be compared with this standard to evaluate the performance of the organisation.

ROLE OF RATIO ANALYSIS It is true that the technique of Ratio Analysis is not a creative technique in the sense that it uses the same figures and information which is already appearing in the financial statements. At the same time, it is also true that what can be achieved by the technique of Ratio Analysis cannot be achieved by the mere preparation of financial statements. Ratio Analysis helps to appraise the firms in term of their profitablity and efficiency of performance, either individually or in relation to those of other firms in the same industry. The process of this appraisal is not complete until the ratios so computed can be compared with something, as the ratios all by themselves do not mean anything. This comparison may be the intra-firm comparison, inter-firm comparison or comparison with standard ratios. Thus, proper comparison of ratios may reveal where a firm is placed as compared with earlier periods or in comparison with other firms in the same industry. Ratio Analysis is one of the best possible techniques available to the management to impart the basic functions like planning and control. As the future is closely related to the immediate past, ratios calculated on the basis of historical financial statements may be of good assistance to predict the future. E.g., On the basis of inventory turnover ratio or debtors turnover ratio in the past, the level of inventory and debtors can easily be ascertained for any given amount of

46

Financial Management

sales. Similarly, the ratio analysis may be able to locate and point out the various areas which need the management’s attention in order to improve the situation. E.g., Current Ratio which shows a constant declining trend may indicate the need for the further introduction of long term finance in order to improve the liquidity position. It should be remembered that a few specific ratios indicate certain specific aspects of the conduct of business. As such, the importance of various ratios may vary for different catagory of persons as well. E.g., the commercial bankers, trade creditors and lenders of short term credit are basically interested in the liquidity position of the organisation and as such the ratios like current ratio, acid test ratio, inventory turnover ratio and average collection period are more important. On the other hands, the financial institutions and lenders of long-term finance are basically interested in the solvency and profitabilty position of the organisation and as such the ratios like debt equity ratio, debt service coverage ratio, interest coverage ratio and return on investment are more important. As the ratio analysis is concerned with all the aspects of a firm’s financial analysis i.e., liquidity, solvency, activity, profitability and overall performance, it enables the interested persons to know the financial and operational characteristics of an organisation and take the suitable decisions. CLASSIFICATIONS OF RATIOS : The ratios may be classified under various ways which may use various criterians to do the same. However, for convenience purposes, we will classify the ratios under the following groups.

(A)

(a)

Liquidity Group.

(d)

Profitability Group

(b)

Turnover Group.

(e)

Overall Profitability Group.

(c)

Solvency Group.

(f)

Miscellaneous Group.

LIQUIDITY GROUP

The ratios computed under this group indicate the short term position of the organisation and also indicate the efficiency with which the working capital is being used. Commercial banks and short term creditors may be basically interested in the ratios under this group. Two most important ratios may be calculated under this group.

Interpretation of Financial Statements (Ratio Analysis)

47

(1)

Current Ratio : It is calculated as : Current Assets Current Liabilities

Components : Current Assets include cash in hand or at bank, marketable securities, sundry debtors, bills receivables, inventories, prepaid expenses and short term loans and advances Current liabilities include sundry creditors, bills payable, outstanding expenses and bank overdraft or cash credit. Following propositions should be considered. (i)

Disagreement may be there for inclusion of bank overdraft or cash credit in current liabilities. Strictly speaking, in legal terminology, cash credit or overdraft facilities are the demand facilities i.e., Banks can ask for repayment at any time. However, in practice, these facilities are usually permanent facilities. Hence, it may be argued that they should be considered as non current liabilities. However, considering the legal implications of the same, it is better to treat them as current liabilities.

(ii)

If bills receivables raised by the organisation are discounted with the Bank, they cease to appear as the receivables in the Balance Sheet except by way of the note to the same. At the same time, they indicate the working capital facility granted by the Bank to that extent. For the purpose of correct computation of current ratio, the amount of bills discounted with Banks should be added to both current assets as well as current liabilities.

Indication/Precautions : Current ratio indicates the backing available to current liabilities in the form of current assets. In other words, a higher current ratio indicates that there are sufficient assets available with the organisation which can be converted in the form of cash, without any reduction in value, in a short span of time i.e., current assets, to pay off the liabilities which are to be paid off in the short span of time, i.e. current liabilities. As such, higher the current ratio, better will be the situation. A current ratio of 2:1 is supposed to be standard and ideal. However, a blind comparison of actual current ratio with the standard current ratio, may lead to unrealistic conclusions. As such, before drawing the conclusion that higher current ratio indicates safe situation, following propositions should be kept in mind. 1)

48

It should be ensured that the valuation of current assets and current liabilities is made on a consistant basis and as per the accepted accounting principles. Financial Management

2)

It should be ensured that the current assets do not include the inventories which are obsolete or non moving and the receivables do not include debts which are outstanding for a very long time and are not provided for which may be almost non recoverable. If the current assets include these types of assets, for correct computation of current ratio, they may be excluded form current assets.

3)

If current ratio is computed on the basis of Balance Sheet figures, abnormal purchases of inventories or abnormal creation of receivables towards the end of accounting period should be considered in the right perspective.

4)

A higher current ratio indicate unnecessarily high investment in current assets in the form of inventories or receivables or both.

(2)

Liquid Ratio or Acid Test Ratio or Quick Ratio It is an improved version of current ratio. It is calculated as : Liquid Assets Liquid Liabilities

Components : Liquid Assets include all current assets except inventories and prepaid expenses. Liquid Liabilities include all current liabilities except bank overdraft or cash credit. Indications/Precautions : Liquid ratio indicates the backing available to liquid liabilities in the form of liquid assets. The term liquid assets indicates the assets which can be converted in the form of cash, without any reduction in value, almost immediately whereas, the term liquid liabilities indicates the liabilities which are required to be paid almost immediately. In other words, a higher liquid ratio indicates that there are sufficient assets available with the organisation which can be converted in the form of cash almost immediately to pay off those liabilities which are to be paid off almost immediately. As such, higher the liquid ratio, better will be situation. A liquid ratio of 1:1 is supposed to be standard and ideal. Before drawing any conclusions regarding the indications given by the liquid ratio, following propositions should be kept in mind: 1)

Liquid assets exclude the current assets in the form of inventories and prepaid expenses, but include the current assets in the form of receivables. Whereas the exclusion of

Interpretation of Financial Statements (Ratio Analysis)

49

prepaid expenses cannot be argued upon as they indicate the assets which cannot be converted in cash, the exclusion of inventories and inclusion of receivables may be challenged. There may be some kinds of inventories which can be disposed off almost immediately, due to their specific nature, and thus may be treated as liquid assets. At the same time, there may be some receivables outstanding for a very long time and not provided for, which may be almost non-recoverable and thus ideally will not be in the form of liquid assets. 2)

(B)

Non consideration of bank overdraft or cash credit as liquid liability can hardly be challanged as by its practical nature, it indicates the liability which is not required to be paid immediately. TURNOVER GROUP

The ratios computed under this group indicate the efficiency of the organisation to use the various kinds of assets by converting them in the form of sales. As the assets can be basically catagorised as Fixed Assets and Current Assets and as the current assets may further be classified according to the individual components of current assets viz. inventory and receivables (debtors) or as net current assets i.e., current assets less current liabilites viz., working capital, under this group of classification of ratios, following ratios may be computed. 1)

Fixed Assets Turnover Ratio : It is calculated as : Net Sales Fixed Assets.

Components : Net sales include sales after returns if any, both cash as well as credit. Fixed assets include net fixed assets i.e., fixed assets after providing for depreciation. Indications/Precautions : A high fixed assets turnover ratio indicates the capability of the organisation to achieve maximum sales with the minimum investment in fixed assets. It indicates that the fixed assets are turned over in the form of sales more number of times. As such, higher the fixed assets turnover ratio, better will be the situation.

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Financial Management

2)

Current Assets Turnover Ratio : It is calculated as : Net Sales Current Assets

Components : Net sales includes sales after returns if any, both cash as well as credit. Current Assets include the assets like inventories, sundry debtors, bills receivables, cash in hand or at bank, marketable securities, prepaid expenses and short term loans and advances. Indications/Precautions : A high current assets turnover ratio indicates the capability of the organisation to achieve maximum sales with the minimum investment in current assets. It indiates that the current assets are turned over in the form of sales more numer of times. As such, higher the current assets turnover ratio, better will be the situation. 3)

Working Capital Turnover Ratio : It is calculated as Net sales Working capital

Components : Net sales include sales after returns if any, both cash as well as credit. Working capital includes difference between current assets and current liabilities. Indications/precautions : A high working capital turnover ratio indicates the capability of the organisation to achieve maximum sales with the minimum investment in working capital. It indicates that working capital is turned over in the form of sales more number of times. As such, higher this ratio, better will be the situation.

Interpretation of Financial Statements (Ratio Analysis)

51

4)

Inventory/Stock Turnover Ratio : It is Calculated as : (a)

Cost of goods sold Average inventory Or

(b)

Net Sales Average inventory Or

(c)

Cost of goods sold Closing inventory Or

(d)

Net sales Closing inventory

It can be seen from above that the inventory turnover ratio may be expressed in either of the four ways as stated above though alternative ‘a’ may be the best possible way to express inventory turnover ratio. It is specifically due to the fact that other alternatives have certain flaws as stated below : (i)

Alternatives ‘b’ and ‘d’ consider the amount of sales as the numerator which includes the amount of profits where as the denominator in the form of either average or closing inventory is normally valued at costs (assuming market price is more.)

(ii)

Alternatives ‘c’ and ‘d’ consider closing inventory which ignores the possibility of certain seasonal or abnormal purchases at the end of accounting period which may increase the closing inventory. Alternative ‘a’ does not have both the above stated limitations. As numerator is in the form of cost of goods sold, it does not consider proft. As denominator is in the form of average inventory, it considers possibility of seasonal or abnormal purchases at the end of accounting period. Ideally, average inventory should be the average of monthly inventory specifically when the size of inventories fluctuates substantially during the year. As such, average inventory may be computed as Opening inventory + inventory at the end of every month 13

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Financial Management

However, in many cases, for conveniance purposes, inventory may be computed as the average of opening and closing inventory only. Indications/Precautions : A high inventory turnover ratio indicates that maximum sales turnover is achieved with the minimum investment in inventory. As such, as a general rule, high inventory turnover ratio is desirable. However, the high inventory turnover ratio should be viewed from some more angles. Firstly, it may indicate that there is under investment in inventory whereby the organisation may loose customer patronage if it is unable to maintain the delivery schedule. Secondly, high inventory turnover ratio may not necessarily indicate profitable situation. An organisation, in order to achieve a large sales volume, may sometimes sacrifice on profits, whereby a high inventory ratio may not result into high amount of profits. On the other hand, a low inventory turnover ratio may indicate over investment in inventory, existence of excessive or obsolete/non moving inventory, improper inventory management, accumulation of inventories at the year end in anticipation of increased prices or sales volume in near future and so on. There can be no standard inventory turnover ratio which may be considered to be ideal. It may depend on nature of industry and marketing stragies followed by the organisation. 5)

Debtors Turnover Ratio : It is calculated as : Net Credit Sales Closing Sundry Debtors

This ratio indicates the speed at which the sundry debtors are converted in the form of cash. However, this intention is not correctly achieved by making the calculations in this way. As such, this ratio is normally supported by the calculations of Average Collection Period, which is calculated as below. (a)

Calculation of daily sales : Net Credit Sales No. of working days

(b)

Calculation of average collection period : Closing Sundry debtors Daily sales.

Interpretation of Financial Statements (Ratio Analysis)

53

Following propositions should be kept in mind. 1)

As the concept of sundry debtors does not come into the picture in case of cash sales, while computing average collection period, only credit sales should be considered. However, in practice, break up of cash sales and credit sales may not be available from the published statement of accounts. Then the total sales may be considered for the computation of this ratio.

2)

While considering the toal amount of debtors, the bill receivables should be considered along with the debtors. Further, debtors not arising out of the regular sales transactions should be excluded as far as possible E.g., Debtors for the sale of fixed assets.

3)

In some cases, while computing this ratio, average sundry debtors instead of only closing sundry debtors may be considered.

4)

For the calculation of daily sales, it is customary to consider 360 days in a year instead of 365 days in a year. In some cases, it is also argued that weightage should be given to the holidays also when there are no busines transactions.

Indications/Precautions : The average collection period as computed above should be compared with the normal credit period extended to the customers. If the average collection period is more than normal credit period allowed to the customers, it may indicate over investment in debtors which may be the result of over-extension of credit period, liberalisation of credit terms, ineffective collection procedures and so on. However, before drawing the conclusions like this, the factor of distribution of sales throughout the year should be considered carefully. In other words, if the credit sales are not evenly distributed throughout the year, the result obtained from the computation of average collection period may be misleading. E.g., Assume a situation, where the total sales amount to Rs.18 Lakhs out of which credit sales are Rs.3.60 Lakhs. The organisation rarely sells on credit basis and the entire amount of credit sales were in the 11th month of the year, with the normal credit period allowed of 60 days. As such, the entire amount of Rs. 3.60 Lakhs will be outstanding at the year end in the form of Sundry debtors. The computation of average collection period will be made as below : (a)

Calculation of daily sales : Net credit sales No. of working days =

Rs. 3,60,000 360

= 54

Rs. 1000/ per day Financial Management

(b)

Calculation of average collection period : Closing sundry debtors Daily sales =

Rs. 3,60,000 Rs. 1000

=

360 days.

The average collection period thus calculated may then be compared with the normal credit period allowed to the customers i.e., 60 days and the conclusion may be drawn that there is a lapse on the part of collection department to collect the dues in time which may be a misleading one, as the outstanding sundry debtors represent the debts which are not yet due for payment. 6)

Capital Turnover Ratio : It is calculated as : Sales Capital Employed

Components : The term in denominator i.e., capital employed indicates the long term funds supplied by creditors and owners of the firms. As such, it can be computed in two ways. (a)

Fixed Assets + Investments + Current Assets - Current Liabilities.

(b)

Share Capital + Reserves and Surplus + Long Term Liabilities.

Indications/Precautions : This ratio indicates the efficiency of the organisation with which the capital employed is being utilised. A high capital turnover ratio indicates the capability of the organisation to achieve maximum sales with minimum amount of capital employed. It indicates that the capital employed is turned over in the form of sales more number of times. As such higher the capital turnover ratio, better will be the situation. (C)

SOLVENCY GROUP

The ratios computed under this group indicate the long term financial prospects of the company. The shareholders, debenture-holders and other lenders of long term finance/term loans may be basically interested in the ratios falling under this group. Following ratios may be computed under this group. Interpretation of Financial Statements (Ratio Analysis)

55

(1)

Debt Equity Ratio : It may be calculated in two ways. (a)

External Liabilities Shareholders’ Funds

(b)

Long Term Liabilities Shareholders’ Funds

Components : As per expression ‘a’ as stated above, the external liabilities include all types of liabilities viz., long term, short term or current. The expression ‘b’ as stated above, considers only long term liabilities which may be in the form of debentures, term loans and deferred payment liabilities. Shareholders’ funds in both the expressions consist of share capital plus reserves and surplus. There are controversial views regarding the treatement of preference shares capital i.e., whether the preference share capital should be treated as a part of debt or equity. No clear-cut principles are available regarding the treatment of preference share capital. However, generally the following type of treatment may be given. In case of the redeemable preference share capital, it they are redeemable after the period of 12 years, they may be treated as a part of equity, assuming the period of 12 years to be a sufficiently longer period of time. However, if the preference shares are redeemable before the period of 12 years, they may be treated as a part debt. It should be noted that the treatment given to the preference share capital as described above is only a matter of convention and practice, and not of any principle. Indications/Precautions : Debt Equity ratio indicates the stake of shareholders or owners in the organisation vis-a-vis that of the creditors. It indicates the cushion available to the creditors on liquidation of the organisations. A high debt equity ratio may indicate that the financial stake of the creditors is more than that of the owners. A very high debt equity ratio may make the proposition of investment in the organisation a risky one. On the other hand, a very low debt equity ratio may mean that the borrowing capacity of the organisation is being underutilised. In this context, the readers of financial management may remember that to borrow the funds form outsiders is one of the best possible ways to increase the earnings available to the equity shareholders, basically due to two reasons. Firstly, the expectations of the creditors in the form of return on

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Financial Management

their investment is comparatively less as compared to the returns expected by the equity shareholders. Secondly, the return on investment paid to the creditors is a tax deductible expenditure. (2)

Proprietory Ratio :

This ratio indicates the relationship between the owners’ funds and total assets. As the assets can be basically fixed or current, this ratio can be further analysed accordingly. As such, it can be calculated as : (a)

Total Assets Owners funds

(b)

Fixed Assests Owners funds

(c)

Current Assets Owners funds

Components : The term in denominator i.e., owners’ funds is the same as the term ‘Equity’ used in Debt Equity Ratio. Indications/Precautions : This ratio indicates the extent to which the owners funds are sunk in different kinds of assets. If the owners’ funds exceed fixed assets, it indicates that a part of owners’ funds is invested in the current assets also. If the owners’ funds are less than fixed assets, it indicates that a part of fixed assets is financed by the creditors-either long term or short term. Similarly, the ratio between the current assets to the owners funds indicates the extent to which owners’ funds are locked up in current assets. In some cases, higher proportion of current assets to owners’ funds, as compared to proportion of fixed assets to owners’ funds may be treated as a sign of good health of the business. (3)

Fixed Assets/Capital Employed Ratio : It is calculated as : Fixed Assets x 100 Capital Employed

Interpretation of Financial Statements (Ratio Analysis)

57

Components : The term in denominator i.e., capital employed indicates the long term funds supplied by creditors and owners of the firm. As such, it can be computed in two ways. (a)

Fixed Assets + Investments + Current Assets - Current Liabilities.

(b)

Share Capital + Reserves and Surplus + Long Term Liabilities.

Indications/Precautions : This ratio indicates the extent to which the long term funds are sunk in fixed assets. It has been an accepted principle of financial management that not only fixed assets should be financed by way of long term funds but also a part of current assets or working capital should be financed by way of long term funds, and this part may be in the form of permanent working capital. A very high trend of this ratio may indicate that a major portion of long term funds is utilised for the purpose of fixed assets leaving a small portion for the investment in current assets or working capital. A very high trend of this ratio coupled with a constant declining trend of current ratio may indicate an urgent need for the introduction of long term funds for financing the working capital in the business. (4)

Interest Coverage Ratio : It is calculated as : Profits before interest and taxes Interest changes

Components : The numerator considers the profits before interest on both term and working capital borrowings. In this connection, it should be noted that income tax should be added while computing the profits because, it is calculated after paying the interest. The denominator considers the interest charges which are in the form of interest on long term borrowing and not the interest on working capital facilities. Indications/Limitations : This ratio indicates the protection available to the lenders of long term capital in the form of funds available to pay the interest charges i.e., profits. Normally a high ratio will be desirable but too high a ratio may indicate under-utilisation of the borrowing capacity of the organisation, whereas too low a ratio may indicate excessive long term borrowings or inefficient operations.

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Financial Management

This ratio suffers from certain limitations.

(5)

(a)

The fixed obligations in the form of preference dividend or instalments of long term borrowings are not considered.

(b)

The funds available for meeting the obligations of interest payments may not be necessarily in the form of profits before interest and taxes only, as the amount of profits so calculated may consider the amount of depreciation debited to profit and loss account which does not involve any outflow of funds.

Debt Service Coverage Ratio (DSCR) :

This may be considered to be one of the most important ratios calculated by the Bankers or Financial Institutions giving long term finance to the organisation and the intention behind calculating this ratio is to ascertain the capability of the organisation to repay the dues arising as a result of long term borrowings. It is calculated as : Net profit after taxes + Depreciation + Interest on Term Loans Interest on Term Loans + Installments of Term Loans Indication/Precautions : Considering the intention of computing this ratio is to give indication about the capability of the organisation to meet the obligations of long term borrowing, the Banker or Financial Institutions will like to get this indication before the money is lent to the organisation. As such, this ratio calculated on estimated basis is considered by the Bankers or Financial Institutions before granting the term finance to the borrowing organisations. Too low a DSCR Indicates insufficient earning capacity of the organisations to meet the obligations of long term borrowings. At the same time, if too high a DSCR is estimated during the currency of the long term borrowings, it is quite likely that the period of term loan may be reduced from whatever is requested by the borrowing organisation. (D)

PROFITABILITY GROUP :

As the name itself suggests, the intention for calculating these ratios is to know the profitability of the organisation. Following ratios may be computed under this group.

Interpretation of Financial Statements (Ratio Analysis)

59

(1)

Gross Profit Ratio : It is calculated as : Gross Profit x 100 Net Sales

Components : The net sales consist of sales after deducting the sales returns if any. The gross profit indicates the difference between net sales on one hand and either of the following on the other hand. (a)

Manufacturing cost or factory cost or production cost in the case of manufacturing concerns.

(b)

Cost of purchases, expenses directly related to purchases and the adjustments for stock variations if any, in cases of trading concerns.

Indications/Precautious : The Gross Profit ratio indicates the relation between production cost and sales and the efficiency with which the goods are produced or purchased. A high gross profit ratio may indicate that the organisation is able to produce or purchase at a relatively lower cost. As such, a high gross profit ratio will be desirable. Gross profit ratio may be increased by any of the following methods : (a)

Increase sales price, production cost remaining the same.

(b)

Reduce production cost, sales price remaining the same.

(c)

Increase sales price, reduce production cost.

(d)

Increase volume of products having high gross profit margin.

An undue increase in gross profit ratio as well as an undue decrease in gross profit ratio should be carefully investigated. Undue increase in gross profit ratio may indicate : (i)

Over-valuation of closing stock.

(ii)

Non-consideration of purchase invoices.

(iii) Consideration of non-sales transactions as sales transactions E.g., Goods sent on consignment basis.

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Financial Management

Undue decrease in gross profit ratio may indicate (i)

Under-valuation of closing Stock

(ii)

Non-consideration of sales invoices.

(iii) Inability of management to control the cost or increase the sales. (iv)

Improper utilisation of infrastuctural facilities.

(2)

Net Profit Ratio : It is calculated as : Net Profit after taxes x 100 Net sales

Indication/Precautions : The Net Profit Ratio indicates that portion of sales available to the owners after the consideration of all types of expenses and costs – either operating or non-operating or normal or abnormal. A high net profit ratio indicates higher profitabliity of the business. As such a high net profit ratio will be desirable. (3)

Operating ratio : It is calculated as Manufacturing cost of goods sold + Operating Expenses

x 100

Net Sales Components : The numerator includes the various operating cost which a business has to incure in order to earn the profits. Following types of non-operating expenses are excluded from the numerator viz., Interest, Dividend (On equity as well as preference shares), loss on the sale and assets/ investments, Indications/Precautions : This ratio indicates the percentage of net sales which is absorbed by the operating costs. A high operating ratio indicates that only a small margin of sales is available to meet the expenses in the form of interest, dividend and other non operating expenses. As such, a low operating ratio will always be desirable. It can be used to measure the profitabliity only to a limited

Interpretation of Financial Statements (Ratio Analysis)

61

extent as the net profits available to the owners will be considering the non operating expenses as well as non operating income. (e)

Overall Profitability Group :

The ratios computed under this group indicate the relationship between the profits of a firm and investment in the firm. These ratios are popularly termed as Return On Investment (ROI). There can be three ways in which the term ‘investment’ may be interpreted i.e., Assets, Capital employed and Shareholders’ Funds. As such, there can be three broad classification of ROI.

(1)

(1)

Return On Assets (ROA)

(2)

Return On Capital Employed (ROCE)

(3)

Return On Shareholders’ Funds.

Return On Asset (ROA) : It is calculated as : Net Profit x 100 Assets

Components : There can be basically two ways in which the term net profit may be treated. Sometimes, net profit may be taken to mean net profit after taxes or sometimes it may be taken to mean net profit after taxes plus interest. Similarly, the term assets may also be treated in two ways. Sometimes assets may mean fixed assets or sometimes they may indicate tangible assets. Indications/Precautions : ‘ROA measures the profitability of the investments in a firm. As such, higher ROA will always be preferred. However, ROA does not indicate the profitability of various sources of funds which finance total assets. (2)

Return On Capital Employed (ROCE) :

It is calculated as : Net Profit + Interest on Long Term Sources

x 100

Capital Employed 62

Financial Management

Components : There can be basically two ways in which the term net profit may be treated. Sometimes, net profit may be taken to mean net profit after taxes or sometimes it may be taken to mean net profit after taxes plus interest. The term capital employed refers to long term funds supplied by creditors and owners of the firm. As such, the term capital employed can be computed in two ways. (a)

Fixed Assets + Investments + Current Assets - Current Liabilities.

(b)

Share Capital + Reserves and Surplus + Long Term Liabilities.

Indications/Precautions : ROCE measures the profitabliity of the capital employed in the business. A high ROCE indicates a better and profitable use of long term funds of owners and creditors. As such, a high ROCE will always be preferred. (3)

Return on Shareholders’ Funds :

This ratio indicates the profitablity of a firm in relation to the funds supplied by the shareholders or owners. As the shareholders can be of two broad types i.e., Equity Shareholders and Preference Shareholders, this ratio can be computed basically in two ways. (a)

Net Profit after taxes x 100 Total shareholders’ funds

Components : The numerator considers the net profit after taxes before the preference dividend. The denominator considers the equity capital, preference capital and reserves and surplus. (b)

Net Profit after taxes – preference dividend x 100 Shareholders’ Funds

Components : The numerator considers net profit after taxes as well as preference dividend as that is the amount which is available to the equity shareholders for the distribution by way of dividend. The denominators considers the equity capital and reserves and surplus.

Interpretation of Financial Statements (Ratio Analysis)

63

Indication/Precautions : This is the most important ratio to measure whether the firm has earned sufficient returns for its shareholders or not. As such, this ratio is the most crucial one from the owners/shareholders point of view. Higher this ratio, better will be the situation. (E) (1)

MISCELLANEOUS GROUP Capital Gearing Ratio : It is calculated as : Fixed Income Bearing Securities Equity Capital

Components : Fixed income bearing securities consist of preference share capital, debentures and long term loans. Interpretation : A high capital gearing ratio indicates that in the capital structure, fixed income bearing securities are more in comparison to the equity capital and in that case the company is said to be highly geared. On the other hand, if fixed income bearing securities are less as compared to equity capital, the company is said to be lowly geared. It may be worth recalling here that a company may attempt to employ the fixed income bearing securities in the overall capital structure with the intention to increase the equity shareholders’ earnings. As such, a high capital gearing ratio, to a certain extent, may be advantageous from the equity shareholders’ point of view. But if it is too high, investment in the company may become risky and further borrowing may not be possible for the company. Further, if the income of the company is unstable, a high capital gearing ratio may prove to be fatal, especially in the years of reducing income when a major portion of the income will be utilised to meet the obligations towards the fixed income bearing securities. (2)

Earnings Per Share (EPS) : It is calculated as : Net Profit after taxes - Preference Dividend Number of Equity Shares Outstanding

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Financial Management

Indications/Precautions : It is widely used ratio to measure the profits available to the equity shareholders on a per share basis. EPS is calculated on the basis of current profit and not on the basis of retained profits. As such, increasing EPS may indicate the increasing trend of current profits per equity share. However, EPS does not indicate how much of the earnings are paid to the owers by way of dividend and how much of the earnings are retained in the business. (3)

Price Earnings Ratio (P/E Ratio) : It is calculated as : Market Price Per Share Earning Per Share

Indications/Precautions : P/E Ratio indicates the price currently being paid in the market for each rupee of EPS. It measures the expectation of the investors. A high P/E Ratio may indicate the possiblity of increase in EPS. A low P/E Ratio may indicate that there is no possiblity of any increase in EPS and the investors will be reluctant to invest in such shares. This ratio is important from investors’ point of view. An ideal investor will compare between the current market price and future EPS as the value of shares depend upon the future EPS also. (4)

Dividend Payment Ratio (D/P Ratio) : It is calculated as : Dividend Per Share x 100 Earnings Per Share

Indications/Precautions : It measures the relationship between the earnings belonging to the equity shareholders and the amount finally paid to them by way of dividend. It indicates the policy of management to pay cash dividend. D/P Ratio when subtracted from 100, gives the indications about the policy of the management to retain the profits in the business with the intention to reinvest the same which is likely to have an effect on future market price of the share. LIMITATIONS OF RATIO ANALYSIS (1)

The basic limitation of the technique of ratio analysis is that it may be difficult to find a basis for making the comparisons. In case of the intrafirm comparison, the performance

Interpretation of Financial Statements (Ratio Analysis)

65

of an organisation may vary widely from year to year. In case of the interfirm comparison, it may become invalid due to various reasons.

66

(i)

The ratios of other organisations in the same industry may not be readily available.

(ii)

The constituent organisations in the same industry may vary from each other in terms of age, location, extent of automation, quality of the management and so on.

(iii)

Different accounting policies may be followed by the constituent organisations in the industry. The accounting policies may be different in the areas of valuation of inventories, provision for depreciation etc.

(2)

Normally, the ratios are calculated on the basis of historical financial statements. An organisation, for the purpose of proper decision making, may need the hint regarding the future happenings rather than transactions in the past. The managment of the organisation may predict the future to some extent on the basis of facts and figures available to it, but the external analyst has to depend upon the past which may not necessarily reflect financial position and performance in future.

(3)

The technique of ratio analysis may prove to be inadequate in some situations if there is difference of opinion regarding the interpretation of certain items while computing certain ratios E.g., In case of the computation of debt-equity ratio, the opinions may differ as to the treatment of preference share capital. Some may treat this as a part of debt while the others may treat this as part of equity.

(4)

As the ratios are computed on the basis of financial statements, the basis limitation which is applicable to the financial statements is equally applicable in case of the technique of ratio analysis. Also i.e., Only those facts which can be expressed in financial terms are considerd by the ratio analysis. E.g., The computation of debt equity ratio of an organisation may show a favourable trend thereby justifying the additional borrowings which the organisation may want to make. However, if the attitude of the management is not to meet the outside obligations in time, the lender of the finance may be misled by the computation of debt equity ratio.

(5)

The technique of ratio analysis has certain limitations of use in the sense that, it only highlights the strong or problem areas. It does not provide any solution to rectify the problem areas. Moreover, the technique of ratio analysis may indicate the strong or problem areas and that too only partially. For the correct and comprehensive analysis of the situations, it is necessary to investigate further in those strong or problem areas. E.g. A very high current ratio may not necessarily indicate good situation. Further investigations are required to be made to ensure that there are no obsolete or non moving

Financial Management

items of stock included in the closing stock or that there are no debts included in sundry debtors, which are outstanding for an unreasonable period of time and which may ideally be treated as bad debts. (6)

Ratio Analysis often gives a misleading indication if the effect of changes in price levels is not taken into account. Two different companies set up in different years and as such, having the infrastructural facilities of different ages cannot be compared on the basis of financial statements only. This is so, as the company which has purchased the infrastructural facilities years ago may be showing their value at a very lower amount while the other company might have purchased the same facilities at a very higher price.

Precautions to be taken : Considering the various limitations in respect of ratio analysis, following precautions should be taken before using it as a technique for interpretation of financial statements. (1)

Ratios are computed on the basis of financial statements. If the statements are reliable, then only the ratios computed therefrom will be meaningful. As such, before using the ratio analysis, the reliability of the financial statements should be confirmed.

(2)

Ratio should be computed on the basis of inter-related figures which have a cause and effect relationship. Computation of ratios on the basis of irrelevant figures may even lead to wrong conclusions. Eg. Ratio between sales and trade investments.

(3)

It should always be remembered that ratios only show symptoms and the indications given by the ratios can be interpreted correctly only after studying the realities behind the financial statements. Eg. A high current ratio should be treated as a good sign only after confirming the fact that there are no non-moving or obsolete stocks or non-recoverable debtors.

(4)

If possible, the impact of the inflationary conditions or changing price levels should be taken into account before computing the ratios. This may be done by using the technique of current purchasing power or current cost accounting.

(5)

In case of inter-firm comparison of ratios, following propositions should be kept in mind. (a)

The constituent units should be comparable in terms of size, age, nature of business, degree of automation etc.

(b)

The constituent units must be following similar accounting policies more particularly in the areas of charging the depreciation and stock valuation.

(c)

There should not be any holding back of any information or data by the constituent units.

Interpretation of Financial Statements (Ratio Analysis)

67

ILLUSTRATIVE PROBLEMS (1)

The current assets and current liabilities of your company as at 30.6.79 were Rs. 16 lakhs and Rs. 8 lakhs respectively. Calculate the effect of each of the following transactions individually and totally on the current ratio of the company : (i)

Purchase of new machinery for Rs. 5 lakhs on C.O.D.

(ii)

Purchase of new machinery for Rs. 10 lakhs on a Medium Term loan from your bank with 20% margin.

(iii)

Payment of dividend of Rs. 2 lakhs of which Rs. 0.47 lakhs was Tax deducted at source.

(iv)

A shipment of raw materials of landed cost Rs.5 lakhs was received against which the Bank finance obtained was Rs. 3 lakhs.

SOLUTION : Current Assets Present Current Ratio

= Current Liabilities Rs. 16 Lakhs =

=

2:1

Rs. 8 Lakhs Transaction 1 Purchase of new machinery on ‘Cash on Delivery’ (COD) basis, will result into increase in the debit balance of Machinery A/c (a non-current asset) and reduction in cash balance (a current asset.) As such, as a result of this transaction, the cash balance and hence current assets will be reduced by Rs.5 Lakhs, current liabilities remaining unaffected. Hence, the revised current ratio will be : Rs. 16 Lakhs - Rs. 5 Lakhs

Rs. 11 Lakhs =

Rs. 8 Lakhs.

= 1.375 : 1.00 Rs. 8 Lakhs.

Transaction 2 Purchase of new machinery for Rs. 10 Lakhs on a Medium Term loan with 20% margin indicates that the debit balance of Machinery A/C (a non-current asset) will increase by Rs. 10 Lakhs and the liability in the form of medium term loan (a non-current liability, ignoring the fact that the installments of loans due within one year may be treated as a part of current liabilities) will be increased to the extent of Rs. 8 Lakhs and the cash balance will be reduced

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Financial Management

to the extent of Rs.2 Lakhs (assuming that the margin money is paid immediately). As such, this transaction will affect current ratio only in one way i.e. reducing the cash balance by Rs. 2 Lakhs, current liabilities remaining unaffected. Hence, the revised current ratio will be : Rs. 16 Lakhs - Rs. 2 Lakhs

Rs. 14 Lakhs =

= 1.75 : 1.00

Rs. 8 Lakhs

Rs. 8 Lakhs

Transaction 3 The effect of payment of dividend of Rs.2 Lakhs of which Rs. 0.47 Lakhs was tax deducted at source, can be viewed basically from two angles. (a)

Assuming that the tax deducted at source is duly paid to the credit of Central Government, the effective outflow of cash will be Rs.2 Lakhs which will reduce the cash balance (a current asset), current liabilities remaining unaffected. Hence, the revised current ratio will be : Rs. 16 Lakhs - Rs. 2 Lakhs

Rs. 14 Lakhs =

= 1.75 : 1.00

Rs. 8 Lakhs (b)

Rs. 8 Lakhs

Assuming that the tax deducted at source is yet to be paid to the credit of Central Government, the cash balance (a current asset) will be reduced to the extent of net payment of dividend i.e. Rs. 1.53 Lakhs, while the current liabililities will be increased by Rs. 0.47 Lakhs. Hence, the revised current ratio will be : Rs. 16 Lakhs - Rs. 1.53 Lakhs

Rs. 14.47 Lakhs =

Rs. 8 Lakhs + Rs. 0.47 Lakhs

=

1.708 : 1.00

Rs. 8.47 Lakhs

Transaction 4 A shipment of raw material of landed cost Rs. 5 Lakhs received against which the Bank finance obtained is Rs.3 Lakhs, will affect the current ratio in three ways. Assuming that the stock so purchased is still not consumed, it will increase the stock in trade (a current asset) by Rs. 5 Lakhs. The fact that bank finance was obtained to the extent of Rs.3 Lakhs indicates that the balance of Rs. 2 Lakhs was paid by the company which will reduce the cash balance (i.e. a current asset). At the same time, bank finance obtained for the purchase of material will be a working capital facility (i.e. a current liability) assuming that the bank finance is still unpaid. Hence, the revised current ratio will be : Rs. 16 Lakhs + Rs. 5 Lakhs - Rs. 2 Lakhs

Rs. 19 Lakhs =

Rs. 8 Lakhs + Rs. 3 Lakhs =

Rs. 11 Lakhs

1.727 : 1.00

Interpretation of Financial Statements (Ratio Analysis)

69

Combined effect of all transactions : Considering all the transactions together, the current ratio will be affected as below : (a)

Assuming alternate ‘a’ in case of Transaction 3 Rs. 16 Lakhs - Rs. 5 Lakhs (1) - Rs. 2 Lakhs (2) - Rs. 2 Lakhs (3) + Rs. 5 Lakhs (4) - Rs. 2 Lakhs (4) Rs. 8 Lakhs + Rs. 3 Lakhs (4) Rs. 10 Lakhs =

= 0.909 : 1.00 Rs.11 Lakhs

(b)

Assuming alternate ‘b’ in case of Transaction 3 Rs. 16 Lakhs - Rs. 5 Lakhs (1) - Rs. 2 Lakhs (2) - Rs. 1.53 Lakhs (3) + Rs. 5 Lakhs (4) - Rs. 2 Lakhs (4) Rs. 8 Lakhs + Rs. 0.47 Lakhs (3) + Rs. 3 Lakhs (4) Rs. 10.47 Lakhs =

=

0.913 : 1.00

Rs. 11.47 Lakhs Note : Number in bracket indicates the transaction number.

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Financial Management

(2)

The following are the figures extracted from the books of XYZ Limited as at 30-9-1977. Particulars

Amount (Rs.)

Net sales

24,00,000

Operating expenses

18,00,000

Gross Profit

6,00,000

Non operating expenses

2,40,000

Net Profit

3,60,000

Current Assets

7,60,000

Inventories

8,00,000

Fixed Assets

14,40,000

Total Assets

30,00,000

Net worth

15,00,000

Debt

9,00,000

Current Liabilities

6,00,000

Total Liabilities

30,00,000

Working Capital

9,60,000

Calculate : (a) Gross profit ratio; (b) Net Profit ratio; (c) Return on assets; (d) Inventory turnover; (e) Working capital turnover and (f) Net worth to debt. SOLUTION : (1)

Gross Profit Ratio Gross Profit x 100 Sales 6,00,000 =

x 100

= 25%

24,00,000

Interpretation of Financial Statements (Ratio Analysis)

71

(2)

Net Profit Ratio Net Profit x 100 Sales 3,60,000 =

x 100

=

15%

=

12%

24,00,000 (3)

Return on Assets Net Profit x 100 Total Assets 3,60,000 =

x 100 30,00,000

(4)

Inventory Turnover Net sales Inventory 24,00,000 =

= 3 8,00,000

(5)

Working Capital Turnover Net sales Working Capital 24,00,000 =

= 2.5 9,60,000

(6)

Net Worth to Debt Net Worth Debt 15,00,000 =

= 1:67:1:00 9,00,000

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Financial Management

(3)

The following data are extracted from the published accounts of two companies in an industry : ABC Ltd.

XYZ Ltd.

Rs.

Rs.

32,00,000

30,00,000

1,23,000

1,58,000

10,00,000

8,00,000

General Reserves

2,32,000

6,42,000

Long term debt

8,00,000

6,60,000

Creditors

3,82,000

5,49,000

60,000

2,00,000

15,99,000

15,90,000

Inventories

3,31,000

8,09,000

Other Current Assets

5,44,000

4,52,000

Sales Net Profit after tax Equity Capital (Rs. 10 per share fully paid)

Bank Credit (short-term) Fixed Assets

You are required to prepare a statement of comparative ratios showing liquidity, profitability, activity and financial position of the two companies. SOLUTION (A)

LIQUIDITY GROUP ABC Ltd.

(1)

XYZ Ltd.

Current Ratio Current Assets

8,75,000

12,61,000

Current Liabilities

4,42,000

7,49,000

= 1.98

= 1.68

i.e. Inventories + Other Current Assets Creditors + Bank Credit

Interpretation of Financial Statements (Ratio Analysis)

73

(2)

Liquid Ratio Liquid Assets

5,44,000

4,52,000

Liquid Liabilities

3,82,000

5,49,000

= 1.42

= 0.82

i.e. Other Current Assets Creditors (B) (1)

PROFITABILITY GROUP Net Profit Ratio Net Profit after tax

1,23,000 x 100

Sales

(2)

30,00,000

= 3.84%

= 5.27%

1,23,000 x 100

Equity Capital

(2)

+ 2,32,000

+ 6,42,000

= 9.98%

= 10.96%

Sales

32,00,000

30,00,000

Fixed Assets

15,99,000

15,90,000

= 2.00

= 1.89

32,00,000

30,00,000

8,75,000

12,61,000

= 3.66

= 2.38

32,00,000

30,00,000

3,31,000

8,09,000

= 9.67

= 3.71

ACTIVITY GROUP Fixed Assets Turnover :

Current Assets Turnover

Inventories + Other Current Assets

Inventory Turnover Sales Inventories

74

x 100 8,00,000

Sales

(3)

1,58,000 x 100

10,00,000

+ General Reserves

(1)

x 100

32,00,000

Return on shareholders funds Net Profit after tax

(C)

1,58,000 x 100

Financial Management

(4)

Other Current Assets Turnover Sales

32,00,000

30,00,000

5,44,000

4,52,000

= 5.88

= 6.64

Sales

32,00,000

30,00,000

Capital Employed i.e.

20,32,000

21,02,000

= 1.57

= 1.43

8,00,000

6,60,000

12,32,000

14,42,000

= 0.65

= 0.46

Total Assets

24,74,000

28,51,000

Owners Funds

12,32,000

14,42,000

= 2.00

= 1.98

Fixed Assets

15,99,000

15,90,000

Capital Employed

20,32,000

21,02,000

= 0.79

= 0.76

Other Current Assets

(5)

Capital Employed Turnover

Equity Capital + General Reserves + Long Term Debt (D) (1)

FINANCIAL POSITION GROUP Debt Equity Ratio Debt Equity Long Term Debt = Equity Capital + General Reserves

(2)

Proprietory Ratio

Total Assets = Equity Capital + General Reserves (3)

Fixed Assets/Capital Employed Ratio

Interpretation of Financial Statements (Ratio Analysis)

75

4)

From the following information, draw the Balance Sheet of M/s. Ravi & Co. as on 31st March, 1993 : Current Ratio

2:1

Liquid Ratio

1:1

Return on Capital Employed

10%

Fixed Assets Turnover Ratio

5:8

Closing Stock was 12.5% of sales Owners’ Equity to Fixed Assets

8 : 15

ACP

1 Month

Debt Equity Ratio

5:4

For the year ended 31st March, 1993, M/s. Ravi & Co. made a profit of Rs. 1,00,000 after paying interest of Rs. 1,20,000 on term loan but before tax. Tax paid for the year was Rs. 40,000, Bank Balance stood at Rs. 1,00,000 besides stock and debtors of the concern. Solution : Balance Sheet as on 31st March, 1993 Liabilities

Rs.

Owners’ Equity Debt

Assets

Rs.

8,00,000

Fixed Assets

15,00,000

10,00,000

Cash & Bank

1,00,000

Stock

3,00,000

Sundry Debtors

2,00,000

Current Liabilities

3,00,000

21,00,000

21,00,000

Working Notes : Profit Before Tax

Rs. 1,00,000

Less : Tax

Rs. 40,000

Hence, Profit After Tax

Rs. 60,000

Return on Capital Employed is known as 10% Hence, Profit After Tax + Interest x 100 = 10 Capital Employed

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Financial Management

As Interest is known as Rs. 1,20,000, Profit After Tax + Interest = Rs. 1,80,000. Hence, Capital Employed will be Rs. 18,00,000. As Debt Equity Ratio is 5:4 Debt

5 =

Eqity

4

Hence, Debt = 1.25 Equity. As Capital Employed is Rs. 18,00,000 Debt + Equity = Rs. 18,00,000 Replacing the value of Debt in the above equation we get, 1.25 Equity + Equity = 18,00,000 Hence, 2.25 Equity = 18,00,000 Hence, Equity = 8,00,000 Hence, Debt = 10,00,000 Owners’ Equity to Fixed Assets is 8 : 15 As Equity is known as Rs. 8,00,000, Fixed Assets = Rs. 15,00,000 As Fixed Assets Turnover Ratio is 5 : 8, Sales/Fixed Assets = 5/8 As Fixed Assets are Rs. 15,00,000, Sales = Rs. 24,00,000 Closing Stock is 12.5% of sales As sales = Rs. 24,00,000, Closing Stock will be Rs. 3,00,000 ACP is 1 month Assuming that all the sales are credit sales, Debtors x 12 =1 Credit Sales

Interpretation of Financial Statements (Ratio Analysis)

77

As Credit Sales are Rs. 24,00,000, Debtors will be Rs. 2,00,000 Currnet Ratio is 2:1, Hence, Current Assets/Current Liabilities = 2 Hence, Current Assets = 2 Current Liabilities Liquid Ratio is 1:1, It is assumed that there is no cash credit or overdraft. Hence,

Current Assets – Stock =1 Current Liabilties

As stock is known as Rs. 3,00,000 2 Current Liabilities – 3,00,000 =1 Current Liabilities This leads us to the conclusion of Current Liabilties = Rs. 3,00,000 Current Assets = Rs. 6,00,000 5)

Complete the following statements on the basis of the ratios given below : Profit & Loss Account for the year ended 30th June 90

Cost of goods sold

6,00,000

Operating expenses

–

EBIT

–

Sales

– Debenture Interest

10,000

Income Tax

–

Net Profit

– –

78

20,00,000

– EBIT

–

–

Financial Management

Balance Sheet as on 30th June, 90 Liabilities

Rs.

Assets

Rs.

Share Capital

–

Fixed Assets

–

Reserves & Surplus

–

Cash

–

10% Debentures

–

Stock

–

Sundry Creditors

60,000

Debtors

–

35,000 –

Additional Information : a.

Net Profit to sales

5%

b.

Current Ratio

1.5

c.

Return on Net Worth

20%

d.

Inventory Turnover (based on cost of goods sold)

15 times

e.

Share Capital to Reserves

4:1

f.

Rate of Income Tax

50%

Solution : Profit & Loss Account for the year ended 30th June, 90 Cost of goods sold

6,00,000

Operating expenses

11,90,000

EBIT

Sales

2,10,000 20,00,000

Debenture Interest

20,00,000

10,000

Income Tax

1,00,000

Net Profit

1,00,000 2,10,000

Interpretation of Financial Statements (Ratio Analysis)

20,00,000 EBIT

2,10,000

2,10,000

79

Balance Sheet as on 30th June, 90 Liabilities

Rs.

Assets

Rs.

Share Capital

4,00,000

Fixed Assets

5,70,000

Reserves & Surplus

1,00,000

Cash

15,000

10% Debentures

1,00,000

Stock

40,000

Sundry Creditors

60,000

Debtors

35,000

6,60,000

6,60,000

Working Notes : a.

Net Profit to Sales is 5% As Sales are Rs. 20,00,000 (given), Net Profit is Rs. 1,00,000. As the rate of Income Tax is 50%, Income Tax = Net Profit Hence, Income Tax will be Rs. 1,00,000.

b.

Current Ratio is = 1.50 As Current Liabilities are Rs. 60,000. Current Assets are Rs. 90,000

c.

Inventory Turnover Ratio is 15. Hence, Cost of goods sold/Closing Stock = 15 As cost of goods sold is Rs. 6,00,000 (given), Closing Stock will be Rs. 40,000.

d.

Out of the Total Current Assets of Rs. 90,000, Stock is Rs. 40,000 and the Debtors are Rs. 35,000. Hence, Cash is Rs. 15,000.

e.

Return on Net Worth is 20% Net Profit/Net Worth x 100 = 20 As Net Profit is Rs. 1,00,000 (as per a above), Net Worth will be Rs. 5,00,000.

f.

Share Capital to Reserves is 4 : 1 and Share Capital + Reserves i.e., Net Worth is Rs. 5,00,000, Hence, Share Capital is Rs. 4,00,000 and Reserves are Rs. 1,00,000.

6)

80

Using the following data, complete the Balance sheet given below : Gross Profit (20% of sales)

–

Rs. 60,000

Shareholders’ Equity

–

Rs. 50,000

Credit sales to Total sales

–

80% Financial Management

Total Assets Turnover

–

3 times

Inventory Turnover (to cost of sales)

–

8 times

ACP (360 days a year)

–

18 days

Current Ratio

–

1.6

Long Term Debt to Equity

–

40%

Balance Sheet Liabilities

Rs.

Creditors

–

Cash

–

Long term Debt

–

Debtors

–

Inventory

–

Fixed Assets

–

Shareholders’ Equity

50,000

Assets

–

Rs.

–

Solution : Balance Sheet Liabilities

Rs.

Assets

Creditors

30,000

Cash

Long term Debt

20,000

Debtors

12,000

Shareholders’ Equity

50,000

Inventory

30,000

Fixed Assets

52,000

1,00,000

Rs. 6,000

1,00,000

Working Notes : 1.

Gross Profit (20% of Sales) is Rs. 60,000. Hence, Total Sales are 60,000 x 100/20 i.e., Rs. 3,00,000......a Hence, Cost of sales is Rs. 2,40,000 i.e., Rs. 3,00,000 – Rs. 60,000....b

2.

Credit Sales to Total Sales are 80% As total sales are Rs. 3,00,000, (as per a above) Credit Sales will be 80% of Rs. 3,00,000 i.e., Rs. 2,40,000 . . . .c

3.

Total Assets Turnover is 3 times Hence, Sales/Total Assets = 3

Interpretation of Financial Statements (Ratio Analysis)

81

Hence, Sales/3 = Total Assets As Sales are Rs. 3,00,000 (as per a above), Hence, Total Assets will be Rs. 1,00,000 . . . . .d Hence, Total Liabilties will be Rs. 1,00,000 . . . . e 4.

Inventory turnover (to Cost of Sales) is 8 times. Hence, Cost of Sales/Inventory = 8 Hence, Cost of Sales/8 = Inventory As Cost of Sales is Rs.2,40,000 (as per b above), Inventory will be Rs. 30,000 . . . . . f

5.

Average Collection Period (360 days a year) is 18 days. Hence, Debtors x 360/Credit Sales = 18 days Hence, Credit Sales x 18/360 = Debtors As Credit Sales are Rs. 2,40,000 (as per c above), Debtors will be Rs. 12,000 . . . . .g

6.

Long Term Debt to Equity is 40% However, Equity is Rs. 50,000 (given). Hence, Long Term Debt will be Rs. 20,000 . . . . .h

7.

Total Liabilities are Rs. 1,00,000 (as per e above). Hence, Creditors + Long Term Debt + Equity = 1,00,000 Hence, Creditors + 20,000 + 50,000 = 1,00,000 Hence, Creditors will be Rs. 30,000 . . . . . . i

8.

Current Ratio 1.6 Hence, Current Assets/Current Liabilities = 1.6 Hence, Current Assets = Creditors x 1.6 As creditors are Rs. 30,000 (as per i above), Hence, Current Assets will be Rs. 48,000 . . . . j

9.

As Current Assets are Rs. 48,000 (as per j above) Cash + Debtors + Inventory = 48,000 Hence, Cash + 12,000 + 30,000 = 48,000 Hence, Cash will be Rs. 6,000 . . . . .k

10. Total Assets are Rs. 1,00,000 (as per d above), Hence, Current Assets + Fixed Assets = 1,00,000 Hence, 48,000 + Fixed Asssets = 1,00,000 Hence, Fixed Assets will be Rs. 52,000 . . . . . . .l

82

Financial Management

Balance Sheet as on 31st December 1983 Capital & Liabilities Issued Capital Reserves Current Liabilities Profit and Loss A/c

Rs.

Assets

Rs.

2,00,000

Land and Building

1,50,000

90,000

Plant & Machinery

80,000

1,30,000 60,000

Stock in trade

1,49,000

Sundry Debtors 75,000 Less : Provision for doubtful debts 4,000 71,000 Cash & Bank balances

30,000

4,80,000

4,80,000

From the above statement, you are required to calculate the following ratios and state the purpose they serve. (1) Current ratio (2) Operating ratio, (3) Stock turnover, (4) Fixed assets turnover, (5) Return on capital employed 4.

Following is the Balance Sheet of Adarsh Products Ltd., as at 31st December 1982. Liabilities

Rs.

Equity Share of Rs. 100 each

4,00,000

Premium on shares

20,000

General Reserves

70,000

Profit and Loss A/c

12,500

Creditors

1,97,700

Proposed Dividend

20,000

Provision for Taxation

27,000 Total

Interpretation of Financial Statements (Ratio Analysis)

7,47,200

115

Assets

Rs.

Fixed Assets (at cost)

4,70,000

Less Depreciation.

81,900

3,88,100

Stock-in-trade

1,70,500

Sundry Debtors

1,42,700

Cash and Bank Balance

45,900 Total

7,47,200

The following additional information is available : (a)

The Profit for the year was Rs. 46,000

you are required to arrange the above items in the form of a financial analysis and compute the following :

5.

(i)

Current Ratio

(ii)

Liquid Ratio (Acid Test Ratio)

(iii)

Return on proprietor’s funds, together with other comments in case of each ratio.

From the Balance Sheet of a corporation given below, compute, (a) Working capital (b) Net Capital Employed (c) Current Ratio (d) Acid Test Ratio (d) Debt Equity Ratio. Balance Sheet as on 31.12.1985 Liabilities Equity Share Capital

Rs. 25,000

Rs.

Fixed Assets

30,000

Preference Share Capital

5,000

Stores

2,000

Reserves & Surplus

4,000

Stock in trade

4,000

Debentures

8,000

Sundry Debtors

1,000

Bank Loans

4,000

Cash in hand

Sundry Creditors

1,000

Balance with Scheduled Bank

Proposed dividends

1,000

Provision for taxation

2,000

50,000

116

Assets

500 2,500

Preliminary Expenses Brokerage on subscription of shares

8,000 2,000 50,000

Financial Management

6.

The following are the summarised Balance Sheet of Sunrise Co. Ltd. (Rs. in Lakhs) Liabilities

31.12.80

31.12.81

Assets

2.00

3.00

Land &

Share Capital

31.12.80

31.12.81

Building

0.50

0.40

General Reserve

0.60

0.70

Machinery

1.50

2.30

Profit & Loss A/c

0.30

0.40

Furniture

0.30

0.30

Debentures

0.50

1.00

Stock

0.40

0.56

Creditors

1.20

1.30

Debtors

1.80

2.40

Provision for taxation

0.60

0.70

Cash and Bank Bal.

0.50

1.04

0.20

0.10

5.20

7.10

Preliminary Expenses 5.20

7.10

The Summarised Profit and Loss Account is as under : 31.12.80

31.12.81

Sales

2.40

4.00

Less : Cost of goods sold

1.60

2.40

Gross Profit

0.80

1.60

Less : Administration and Selling Expenses

0.32

0.60

Net Profit

0.48

1.00

Calculate the following accounting ratios and comment in brief on each of them. (a)

Gross Profit Ratio

(b)

Net Profit Ratio

(c)

Return on Capital Employed

(d)

Stock Turnover Ratio

Interpretation of Financial Statements (Ratio Analysis)

117

7.

(e)

Current Ratio

(f)

Debt Equity Ratio

From the following Annual Accounts of ABC Ltd. for the year ended 31st March 1984, you are required to calculate the following ratios and state the significance of each. (1)

Current Ratio

(2)

Acid Test Ratio

(3)

Operating Ratio

(4)

Stock Turnover Ratio

(5)

Debtors Turnover Ratio

(6)

Return on Proprietors Ratio Balance Sheet as on 31st March 1984 (Omitted’ 000)

Liabilities

Rs.

Assets

Rs.

Share Capital

500

Land & Building

500

General Reserve

400

Plant & Machinery

200

Profit and Loss A/c

150

Stock

150

Sundry Creditors

200

Sundry Debtors

250

Cash & Bank Balances

150

1250

118

1250

Financial Management

Profit & Loss Account for the year ended 31st March 1984 (Omitted’ 000) To, Opening Stock To, Purchases

250 1050

To, G.P. c/d

By Sales By Closing Stock

150

650 1950

1950

To, Selling Expenses

100

By G.P. b/d

To, Administration Expenses

230

By Profit on sale of fixed assets

To, Miscellaneous Expenses To, Net Profit

650

50

20 350 700

8.

1800

700

From the following statement of a Limited Company as on 31st December, 1988 prepare a statement showing (1)

Current Ratio

(2)

Liquid Ratio

(3)

Debt Equity Ratio

(4)

Return on Proprietory Fund

(5)

Capital Gearing Ratio

The Profit for the year was Rs. 90,000 Financial Statement as at 31st December, 1988 Rs. Issued and Paid up Share Capital Preference. Shares of Rs. 100 each

2,00,000

Ordinary. Shares of Rs. 10 each

5,00,000

Interpretation of Financial Statements (Ratio Analysis)

119

Reserves and Surplus General Reserves

80,000

P & L A/c Balance

10,000 7,90,000

Debentures

1,00,000 8,90,000

Current Assets : Closing Stock

3,50,000

Sundry Debtors

2,50,000

Cash in Hand

15,000

Cash at Bank

35,000 6,50,000

Less Current Liabilities : Sundry Creditors Proposed Dividend

3,00,000 25,000

Interest Accrued

5,000

Provision for Tax

20,000 3,50,000

Net Current Assets :

3,00,000

Fixed Assets

6,90,000

Less Depreciation

1,00,000

5,90,000 8,90,000

120

Financial Management

9.

Following are the financial statements of Greenfield India Ltd. for the year 1986 Balance Sheet as on 31st December 1986 Owners Equity

Rs.

Fixed Assets

Rs.

7% Preference Shares Capital

1,00,000

Buildings

3,00,000

Equity Share Capital

4,00,000

Plant & Machinery

2,00,000

General Reserve

4,50,000

Furniture

1,00,000

Retained Earning

12,500

Debt

Patents

25,000

Current Assets

6% Debenture

50,000

Cash

1,10,000

Loan (Long Term)

40,000

Bank

65,000

8% Bonds

10,000

Investments (Government Securities)

90,000

Current Liabilities Creditors

30,000

Sundry Debtors

57,500

Bills Payable

10,000

Bills Receivable

40,000

Bank Overdraft

10,000

Stock

Outstanding Expenses

10,000

Prepaid Expenses

Proposed Dividend

25,000

1,50,000

11,47,500

10,000

11,47,500

Profit and Loss Account for the year ended on 31st December 1986 Rs. Sales

12,00,000

Less : Cost of Goods Sold

8,00,000

Gross Profit

4,00,000

Less : Expenses

3,50,000

Net Profit

50,000

Interpretation of Financial Statements (Ratio Analysis)

121

Compute the following ratios (1)

Current Ratio

(2)

Acid Test Ratio

(3) (4)

Gross Profit Ratio Return on Proprietors’ Funds

(5) (6)

Debt Equity Ratio Fixed Assets to Net Tangible Worth Ratio

(7)

Current Assets to Proprietors Funds Ratio

(8) (9)

Total Assets Turnover Ratio Operating Ratio

(10) Return on Capital Employed. 10. Following is the Balance Sheet of Standard Ltd. as on 31st December 1985. Liabilities Equity Share Capital Capital Reserve 8% loan on Mortgage Trade Creditors Bank Overdraft Taxation - Current - Future

Rs. 20,000 4,000 16,000 8,000 2,000 2,000

Assets Goodwill

Rs. 12,000

Fixed Assets

28,000

Stock Debtors

6,000 6,000

Investments Bank

2,000 6,000

2,000

Profit & Loss Account profit after Interest and taxation Less : Transfer to Reserves Dividends

12,000 4,000 2,000 6,000

6,000

60,000

60,000

Sales amounted to Rs. 120,000 You are required to calculate ratios for (a) Testing Liquidity

122

(b) (c)

Testing Solvency Testing Profitability

(d)

Testing Capital Gearing

(e)

Testing Capitalisation

Financial Management

11.

The ABC Company’s financial statements contain the following information. Balance Sheets 31.3.94

31.3.95

Cash

2,00,000

1,60,000

Sundry Debtors Temporary Investments

3,20,000 2,00,000

4,00,000 3,20,000

18,40,000

21,60,000

28,000

12,000

Total Current Assets

25,88,000

30,52,000

Total Assets Current Liabilities

56,00,000 6,40,000

64,00,000 8,00,000

10% Debentures

16,00,000

16,00,000

Equity Share Capital

20,00,000

20,00,000

4,68,000

8,12,000

Stock Prepaid Expenses

Retained Earnings

Profitability Statement for the year ended 31.3.95 Sales Less : Cost of goods sold 28,00,000 Interest 1,60,000

40,00,000

Net Profit for 1995 Less : Taxes @50%

29,60,000 10,40,000 5,20,000 5,20,000

Dividend declared on Equity Shares Rs. 2,20,000 From the above figures, appraise the financial position of the company from the point of view of (i) liquidity, (ii) solvency, (iii) profitability and (iv) activity. 12. From the information given below, calculate the six ratios for use of management. Explain the object of each ratio and indicate, where appropriate, how, it might be refined by the use of more detailed information than it is here available. Summarised Balance Sheet of Prosperous Ltd. as on 31st September 1984 Equity share capital Issued and fully paid up Reserves and Surplus Profit & Loss Account Opening Balance Profit for the year Long term loan Provision for taxation for the year Trade Creditors

Rs. in ’000

Fixed Assets 1,395 963 695 850 690

Cost 4,923 Less : Depreciation 2,599 Stocks Finished Goods Raw Material & WIP Trade Debtors Cash

2,324 1,407 840 1,277 41

900 396 5,889

Interpretation of Financial Statements (Ratio Analysis)

5,889

123

Net sales for the year ended 30.9.84 amounted to Rs. 70 lakhs, earnings before interest and tax (EBIT) amounted to Rs. 18.5 lakhs, interest on long term borrowing is Rs. 1 lakh and net profit after tax figured at Rs. 8.5 lakhs Purpose of each ratio to be determined (1)

Profitability of funds employed

(2)

Average Profit Margin

(3)

Turnover of funds employed

(4)

Measure of short term financial stability

(5)

Credit allowed to debtors.

(6)

Return on Equity.

13. From the following information of M/s. Goodwill Co. Ltd. for the year 1982, 1983 and 1984 you are required to calculate (i)

Current Ratio

(ii)

Debtors turnover ratio and number of days required to get realisation and number of days the inventory would last.

(iii)

Inventory Turnover Ratio

(iv)

Net Profitablity Ratio

You are required to make comments on the changes in the profitability liquidity i.e., calculate these ratios. 1982

1983

1984

Rs.

Rs.

Rs.

Debtors

3,00,000

5,00,000

6,00,000

Inventory

5,00,000

5,00,000

7,00,000

Plant, Machinery & Equipment

1,20,000

1,50,000

2,00,000

Buildings

1,00,000

1,00,000

1,00,000

10,20,000

12,50,000

16,00,000

Assets

124

Financial Management

Liabilities Bank Overdraft

1,10,000

2,60,000

3,90,000

Trade Creditors

2,50,000

3,00,000

5,00,000

Profit and Loss Account

1,00,000

1,30,000

1,50,000

5,60,000

5,60,000

5,60,000

10,20,000

12,50,000

16,00,000

10,00,000

15,00,000

15,00,000

50,000

70,000

50,000

Paid up capital - Rs. 100 Share Rs. 75 paid up

Sales Net Profit

The opening stock at the begining of the year 1982 was Rs. 40,000 and sundry debtors were Rs. 3,00,000

14. On the basis of the following financial statements calculate following ratios and also comment on them : (a)

Current Ratio

(b)

Operating Ratio

(c)

Return on Investment Ratio

(d)

Inventory Turnover Ratio

Income Statement for 1975 Net Sales

Rs. 10,00,000

Cost of Goods

7,56,000

Operating Expenses

1,25,000

Depreciation Income from Investment Income Tax

Interpretation of Financial Statements (Ratio Analysis)

44,000 1,40,000 65,000

125

Balance Sheet as at 31st December 1975 Liabilities

Rs.

Assets

Rs.

Share Capital

3,00,000

Building

2,50,000

Debentures

2,00,000

Plant and Machinery

2,10,000

Profit After Tax

1,50,000

Investments

Bills Payable

1,30,000

Stocks

1,15,000 1,60,000

80,000

Sundry creditors

60,000

Bills Receivables

Provisions for Taxation

65,000

Sundry Debtors

45,000

Outstanding Expenses

5,000

Accrued Income

15,000

Cash

35,000

9,10,000

9,10,000

15. A corporation gives the following information during the period ending 31.12.79 and 31.12.80. You are required to find out : (a)

Current Ratio

(b)

Quick Ratio

(c)

Average collection Period

(d)

Receivables Turnover Ratio.

(e)

Inventory Turnover Ratio. Balance Sheet

Liabilities

1980

1979

Equity stock

Assets Land & Building Less : Depreciation

1980

1979

10.00

6.00

1.20

0.72

8.80

5.28

(Rs.10 per share)

3.00

3.00

Free Reserves

6.00

3.50

12% Debentures

5.00

5.00

Plant & Machinery

4.00

3.78

Bills Payable

2.00

1.75

Less : Depreciation

0.50

0.56

Outstanding Taxes

0.80

0.30

3.50

3.22

2.50

2.80

2.00

2.25

16.80

13.55

Inventory Receivables 16.80

126

Rs. in Lakhs

13.55

Financial Management

Income Statement 1980

1979

Rs.

Rs.

Net Sales (60% on credit)

45.00

36.00

Cost of goods sold

33.00

29.00

Gross Profit

12.00

7.00

Distributing Expenses

5.00

3.00

P.B.T.

7.00

4.00

Taxes (50%)

3.50

2.00

P.A.T.

3.50

2.00

Free Reserves at the beginning

3.50

2.00

7.00

4.00

Payment of Cash Dividend

1.00

0.50

Free Reserves at the end

6.00

3.50

Inventory was valued at Rs. 2.96 lakhs as on 31.12.78 16. Following accounting information is obtained relating to a limited company Rs. Sales

30,00,000

Cost of goods sold

15,00,000 15,00,000

Administrative expenses

5,00,000 10,00,000

Taxes

5,00,000

Net Profit

5,00,000

Interpretation of Financial Statements (Ratio Analysis)

127

Balance Sheet Liabilities

Rs.

Assets

Rs.

10% Preference Share capital

20,00,000

Fixed Assets

Equity share capital

20,00,000

Stock

2,00,000

Reserves

10,00,000

Debtors

4,00,000

10% Debentures

11,00,000

Cash

2,00,000

Current Liabilities

3,00,000

Ficticious Assets

1,00,000

64,00,000

55,00,000

64,00,000

Opening Stock was Rs. 3,00,000 Administration expenses include depreciation and debenture interest. Assume 360 days in a year Compute the following ratios (a)

Gross Profit Ratio

(b)

Net Profit Ratio

(c)

Current Ratio

(d)

Liquid Ratio

(e)

Proprietory Ratio

(f)

Rate of Return on Equity share capital

17. From the following financial statements of X Ltd. calculate :

128

(a)

Current Ratio

(b)

Liquid Ratio

(c)

Gross Profit Ratio

(d)

Net Profit Ratio

(e)

Fixed Assets Turnover

(f)

Net Profit to capital employed

(g)

Sales to capital employed

(h)

Debtors Turnover Financial Management

Income statement for the year ending 31st December, 1988 Rs. Sales

- Cash

64,000

- Credit

6,84,000

Rs.

7,48,000 Less

- Cost of Sales

5,96,000

Gross Profit

1,52,000

Less - Expenses Warehouseing & Transport

48,000

Administration

38,000

Selling

28,000

Debenture Interest

4,000 1,18,000

Net Profit

34,000 Balance Sheet as at 31st December, 1988

Liabilities Share Capital

Rs. 1,50,000

Assets Fixed Assets (Net)

Rs. 80,000

Reserves

60,000

Current Assets

Profit & Loss A/c

24,000

Stock

1,88,000

Debenture

60,000

Debtors

1,64,000

Current Liabilities

1,52,000 4,46,000

Interpretation of Financial Statements (Ratio Analysis)

Cash

14,000 4,46,000

129

18. Using the following information, complete the Balance Sheet of XYZ Ltd. Long term Debt to net worth

- 0.5 to 1

Total Assets Turnover

- 2.5 times

Average collection period

-1/2 Month

Inventory turnover

- 9 times

Gross Profit Margin

- 10%

Acid test ratio

-1:1

Balance sheet of XYZ Ltd., on 31st December 1980 Liabilities

Rs.

Assets

Rs.

Equity Capital

1,00,000

Fixed Assets

–

Retained earnings

1,00,000

Inventory

–

Debtors

–

Cash

–

Long term Debt Creditors

– 1,00,000

–––––

–––––

–

–

–––––

–––––

19. From the following details, you are required to prepare the Balance Sheet of M/s. Phule & Ghule as on 31-3-1987. (a)

Stock Velocity

:

6

(b)

Capital turnover ratio

:

2

(c)

Fixed Assets turnover ratio

:

4

(d)

Gross Profit as % of sales

:

20

(e)

Debt collection period in Months

:

2

(f)

Creditors payment period in days

:

73

The gross profit for the year ending on 31-3-1987 was Rs. 60,000. Closing stock was Rs. 5,000 in excess of opening stock. Assume purchases and sales are on credit. 130

Financial Management

20. From the following information, you are required to prepare a Balance Sheet. Working Capital

-

Rs. 75,000

Reserves & Surplus

-

Rs. 1,00,000

Overdraft

-

Rs. 60,000

Current Ratio

-

1.75

Liquid Ratio

-

1.25

Fixed Assets/Proprietors’ funds

-

0.75

Long Term Liabilities

-

Nil

21. From the following information, prepare the Balance Sheet of Rameshpathy as on 31.3.83. Fixed Assets

Rs. 6 lakhs

Working capital

Rs. 4 lakhs

Current Ratio

2

Fixed Assets to turnover

4

G.P.

25%

Debtors velocity

1.5 months

Creditors velocity

2 months

Stock velocity

2 months

Net Profit 5% of turnover Reserve 2/3rd of net profits Capital Gearing

1:1

22. With the following ratios and further information given below, prepare a Trading Account, Profit and loss Account and Balance Sheet of Shri Narain. (i)

Gross Profit Ratio

-

25%

(ii)

Net Profit/Sales

-

20%

(iii) Stock Turnover Ratio

-

10%

Interpretation of Financial Statements (Ratio Analysis)

131

(iv)

-

1/5

-

1/2

-

5/4

(vii) Fixed Assets/Total current Assts

-

5/7

(viii) Fixed Assets

-

Rs. 10,00,000

(ix) Closing stock

-

Rs. 1,00,000

(v) (vi)

Net Profit/Capital Capital/Total Liabilities Fixed Assets/Capital

23. The assets of ABC Ltd. consists of fixed assets and current assets while its current liabilties comprise of bank credit and trade credit in the ratio of 2:1. From the following figures relating to the company for the year 1985, prepare its balance sheet, showing the details of working. Share Capital

Rs. 1,99,500

Working Capital (CA-CL)

Rs. 45,000

Gross Margin

20%

Inventory Turnover

6

Average Collection Period

2 months

Current Ratio

1.5

Quick Ratio

0.9

Reserves & Surplus to cash.

3

24. You are adviced by the management of ABC Ltd. to project a Trading and Profit and Loss Account and the Balance sheet on the basis of the following estimated figures and ratios, for next financial year ending March 31, 1986.

132

Ratio of Gross Profit

25%

Stock Turnover Ratio

5 times

Average Debt Collection Period

3 months

Creditors Velocity

3 months

Current Ratio

2

Financial Management

Proprietory Ratio (Fixed Assets to Capital Employed)

80%

Capital Gearing Ratio (Preference Shares & Debentures to equity

30%

Net profit to issued capital (equity)

10%

General Reserve and Profit & Loss A/c to Capital (Equity)

25%

Preference share capital to Debentures

2

Cost of sales consists of 50% for materials. Gross Profit is Rs. 12,50,000 Working should be clearly shown. 25. Following information is available to you from which you are required to prepare Balance Sheet as on 30th September, 1984. Current Ratio

-

1.8 : 1.00

Working Capital

-

Rs. 40,000

Liquid Ratio

-

1.5 : 1.00

Fixed Assets to shareholders capital

-

90%

Rate of Gross Profit to Turnover

-

25%

Rate of Net Profit to share capital

-

10%

Share Capital

-

Rs. 400,000

Stock Turnover Ratio on cost of goods sold

-

10 times

Average rate of outstandings for the year

-

54 days

(On the basis of Current Liabilities)

On 30th September 1984, Current Assets include stock, debtors and bank balances. Liabilties include share capital and current liabilities. Assets include fixed assets, current assets and development expenditure (not written off so far).

Interpretation of Financial Statements (Ratio Analysis)

133

26. You have been asked by the management of “The Wonderful suppliers Ltd.” to project a Trading and Profit & Loss Account and the Balance Sheet on the basis of the following estimated figures and ratios, for the next financial year ending 31st March, 1983. Ratio of Gross Profit

25%

Stock Turnover Ratio

5 times

Average Debt Collection Period

3 months

Creditors velocity

3 months

Current Ratio

2

Fixed Assets to Capital Employed

80%

Preference share & Debenture to Equity

30%

Net Profit to Issued Equity Capital

10%

General Reserve & Profit and loss a/c to issued Equity Capital

25%

Preference share capital to Debentures

2

Cost of sales consist of 50% for materials Gross Profit Rs. 12,50,000 Working should be clearly shown. 27. Prepare Balance Sheet and Profit & Loss Account from the following information : Rs. Capital

4,00,000

Working Capital

1,80,000

Bank overdraft

30,000

There are no fictitious assets. In current assets, there is no asset other than stock, debtors and cash. Closing Stock is 20% higher than opening stock

134

(1)

Current Ratio

-

2.5

(2)

Quick Ratio

-

2.0 Financial Management

(3)

Proprietory Ratio i.e. Fixed Assets/Proprietory funds.)

-

0.6

(4)

Gross Profit Ratio

-

20% (To sales)

(5)

Stock velocity

-

5

(6)

Debtors velocity

-

73 days

(7)

Net Profit Ratio

-

10% (To capital employed.)

28. Below are given summarised accounts of Alok Ltd. for the years ended 31st December, 1978 and 31st December, 1979. Balance Sheet

Rs. in Lakhs

78

79

78

79

Rs

Rs.

Rs.

Rs.

Share Capital

250

250

Fixed Assets (At cost)

500

500

General Reserve

100

172

Less : Depreciation

80

115

Debentures

180

150

420

385

Inventories

90

113

Term loan from IFCI

30

30

Cash

55

85

Creditors

70

56

Debtors

65

75

630

658

630

658

Interpretation of Financial Statements (Ratio Analysis)

135

Income Statement

Rs. in Lakhs Year 1978

Year 1979

350

450

Less :Cost of Material

90

113

Less :Wages

70

70

Cost of goods sold

160

183

Gross profit

190

267

50

60

140

207

30

35

110

172

25

27

85

145

15

48

70

97

25

25

45

72

Net Sales

Less :Selling, General & Administration costs Earning before depreciation, interest and tax Less :Depreciation Earnings before interest and tax Less :Interest Earnings before tax Less :Tax Earnings after tax Less :Dividends Retained earnings

Compute liquidity leverages, activity and profitability ratios and comment. 29.

136

Certain items of the annual accounts of ABC Ltd. are missing as shown below.

Financial Management

Trading and Profit & Loss Account for the year ended 31 st March, 1986 Rs. To, Opening stock

Rs.

3,50,000

To, Purchases To, Other Expenses

-87,500

To , Gross Profit

By Sales

--

By Closing Stock

--

---

To, Office & Other expenses

--

3,70,000

To, Interest on debentures

By, Gross Profit

30,000

To, Provision for taxation

--

To, Net Profit for year

--

By, Commision

--

-50,000

--

To, Proposed Dividends

--

By, Balance b/fd

To, Transfer to General Reserve

--

By, Net profit for year

To, Balance transferred to Balance sheet

– --

70,000 --

--

Balance sheet as on 31st March, 1986 Liabilities Paid up capital

Rs.

Assets

5,00,000

Rs.

Fixed Assets

General Reserves

Plant & Machinery

–

Balance at beginning

Other Fixed Assets

--

of the year

--

Current Assets

Proposed Addition

--

Stock in trade

--

Sundry Debtors

--

Profit & Loss App. A/c

--

10% Debentures

--

Current Liabilities

---

Interpretation of Financial Statements (Ratio Analysis)

Bank Balance

62,500

--

137

You are required to supply missing figures with the help of following information : (1)

Current Ratio 2 : 1.

(2)

Closing stock is 25% of sales.

(3)

Proposed dividends are 40% of paid up capital.

(4)

Gross Profit Ratio is 60%.

(5)

Ratio of Current Liabilities to debenture is 2:1.

(6)

Transfer to General Reserves is equal to proposed dividends.

(7)

Profits carried forward are 10% of the proposed dividends.

(8)

Provision for taxation is 5% of profits.

(9)

Balance to the credit of General Reserves at the beginning of the year is twice the amount transferred to that account from the current profits. Working should form part of your answer.

30. From the ratios given below, draw the profit and loss account and the Balance Sheet of A Co. Ltd. Trading and Profit and Loss Account for the year ended on 31st December, 1982 Liabilities Opening stock Purchases Purchase Expenses Gross profit

Rs.

Assets

4,80,000 --

Sales

--

Closing stock

--

40,000 ---

--

Office Expenses

2,40,000

Gross Profit

--

Selling Expenses

1,86,000

Commission

--

Interest on debentures

30,000

Provision for taxation

--

Net Profit for the year

---

138

Rs.

-Financial Management

Liabilities

Rs.

Proposed Dividends

Assets

Rs.

--

Balance b/fd

62,500

--

Net Profit for the year

Transfer to General Reserve

--

Balance carried to Balance sheet

---

--

Balance sheet as --at 31st December 1982 Liabilities

Rs.

Assets

Share Capital Authorised

Fixed Assets

5,000 Equity shares of

Goodwill

Rs. 100 each

5,00,000

Issued subscribed &

Land

Rs.

72,000 3,00,000

Plant & Machine 2,00,000

Paid up 4,000 Equity shares of Rs. 100 each

--

5,72,000 4,00,000

Reserves & surplus

Current Assets

Reserves-on Balance

--

Stock in trade

--

Proposed additions

--

Sundry Debtors

--

Bank Balance

40,000

Surplus - Balance from P & L Appropriation A/c

--

Secured Loans 15% Debentures of Rs. 100 each

--

Current Liabilities

---

(1)

Dividends proposed are 30% of share capital.

(2)

Current Ratio - 2 : 1.

(3)

Sundry Debtors represent 2 month’s sales.

Interpretation of Financial Statements (Ratio Analysis)

--

139

(4)

Stock turnover ratio 6 2/3.

(5)

Gross Profit Ratio 33 1/3%.

(6)

Provision for taxation is at 50% of profits.

(7)

Profits carried forward were 10% of the transfer to General Reserve.

(8)

Transfer to General Reserve was equal to proposed dividends.

(9)

Secured Loans were half of current liabilities.

(10) Balance to the credit of General Reserves at the beginning of the year was twice the amount transferred to that account from current profits. Working should form part of your answer. 31. The following are the summarised Accounts of A Ltd. an B Ltd. for the two years 1979 and 1980 : A Ltd. Rs. in Lakhs 1980

1979

1980

1979

Turnover

54.12

45.75

17.52

14.47

Manufacturing & other expenses

51.04

43.56

14.96

11.82

Depreciation

0.56

0.51

0.60

0.35

Profit before tax

2.52

1.68

1.96

2.30

54.12

45.75

17.52

14.47

Intangible Assets

1.65

1.69

--

--

Fixed Assets

8.36

9.41

3.51

2.75

11.24

12.19

1.77

2.26

Debtors

7.28

8.24

5.82

4.02

Bank

0.93

0.33

4.64

2.46

29.46

31.86

15.74

11.49

Creditors

9.47

9.26

2.33

1.75

Taxation (Less Advance Tax)

0.56

0.68

0.87

0.58

Short Term Borrowings

4.24

8.00

4.64

2.16

Long Term Borrowings

2.54

2.10

0.10

--

Capital and Reserves

12.65

11.82

7.80

7.00

29.46

31.86

15.74

11.49

Stock

140

B. Ltd. Rs. in Lakhs

Financial Management

You are required to (1)

Indicate and calculate five ratios which in your opinion are relevant in determining the stability of two companies as going concerns.

(2)

Compare the ratios so determined for two companies and indicate what conclusions can be drawn therefrom.

(3)

Discuss the limitations of ratio analysis as a predictor of failure.

32. From the Following data, Find(1)

Sales

(2)

Sundry Debtors

(3)

Sundry Creditors

(4)

Closing Stock

(5)

Opening Stock Debtors’ Velocity

- 3 Months

Creditors’ Velocity

- 2 Months

Stock Velocity

- 8 Months

Gross Profit Ratio

- 25%

Gross Profit

- Rs. 80,000

Closing Stock for the year is Rs. 2,000 more than the opening Stock. All the Sales and purchases are on Credit.

Interpretation of Financial Statements (Ratio Analysis)

141

33. From the following statements, calculate the various ratios alongwith your comments. Condensed income statement of Goodluck & Co. for the year ending 31.12.1993 Rs.

% of Sales

12,00,000

100.00

Less : Cost of goods sold

7,20,000

60.00

Gross Profit

4,80,000

40.00

Overheads

3,12,000

26.00

Operating Profit

1,68,000

14.00

8,000

0.66

1,60,000

13.34

Income Tax provision

80,000

6.67

Net Income after tax

80,000

6.67

Net Sales

Interest Income before tax

Balance Sheet of Goodluck & Co. as on 31.12.1992 and 31.12.1993 31.12.92

31.12.93

1,20,000

1,60,000

Accounts Receivable (Net)

1,20,000

1,20,000

Inventories

2,00,000

2,40,000

40,000

40,000

4,80,000

5,60,000

1,20,000

1,20,000

Buildings & Structures

4,80,000

4,80,000

Less : Depreciation

2,40,000

2,80,000

Net Buildings & Structures

2,40,000

2,00,000

3,60,000

3,20,000

–

40,000

8,40,000

9,20,000

Assets : Current Assets : Cash

Prepaid Expenses Fixed Assets : Land

Total Fixed Assets Other Assets : Goodwill & patents TOTAL ASSETS

142

Financial Management

Liabilties & Equities : Current Liabilities : Accounts payable

1,00,000

1,20,000

Wages & Taxes outstanding

60,000

40,000

Income Tax payable

40,000

80,000

2,00,000

2,40,000

1,60,000

1,60,000

3,60,000

4,00,000

of Rs. 20 each fully paid)

2,40,000

2,60,000

Retained earnings

2,40,000

2,60,000

Total Shareholder’ Equity

4,80,000

5,20,000

TOTAL LIABILITIES & EQUITY

8,40,000

9,20,000

Long Term Liabilities : 4% Mortgage Debentures Total Liabilities Shareholders’ Equity : Share Capital (12,000 shares

Interpretation of Financial Statements (Ratio Analysis)

143

NOTES

144

Financial Management

4)

Depreciation for a full one year is charged at following rates. a)

Building 5%

b)

Machinery 10%

c)

Furniture 10%

5)

A building worth Rs. 70,000 was sold on 1.1.1987 at Rs. 60,000 and a new building was constructed at a value at Rs. 25,000 on 31.12.1987.

6)

A machine was purchased at a cost of Rs. 40,000 on 1.1.87, while a machine having a book value of Rs. 10,000 was sold on 1.7.87 at Rs. 20,000.

Prepare a statement showing movement in working capital, profit and loss appropriation account and a statement showing the sources and application of funds. Solution : Statement showing sources and application of funds. Sources Operating Profit Issue of 2,000 Share of Rs. 100/Share Premium Sale of Building Sale of Machine

Rs. 1,76,000 2,00,000 10,000 60,000 20,000

4,66,000

176

Application Construction of Building Equity Purchase of Machine Purchase of Invesments Repayment of Debentures Secured Loan Income Tax Paid Dividend Paid Increase in Working Capital

Rs.

25,000 40,000 2,10,000 10,000 1,00,000 30,000 48,000 3,000 4,66,000

Financial Management

Statement showing movement in working capital

Current Assets Cash in hand Stock Debtors Bills Receivable

Current Liabilities

Increase in working Capital

1987

1988

Increase

Decrease

5,000 1,55,000 1,80,000 4,000

8,000 1,45,000 1,60,000 40,000

3,000 – – 36,000

– 10,000 20,000 –

3,44,000

3,53,000

24,000

30,000

3,20,000

3,23,000

6,000

3,000 3,23,000

3,000 3,23,000

39,000

39,000

Profit And Loss Account To, Dividend Paid To, Income Tax Provision To, Transfer to Debenture Redemption Reserve To, Depreciation To, Loss on sale of building To, Balance c/fd

48,000 25,000 10,000 73,000

By, Balance b/fd By, Profit on sale of Machine By, Operating Profit (Balancing figure)

2,00,000 10,000 1,76,000

10,000 2,20,000 3,86,000

3,86,000

Working Notes : (a) To, Balance b/fd. To, Bank (Purchase)

Building Account 5,70,000 25,000

By, Bank (Sale) By, P & L A/c (Loss on Sale) By, Depreciation By, Balance c/fd

5,95,000

Interpretation of Financial Statements (Funds Flow/Cash Flow Statements)

60,000 10,000 25,000 5,00,000 5,95,000

177

(b)

Machinery Account

To, Balance b/fd. To, Bank (Purchase) To, P & L A/c (Profit on Sale)

3,60,000 40,000

By, Bank (Sale) By, Depreciation By, Balance c/fd

20,000 39,000 3,51,000

10,000 4,10,000

(c)

4,10,000

Furniture Account

To, Balance b/fd.

90,000

By, Depreciation By, Balance c/fd.

90,000

9,000 81,000 90,000

Interpretation of funds flow statement For the correct interpretation of the funds flow statement, the sources and application of funds can be catagorised as below. (a) Sources : i)

ii)

Long Term sources – Following types of sources may be treated as long term sources. –

Issue of shares/debentures.

–

Long Term borrowing of funds.

–

Operating Profit.

–

Sale of fixed assets.

Short Term sources – Following types of sources may be treated as short term sources. –

Short term borrowing of funds.

–

Increase in current liabilities.

–

Decrease in current assets.

(b) Applications : i)

ii)

178

Long Term applications – Following types of applications may be treated as long term applications. –

Purchases of fixed assets.

–

Redemption of preference shares/debentures.

–

Repayment of long term borrowings.

Short Term applications – Following types of applications may be treated as short term applications.

Financial Management

–

Increase in current assets.

–

Decrease in current Liabilities.

–

Repayment of short term loans/deposits

–

Dividends/Taxes.

After catagorising the sources and applications as above, a proper interpretation of the funds flow statement can be carried out after keeping in mind the following propositions. 1)

Generally, long term sources of funds should be used for long term applications.

2)

Generally, short term sources of funds should be used for short term applications.

3)

In some cases, the long term sources of funds can be used for short term applications (e.g. investment in core current assets), however under no circumstances, short term sources of funds should be used for long term applications. If the short term sources of funds are used for long term applications, it results into diversion of funds. It indicates that the funds raised are not utilised for the purpose for which they are intended. It indicates that the funds which are repayable or adjustable in the immediate future, are applied for such purposes, the returns from which are not likely to be received in the immediate future but are likely to be spread over a longer period of time. This indicates financial imprudency on the part of the organisation.

PROBLEMS (1)

Following are the Balance Sheets on 31.12.85 and 31.12.86 and you are required to prepare a statement of cash flow for the year 1986 showing particulars of your working in details.

Share Capital Share Premium P & L A/c Debentures Bank overdraft Creditors Proposed Dividend Depreciation Plant Fixtures

31.12.85

31.12.86

2,00,000 30,000 56,000 1,40,000 28,000 68,000

3,00,000 70,000 1,40,000 60,000 – 96,000

30,000

40,000

90,000 26,000

1,08,000 30,000

6,68,000

31.12.85

31.12.86

2,20,000

260,000

2,40,000 48,000 74,000 86,000 –

3,02,000 58,000 1,02,000 88,000 32,000

– 6,68,000

2,000 8,44,000

Freehold property At cost) Plant & Machinery Fixtures Stocks Debtors Bank Balance Premium on redemption of Debentures

8,44,000

Interpretation of Financial Statements (Funds Flow/Cash Flow Statements)

179

Additional information : (1)

There has been no disposal of freehold property in the year.

(2)

A machine tool which has cost of Rs, 16,000 and in respect of which depreciation of Rs. 12,000 was provided, was sold for Rs. 6,000 and fixtures which had cost of Rs. 10,000 in respect of which depreciation of Rs. 4,000 was provided was sold for Rs. 2,000. The profit and loss on these transaction has been dealt through Profit and Loss A/C.

(3)

The actual premium on redemption of debentures was Rs. 4,000 of which Rs. 2000 had been written off to Profit and Loss A/C.

(4)

No interim dividend had been paid.

(2)

Following are the Balance Sheets of A Ltd. 1986

1987

Issued Capital Equity

Fixed Assets 15,00,000

15,00,000

3,00,000

4,00,000

30,000

40,000

Debentures

5,00,000

5,00,000

Current Liabilities

6,20,000

4,40,000

1,80,000

1,95,000

Doubtful debts

6,000

5,000

Balance of P & L A./c From Previous year

24,400

1,91,500

1.67,100

1,55,800

33,27,500

34,27,300

Preference Share Share Premium

Current Assets

1986

1987

23,36,960

24,60,500

9,60,540

9,41,800

30,000

25,000

33,27,500

34,27,300

Debenture Discount

Provision For Depreciation

For the year

180

Financial Management

Additional information : (1)

During the year 87, machinery costing Rs. 2,00,000 (accumulated provision for depreciations Rs. 60,000) was sold for Rs. 1,50,000.

(2)

Rs. 1,00,000 Preference shares Capital was isssued during the year 87 at a premium of Rs. 10,000.

(3)

The net profit for 87 was arrived at after taking into account credit for profit on sale of machinery, reduction in the provision for doubtful debts, and writting off the discount on the issue of debentures.

You are required to prepare (a)

Statement showing net increasing in working capital during 87.

(b)

Statement showing sources of funds and application thereof.

(3)

From the following information, prepare a cash flow statment for the year. (Rs. in Thousands) 31.12.85

31.12.86

140

140

Reserves

74

105

Sundry Creditors

32

35

Equity capital

Wages Outstanding

3

4

11

3

260

287

31.12.85

31.12.86

Fixed Assets

90

87

Cash

75

97

Sundry Debtors

43

40

Inventory

49

58

3

5

260

287

Prepaid Rent

Misc. expenses outstanding

Other Information : Sales

300

Wages

23

Misc. operating expenses

47

Cost of goods sold

190

Rent

6

Depreciation

3

Interpretation of Financial Statements (Funds Flow/Cash Flow Statements)

181

(4)

The following are the summerised Balances of Assets and Liabilities of A Ltd. as on 31st Dec. 1987 and 88 :

Liabilities Share Capital General Reserve

1987

1988

4,50,000

4,50,000

Fixed Assets

3,00,000

3,10,000

Current Assets Investments

56,000

68,000

1,68,000

1,34,000

P & L A/c Creditors Provision for Tax

75,000

Loan

Assets

1987

1988

4,00,000

3,20,000

50,000

60,000

Stock

2,40,000

2,10,000

Debtors

2,10,000

4,55,000

Bank

1,49,000

1,97,000

10,49,000

12,42,000

10,000 2,70,000

10,49,000

12,42,000

Additional Information :

182

(a)

Investment costing Rs. 8,000 were sold during the year 1988 for Rs. 8,500 and further investments were purchased for Rs. 18,000.

(b)

The net profit for the year was Rs. 62,000, after charging depreciation on fixed assets Rs. 70,000 for the year and provision for taxation Rs. 10,000.

(c)

During the year, part of fixed assets costing Rs. 10,000 were sold for Rs. 12,000. The profit was included in Profit and Loss Account.

(d)

Dividend paid during the year amounted to Rs. 40,000. Prepare a statement showing sources and application of funds for the year end 31st December, 1988.

Financial Management

(5)

Following are the Balance sheets of Unique Ltd.

Creditors Oustanding Expenses

1.1.86

31.12.86

1,63,000

1,46,000

13,000

22,000

Cash/Bank Balances Debtors

5% Debentures (Rs. 100 each) Dep. Fund

90,000 40,000

70,000 44,000

Stock Prepaid Expenses

Capital Reserve

6,000

7,800

Land &

10,000

15,200

Building

P & L A/c Equity Share Capital

Machinery 1,80,000

1,80,000

5,02,000

4,85,000

1.1.86

31.12.86

50,000 77,000

40,000 73,000

2,02,000

1,90,000

1,000

2,000

1,00,000

1,00,000

72,000

80,000

5,02,000

4,85,000

Following additional information is also available. (1)

10% dividend on Equity Share Capital was paid in cash.

(2)

An old machine costing Rs. 12,000 was sold for Rs. 4,000 and accumulated depreciation on that was Rs. 6,000.

(3)

5% Debentures of Rs. 5,000 were redeemed to purchase from open market at Rs. 96 per debenture. Profit on this redemption was transferred to Captial Reserve.

You are required to prepare schedule of changes in working capital and statement showing sources and application of funds. (6)

From the Balance Sheets of A Ltd. as on 31.3.86 and 31.3.87 prepare – Statement showing changes in wokring captial. Statement of sources and application of funds. Fixed Assets Account. Profit and Loss Account.

Interpretation of Financial Statements (Funds Flow/Cash Flow Statements)

183

Share Capital

31.3.86

31.3.87

6,75,000

6,75,000

Sundry Creditors

2,52,000

2,01,000

Tax Provision

1,12,500

15,000

General Reserve

4,50,000

4,65,000

84,000 –

1,02,000 4,05,000

15,73,500

18,63,000

P & L A/c Mortgage Loan

31.3.86

31.3.87

Fixed Assets

6,00,000

4,80,000

Investments Stock

75,000 3,60,000

90,000 3,15,500

Debtors

3,15,000

6,82,000

Cash/Bank

2,23,500

2,95,500

15,73,500

18,63,000

Additional Information : (1)

Net profit for the year was Rs. 93,000 after charging provision for taxation Rs. 15,000 and depreciation on fixed assets.

(2)

During the year, part of fixed assets costing Rs. 15,000 were disposed off for Rs. 18,000 and the profit is included in the above profit.

(3)

Dividend paid during the year Rs. 60,000.

(4)

Investments costing Rs. 12,000 were sold for Rs.12,750 and further investments were acquired for Rs. 27,000.

(7)

The following are the Balance Sheets as at 31st December 1984 and 31st December 1985

Liabilities Share Capital – 10,000 Shares of Rs.10/- each Profit & Loss Account Bank Overdraft Loan against mortgage of building Sundry creditors

184

1984

1985

1,00,000

1,00,000

6,000

8,000

16,000

50,000

–

20,000

20,000

60,000

1,42,000

2,38,000

Financial Management

Liabilities

1984

1985

Land & Building

30,000

60,000

Machinery

50,000

60,000

Less : Depreciation upto date

12,000

18,000

38,000

42,000

11,600

12,400

5,600

8,400

6,000

4,000

Stock

22,000

72,000

Debtors

46,000

60,000

1,42,000

2,38,000

Assets :

Vehicles Less : Depreciation upto date

During the year 1985, the company purchased a building for Rs. 30,000 out of which Rs. 10,000 was paid in cash and for the rest, the building was mortgaged to the seller. During the year 1985, a dividend of 10% was distributed to the shareholders. On. 1.1.85, a vehicle which originally cost Rs. 2,000 and showing book value of Rs. 1,000 was sold for Rs. 1,600. You are required to prepare a statement of cash flows for the year 1985, showing particulars of your working in details.

Interpretation of Financial Statements (Funds Flow/Cash Flow Statements)

185

(8)

From the following financial statements and additional data condensed from reports of Rokad Chillar Ltd. prepare a cash flow statement for the year ended 31st December 1984 Profit and Loss A/c for the year ended 31.12.84 1983

1984

10,00,000

14,00,000

Opening Stock

2,50,000

1,20,000

Add : Purchases

8,50,000

8,00,000

11,00,000

9,20,000

1,20,000

1,60,000

9,80,000

7,60,000

20,000

6,40,000

2,80,000

3,20,000

(2,60,000)

3,20,000

Balance of undistributed Profit/(Loss)

1,80,000

(80,000)

Balance available for distribution

(80,000)

2,40,000

–

2,00,000

(80,000)

40,000

(a)

Sales

(b)

Cost of Sales

Less : Closing Stock

(c)

Gross Profit a – b

Less : Operating Expenses Net Profit/(Loss) for the year

Less : Dividends Paid Balance of undistributed Profit/(Loss) Balance Sheets as on 31.12

(Rs. in Lakhs) 83

84

Expenses Payable

0.50

0.40

Sundry Creditors

1.50

Long Term Loans Paid up Capital P & L Account

83

84

Cash

0.80

1.00

2.60

Prepaid Expenses

0.10

0.20

4.00

2.00

Sundry Debtors

0.10

0.20

2.00

4.00

Stock

1.20

1.60

–

0.40

Investments

1.00

2.40

Fixed Assets

4.00

4.00

P & L Account

0.80

–

8.00

9.40

8.00

186

9.40

Financial Management

Additional Information :

(9)

(1)

Depreciation charged for 1984 Rs. 40,000

(2)

There are no sales of fixed assets during the period.

From the following information, prepare a statement showing sources and application of the funds for the year ended 31st December 1984. Balance Sheets (Rs. in Lakhs) 83

84

83

84

Share Capital

4.50

4.50

Fixed Assts

4.00

3.20

General Reserve

3.00

3.10

Investments (Non-current)

0.50

0.60

P & L Account

0.56

0.68

Inventories

2.40

2.10

Creditors

1.68

1.34

Debtors

2.10

4.55

Provision for Tax

0.75

0.10

Bank

1.49

1.97

–

2.70

10.49

12.42

10.49

12.42

Mortgage Loan

Additional Information : (1)

Investments costing Rs. 8,000 were sold during 1984 for Rs. 8,500.

(2)

Provision for taxation made during the year was Rs. 9,000.

(3)

During the year, part of the fixed assets having the book value of Rs. 10,000 was sold for Rs. 12,000, the profit included in Profit and Loss Account.

(4)

Dividend paid during the year amounted to Rs. 40,000.

Interpretation of Financial Statements (Funds Flow/Cash Flow Statements)

187

(10) From the following Balance Sheets, prepare a movement of funds statement showing the increase or decrease in working capital separately. 1.1.75

31.12.75

1.1.75

31.12.75

Rs.

Rs.

Rs.

Rs.

100.0

120.0

Building

55.4

113.2

–

10.0

Machinery

35.6

51.3

General Reserve

6.0

11.0

Furniture

2.4

2.5

P & L A/c

7.5

20.7

Stock

36.5

38.0

–

26.0

Debtors

32.1

38.0

33.5

36.4

Bank

4.8

4.0

9.8

10.9

10.0

12.0

166.8

247.0

166.8

247.0

Equity Share Capital Share Premium

5% Debentures Sundry Creditors Provision for Taxation Proposed Dividend

Depreciation written off during the year. Machinery

Rs. 12,800

Furniture

Rs. 400

(11) From the following Balance Sheet as on 31.12.87 and 31.12.88, you are required to prepare statements showing flow of funds. 31.12.87

31.12.88

31.12.87

31.12.88

Rs.

Rs.

Rs.

Rs.

30,000

47,000

1,20,000

1,15,000

Capital and

Assets

Liabilities Share Capital

2,00,000

2,50,000

Trade Creditors

70,000

45,000

Debtors

Retained Earnings

10,000

23,000

Stock in trade

80,000

90,000

Land

50,000

66,000

2,80,000

3,18,000

2,80,000

188

3,18,000

Cash

Financial Management

(12)

From the following information, prepare cash flow statement of Jai Kisan Co. Ltd. for the year ended on 31.12.1985. Balance Sheet

Liabilities

1984

1985

Rs.

Rs.

Plant & Machinery

50,000

91,000

40,000

Inventory

15,000

40,000

14,000

39,000

Debtors

5,000

20,000

Tax Payable

1,000

3,000

20,000

7,000

P&L Alc.

7,000

10,000

2,000

4,000

92,000

1,62,000

92,000

1,62,000

Share Capital Secured Loans (Repayable 1995) Creditors

1984

1985

Rs.

Rs.

70,000

70,000

–

Assets

Cash Expenses

Profit and Loss Account for the year ended 31.12.85 Rs.

Rs.

To, Opening Inventory

15,000

By Sales

To, Purchases

98,000

By Closing Inventory

To, Gross Profit

27,000 1,40,000

To, General Expenses

11,000

To, Depreciation

8,000

To, Taxes

4,000

To, Net Profit c/fd

4,000

To Balance c/fd

40,000

1,40,000 By Gross Profit b/fd

27,000 To Dividend

1,00,000

27,000

27,000

1,000

By Balance b/fd

7,000

10,000

By Net Profit b/fd

4,000

11,000

Interpretation of Financial Statements (Funds Flow/Cash Flow Statements)

11,000

189

(13) The following details are available from Narayan Company.

Share Capital Debentures

31.12.85

31.12.86

70,000

74,000

12,000

6,000

Reserve for Doubtful debts

31.12.85

31.12.86

9,000

7,800

Investment

14,900

17,700

Stock

49,200

42,700

Cash

700

800

Trade Creditors

10,360

11,840

Land

20,000

30,000

P & L A/c

10,040

10,560

Goodwill

10,000

5,000

1,03,100

1,03,200

1,03,100

1,03,200

In addition you are given (1)

Dividend paid total Rs. 3,500.

(2)

Land was purchased for Rs. 10,000. Amount provided for amortisation of goodwill Rs. 5,000.

(3)

Debentures paid off Rs. 6,000. (a)

Prepare cash flow statement.

(b)

Prepare funds flow statement and statement of the change in working capital.

14.Following is a summary of Balance Sheets of X Ample Ltd. as at 31st December.

Capital P & L A/c Current Liabilities

1982

1983

47,800 6,950 11,000

62,800 7,170 12,030

65,750

82,000

Fixed Assets (Less : Dep.) Current Assets Goodwill

1982

1983

23,890 32,860 9,000

31,090 40,910 10,000

65,750

82,000

Additional Information :

190

(1)

A dividend of Rs. 4,780 was paid out of profits.

(2)

Rs. 1,000 were written off the goodwill account.

Financial Management

(3)

In June 1983, the company spent Rs. 17,000 for acquiring the following assets from another company. Fixed assets

Rs. 10,000

Current Assets

Rs. 5,000

Goodwill

Rs. 2,000

In order to finance the acquisition, Rs. 10,000 worth fully subscribed shares were issued to shareholders of X Ample Ltd. (4)

Fixed assets were sold for Rs. 100 and these assets cost Rs. 1,200 and their present book value was Rs. 400. The loss on the disposal of these assets was charged to the profits of 1983.

(5)

Profit for the year amounted to Rs. 6,000 after providing for depreciation Rs. 2,400 Prepare funds flow statement for 1983.

(15) The following are the summarised balance sheets of Ashoka Ltd. as on 31.12.1977 and 31.12.1978. (Rs. in Lakhs) Liabilities

77

78

Rs.

Rs.

4.00

4.80

–

0.20

General Reserves

0.60

1.00

Plant and Machinery

P & L A/c

0.96

1.36

12% Debentures

1.00

–

Equity Share Capital of Rs. 10 Each Share Premium A/c

Creditors Proposed Dividend

2.60 0.40

9.56

2.80 0.48

Assets

77

78

Rs.

Rs.

2.10

2.80

Cost

5.80

6.40

Less: Dep.

2.80

3.00

3.00

3.40

Equipments Cost

0.18

0.20

Less : Dep

0.12

0.08

0.06

0.12

Inventories

2.60

2.10

Debtors

1.50

1.70

Cash

0.30

0.52

9.56

10.64

Free hold Land and Building

10.64

Interpretation of Financial Statements (Funds Flow/Cash Flow Statements)

191

Note : (1)

The plant and machinery which cost Rs. 40,000 and in respect of which Rs. 26,000 had been written off as depreciation was sold during the year 1978 for Rs. 6,000.

(2)

Equipments which cost Rs. 10,000 and in respect of which Rs. 8,000 had been written off as depreciation was sold for Rs. 4,000 during 1978.

(3)

The dividend which was declared in 1977 was paid during 1978. You are required to prepare (a)

A statement showing the change in working capital during 1978.

(b)

A statement showing the sources and applications of working capital (funds flow statement) during 1978.

(16) Prepare a funds flow statement of Atlantic Business Corporation from following information. Balance Sheets Liabilities

1.1.80

31.12.80

Assets

1.1.80

31.12.80

Current Liabilities

30,000

32,000

Cash at Bank

40,000

44,400

Debentures

20,000

20,000

Accounts Receivable

10,000

20,700

15,000

15,000

4,000

4,000

Business Premises

20,000

16,000

Plant & Equipment

15,000

17,000

Accmulated Dep.

(5,000)

(2,800)

1,000

900

1,00,000

1,15,200

Retained Earnings

15,000

21,200

Inventories

Share Capital

35,000

42,000

Land

Patents & Trade Mark 1,00,000

192

1,15,200

Financial Management

Additional Information : (1)

Income for the period Rs. 10,000.

(2)

A building that costs Rs. 4,000 and which had a book value of Rs. 1,000 was sold for Rs. 1,400.

(3)

The depreciation charge for the period was Rs. 800.

(4)

There was an issue of rights shares of Rs. 7,000.

(5)

Cash dividend of Rs. 2,000 was declared.

(17) From the following Balance Sheets of Shri Hari Synthetics Limited, prepare a statement of sources and application of funds and a schedule of changes in working capital for 1980. Balance Sheets Liabilties

Share Capital General Reserve

1979

1980

Rs.

Rs.

1,00,000

1,25,000

25,000

30,000

Assets

1979

1980

Rs.

Rs.

1,00,000

95,000

Plant & Machinery

75,000

84,500

Inventories

50,000

37,000

Debtors

40,000

32,000

Land & Building

P & L A/c

15,250

15,300

Bank Loan

35,000

Nill

Creditors

75,000

67,500

Cash

250

300

Provision for taxation

15,000

17,500

Bank

Nil

4,000

Goodwill

Nil

2,500

2,65,250

2,55,300

2,65,250

2,55,300

Additional Information : (1)

Dividend of Rs. 11,000 was paid during 1980.

(2)

Depreciation on plant written off this year was Rs. 7,000.

(3)

A provision for Income Tax for Rs. 16,500 was made during the year.

Interpretation of Financial Statements (Funds Flow/Cash Flow Statements)

193

(18) From the details given below, prepare the Cash Flow Statement of a Company for the Year ended 31st March 80. (a) Share Capital

Reserves and Surplus Long term Loan

31.3.79

31.3.80

80,000

80,000

60,000

1,10,000

40,000

60,000

Current Liabilities

30,000

52,000

Dividend Provision

–

16,000

2,10,000

3,18,000

(b)

31.3.79

31.3.80

1,20,000

1,85,000

Depreciation

35,000

55,000

Inventory

85,000 80,000

1,30,000 70,000

Accounts Receivables

40,000

68,000

5,000

50,000

2,10,000

3,18,000

Fixed Assets (Gross)

Cash

Income statement for the year ended 31-3-1980. Sales

:

Rs. 2,90,000

Cost of Sales

:

Rs. 1,99,000

Tax Provision

:

Rs. 25,000

Dividend provided

:

Rs. 16,000

(19) The following are the summarised Balance Sheets of Honesty Ltd., as at 31st December 1981 and 31st December, 1982. 31.12.81

31.12.82

Rs

Rs.

8,00,000

8,00,000

Capital Reserve

–

2,00,000

8% debentures

–

2,50,000

4,00,000

5,00,000

Liabilities : Issued Share Capital

Provision for depreciation of fixed assets

194

Financial Management

31.12.81

31.12.82

Rs

Rs.

P & L A/c balance on 1st January

3,00,000

4,50,000

Net Profit for the year

2,30,000

3,00,000

20,000

35,000

Current Liabilities

3,50,000

2,50,000

Bank overdraft

2,80,000

1,00,000

23,80,000

28,85,000

–

5,000

5,80,000

4,80,000

10,00,000

12,50,000

Trade Investments (at cost)

1,00,000

3,00,000

Current Assets

7,00,000

8,50,000

23,80,000

28,85,000

Provision for doubtful debts

Assets Discount on issue of debentures Land and Building Plant and Machinery

The following information is available : (1)

During the year, Land and Building having an original cost of Rs. 1,00,000 and a written down value of Rs. 75,000 have been sold for Rs. 3,00,000. The capital profit has been transferred to Capital Reserve and the profit equivalent to the depreciation written off in the past has been included in the profit for the year.

(2)

On 1st January, 1982, the company issued debentures of a face value of Rs. 2,50,000 at a discount of 5%. Part of the discount has been written off out of the profits.

Prepare a statement of sources and application of funds during the year.

Interpretation of Financial Statements (Funds Flow/Cash Flow Statements)

195

(20) Following are the comparative Balance Sheets of Bharat company as at December 31

Capital and Liabilities

1982 Rs.

1983 Rs.

Share Capital

70,000

74,000

P & L A/c

10,040

10,560

Debenture

12,000

6,000

700

800

Provision for doubtful

Assets

1982 Rs.

1983 Rs.

Goodwill

10,000

5,000

Land

20,000

30,000

Stock in trade

49,200

42,700

Debtors (good)

14,900

17,700

9,000

7,800

1,03,100

1,03,200

debts Trade Creditors

Cash 10,360

11,840

1,03,100

1,03,200

Information : (1)

Dividend were paid totalling Rs. 3,500.

(2)

Land was purchased for Rs. 10,000 and amount provided for the amortization of goodwill totalled Rs. 5,000.

(3)

Debenture loan was repaid Rs. 6,000. You are required to prepare funds flow statement and statement of the change in working capital and other assets.

(21) Balance Sheets of X and Y on 1-1-1987 and 31-12-1987 were as follows : Balance Sheet Liabilities

1-1-87 Rs.

31-12-87 Rs.

Creditors

40,000

44,000

Mrs X’s Loan

25,000

–

Loan from Bank

40,000

50,000

1,25,000

1,53,000

Capital

2,30,000

196

2,47,000

Assets

1-1-87 Rs.

31-12-87 Rs.

Cash

10,000

7,000

Debtors

30,000

50,000

Stock

35,000

25,000

Machinery

80,000

55,000

Land

40,000

50,000

Building

35,000

60,000

2,30,000

2,47,000

Financial Management

During the year, a machine costing Rs. 10,000 (Accumulated depreciation Rs. 3000) was sold for Rs. 5,000. The provisions for depreciation against machinery as on 1-1-87 was Rs. 25,000 and on 31-1287 it was Rs. 40,000. Net Profit for the year 1987 amounted to Rs. 45,000. You are required to prepare cash flow statement. (22) From the given Balance Sheets of A B C Co. Ltd. prepare a statement of sources and application of funds. A B C Co. Ltd. Balance Sheet (Rs. In Lakhs) Liabilities

Paidup share capital

As at

As at

31.12.70

31.12.71

400

450

Reserve and surplus

190

226

Secured loans

110

70

Sundry Creditors

170

120

870

Assets

As at

As at

31.12.70

31.12.71

Fixed Assets

607

617

Inventories

180

155

Debtors

35

56

Cash & Bank Balances

17

20

Investment

31

18

870

866

866

Interpretation of Financial Statements (Funds Flow/Cash Flow Statements)

197

23. Following are the Balance Sheets of M/s Sanjeev Ltd. in the condensed form

Sundry Creditors Outstanding Expenses 8% Debentures

1.1.87

31.12.87

51,500

48,000

6,500

6,000

45,000

35,000

1.1.87

31.12.87

Cash/Bank Balance

45,000

45,000

Sundry Debtors

33,500

21,500

Term Investments

55,000

37,000

500

1,000

Depreciation fund

20,000

22,000

Prepaid Expense

Reserve for Contingencies

30,000

30,000

Stock

41,000

53,000

8,000

11,500

Land & Building

75,000

75,000

Machinery

26,000

35,000

2,76,000

2,67,500

P & L A/c Capital

1,15,000

1,15,000

2,76,000

2,67,500

Following information is available : (1)

10% dividend was paid in cash.

(2)

New machinery for Rs. 15,000 was purchased but old machinery costing Rs. 6,000 was sold for Rs. 2,000. Accumulated depreciation was Rs. 3,000

(3)

Rs. 10,000 8% Debentures were redeemed by purchase from open market at Rs. 96 for a debenture of Rs. 100.

(4)

Rs. 18,000 investment were sold at book value. Prepare cash flow statement.

198

Financial Management

(24) The following are the summaries of the Balance Sheets of a Company as on 31.3.82 and 31.3 83 (Rs. in Lakhs)

Share Capital

1982

1983

4.00

6.00

Land & Building (at Cost)

1982

1983

3.00

4.00

Reserves & Surplus

2.50

3.50

Plant & Machinery (at Cost)

4.60

6.30

Depreciation fund

0.80

1.20

Inventories

1.80

2.00

Bank Loan

1.60

0.80

Sundry Debtors

1.00

1.55

Sundry Creditors

1.20

1.35

Cash & Bank Bal.

0.50

0.15

10.90

14.00

Proposed dividend

0.40

0.60

Provision for taxation

0.40

0.55

10.90

14.00

(1)

A machinery which was purchased earlier for Rs. 60,000 was sold for Rs. 4,000. The book value of the machine was Rs. 6,000. The company also purchased new equipments during the year.

(2)

The company has issued new shares to the extent of Rs. 2,00,000 for cash. You are required to prepare

(1)

Changes in the working capital and

(2)

Statement of sources and application of funds.

Interpretation of Financial Statements (Funds Flow/Cash Flow Statements)

199

(25) The Balance Sheets of Narula Ltd. as at the end of 1980 and 1981 are given as below.

Share Capital Share Premium General Reserve

P & L A/c

6% Debentures Depreciation Reserve Plant

1980

1981

1980

1981

Rs.

Rs.

Rs.

Rs.

1,00,000

1,50,000

Freehold Land

1,00,000

1,00,000

–

5,000

Plant at Cost

1,04,000

1,00,000

50,000

60,000

Furniture at cost

7,000

9,000

Investment at cost

60,000

80,000

Debtors

32,000

75,000

Stock

60,000

65,000

Cash

30,000

45,000

3,93,000

4,74,000

10,000

70,000

17,000

50,000

50,000

56,000

Furniture

5,000

6,000

Provision for tax

20,000

30,000

Sundry Creditors

86,000

95,000

2,000

5,000

3,93,000

4,74,000

Reserve for Bad Debts Total

A plant purchased for Rs. 4,000 (Depreciation Rs. 2,000) was sold for cash Rs. 800 on 30.9.81, an item of old furniture was purchased for Rs. 2,000. Depreciation on plant was provided at 8% on cost (excluding sold out items) and on furniture at 12 1/2% on average cost. A dividend of 22 1/2% on original shares was paid. Prepare a funds flow statement for 1981.

200

Financial Management

(26) The following are the summarised trial balances of ABC Company Limited as on 31.3.79 and 31.3.80 31.3.79 DR Fixed Assets

31.3.80 CR

DR

CR

23,36,960

–

24,60,500

–

9,60,540

–

7,91,800

–

30,000

–

25,000

–

Issued Capital Equity

–

15,00,000

–

15,00,000

Preference

–

3,00,000

–

4,00,000

Share Premium A/c

–

30,000

–

40,000

Debentures

–

5,00,000

–

5,00,000

Current Liabilities

–

6,20,000

–

4,40,000

Provision for dep.

–

1,80,000

–

1,95,000

Provision for doubtful debts

–

6,000

–

5,000

Dividend

–

–

1,50,000

–

Bal. Of P & L A/c from Previous year

–

24,400

–

1,91,500

Net Profit for the year

–

1,67,100

–

1,55,800

33,27,500

33,27,500

34,27,300

34,27,300

Current Assets Debenture Discount

Total (1)

During the year ended 31.3.80, Machinery costing Rs. 2,00,000 (accumulated provision for depreciation Rs. 60,000) was sold for Rs. 1,50,000.

(2)

Rs. 1,00,000 preference shares capital was issued during 1979-80 at a premium of Rs. 10,000.

(3)

The net profit for 1979-80 was arrived at after taking credit for the profit on the sale of Machinery, reduction in the provision for doubtful debts and writting off the discount on issue of debentures.

You are required to prepare (a)

A statement showing the net increase in working capital during the year 1979-80.

(b)

A statement showing the sources of the increase in the working capital and application thereof during the year.

Interpretation of Financial Statements (Funds Flow/Cash Flow Statements)

201

(27) The financial position of ABC Ltd. on 1.1.86 and 31.12.86 was as follows Liabilities

Current Liabilities Loan from Associate Company Loan from Bank Capital Reserve

1-1-86

31-12-86

Rs.

Rs.

72,000

82,000

–

40,000

60,000

50,000

2,96,000

2,98,000

Assets

1-1-86

31-12-86

Rs.

Rs.

8,000

7,200

Debtors

70,000

76,800

Stock

50,000

44,000

Land

40,000

60,000

1,00,000

1,10,000

2,14,000

2,44,000

54,000

72,000

1,60,000

1,72,000

4,28,000

4,70,000

Cash

Buildings Machinery Cost Less: Provision for Dep.

Total

4,28,000

4,70,000

During the year, Rs. 52,000 were paid as dividends. You are required to prepare the cash flow statement as well as funds flow statement. (28) Robinson Crusee Ltd. present the following financial statements for 1980 and 1981 Prepare a sources and application of funds statements and evaluate your findings. Liabilities

Rs. (80)

Rs.(81)

Sundry creditors

8,26,000

12,54,000

Bills Payable

4,52,000

Loan from Bank

Rs.(80)

Rs. (81)

Cash

1,06,000

62,000

6,28,000

Investment

1,74,000

–

2,00,000

4,70,000

Sundry Debtors

6,92,000

10,56,000

Reserves & surplus

13,84,000

17,28,000

Stock in trade

8,64,000

13,66,000

Share Capital

12,00,000

12,00,000

Net Fixed Assets

22,26,000

27,96,000

40,62,000

52,80,000

40,62,000

202

52,80,000

Assets

Financial Management

Depreciation of Rs. 3,78,000 was written off for 1981 on fixed assets. (29) Following is the Balance Sheet of Sphnix Limited.

Share Capital

Rs. in Lakhs

As on

As on

As on

As on

30.6.80

30.6.81

30.6.80

30.6.81

10.00

20.00

Plant

13.00

18.00

Stock

8.00

9.50

15.00

14.50

Equity Shares of Rs. 100 each 10% Redeemable Preference shares of Rs. 100 each

7.50

2.50

Debtors

Share Premium

0.50

0.25

Bank Balance

3.00

2.50

Misc. Exp.

1.00

1.00

–

5.00

General Reserve

8.00

4.50

P & L Account

3.00

5.00

Provision for taxation

5.00

6.00

Current Liabilities

6.00

2.25

40.00

45.50

40.00

45.50

Capital Redemption Reserve

Following further information is furnished. (1)

The company declared a dividend of 20% for the year ended 30.6.80 to equity share holders as on 30.9.80. Dividend on preference shares capital for the year ended 30.6.80 was paid on 30.6.80.

(2)

The company issued notice to preference shareholders holding preference shares of the face value of Rs. 5 Lakhs for redemption at a premium of 5% on 1.2.80 and the entire proceedings were completed before 31.12.80 in accordance with the law.

(3)

The company provided depreciation at 10% on closing balance of plant. During the year one Plant, whose book value was Rs. 2,00,000 was sold at a loss of Rs. 30,000.

(4)

Miscellaneous expenditure incurred during the year ended 30.6.81 Rs. 25,000 for share issue and other expenses

Interpretation of Financial Statements (Funds Flow/Cash Flow Statements)

203

(5)

A sum of Rs. 4 lakhs has been provided for taxation for the year. Prepare a statement of sources and application of funds for the period ended 30.6.81.

(30) The summarised balance sheets of P Ltd. as on 31.12.81 and 31.12.82 are as follows. (Rs. in Lakhs) Liabilities

31.12.81

31.12.82

6.00

8.00

Fixed Assets

–

0.20

Cost

General Reserve

3.40

4.00

Less : Dep.

P & L Account

1.20

1.50

Share Capital Capital Reserve

Debentures

4.00

2.80

Liabilities for

31.12.81

31.12.82

16.00

19.00

4.60

5.80

11.40

13.20

Investments

2.00

1.60

Current Assets

5.60

6.60

0.40

0.20

19.40

21.60

Trade

Preliminary

goods and services

Assets

expenses 2.40

2.60

1.80

1.70

0.60

0.72

–

0.08

19.40

21.60

Provision for tax Proposed Dividend Unpaid Dividend

During 1982 the Company : (1)

Sold one machine for Rs. 50,000, the cost of the machine was Rs. 1,28,000 and the depreciation provided for it amounted to Rs. 70,000

(2)

Provided Rs. 1,90,000 as depreciation.

(3)

Redeemed 30% of debentures at Rs. 103.

(4)

Sold some trade investments and profit credited to Capital Reserve.

(5)

Decided to value the stock at cost, whereas previously the practice was to value the stock at cost less 10%. The stock according to books as on 31.12.81 was Rs. 1.08,000. The stock on 31.12.82 Rs. 1,50,000 was correctly valued at cost. You are required to prepare the fund flow statment during 1982.

204

Financial Management

(31) The Balance Sheets of AB Ltd. as on 31.12.85 and 31.12.86 are as under (Rs. in Lakhs) Liabilities

31.12.81

31-12-82

Share Capital Equity

1.50

2.50

31-12-82

0.60

0.47

1.00

0.75

0.90

1.91

0.10

0.35

Stock

0.85

0.78

0.60

0.90

Receivable

0.15

0.18

Goodwill Land &

1.50

1.00

Reserves &

Building Plant &

surplus General Reserve

31-12-81

Fixed Assets

8% Redeemable Preference

Assets

Machinery 0.20

0.30

Trade Investment

Capital Reserve P & L Account

–

0.25

Current Assets

0.18

0.27

Loan & Adv.

Current Liabilities and provisions Sundry Creditors

0.26

0.53

Sundry Debtors

Bills Payable

0.18

0.12

Bills

Provision for taxation

0.28

0.32

Cash at Bank

0.10

0.22

0.27

0.33

Cash in hand

0.07

0.06

4.37

5.62

Total

4.37

5.62

Proposed Dividend Total

The following further particulars are given : (1)

In 1986, Rs. 18,000 depreciation has been written off plant and machinery, and no depreciation has been charged on Land and Building.

(2)

A piece of Land had been sold out and the balance has been revalued. Profit on such sale and revaluation being transferred to Capital Reserve. There is no other entry in Capital Reserve account.

(3) (4)

A plant was sold for Rs. 12,000 (WDV Rs. 15,000) Dividend received amounted to Rs. 2100 which includes Preacquisition dividend of Rs. 600.

(5)

An interim dividend of Rs. 10,000 has been paid in 1986. You are required to prepare i) Statement of sources and application of funds and ii) Statement of changes in working capital for the year 1986. All workings should form part of your answer.

Interpretation of Financial Statements (Funds Flow/Cash Flow Statements)

205

(32) The following are the summaries of the balance sheets of a limited company as on 31st December 1986 and 1987. Liabilities

1986

1987

1,00,000

1,00,000

General Reserve

38,400

42,000

Sundry Creditors

9,750

6,380

19,000

21,000

1,000

1,200

1,68,150

1,70,580

1986

1987

Building

46,800

45,000

Plant & Machinery

38,280

42,030

Goodwill

13,000

13,000

Investment

10,000

11,250

Stock

30,000

28,000

Sundry Debtors

22,070

22,300

8,000

9,000

1,68,150

1,70,580

Paid Up Share Capital

Provision for Taxation Provision for doubtful debts

Assets

Cash

After taking the following information into account, prepare a statement showing the changes in working capital during 1987 and a statement of sources and application of funds during the year.

206

a.

The profit for 1987 was Rs. 8,600. Against this has been charged depreciation Rs. 3,050 and increase in provision for doubtful debts Rs. 200.

b.

Income tax Rs. 18,000 was paid during the year charged against the provision and in addition Rs. 20,000 was charged against the profit and carried to the provision.

c.

An interim dividend of Rs. 5,000 was paid in October 1987.

d.

Additional plant was purchased in May 1987 for Rs. 5,000.

e.

Investment (Cost Rs. 5,000) were sold in November 1987 for Rs. 4,800 and on 1st December 1987, another investment was made for Rs. 6,250.

Financial Management

(33) From the following balance sheets and information of A Ltd. 1985 and 1986, prepare a funds flow statement and statement of changes in working capital for 1986. Liabilities

1985

1986

Equity Share Capital

2,00,000

3,00,000

8% Preference Share Capital (Redeemable)

1,00,000

50,000

20,000

30,000

–

25,000

Profit & Loss Account

18,000

27,000

Proposed Dividend

28,000

39,000

Sundry Creditors

25,000

47,000

Bills Payable

10,000

6,000

8,000

6,000

28,000

32,000

4,37,000

5,62,000

1985

1986

50,000

40,000

1,00,000

75,000

Plant

90,000

1,91,000

Trade Investments

10,000

35,000

Sundry Debtors

60,000

90,000

Stock

85,000

78,000

Bills Receivable

15,000

18,000

Cash in Hand

7,000

6,000

Cash at Bank

10,000

22,000

Preliminary Expenses

10,000

7,000

4,37,000

5,62,000

General Reserve Capital Reserve

Liabilities for expenses Provision for Taxation

Assets Goodwill Land and Building

a.

In 1986, Rs. 18,000 depreciation has been written off on plant account and no depreciation has been charged on land and buildings.

b.

A piece of land has been sold out and the balance has been revalued, profits on revaluation and sale being transferred to capital reserve. There is no other entry in capital reserve account.

Interpretation of Financial Statements (Funds Flow/Cash Flow Statements)

207

c.

A plant was sold for Rs. 12,000 (WDV Rs. 15,000)

d.

Rs. 2,100 dividend has been received, but it includes Rs. 600 pre-acquisition dividend.

e.

An interium dividend of Rs. 10,000 has been paid in 1986.

(34) The balance sheet of X Ltd. as on 31st March 1989 and 1990 are given below : Liabilities

1989

1990

3,00,000

4,00,000

50,000

65,000

–

10,000

Profit & Loss Account

1,70,000

2,00,000

Current Liabilities

1,40,000

1,50,000

Provision for Income Tax

90,000

80,000

Proposed Dividend

36,000

48,000

7,86,000

9,53,000

1986

1987

Machinery at cost

5,00,000

6,00,000

Less : Depreciation

1,50,000

1,70,000

3,50,000

4,30,000

80,000

60,000

Stock

2,00,000

2,63,000

Sundry Debtors

1,06,000

1,50,000

Cash/Bank

30,000

40,000

Preliminary Expenses

20,000

10,000

7,86,000

9,53,000

Share Capital General Reserve Capital Reserve

Assets

Trade Investments

During the year ended 31st March 1990, the company : a.

Sold one machine for Rs. 30,000 the cost of which was Rs. 60,000 and depreciation provided on it was Rs. 20,000.

b.

Sold trade investment at a profit which was credited to capital reserve.

c.

Decided to write off fixed assets costing Rs. 10,000 (fully depreciated),

Prepare the statement of sources and application of funds during the year ended 31st March, 1990, showing the changes in the working capital. Show all other workings also.

208

Financial Management

NOTES

Interpretation of Financial Statements (Funds Flow/Cash Flow Statements)

209

NOTES

210

Financial Management

Chapter 6 CAPITALISATION

The assessment of the funds needed by the company should be done in such a way that the total amount of funds available should be neither too large nor too less. As such, one of the most important financial decisions becomes the determination of the amount which the company should have at its disposal (which may consist of funds required for fixed assets as well as the portion of current assets to be financed by the company out of long term sources.) This is capitalisation. Thus the term capitalisation means total amount of long term funds available to the company. In the words of Dewing “Capitalisation includes capital stock and debt”. Therefore capitalisation includes shares and debentures issued by the company and also the long term loans taken from the financial institutions. The question arises regarding the inclusion of non-distributed profit in the capitalisation. As far as earned profits remained to be distributed (i.e. Reserves and Surplus) are concerned; it is necessary to classify them as either capital surplus or revenue surplus. Capital Surplus will always be a part of total capitilisation, though it is available for cash dividend under certain circumstances. Revenue Surplus will be a part of capitalisation if the management wants to retain it in the business. IMPORTANCE The importance of the determination of amount of capitalisation need not be over-emphasised. The amount of capitalisation should be only that much which can be justified by its profits and by the normal rate of return for the industry concerned. If the company earns less than the other companies in the same industry, value of the shares of company will reduce and the company will suffer. E.g. If the company earns an after tax profit of Rs. 20 lakhs and the other companies in the same industry earn after tax return of 10% on their capitalisation, the expectation of investors will be the same from company. As such, the ideal capitalisation for the company will be Rs. 200 lakhs. If the actual capitalisation is Rs. 250 lakhs, the after tax return for the company

Capitalisation

211

becomes 8% which is less than the industry standards. As a result, price of the shares of the company will be less than that of other companies in the same industry. THEORIES OF CAPITALISATION There are two important theories which act as guidelines for determining the amount of capitalisation. Cost Theory : Cost theory of capitalisation considers the amount of capitalisation on the basis of cost of various assets required to set up the organisation. It gives more stress on current outlays than on the requirements which are necessary to accommodate the investment on a going concern basis. The company may need the funds to invest in fixed and current assets and also to meet promotional and organisational expenses. The total sum required for all these purposes gives the amount of capitalisation. The cost theory of capitalisation seems to be ideal as it considers the actual funds to acquire various assets, but it does not consider the earnings capacity of these assets. If the amount of capitalisation arrived at on this basis includes the cost of assets acquired at inflated costs or the cost of idle and obsolete assets, the earnings are bound to be low which will not be able to pay favourable return on the cost of assets and this will result into over-capitalisation. Similarly, cost theory of capitalisation may not be useful in case of company with irregular earnings. Earnings Theory : Earnings theory of capitalisation considers the amount of capitalisation on the basis of expected future earnings of the company, by capitalising the future earnings at the appropriate capitalisation rate. Thus, for determining the amount of capitalisation, it is necessary to take the following steps: (a)

To decide future earnings : Estimations of future earnings may be comparatively an easy task in case of established concerns as there can be some basis of past data. In case of new concerns, estimating the future earnings is a difficult task. While estimating future earnings, following factors should be kept in mind.

212

(i)

Smaller the period, more accurate will be the estimations of future earnings. While estimating future earnings on the basis of past earnings, weighted average of past earnings may be considered giving maximum weightage to recent earnings.

(ii)

While considering future earnings on the basis of past earning, care should be taken to adjust the earnings on account of non-recurring factors. Moreover, adjustments should be made for known factors in future. Financial Management

(iii) In case of new concerns, the estimations of future earnings depend upon correct estimation of future sales (which in turn should be based upon proper sale forecast) and future costs. Allowance should be made for contingencies. (b)

To determine Capitalisation rate : This is the most tricky and delicate issue and is entirely a subjective concept. The concepts of capitalisation rate may take any of the following forms: (i)

It is the rate of return that is required to attract investors to the particular organisation.

(ii)

It is the cost of capital.

(iii) It is the rate of earnings of the similar organisations in the same industry. (c)

To capitalise the future earnings at the decided rate of Capitalisation :

Following example will illustrate the working of earnings theory of capitalisation. IIIustration : Expected future earnings of A Ltd. are Rs. 3,00,000. Find out the amount of capitalisation if rate of return earned by similar types of companies is 15%. Amount of capitalisation

=

Rs. 3,00,000 x 100 15

=

Rs. 20,00,000.

The earnings theory of capitalisation is ideal in the sense that it considers earnings capacity of the organisation. But it has limitations in the sense that it involves the estimation of two variables i.e. future earnings and capitalisation rate, which are too difficult to accertain. As such, in case of established concerns, earnings theory may be useful, whereas new concerns may prefer cost theory to decide the amount of capitalisation. OVERCAPITALISATION : In simple terms, overcapitalisation means existence of excess capital as compared to the level of activity and requirements. E.g. If a company is earning a profit of Rs. 50,000 and the normal rate of return applicable for the same industry is 10%, it means that the amount of shares and debentures should be Rs. 5,00,000. If the amount of shares and debentures issued by the company is more than Rs. 500,000, then the company will be said to be overcapitalised.

Capitalisation

213

The term overcapitalisation should not be taken to mean excess funds. There can be situation of overcapitalisation; still the company may not be having sufficient funds. Similarly, the company may be having more funds and still may be having a low earning capacity thus resulting into overcapitalisation. Causes of overcapitalisation : The situation of overcapitalisation may arise due to various reasons as stated below:

214

(1)

The assets might have been purchased during the inflationary situations. As such the real value of the assets is less than the book value of the assets.

(2)

Adequate provision might not have been made for depreciation on the assets. As such, the real value of the assets is less than the book value of the assets.

(3)

The company might have spent huge amounts during its formation stage or might have spent huge amounts for the purchase of intangible assets like goodwill, patents, trademarks, copyrights and designs etc. As a result, the earning capacity of the company may be adversely affected.

(4)

The requirement of funds might not have been properly planned by the company. As a result, the company may have shortage of capital and to overcome the situation of shortage of capital, the company may borrow the funds at unremunerative rates of interest, which in its turn will reduce the earnings of the company.

(5)

The company might have followed the lenient dividend policy without bothering much about building up the reserves. As a result, the retained profits of the company may be adversely affected.

(6)

If there is a very high rate of taxation for companies, the company may not be having sufficient funds left with it for modernisation or renovation programmes. As such, the real value and the earning capacity of the assets will be lower.

(7)

There may be many instances, where the management of the company may raise large amounts by issuing securities, irrespective of the fact whether they are really required or not, in order to take benefit of favourable capital market conditions. As a result, only the liability of the company increases but not the earning capacity.

(8)

According to the earnings theory of capitalisation, the capitalisation is the amount of earnings capitalised at a representative rate of return. As such, if the capitalisation rate is wrong, the amount of capitalisation will be wrong, in such a way that lower the rate of capitalisation, higher will be amount of capitalisation.

Financial Management

Effects of Overcapitalization : (1)

On Company : The real value of the business and its earning capacity reduces with the adverse affect on market value of shares. Credit standing of the company in the market falls down and it is difficult to raise further capital. The temporary means like lower amount of depreciation and maintenance charges are followed to improve the earnings which aggravates the situation further.

(2)

On Shareholders : This is the worst affected class. The shares held by them are not having any backing of tangible assets. Due to the reduced market values, the shares become non-transferable or are required to be transferred at extremely low prices.

(3)

On Consumers : To overcome the situation of overcapitalisation and to improve the earnings, the company may be tempted of increase the selling price, more particulary in monopoly conditions. Due to this, the quality of the produts may also be affected.

(4)

On Society at Large : The increasing selling prices and reducing quality can’t be continued for a very long time due to the competition existing in the market. The situation like this means loosing the backing of the shareholders as well as the consumers. As a result, the company is dragged towards the winding up which ultimately affects the society at large in the adverse way in terms of lost industrial production, unemployment generated, unrest among the workers as a part of society etc.

Remedies Available : In order to overcome the situation of overcapitalisation, the company may resort to any of the following remedial measures: (1)

To reduce the debts by repaying them. But the debts should be repaid out of the own earnings of the company. There is no point in repaying the debts out of the fresh issue of shares or debentures, as it does not reduce the amount of capitalisation.

(2)

To redeem the preference shares if they carry too high rate of dividend.

(3)

The persons holding the debentures may be pursuaded to accept new debentures which carry lower rate of interest.

(4)

The par value of the equity shares may be reduced but this also will have to be done only after taking the shareholders into confidence.

Capitalisation

215

(5)

The number of equity shares may be reduced but this also will have to be done only after taking the shareholders into confidence.

UNDERCAPITALISATION As against the indication of overcapitalisation, the situation of undercapitalisation indicates the excess of real worth of the assets over the aggregate of shares and debentures outstanding. Thus, if a company succeeds in earning abnormally high income continuously for a very long period of time, it indicates symptoms of undercapitalisation. As such, undercapitalisation is an indication of effective and proper utilisation of funds employed in the business. It also indicates sound financial position and good management of the company. Hence it is said that “undercapitalisation is not an economic problem but a problem in adjusting capital structure”. Causes of Undercapitalisation : The situation of undercapitalisation may arise due to various reasons as stated below : (1)

Sometimes, it may so happen that while deciding the amount of shares and debentures to be issued, the future earnings may be underestimated. As a result, if the actual earnings turn out to be higher, capitalisation of these earnings may result into undercapitalisation. Similarly, use of low rate of capitalisation for capitalising the future earnings may also result in undercapitalisation.

(2)

There may be cases where the earnings of the business come as a windfall. This may arise during transition from depression to boom. Thus, while recovering from depression, the companies may find their earnings too high to result into the state of undercapitalisation.

(3)

Sometimes, the company may follow too conservative policy for paying the dividends keeping aside more and more profit for making further additions and investments. As a result, the company may find itself to be in too high profits and thus undercapitalisation.

(4)

The company may be in the position to improve its efficiency through constant modernisation programmes financed out of its own savings. As such the earnings capacity of the company may increase to such an extent that the real value of the assets is much more than the book value which results into the state of undercapitalisation.

Effects of Undercapitalisation : (1)

On Company : Financial stability and solvency of the company is not affected due to undercapitalisation, but it still affects the company adversely. (a)

216

As earnings per share ratio is very high, it increases the competition unduly by creating a feeling that the line of business is very lucrative.

Financial Management

(b)

Increasing amounts of profits increases the tax liability of the company.

(c)

Marketability of the shares of the company gets restricted due to very high market prices of shares.

(d)

Very high profitability of the company induces the employees to demand increase in wages, reduced working hours, more welfare schemes and more social amenities.

(e)

Very high profitability of the company creates a feeling among the customers that the company is charging very high prices for its products. They try to bring pressure on the company for reducing the prices of the product.

(f)

Increasing profitability coupled with unrest among the employees as well as consumers increases the possibility of Government control and intervention over such companies. This proves to be quite embarrassing for the company.

(2)

On Shareholders : Generally, the shareholders of an undercapitalised concerns are benefited. Firstly, they get a very high dividend income regularly. Due to the increasing share prices, the investment of shareholders in the company appreciates considerably which can be encashed at any time. Secondly, in times of need, the shareholders may get loans on the security of these shares on easy terms due to high credit standing of the company in market. However, the shareholders of the undercapitalised concerns may suffer in the sense that the market for the shares is limited due to very high market prices of the shares.

(3)

On Society : The effects of undercapitalisation on the society as a whole may not necessarily be adverse ones. It may encourage new enterpreneurs to start new ventures or existing ones to expand. This may increase the industrial production and reduce the unemployment problems. The consumers may get variety of products at the competitive prices. However, society may not be benefited if the state of undercapitalisation is not taken into right spirit. If the feeling is developed among the workers and consumers that they are being exploited due to ever-increasing profitability of the undercapitalised company, it may disturb not only the company itself but also the society as a whole. Possibility of Government intervention and introduction of various control measures (say in the form of price control, dividend ceiling and dividend freeze) increases.

Remedies Availabe : The main indications about existence of the situation of undercapitalisation is the ever-increasing amount of earnings per share. If the situation of undercapitalisation is to be resolved, the company can take any of the following two measures in order to reduce the amount of earnings per share. Capitalisation

217

(1)

Issue of Bonus Shares : If the company has sufficient amount of reserves and surplus in hand, whole or a part of reserves and surplus may be capitalised by way of bonus shares. As a result, number of shares as well as amount of share capital will increase and amount of reserves and surplus will be reduced. It should be noted that it will affect neither the amount of capitalisation nor the total income of the shareholders. But it will reduce the amount of earnings per share. E.g. Suppose that the present capitalisation of the company comprise of Equity Share Capital of Rs. 1,00,000 (divided into 1000 Equity Shares of Rs. 100/- each) and reserves of Rs. 75,000. If the present earnings are Rs. 50,000, the present earnings per share will Rs. 50 i.e. Rs. 50,000/- : 1000 equity shares. The company decides to issue 500 equity shares of Rs. 100/- each as bonus shares. As such, the equity share capital will increase to Rs. 150,000 and reserves will reduce to Rs. 25,000. The earnings of the company will be considered against total of 1500 equity shares and as such, earnings per share will reduce to Rs. 33.33 i.e. Rs. 50,000/1500 Equity Shares.

(2)

Splitting the Shares : To overcome the situation of undercapitalisation, the company may decide to spilt the shares in order to spread the earnings over a greater number of shares so that the earnings per share may be reduced. E.g. Suppose that the present capitalisation of the company consists of equity share capital of Rs. 1,00,000 (divided into 1000 equity shares of Rs. 100/- each) and its present earnings are Rs. 50,000. As such, present earning per share will be Rs. 50, i.e. 50,000/ 1000 equity shares. The company decided to reduce per value of shares by 50% and increase the number of shares in the same proportion. As such, now the number of equity shares will become 2,000 and the earnings of Rs. 50,000 will be distributed over 2,000 equity shares of Rs. 50/-each and earnings per share will reduce to Rs. 25/- i.e. Rs. 50,000/-2,000 equity shares.

OVERCAPITALISATION VS. UNDERCAPITALISATION : If effects of both of these situations of overcapitalisation and undercapitalisation are studied and observed carefully, one will find that both the situations are having bad effects. But the effects of overcapitalisation are more serious which affect the company, shareholders, consumers and society at large in an adverse way and the ultimatum involved with this situation is only the liquidation and winding up of the company, which is a very high cost for the company to pay. Situation of undercapitalisation increases the competition for the company, there is discontentment on the part of the employees and the consumers get the feeling that they are being exploited. But the fact still remains that the shareholders and the society at 218

Financial Management

large are benefited due to the increased prosperity of the company. Naturally, if the choice is to be made between these two situations, undercapitalisation will be preferable situation. As such a statement is usually made – “Both overcapitalisation and undercapitalisation are undesirable. Of the two, however, overcapitalisation is more fatal and dangerous”. However, ideally the company should try to avoide both the extremes of overcapitalisation as well as undercapitalisation. It should ideally aim at a fair capitalisation or balanced capitalisation. WATERED STOCK/WATERED CAPITAL : When share capital is not represented by the assets of equal value, the situation may mean introduction of water in the capital or watered capital. This situation may arise due to following reasons : (1)

The services of the promoters are valued highly and they are paid usually in the form of shares of the company. As such, share capital is increased but no assets are created.

(2)

Sometimes, the company pays higher price to the vendors of the assets transferred i.e., the price which is more than the worth of the assets.

As such, possibility of the existence of the watered stock or watered capital can be traced to the intention of the promoters who sell the shares. If the promoters deliberately acquire the assets at inflated prices, the situation of watered capital may exist. WATERED CAPITAL VS. OVERCAPITALISATION : Some times, the terms watered capital and overcapitalisation are confused for each other, but it is not true. The concept of watered capital is confined to the time of promotion of the company. Thus, at the time of promotion, the company is expected to acquire the assets at a price which justifies its real worth. If the assets prove to be worthless or are bought at an inflated price, the situation of watered capital may exist. On the other hand, if the company has worked for several years and during these years has failed to earn sufficient earnings to justify the amount of its capital, the company will be in the state of overcapitalisation. Thus, the existence of watered capital may be one of the causes of overcapitalisation, but it is not inevitably the cause of overcapitalisation as the subsequent earnings may justify the amount of capitalisation though the capital may remain watered. The following illustration may make the relationship between watered capital and overcapitalisation more clear:

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219

Suppose, that a company issues and subscribes for 1000 equity share of Rs. 100 each (i.e., total equity share capital is Rs. 1,00,000). This amount has been used to purchase the fixed assets of the company, the real value of which is only Rs. 75,000. It means that the company is watered to the tune of Rs. 25,000. The company operates for six years during which it has earned the average profits of Rs. 16,000. If the earnings are capitalised at the rate of 5%, the capitalised value of earnings will be Rs. 3,20,000. It means that the company will be having watered capital but it will not be overcapitalised. Now suppose, that the original amount of Rs. 1,00,000 is used by the company to purchase fixed assets, the real worth of which is really Rs. 1,00,000. It means that there is no watered capital. However after operating for six years the company is able to earn the average profits of only Rs. 3,000. If the earnings are capitalised at the rate of 5%, the capitalised value of the earnings will be Rs. 60,000. It means that at the company has no water in capital but it is overcapitalised.

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QUESTIONS 1.

“As between under and overcapitalisation, the former is the lesser evil of the two but still both should be discouraged and the ideal should be fair capitalisation.” Comment.

2.

What are the causes of overcapitalisation? State the dangers of overcapitalisation to the society. How will you secure balanced capitalisation?

3.

Discuss the symptoms, causes and remedies of overcapitalisation.

4.

What are the causes of undercapitalisation? State the dangers and disadvantages of undercapitalisation.

5.

“Both overcapitalisation and undercapitalisation are undesirable. Of the two, overcapitalisation is more fatal and dangerous” – Discuss.

6.

Write short notes on : (a)

Balanced Capitalisation

(b)

Undercapitalisation

(c)

Watered Capital

(d)

Earings theory of capitalisation.

(e)

Theories of capitalisation

(f)

Overcapitalisation.

Capitalisation

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NOTES

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NOTES

Capitalisation

223

NOTES

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Chapter 7 SOURCES OF LONG TERM AND MEDIUM TERM FINANCE

While discussing about capitalisation, we have seen that the amount of long term capital should not be less than requirement nor it should be more than requirement. There should be a situation of what can be called as fair capitalization. The next question which arises is what should be the various sources from which the long term capital may be raised? The various sources from which a company may meet its long term and medium term requirement of funds are discussed under the following headings: a.

Shares

b.

Debentures

c.

Term Loans

d.

Public Deposits

e.

Leasing and Hire Purchase

f.

Retained Earnings

SHARES A share indicates a smaller unit into which the overall requirement of capital of a company is subdivided. E.g. If the capital required by a company is Rs. 10 Crores, it can be subdivided into 1 crore smaller units called as “Shares”, each one of the units having the value of Rs.10 each, which in technical words is referred to as “Face Value” or “Nominal Value”. In the Indian circumstances, the Face Value or Nominal Value can be decided by the company on its own. Generally found face value or nominal value is Rs. 10 or Rs. 100 each share. In the Indian circumstances, a company can raise the long term funds by issuing two types of shares. a.

Equity Shares

b.

Preference Shares

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EQUITY SHARES These are the corner stones of the financial structure of the company. On the strength of these shares, the company procures other sources of capital. Equity Shares as a source of long term funds for the company has the following characteristic features –

226

1.

Investors in the equity shares are the real owners of the company. As such, the investors in equity shares are entitled to the profits earned by the company or the losses incurred by the company.

2.

Funds raised by the company by way of equity shares are available on permanent basis. In other words, funds raised by the company by way of equity shares are not required to be repaid by the company during the lifetime of the company. They are required to be repaid only at the time of closing down of the company i.e. winding up of the company.

3.

Funds raised by the company by way of equity shares are available to the company on unsecured basis i.e. the company does not offer any of its assets by way of security to the investors in equity shares.

4.

Return which the company pays on equity shares is in the form of dividend. The rate of dividend is not fixed. It generally depends upon the profits earned by the company. However, a profit making company is under no obligation to pay dividend on equity shares.

5.

Equity shares as a source of raising the long term funds is a risk free source for the company, as the company does not commit anything on equity shares.

6.

Equity shares as an investment is very risky for the investors. As such, the investors are granted the voting rights. By exercising the voting rights, the investors can participate in the affairs regarding the business of the company. These voting rights are generally proportionate voting rights, in the sense the voting rights of the investors are in proportion to their investment on the overall capital of the company. However, it should be noted that due to some recent amendments to the companies Act, 1956, it may be possible for the companies to issue the equity shares with disproportionate voting rights.

7.

Equity shareholders may not be able to compel the company to pay the dividend, but they enjoy the right to maintain the proportionate interest in profits, assets and control of the company. As such, if the company wants to issue additional equity shares, it is under legal obligation to offer these equity shares to the existing shareholders first, before going to the open market as a general offer. This right of equity shareholders is called “Pre-emptive Right”.

8.

In financial terms, equity shares as a source of raising the funds is a costly source available to the company. The reasons for this will be discussed in the following paragraphs.

Financial Management

Advantages of Equity Shares To the Company While issuing the equity shares, the company does not accept any obligation of any type. The company neither offers any security to the investors in the form of assets of the company nor commits the repayment of these shares during the life time of the company nor commits the payment of any dividend to the shareholders. This is a total risk free source of capital for the company. To the investors a.

As per the law, the liability of the equity shareholders is restricted only to the extent of face value of the shares purchased by the investors. The personal properties of the investors are not at stake even if the company fails to fulfil its contractual obligations.

b.

Possibility of getting higher returns is always there in case of equity shares. The investors can gain from equity shares in two forms. One, the regular dividend paid by the company in the form of cash or by way of bonus shares and Second, the capital appreciation received by the investors by selling the equity shares in the secondary market i.e. stock exchanges. As such, equity shares is a good investment attracting the risk taking investors.

Disadvantages of Equity Shares a.

As the investors in equity shares enjoy the voting powers to control the affairs of the company, the management of the company is always under constant danger of getting interfered and disturbed in the regular administration.

b.

The cost associated with the equity shares is on the higher side as compared to the borrowed capital. By issuing more and more equity shares, the company looses the cost advantage.

c.

Many categories of investors i.e. institutional investors may not be able to invest in the equity shares due to various statutory restrictions.

d.

The excessive issue of equity shares may result in over capitalization to be realized in future.

PREFERENCE SHARES These are the shares which enjoy preferential treatment as compared to the equity shares in respect of the following factors – a.

Unlike in case of equity shares, the preference shares carry the dividend at a fixed rate which is payable even before any dividend is paid on equity shares.

b.

In the case of winding up of the company, preference shareholders are paid back their investment even before the investment of equity shareholders is paid off.

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Preference Shares as a source of funds for the company involves the following characteristic features – 1.

Investors in preference shares are not the absolute owners of the company.

2.

Funds raised by the company by way of preference shares are required to be repaid during the existence of the company. As per the provisions of Section 80 of the Companies Act, the company can issue the preference shares maximum for the duration of 20 years. As such, unlike equity shares, preference shares is not a permanent capital available for the company.

3.

Like in case of equity shares, funds raised by the company by way of preference shares are available to the company on unsecured basis i.e. the company does not offer any of its assets by way of security to the investors in preference shares.

4.

Return which the company pays on preference shares is also in the form of dividend which is payable by the company out of the profits earned. However, unlike in case of equity shares, the rate of dividend is prefixed and precommunicated to the investors.

5.

As compared to equity shares, risk on the part of company is more in case of preference shares.

6.

Preference shares as an investment is comparatively less risky for the investors. As such, generally, preference shares do not carry any voting rights and hence they do not have any say in controlling the affairs of the company. However, Companies Act, 1956 provides for voting rights to preference shareholders in the following circumstances.

a.

If any resolution directly affecting the rights of the preference shareholders is discussed by the equity shareholders (e.g. winding up of the company or reduction of share capital etc.), the preference shareholders can vote on such resolutions.

b.

If the dividend has not been paid on the preference shares, in case of cumulative preference shares for an aggregate period of two years and in case of non-cumulative preference shares, either for a period of two consecutive years or for an aggregate period of three years out of the six preceding years, then the preference shareholders can vote on all the matters placed before the company in the meeting of the equity shareholders.

Types of Preference Shares If the company wants to issue the preference shares, they can be of different varieties. 1.

Convertible Vs. Non-convertible Convertible Preference Shares are those which can be converted in the equity shares at a later date, the terms of conversion (i.e. when the conversion will take place, at what rate it will take place etc.) being known to the investors in the beginning only.

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Financial Management

Non-convertible Preference Shares are those which can not be converted in the form of equity shares. They are issued as preference shares and they remain the preference shares. 2.

Cumulative Vs. Non-cumulative Preference Shares are to be paid dividend at a fixed rate. However, dividend is payable only if there are profits. The question arises as to what happens if the company is unable to pay dividend as there are no profits earned by the company. It depends upon the types of preference shares. If the preference shares are cumulative preference shares and the company is unable to pay the dividend in a certain year due to non-availability of profits, the arrears of dividend go on accumulating till the company earns the profits and once the company earns the profits, the arrears of preference dividend are required to be paid first, then only the dividend can be paid on equity shares. If the preference shares are non-cumulative preference shares and the company is unable to pay the dividend in a certain year due to non-availability of profits, the arrears of preference dividend do not accumulate. The dividend lapses in the year of loss.

DEBENTURES In simple words, Debenture means a document containing an acknowledgement of indebtedness issued by a company and giving an undertaking to repay the debt at a specified date or at the option of the company and in the meantime to pay the interest at a fixed rate and at the intervals stated in the debenture. The above description of debentures indicates the following characteristic features of debentures. 1.

Investors who invest in the debentures of the company are not the owners of the company. They are the creditors of the company or in other words, the company borrows the money from them.

2.

Funds raised by the company by way of debentures are required to be repaid during the life time of the company at the time stipulated by the company. As such, debentures is not a source of permanent capital. It can be considered to be a long term source.

3.

In practical circumstances, debentures are generally secured i.e. the company offers some of the assets as security to the investors in debentures.

4.

Return paid by the company is in the form of interest. Rate of interest is predetermined, but the same can be freely decided by the company. The interest on debenture is payable even if the company does not earn the profits.

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5.

Debentures as a source of raising long term funds is very risky from company’s point of view. The risk accepted by the company in case of debentures is twofold. One, to pay the interest at the predecided rate and at predecided time intervals irrespective of nonavailability of profits and Second, to repay the principal amount of debentures during the life time of the company.

6.

Risk on the part of investors is very less in case of debentures. The investors in debentures being the creditors of the company, they can not control the affairs of the company. As such, the debentures do not carry any voting rights. However, in the event of non-payment of interest or principal amount, they can interfere in the operations of the company by taking legal action.

7.

In financial terms, debentures prove to be a cheap source of funds from the company’s point of view. The reasons for this will be discussed in the following paragraphs.

Types of Debentures A Company can issue debentures of different varieties as described below – a.

Registered Vs. Bearer Registered Debentures are those the holders of which are registered in the company as debenture holders and those can be transferred to another person only through the company. Holders of bearer debentures are not registered with the company and can be transferred to anybody by mere delivery.

b.

Convertible Vs. Non-Convertible Convertible Debentures are the debentures which have the right to get converted into the equity shares of the company. Non-Convertible Debentures do not enjoy such right. Based upon the conversion criteria, debentures can be classified as below – a.

Fully Convertible Debentures (FCD)

b.

Partly Convertible Debentures (PCD)

c.

Non-Convertible Debentures (NCD)

d.

Optionally Convertible Debentures

FCDs are the debentures which are entirely convertible in the form of equity shares of the company. E.g. the terms of issue may provide that the face value of the debenture is Rs. 100. At the end of 5 years, the investors will get 1 equity share of the company. This is the case of FCD.

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Financial Management

PCDs are the debentures which are partly convertible in the form of equity shares of the company. E.g. the terms of issue may provide that the face value of the debenture is Rs. 200. At the end of 5 years, the investors will get one equity share of Rs. 100 each while the remaining amount of Rs. 100 will be repaid at the end of 7 years. This is the case of PCD. NCDs are the debentures which are not convertible in the equity shares of the company. They are issued as debentures, they are repaid as debentures. In case of optionally convertible debentures, the investors are given the option to convert their investment in the form of equity shares of the company. Advantages of Debentures To the company a.

By issuing the debentures, the controlling position of the existing equity shareholders does not get affected as the debentures do not carry any voting rights.

b.

Cost associated with debentures is comparatively less than the cost associated with the equity shares. As such, it is economical for the company to issue debentures.

c.

During the period of depression when the investors are not prepared to take much of the risk, the company may be compelled to issue debentures as a source of raising long term capital.

d.

The company might have borrowed various small amount of debts of short duration which may prove to be costly and burdensome for the company. All these small debts may be converted into a single issue of debentures which may prove to be less costly for the company.

To the investors Debentures prove to be a good investment option for the conservative investors as well as the institutional investors, mainly due to following two reasons – a.

Fixed rate of interest payable by the company irrespective of non-availability of profits.

b.

Security available for the investment.

Disadvantages of Debentures a.

By issuing the debentures, the company accepts the risk of two types. One to pay the interest at a fixed rate, irrespective of the non-availability of profits and Second, repayment of principal amount at the predecided time. If earnings of the company are not stable or

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231

if the demand for the products of the company is highly elastic, debentures prove to be a very risky proposition for the company. Any adverse change in the earnings or demand may prove to be fatal for the company. b.

Debentures is usually a secured source for raising the long term requirements of funds and usually the security offered to the investors is the fixed assets of the company. A company which requires less investment in fixed assets, viz. A trading company, may find debentures as a wrong source for raising the long term requirement of funds as it does not have sufficient fixed assets to offer as security.

Protection of interests of Debentureholders Recent amendments to Companies Act, 1956 have made some provisions with the intention to protect the interests of the debentureholders. a.

b.

232

A Company accepting the funds from debentureholders shall appoint one or more debenture trustees and in Prospectus or the Letter of Offer, the company should state that the debenture trustee or trustees have given their consent to the company to act in the same capacity. The debenture trustee will be primarily responsible to ensure that the interests of the debentureholders are protected (including the creation of security) and the grievances of the debentureholders are effectively redressed. To be more specific, the debenture trustee should take following effective steps – i)

To ensure that the assets of the company and of the guarantors are sufficient to discharge the principal amount at all times. If it is concluded that the assets of the company are insufficient to discharge the principal amount, the trustees may file a petition before the Company Law Board who, after hearing both the parties, may impose restrictions on the incurring of any further liabilities by the company.

ii)

To satisfy himself that the prospectus or the letter of offer does not contain any matter inconsistent with the terms of debentures or with the trust deed.

iii)

To ensure that the company does not commit any breach of the provisions of the trust deed.

iv)

To take steps to remedy any breach of the provisions of trust deed or terms of issue of debentures.

v)

To take steps to call meeting of the debentureholders as and when required.

The trust deed for securing the issue of debentures should be executed in the prescribed form and within stipulated period. This trust deed shall be open for inspection by any member or debentureholder of the company and he can take the copies of the same on the payment of prescribed fees. If the trust deed is not made available to the member or

Financial Management

the debentureholder, the company and every responsible officer shall be punishable with a fine which may extend to Rs. 500 per day during which the offence continues. c.

A company issuing debentures is required to create debenture redemption reserve for the redemption of debentures and every year adequate amount should be credited to this reserve out of the profits until such debentures are redeemed. The amount standing to the credit of debenture redemption reserve shall be available only for the redemption of debentures. If the company fails to redeem the debentures on the date of maturity, on the application of any or all the debentureholders, the Company Law Board can order the company to pay the principal amount of debentures and the interest thereon. In case of any default in complying with the order of Company Law Board, every responsible officer shall be punishable with a fine which may extend to Rs. 500 per day during which the offence continues.

TERM LOANS Term Loans indicate liabilities accepted by the company which are for the purpose of purchasing the fixed assets and are repayable over a period of 3 to 10 years. The term loans may be granted by the Banks (nationalized, cooperative, rural etc.) or the Financial Institutions like Industrial Development Bank of India (IDBI), Industrial Credit and Investment Corporation of India (ICICI), Industrial Finance Corporation of India (IFCI) etc. Features of Term Loans 1.

Banks or Financial Institutions granting the term loans are not at all the owners of the company. They are creditors of the company. They lend the funds to the company.

2.

Term Loans are required to be repaid during the life time of the company at the predecided intervals say monthly, quarterly, yearly etc. The initial gap after which the repayment of term loan starts (technically referred to as the morotorium period) also depends upon the agreement between the borrowing company and the lending bank or financial institution.

3.

The term loans may be secured or unsecured, though normally all the term loans are secured. The security which is offered for the term loans is the hypothecation or mortgage of the fixed assets purchased with the help of term loans.

4.

Return payable by the company on term loans is in the form of interest which may be calculated on monthly or quarterly or half yearly basis at a predecided rate on the outstanding balance of the term loan. The interest on term loan is payable despite the non-availability of profits.

5.

Term Loans as a source of raising long term funds is very risky from company’s point of view. The risk accepted by the company in case of term loans is twofold. One, to pay the interest at the predecided rate and at predecided time intervals irrespective of non-availabilty of profits and Second, to repay the principal amount of term loans.

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6.

Risk on the part of lending bank or financial institution is very less in case of term loans. The banks or financial institutions being the creditors of the company, they can not control the affairs of the company. As such, they do not have any voting rights. However, in the event of non-payment of interest or principal amount, they can interfere in the operations of the company by taking legal action.

7.

In financial terms, as in case of debentures, term loans also prove to be a cheap source of funds from the company’s point of view. The reasons for this will be discussed in the following paragraphs.

Operational Formalities Term Loans is a contract between the borrowing company and lending bank or financial institution. This contract is a written contract referred to as “term loan agreement”. The term loan agreement stipulates the various terms and conditions on which the relationship between the borrowing company and lending bank or financial institution is regulated. Term Loan agreement has various clauses. 1.

Amount of loan and the period of repayment

2.

Rate of interest payable and the method of payment of interest

3.

Nature of security offered

In addition to the general security offered for the term loan, the agreement may provide for certain additional covenants in order to protect the interests of the lender. These covenants may take various forms, some of which are stated below -

234

1.

That the borrowing company will submit the copy of Annual Accounts to the lender, soon after they are finalised.

2.

That the assets purchased with the help of term loans will be properly maintained and insured by the borrowing company.

3.

That the lender may have a representative on the Board of Directors of the company ( viz. Nominee Director) if the loan amount is sizeable.

4.

The lender will like to ensure that the borrowing company has the liquid resources in its hands whenever the interest or the installments of the term loans are due. As such, the lender will like to confirm that the liquid resources of the company are not blocked for unnecessary purposes. Hence, the agreement may stipulate that – a.

The company will not pay dividend without the consent of the lender.

b.

The company will not make long term loans to directors/officers.

c.

The company will not invest in outside corporate securities.

d.

The company will not redeem the debt before maturity. Financial Management

PUBLIC DEPOSITS In the recent past, Public Deposits has become one of the most important sources available to the companies for meeting the medium term requirement of funds. The companies find public deposits as an attractive source mainly due to following reasons – a.

Raising the funds in the form of public deposits is more convenient than borrowing the funds from banks and financial institutions. Borrowing the funds from banks or financial institutions is a tedious job involving the compliance with many procedural requirements like margin money stipulations, security requirements, submission of periodical statements etc. None of these procedural requirements are required to be complied with in case of public deposits.

b.

The rate of interest which the company is required to pay on public deposits is comparatively less than the rate of interest payable on the funds borrowed from banks or financial institutions.

c.

Public Deposits are unsecured borrowings for the company.

d.

The company can raise the funds in the form of public deposits which can be used for any purposes. The end use of the funds raised in the form of public deposits is not committed by the company.

e.

In the situations of credit squeeze introduced by the banks, public deposits plays a very important role.

Control over Public Deposits The phenomenal growth of public deposits as a source of funds for the companies was an issue of concern for the Government, as it distorted the interest pattern and it encouraged the non-priority sectors to grow. As such, the deposits of the Governments owned agencies like banks, UTI, LIC etc. were diverted to public deposits. Hence, it was thought necessary to exercise control over the growth of public deposits as a source of funds for the companies. This came into application by the introduction of Section 58A and 58B to the Companies Act, 1956 vide Amendment Act, 1974 and the announcement of Companies (Acceptance of Deposits) Rules, 1975 which applies to the companies which are not Non-Banking Finance Companies (NBFCs). The main provisions of these regulations are discussed below – Applicability : In the word “deposits”, all types of loans and deposits are covered, however the following deposits are excluded. a.

Any amount received from Government, Local Authority and Foreign Government/Citizens/ Authority/Person and any amount whose repayment is guaranteed by Government.

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235

b.

Any loans from Banks/Financial Institutions.

c.

Amount received by a company from another company.

d.

Security deposits from employees.

e.

Advance for purchase or sales.

f.

Amounts received for subscribing to shares/debentures pending allotment.

g.

Amounts received in trust or amounts in transit.

h.

Amounts received from directors or from shareholders of a Private Limited Company.

Acceptance of deposits : While accepting the deposits, the company will have to comply with following requirements. a)

No company shall accept any deposit which is repayable on demand.

b)

Minimum period for which any deposit can be accepted will be 6 months and the maximum period will be 36 months. Note : A company, may, for the purpose of meeting its short term requirement of funds, accept the deposits for a period of less than 6 months but not less than 3 months, but their amount should not exceed 10% of paid up share capital and free reserves.

c)

The maximum amount of deposits which a company may accept will be 25% of the aggregate of paid up share capital and free reserves out of which not more than 10% should be from a shareholder of non-private limited companies or should be guaranteed by any director.

d)

The maximum interest which a company may pay on the deposits will be 12.5% at monthly rests. If the interest is paid at shorter rests, the amount of interest shall be discounted so as not to exceed the interest calculated at monthly rests.

e)

The maximum amount of brokerage which a company may pay on deposits accepted will be following percentage of deposits : 1% for deposits upto one year. 1.5% for deposits upto two years. 2% for deposits upto three years. Notes : Free reserves as mentioned above will include capital redemption reserve and share premium but will not include,

236

i)

Accumulated loss amount, deferred revenue expenses, and other intangible assets.

ii)

Revaluation reserve.

iii)

Depreciation reserve or bad debts reserve. Financial Management

Maintenance of liquid assets : Every company, before 30th day of April every year should deposit or invest, a sum equal to atleast 15% of the deposits maturing during the year ending on 31st March next following in the form of: (i)

Current or other deposit account with any scheduled Bank.

(ii)

Central or State Government Securities.

(iii) Bonds issued by Housing Development Finance Corporation Limited. The amount so deposited or invested shall not be utilised for any purpose other than repayment of deposits maturing during the year. Advertisement : If a company decides to invite the public deposits, it should publish an advertisement in a leading English newspaper and in one local newspaper circulating in the state in which registered office of the company is situated. Such advertisement should be issued on the authority and in the name of the Board of Directors of the company and should contain a reference to the date on which the Board of Directors has approved the text of the advertisement. The advertisement should contain the following details : a)

Name of the company

b)

Date of incorporation of the company

c)

Business carried on by the company and its subsidiaries with the details of its branches or units, if any.

d)

Brief particulars of management of the company.

e)

Names, addresses and occupations of the Directors

f)

Profits before tax and profits after tax, for the three financial years immediately preceding the date of advertisement.

g)

Summarised financial Position of the company (in the form prescribed by Schedule VI of the Companies Act, 1956) as in the two audited balance sheets immediately preceding the date of advertisement.

h)

The amount of deposits which can be raised by the company and the aggregate of deposits actually held on the last day of the immediately preceding financial year.

i)

A statement to the effect that on the date of advertisement, the company has no overdue deposits other than the unclaimed deposits or a statement showing the amount of such overdue deposits.

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j)

A declaration to the effect – i)

That the company has complied with the provisions of these rules.

ii)

That the compliance with these rules does not imply that repayment of deposits is guaranteed by the Central Government.

iii)

That the deposits accepted by the company are unsecured and rank pari passu with the other unsecured liabilities.

iv)

That the company is not in default in the repayments of deposits and interest thereupon in accordance with the terms and conditions of such deposits.

Before the advertisement is issued, a copy of the same, signed by a majority of the Directors, should be delivered to the Registrar of Companies. The advertisement so issued shall be valid until the expiry of six months from the date of closure of the financial year in which it is issued or the date on which balance sheet is laid before the company in general meeting, and if the Annual General Meeting has not been held, the latest day on which the meeting should have been held, whichever is earlier. If a company wants to accept the deposits without making public invitation, before accepting the deposits it should deliver a statement in lieu of advertisement to the Registrar of Companies. Such statement in lieu of advertisement attracts the same provisions as applicable to the advertisement as to the contents and the validity. Application form : A Company can accept or renew deposits, only on application being made by the intending depositor. Such application form shall be accompanied by a statement made by the company containing all the particulars stated under the head “Advertisement” as stated above. Deposit Receipt : After accepting the deposits, every company should furnish to the depositor, within the period of 8 weeks from the date of receipt of money or realisation of cheques, the deposit receipt containing the following particulars.

238

i)

Date of deposit

ii)

Name and address of depositor

iii)

Amount of deposit.

iv)

Rate of interest.

v)

Date of maturity.

Financial Management

Deposit Register : Every company accepting the deposits should maintain registers, at the registered office, showing the following particulars. i)

Name and address of depositor

ii)

Date and amount of deposit.

iii)

Duration of deposit.

iv)

Date of repayment.

v)

Rate of interest.

vi)

Date or dates on which interest is payable.

vii)

Any other particulars.

Prepayment of deposits : If a deposit is repaid after 6 months from the date of deposit but before its expiry, the rate of interest on such deposit shall be reduced by 1% from the rate which the company would have paid had the deposit been accepted for the period for which such deposit had run. Annual Returns : The companies to whom these rules apply, are required to file with Registrar of Companies, a return in prescribed form, on or before 30th June every year and the return should contain information of deposits as on 31st March of that year. Such return should be duly certified by the auditor of the company. A copy of this return is required to be sent to Reserve Bank of India. Protection of interests of depositors : Section 58-A of the Companies Act, 1956, makes the provision for the protection of interests of depositors. The said section provides that if a company fails to repay any deposit or any part thereof as per its terms and conditions, the Company Law Board has been empowered to order the company to make the repayment of such deposit or the part thereof forthwith or within such time and subject to such conditions as may be prescribed. Such action can be taken by Company Law Board on its own motion or on the application of the depositors. However, before making the order, company Law Board should give reasonable opportunity of being heard to the company and other interested persons. It is further provided that whosoever fails to comply with the order of Company Law Board Shall be punishable with imprisonment which may extend to three years and shall also be liable to a fine of not less than Rs. 500 per day during which such non-compliance continues.

Sources of Long Term and Medium Term Finance

239

Provisions to protect the interests of small depositors : Companies Amendment Act, 2000 has made certain provisions to protect the interests of small depositors. A “small depositor” means a depositor who has deposited in a financial year a sum not exceeding Rs. 20,000 in a company. The provisions are stated below : a.

Every company accepting deposits from the small depositors shall inform the Company Law Board of any default made by it in respect of repayment of deposit or interest thereon.

b.

A Company shall not accept any further deposit from the small depositor unless each small depositor whose deposit has matured has been paid the amount of his deposit and interest thereon.

c.

Every company who has defaulted in the repayment of deposit or the payment of interest thereon to a small depositor, shall state, in every further advertisement and application form inviting deposits from the public, the total number of small depositors and the amount due to them in respect of which default has been made.

d.

If any interest accrued on the deposits of small depositors has been waived, the fact of such waiver shall be mentioned by the company in every advertisement and application form inviting deposits issued after such waiver.

e.

Every application form issued by the company to small depositor shall contain a statement stating that the applicant has been appraised of –

f.

1.

Every past default of the company in the repayment of deposit or interest thereon, if any such default has taken place.

2.

The waiver of interest if any and reasons therefor.

If anybody knowingly fails to comply with the above requirements or fails to comply with any order of Company Law Board, he shall be punishable with the imprisonment upto three years and shall be liable to pay fine of not less than Rs. 500 per day during which default continues.

Point to be noted here is that the above provisions apply only in case of small depositors and not in case of large depositors. LEASE FINANCING In the recent years, the lease financing has emerged as one of the most important sources of long term financing. Under the leasing agreements, the company acquires the right to use the asset without holding the title to it. Thus, it is the written agreement between the owner of the assets, called “the lessor”, and the user of the assets, called “the lessee” whereby the lessor

240

Financial Management

permits the lessee to economically use the asset for a specified period of time but the title of the asset is retained by the lessor. This economical use of the asset is permitted by the lessor on the payment of periodical amount which is in the form of “lease rent”. Lease Agreement or Lease Deed : Lease agreement/deed is the most important document in any leasing activity as it starts the legal relationship between the lessor and lessee. The usual contents of the lease agreement/deed are as stated below. 1)

Description and cost of equipment to be acquired.

2)

Commencement date for lease contract.

3)

Amount of lease rentals and mode of payments.

4)

Fixed period of lease, renewal options and the terms during secondary period as to the amount of lease rentals or purchase option. Note : After the fixed period of lease, the lease is usually given the option either to renew the lease from time to time at a nominal lease rental or to purchase the asset at a price which is reasonably lower than the fair value of asset.

5)

Guarantee for payment of lease rental by lessee.

6)

Variation of lease rentals.

7)

Termination of the lease agreement in the event of certain occurrences.

8)

In order to protect the interests of the lessor and lessee, certain covenants as stated below may also be incorporated as a part of lease deed.

i)

That lessee will maintain the asset in good working condition and pay all taxes, insurance etc.

ii)

That lessee will not sell or mortgage or charge the land or building on which equipment is installed without notifying to lessor.

iii)

That lessee will not claim any grant or relief available to the lessor.

iv)

That lessee will not alter or modify equipment without lessor’s knowledge.

v)

That lessee will accept the lessor’s right to inspect the equipment.

Advantages of Leasing for the lessee : 1)

Risks of ownership : Leasing facilitates lessee to avoid the risks attached with the ownership of the equipments, say risk of obsolescence in the area of everchanging technologies.

2)

Saving of capital outlay : Leasing enables lessee to make full use of the asset without making immediate payments of the purchase price which otherwise would be payable

Sources of Long Term and Medium Term Finance

241

by him. Some lessors may also finance to the extent of 100% of the cost of the equipment where lessee is not required to make any provision for asset acquisition. 3)

Tax advantages : Under the leasing propositions, the payment of lease rents is the tax deductible expenditure. On the other hand, if the company decides to own the same asset by resorting to the borrowing, the expenses which are available for deduction for tax purposes are in the form of depreciation and interest on borrowing.

4)

Structuring of lease rents : Lessor may structure the payments of lease rents in such a way that it matches the revenue expectations of the lessee from the equipments, which may not be possible if lessee resorts to borrowing for owning the asset.

5)

No effect on borrowing power : As the obligations accepted by the lessee under the lease deed appear nowhere on the balance sheet as debt, the borrowing power of the lessee still remains unaffected. The lessee may still resort to debt capital provided equity base of the company permits further borrowing.

6)

Convenience : Leasing is the quickest method of financing the requirements of long term capital and lessee is relieved from the rigid and time consuming procedures and terms and conditions involved in other forms of term borrowings say term loans.

Evaluation of lease financing : The alternative of leasing can be evaluated under the following headings:

242

a)

Does leasing increase borrowing capacity of a firm. The answer to this question is yes, E.g. suppose that at present a company is having the fixed assets the cost of which is Rs. 200 lakhs which are financed by way of equity shares of Rs. 100 lakhs and Rs. 100 lakhs by way of debentures. As such the present debt equity ratio is 1:1. Now, if the company wants to acquire further fixed assets worth Rs. 100 lakhs, it can purchase it outright by financing the same out of debt capital in which case, the debt equity ratio will be 2:1 which will inevitably mean reduced borrowing capacity. If the company decides to take these assets on lease, its debt equity ratio will remain unaffected as it gets only the right to use the assets and not the ownership of the assets. As such, due to lease transactions, the debt equity ratio of the company remains unaffected which indicates increased borrowing capacity. However, with greater sophistication in financial appraisal and improved financial disclosure practices, leases are likely to be viewed as debts.

b)

Does leasing release the firm from bad investment. An investment may turn out to be bad if the basic purpose for which it is made is defeated. E.g. Investment made by a company in a machine may turn out to be bad if the machine becomes obsolete or nonuseable in terms of the rapid technological development. Under these circumstances it can be said that leasing releases a firm from bad investment as in case of leasing, the

Financial Management

risk of obsolescence is transferred to the lessor i.e. the owner of the asset, and the funds of the firm may be used for more profitable purposes. However, this argument may not be valid under all the circumstances. Lessor, if aware.of the risk of obsolescence, may charge the lessee for bearing the risk and it will be in the form of higher amount of lease rentals. In that case, lessee will not be really released from the risk of bad investment unless the risk of obsolescence on the assets is greater than as estimated by the lessor and as recovered by way of lease rentals Hire Purchasing : Nowdays, in addition to Lease Financing, Hire Purchasing is also emerging as a popular source of long term financing whereby the company can acquire long term infrastructural facilities, say fixed assets. It will be pertinent to note here the relationship between lease financing and hire purchasing. Hire purchase indicates an agreement between the owner of goods, called as “the hiree” and the user of the goods, called as “the hirer” whereby the hiree deliver the goods to the hirer but the ownership of the goods remains with the hiree. In return, the hirer makes the periodical payments of hire charges which are partly against the capital repayment and partly against the interest payable. For accounting and tax purposes, only the interest is treated as revenue expenditure and is considered to be a tax deductible expenditure. The hirer capitalises the asset purchased under the hire purchase agreement though he is not the owner of the assets. Depreciation is considered by the hirer as an expenditure, debiting the same to profit and loss account and hence becomes the tax deductible expenditure. The further hire purchase installments towards capital which are not yet due are shown as liability on the Balance Sheet. After the hire charges are paid by the hirer in full, he gets an option of purchasing the asset entirely in which case the installments paid earlier are converted into the purchase price and the ownership of the asset is transferred to the hirer. If the hirer fails to pay any installment, hiree can take the possession of the asset without refunding any installment paid earlier. It is the duty of the hirer to keep the asset in good condition. As such, the hiree may stipulate that the assets should be properly insured, the premium being paid by the hirer. Further, it may also be stipulated that the hirer will not sell or exchange the asset till he becomes the owner of the asset. The hirer has a right to put an end to the agreement before the last installment is paid, but the installments paid by him previously are not refunded to him. Accounting for Leasing and Hire Purchase : It can be seen from the above discussion that leasing and hire purchase are similar to each other in certain respects. In both the cases, right to use the asset is available to the lessee or hirer but ownership of the asset remains with the lessor or hiree.

Sources of Long Term and Medium Term Finance

243

Accounting of lease transactions : a)

Entire amount of lease rentals paid by the lessee to the lessor are considered to be revenue expenditure for the lessee hence are debited to the Profit & Loss Account, reducing the profits or increasing the losses. Lease rentals paid by the lessee are considered to be tax deductible expenditure for the lessee.

b)

Asset which is taken on lease by the lessee is not capitalised by the lessee and as such, lessee is not able to claim depreciation on the asset. Similarly, the liability for the future lease rentals is also not shown in the balance sheet of the lessee as a liability. Thus, in case of lease transactions, neither the assets side nor the liabilities side of the balance sheet of lessee gets affected. This means that borrowing capacity of the lessee or the debt equity ratio of the lessee remains intact in case of lease transactions. Hence, leasing is referred to as “off the balance sheet mode of financing” for the lessee.

Accounting of hire purchase transactions : a)

Entire amount of hire charges paid by the hirer to the hiree are not considered to be revenue expenditure in the books of hirer. The hire charges paid by the hirer are split as the payment against capital repayment and the payment against the interest. The component of interest payment only is debited to Profit & Loss account, whereas the payment against the capital repayment reduces liability for the hirer.

b)

Asset taken by the hirer on hire is capitalised in the books of hirer, though the ownership does not transfer to the hirer till the last installment of hire charges is paid by him. Only the payment against interest payment is a tax deductible expenditure for the hirer. Similarly, liability for the future hire charges is also disclosed as the liability on the balance sheet of the hirer. Hirer claims the depreciation on the asset taken by him on hire purchase and the same is treated as a tax deductible expenditure for the hirer. Thus, unlike in case of leasing transactions, hire purchase is not a “off the balance sheet mode of financing” for the hirer.

Types of Leases a)

Financial Lease :

In this type of lease, the lessor acts as a financier. Lessee selects the asset and bears the cost of repairs, maintenance and insurance of the asset. Lessor reserves the right to confiscate the asset in the event of any default on the part of lessee. The lessor recovers a major part of the cost of asset by way of lease rent during the lease period, the lessor agrees to transfer the ownership of the asset to the lessee by paying a nominal price which is referred to as “repurchase Price”. This type of lease is also referred to as “capital lease”.

244

Financial Management

b)

Operating Lease :

In this type of lease, the lessee gets a limited right to use the asset. Lessor selects and purchases the asset and leases the same to the lessee. Lessor bears the cost of repairs, maintenance and insurance of the asset. Operating lease is for a smaller duration of time and imposes no long term obligation either on the lessor or on the lessee. The lease rent paid by the lessee does not contain any part towards the cost of the asset. After the lease period is over, the possession of the asset reverts back to the lessor who can lease out the asset to another party. The lease deed is cancellable at the option of the lessor or the lessee after giving specific notice. c)

Sale and Lease Back :

In this type of lease, the lessee purchases the asset of his own choice and then sells the same to the lessor. On the sale of asset to the lessor, the ownership of the asset gets transferred to the lessor. Lessor then leases out the same asset to the lessee. After this stage, it becomes a routine lease transaction both for the lessor as well as for the lessee. In practical circumstances, this type of lease is very regularly found in case of some old asset which is used by an organisation for a certain duration of time. To explain the concept of sale and lease back, let us take an example. Company A has purchased an equipment 10 years back for an amount of Rs. 5,00,000 and has been using the same since then. After providing for depreciation for the last 10 years, written down value of the equipment in the books of the company is only Rs. 15,000. This equipment is sold by the company to a leasing company for an amount of Rs. 5,00,000. Leasing company pays the purchase consideration of Rs. 5,00,000 to the company and leases back the same equipment to the company. In this arrangement, both the company as well as the lessor are benefited. The company gets benefited as the company receives an amount of Rs. 5,00,000 for an equipment which is 10 year old equipment, without parting with the equipment. For lessor, it is a business proposition. Being a lease transaction, the lessor can claim the depreciation on the asset leased out by him. Under ideal circumstances, lessor should be able to claim the depreciation on Rs. 5,00,000 being the consideration paid by the lessor to the company. However, in the light of recent amendments made to the Income Tax Act, 1961, the lessor can claim the depreciation on Rs. 15,000 only which is the written down value of the asset in the books of company at the time of transfer of the asset to the lessor.

Sources of Long Term and Medium Term Finance

245

RETAINED EARNINGS Retained earnings or ploughed back profits is one of the best source of raising long term funds for the company. It indicates that whatever profits are earned by the company are not distributed by it by way of dividend but are kept aside for being used in future for expansion or other purposes. If the company follows a regular policy of ploughing back of profits i.e. keeping aside profits without distributing them, the shareholders may resent this policy. As such, while deciding the amount of profits to be retained, the company has to be very careful, about its consequences on the expectations of shareholders and also on the prices of the shares.

246

Financial Management

QUESTIONS 1)

Examine critically ‘Debentures’ as a source of corporation finance.

2)

Examine the comparative merits and demerits of the following methods of raising additional finance required by a joint stock company. (i)

Redeemable Preference Shares

(ii)

Debentures

(iii) Public Deposits 3)

Critically appraise the preference shares as a source of finance in Indian corporate sector.

4)

Does leasing increase a firm’s borrowing capacity? Does it release the firm from bad investment and freeing of funds for more profitable uses?

5)

Account for the growing amount of public deposits with corporate organisations. Explain the control and regulations of public deposits.

6)

What is meant by lease financing? State and explain different types of lease.

7)

Write short notes : a)

Public deposits

b)

Regulation of public deposits

c)

Convertible Debentures

d)

Lease financing

Sources of Long Term and Medium Term Finance

247

NOTES

248

Financial Management

capital. However, if the company introduces more and more doses of debt capital in the overall capital structure, it makes the investment in the company a risky proposition. As such, the expectations of the investors in terms of return on their investment may increase and share prices of the company may decrease. These increased expectations of the investors or the decreased share prices may be considered to be implicit cost of debt capital. IMPORTANCE OF COST OF CAPITAL The term cost of capital is important for a company basically for following purposes : (1)

The concept of cost of capital is used as a tool for screening the investment proposals. (The various methods for appraising investment proposals are discussed in details in the following chapters.) E.g. In case of the net present value method, the cost of capital is used as the discounting rate for discounting the future inflow of funds. Any project resulting into positive net present value only will be accepted. All other projects will be rejected. Similarly, in case of Internal Rate of Return Method (IRR), the resultant IRR is compared with the cost of capital. It is expected, that if a project is to be accepted, IRR resulting from the same should be more than cost of capital. If project generates IRR which is less than cost of capital, the project will be rejected.

(2)

The cost of capital is used as the capitalisation rate to decide the amount of capitalisation in case of a new concern.

(3)

The concept of cost of capital provides useful guidelines for determining the optimal capital structure (This concept is discussed in details in the following pages). Optimal capital structure is the one where overall cost of capital is minimum and the overall valuation of the firm is maximum.

MEASUREMENT OF COST OF CAPITAL (a)

256

Cost of Debt : The debts may be either short term debts or long term debts. Very naturally, the cost of capital in the form of debt is the interest which the company has to pay. But this is not the real cost attached with debt capital. The real cost is something less than the rate of interest which the company has to pay. This is due to the fact that the interest on debt is a tax deductible expenditure. If the amount of interest is considered as a part of expenses, the tax liability of the company reduces proportionately. As such, while computing the cost of debt, adjustments are required to be made for its tax impact. E.g. Suppose a company issues the debentures having the face value of Rs. 100 and bearing the rate of interest of 10% p.a. If the tax rate applicable to the company is 50%, the cost of debentures is not 10% which is the rate of interest, but it is to be duly reduced by the tax benefit available for this interest. The tax benefit is 50% of 10%, hence the cost of debentures is only 5%. Further, the interest payable on the debentures Financial Management

has to be viewed from the angle of the amount actually received on their issue. E.g. A company issues 1000 debentures of Rs. 100 each bearing interest @8% p.a. Company incurres the expenses in connection with the issue of debentures to the extent of Rs. 10,000 (These expenses may be in the form of discount allowed, underwriting commission, advertisement etc.) Thus, the company will have to pay the annual interest of Rs. 8,000 on the net amount received to the extent of only Rs. 90,000 (i.e. Rs. 1,00,000 minus Rs. 10,000). Cost of debentures in this case works out to around 8.89% and assuming that the tax rate applicable is 50%, the tax benefit makes the cost of debentures equal to 4.45%. However, the debt capital has a hidden cost also. If the debt content in the capital structure of a company exceeds the optimum level, the investors start considering company as too risky and their expectations from equity shares increase. This is the hidden cost of debt. (b)

Cost of Preference Shares : The cost of capital preference shares is the dividend rate payable on them. As in case of debentures, the cost capital is adjusted for the amount excess or less received on the issue of preference shares. Eg. Suppose, a company issues 1,000 preference shares of Rs. 100 each at the value of Rs. 105 each. Rate of dividend is 10% and the expenses involved with the issue of preference shares amount to Rs. 10,000. Thus the net amount received works out to Rs. 95,000 whereas the amount of the dividend is Rs. 10,000. Here, the cost of capital works out to Rs. 10,000 x 100 = 10.52% Rs. 95,000 As the amount of dividend payable on preference shares is not a tax deductible expenditure, there is no question of further adjustment for the tax benefit.

(c)

Cost of Equity Shares : Computation of cost of equity shares is the most complex procedure. It is due to the fact that unlike preference shares or debentures, equity shares do not have either the interest or dividend to be paid at a fixed rate. The cost of equity shares basically depends upon the expectations of the equity shareholders. There are following approaches to compute the cost of equity shares.

(1)

D/P Approach : According to this approach, before an investor pays certain price for purchasing equity shares of the company, he expects certain return on the investment which is in the form of the dividend. The expected rate of dividend is the cost of equity shares. This means, that the investor calculates the market price of the shares by capitalising the present dividend rate which is expected to be same for all times to come at a given level. E.g. If the market price of Equity shares of a company (Face value Rs. 10) is Rs. 15 and if the company at present is paying the dividend @ 20% which is expected to be continued in future also, the cost of Equity Shares will be :

Capital Structure

257

20% x

Rs. 10 = 13.3% Rs. 15

However, it can also be argued that the cost of equity shares may be 20%, because on the expectation of rate of dividend at 20%, market price of the shares is Rs. 15. This approach is objected on certain grounds. Firstly, this presupposes that an investor looks forward only to receive dividend on equity shares. This may not always be correct. He may also look forward to capital appreciation in the value of his shares. Secondly, this approach assumes that the company will not earn on its retained earnings and that the retained earnings will not result in either appreciation of the market price or increase in dividends. This assumption can be a wrong assumption which may lead to wrong conclusions. (2)

E/P Approach : According to this approach, the cost of equity shares is based upon the stream of unchanged earnings earned by a company. This approach holds that each investor expects a certain amount of earnings whether distributed by way of dividend or not, from the company in whose shares he invests. Thus, if an investor expects that the company in which he is investing should have at least 20% rate of earnings, cost of equity shares will be calculated on that basis. If a company is expected to earn 30%, he will be prepared to pay Rs. 150 for one share of Rs. 100 each. This approach can be objected on the following grounds. Firstly, it wrongly assumes that the earnings per share will remain constant in future. Secondly, the market prices of the shares will not remain constant as the shareholders will expect capital gains as a result of reinvestment of retained earnings. Thirdly, all the earnings may not be distributed among the shareholders by way of dividend.

(3)

D/P + G Approach : According to this approach, the investor is prepared to pay the market price of the shares as he expects not only the payment of the dividend but also expects a growth in the dividend rate at a uniform rate perpetually. Thus, the cost of equity shares can be calculated as D + G where P D = Expected dividend per share P = Market price per share G = Growth in expected dividends.

258

Financial Management

E.g. If the dividend per share is Re. 1 per share with the expected growth of 6% per year perpetually, the cost of equity shares, with the assumed market price of the share of Rs. 25, will be Re. 1 Rs. 25

+ 0.06 = 0.04 + 0.06 = 10%

This approach involves the difficulty of determining the growth rate. (4)

Realised Yield Approach : According to this approach, the cost of equity shares may be decided on the basis of yields actually realised over the period of past few years which may be expected to be continued in future also. This approach basically consider D/P + G approach, but instead of considering the future expectations of dividends and growth factor, the actual yields in past are considered.

(d)

Cost of Retained Earnings : Many a times, it is argued that the retained earnings do not cost anything to the company. This is argued like this as there is no obligation, either formal or implied, to pay return on retained earnings even though they constitute one of the major sources of funds for the company. In case of debt, the company has fixed obligation to pay interest on it. Almost similar obligation exists in case of preference share also. In case of equity shares, though there is no legal obligation, the expectations of the shareholders at least provides a starting point for computing the cost of equity shares. The retained earnings do not involved any of such obligations, either, formal or implied. As such, it may be felt that retained earnings involve no cost as they are not raised from outside source. But this contention is not correct. Retained earnings involve cost and this cost is in the form of the opportunity cost in terms of dividend foregone by or withheld from the equity shareholders. E.g. Assuming that the profits earned by the company are not retained but are distributed among shareholders by way of dividend. These amounts of dividends which would have been received by the shareholders, after due adjustments for tax deducted at source, could have been invested by the shareholders elsewhere to earn some return. The company, by retaining the profits, prohibits the shareholder from earnings these returns. As such, the company is required to earn on the retained earnings atleast equal to the rate which would have been earned by the shareholders if they were distributed to them. This is the cost of retained earnings.

COMPOSITE COST OF CAPITAL After ascertaining the cost of each source of the capital constituting the capital structure, the

Capital Structure

259

next step is to compute the composite cost of capital which is defined as the weighted average of the cost of each specific type of capital. The reason behind considering weighted average and not the simple average is to give consideration to the proportion of various sources of funds in the capital structure of the company. Thus, the process of computing the composite cost of capital is carried on by following the steps stated below. (1)

Assign weights to various sources of funds. It may be stated here that the weights may be in the form of book value of funds or market value of funds.

(2)

Multiply the cost of each source of funds by the weights assigned.

(3)

Calculate the composite cost by dividing total weighted cost by the total weights.

The above process can be explained with the help of following illustrations. Illustration I : The capital structure of a company and the cost of specific sources of funds is as below : Sources of funds

Book value (weights) Rs.

Specific Cost

Weighted cost Rs.

1

2

3 (1 x 2)

1,50,000

5%

7,500

50,000

9%

4,500

Equity shares

2,00,000

15%

30,000

Retained earnings

1,00,000

8%

8,000

Debentures Preference shares

5,00,000 Composite cost of capital

=

Total weighted costs

50,000

x 100

Total weights =

50,000 x 100 5,00,000

=

10%

Illustration II : From the information given below, calculate the weighted cost of capital (before tax) for Z Ltd.

260

Financial Management

Rs. in Lakhs 1.

Shareholders' funds Share Capital

– Equity

500

– Preference

100

Retained Earnings 2.

300

Loan Funds Secured Loans

800

Unsecured Loans (Incl. intercorporate deposit)

700 2,400

(a)

Normal yield on Equity shareholders' fund anticipated at 15%.

(b)

Dividend rate on preference shares - 12%.

(c)

Tax rate for Z Ltd. - 60%.

(d)

Interest on secured loans - 16.25%.

(e)

Interest on unsecured loans - 20%.

Solution : Computation of after tax cost of capital – Source

Book value (weights) 2

Tax Adjusted Cost 3

Weighted Cost

Equity shares

500

15%

75

Preference shares

100

12%

12

Retained Earnings

300

15%

45

Secured Loans

800

6.50% i.e.

52

1

4 i.e. 2 x 3

40% of 16.25% Unsecured loans

700

8% i.e.

56

40% of 20% 2400

Capital Structure

240

261

Weighted Average Cost After tax

= Weighted cost

x 100

Total weights =

240

x 100

2,400 = 10% Computation of before tax cost of capital : = After tax cost of capital (100% – Tax rate) =

10% (100% – 60%)

= 10% 40% = 25%

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Financial Management

PART III – LEVERAGES Before we go ahead with discussing the concept of Leverages, consider the following example– Let us assume that there are two companies A and B which are exactly similar to each other in terms of nature of business, size, extent of turnover etc. As such, the amount of capitalization is also the same for both the companies which is assumed to be Rs. 10,000. However, strategies for raising the capital are different from each other. Assuming that the required capital can be raised either by way of equity or debt, following particulars are available : Company A

Company B

(Each Share of Rs. 10 each)

1,000

9,000

10% Debentures

9,000

1,000

10,000

10,000

Equity Share capital

Profitability statements of both the companies when the sales are Rs. 20,000 and Rs. 18,000 are as below Company A

Company B

Sales Less : Variable Cost

20,000 10,000

18,000 9,000

20,000 10,000

18,000 9,000

Contribution Less : Fixed Cost

10,000 5,000

9,000 5,000

10,000 5,000

9,000 5,000

PBIT Less : Interest

5,000 900

4,000 900

5,000 100

4,000 100

PBT Less : Income Tax @50%

4,100 2,050

3,100 1,550

4,900 2,450

3,900 1,950

PAT

2,050

1,550

2,450

1,950

Number of Equity Shares Earnings per share

100 20.50

100 15.50

900 2.72

900 2.16

It can be noted from the above example that A Ltd. is able to earn more amount per equity share because in its capital structure, the amount of debentures is more and also because the interest paid on debentures is tax deductible expenditure and amount of tax is less in case of A Ltd. It can also be noted from the above example that a 10% reduction in sales in case of A Ltd. reduces the earnings per share by around 24% while the same percentage of reduction in

Capital Structure

263

sales in case of B Ltd. reduces the earnings per share by around 20%. It happens so because the risk of reduction in sales and earnings gets distributed among less number of equity shares in case of company A Ltd., while the said risk gets distributed among more number of equity shares in case of company B Ltd. Explanations Operating costs incurred by a company can be classified into three categories a.

Variable Cost

b.

Fixed Cost

c.

Semi-variable Cost

Fixed Cost is the cost which remains constant irrespective of changes in the sales revenue, at least over a shorter span of time. Variable Cost is the cost which varies in direct proportion to the sales revenue. Semi-variable Cost lies in between the two extremes of fixed cost and variable cost. Such costs remain constant upto a certain sales revenue and increase if the sales revenue increases beyond a certain point. There may be some statistical or mathematical techniques available whereby the semi-variable cost can be segregated into the fixed cost component and variable cost component. Hence, let us assume that the costs can be either fixed costs or variable costs. Difference between the sales revenue and variable cost is referred to as contribution or marginal contribution. Significance of the term contribution is that it is equated with the term profits over a shorter period of time, as the fixed cost remains the same at all levels of activities. As such, sales revenue generated by the company after deducting the variable cost incurred for the same contributes towards the profits which is technically referred to as contribution. The operating profit earned by the company is in the form of contribution duly reduced by the fixed operating cost. As such, using the above referred terms, the operating statement of a company can be presented as below -

Less :

Sales Revenue Variable Operating Cost

Less :

Contribution Fixed Operating Cost Operating Profit

264

Financial Management

Break even point is that level of sales revenue at which there is no profit or no loss. Till the sales revenue reaches the break even point, the company incurres the losses. It is only after crossing the break even point that the profit generating capacity of the company starts. As such, it is the intention of every company to reach the break even point as early as possible. The essential implication of high fixed cost in the cost structure is that the break even point is high which indicates that the amount of sales revenue a company is required to generate to be in a no profit no loss situation is very high which makes the company a very risky proposition. The operating profit earned by a company is also referred to as Profit Before Interest and Taxes (PBIT) in financial terms. After the level of operating profit, the company is contractually required to pay the interest on the long term borrowed capital like debentures, term loans etc. The amount of profit earned after recovering the interest on long term sources of capital is referred to as Profit Before Taxes (PBT). The company is required to pay the taxes as per the provision of Income Tax Act, 1961 after the amount of profit before taxes is arrived at. Profit remaining after the payment of income tax is referred to as Profit After Taxes (PAT). This profit can be distributed among the owners of the company by way of dividend. We have already seen that before the company can pay the dividend on Equity Shares, it is bound to pay the dividend on Preference Shares. After paying the dividend on preference shares, remaining profits can be distributed among the equity shareholders by way of dividend and hence are referred to as distributable profits. In financial terms, Profit Before Interest and Taxes (PBIT) can be referred as Earnings Before Interest and Taxes (EBIT) and Profit After Tax (PAT) can be referred to as Earnings After Tax (EAT). Using the above terms, the profitability statement of a company takes the following form -

Less :

Profit before Interest & Taxes (PBIT) Interest on long term borrowings

Less :

Profit before Taxes (PBT) Taxes

Less :

Profit after Taxes (PAT) Preference Dividend Distributable Profits for Equity

If both the calculations are merged together, following relationship emerges.

Less :

Sales Revenue Variable Operating Cost Contribution

Capital Structure

265

Less :

Fixed Operating Cost Profit before Interest & Taxes (PBIT)

Less :

Interest on Long term borrowings

Less :

Profit before Taxes (PBT) Taxes

Less :

Profit after Taxes (PAT) Preference Dividend Distributable Profits for Equity

In continuation of these calculations, following two calculations are made very frequently in practical situations Earnings Per Share (EPS) Earnings Per Share is a very widely used ratio to measure the profits available to the equity shareholders on a per share basis. EPS is calculated as Profit after Tax - Preference Dividend No. of Equity Shares EPS is calculated on the basis of current profits and not on the basis of retained profits. EPS does not indicate the amount of profits distributed among the owners by way of dividend and also the amount of profits retained in the business. This calculation is very significant for an investor in equity shares as higher EPS indicates higher amount of profits available to him. Price Earning Ratio (P/E Ratio) Price Earning Ratio indicates the price currently being paid in the stock market for every one rupee of EPS. P/E Ratio is calculated as Market Price Per Share Earnings Per Share P/E Ratio is of great significance to an operator on the stock exchange buying and selling the

266

Financial Management

shares. An ideal investor makes an comparison between the current market price and future EPS as the market value of shares depends upon the future EPS also. Leverages : In very simple words, the term leverage measures relationship between two variables. In financial analysis, the term leverage represents the influence of one financial variable over some other financial variable. In financial analysis generally three types of leverages may be computed. 1.

Operating Leverage

2.

Financial Leverage

3.

Combined Leverage

1.

Operating Leverage

It measures the effect of change in sales quantity on Earnings Before Interest and Taxes (EBIT) It is computed as : Sales - Variable Cost (i.e. Contribution) Earnings before interest and tax Indications : A high degree of operating leverage means that the component of fixed cost is too high in the overall cost structure. A low degree of operating average means that the component of fixed cost is less in the overall cost structure. In other words, operating leverage measures the impact of percentage increase or decrease in sales on earnings before interest and taxes. E.g. In the example cited above, when sales are Rs. 20,000 contribution is Rs. 10,000 and earnings before interest and taxes are Rs. 5,000. As such operating leverage can be calculated as : Contribution EBIT

=

Rs. 10,000 Rs. 5,000

= 2 It means that every 1% increase in contribution will increase the EBIT by 2% and vice versa. As such, when contribution is Rs. 9,000 instead of Rs. 10,000 i.e. the contribution is reduced by 10%, the EBIT is reduced by 20% i.e. the EBIT has become Rs. 4,000 instead of Rs. 5,000.

Capital Structure

267

2.

Financial Leverage :

It indicates the firm's ability to use fixed financial charges to magnify the effects of changes in EBIT on the firm's EPS. It indicates the extent to which the Earnings Per Share (EPS) will be affected with the change in Earnings Before Interest and Tax (EBIT). It is computed as : EBIT EBIT - Interest Indications : A high degree of financial leverage indicates high use of fixed income bearings securities in the capital structure of the company. A low degree of financial leverage indicates less use of fixed income bearing securities in the capital structure of the company. E.g. In the example cited above, in case of A Ltd., the EBIT is Rs. 5,000 and interest on debentures is Rs. 900, when sales are Rs. 20,000 whereas in case of B Ltd., the EBIT is Rs. 5,000 and interest on debentures is Rs. 100 when sales are Rs. 20,000. As such, the degree of financial leverage can be computed as EBIT EBIT - Interest A Ltd. Financial leverage

=

Rs. 5,000

B Ltd. =

Rs. 5,000 - Rs. 900 =

Rs. 5,000

Rs. 5,000 - Rs. 100 =

Rs. 4,100 =

1.22

Rs. 5,000

Rs. 5,000 Rs. 4,900

=

1.02

High degree of financial leverage is supported by the knowledge of the fact that in the capital structure of A Ltd, 90% is the debt capital component, whereas in case of B Ltd, 10% is the debt capital component. It means that in case of A Ltd. every 1% increase in EBIT will increase EPS by 1.22% and vice versa. As such, when EBIT is reduced from Rs. 5,000 to Rs. 4,000 (i.e. 20% reduction), EPS of A Ltd. gets reduced from Rs. 20.50 to Rs. 15.50 (i.e. 24.40% reduction) and EPS of B Ltd. gets reduced from Rs. 2.72 to Rs. 2.16 (i.e. 20.40% reduction). Uses of Financial Leverage : The degree of financial leverage gives an indication regarding the extent to which EPS may be 268

Financial Management

affected due to every change in EBIT. As the use of debt capital in the capital structure increases the EPS, the company may like to use more and more debt capital in its capital structure by using the financial leverage. As explained in the example cited above, EPS in case of A Ltd. is Rs. 20.50 when sales are Rs. 20,000, as 90% of its capital is debt capital. But in case of B Ltd. EPS is only Rs. 2.72 when sales are Rs. 20,000, as only 10% of its total capital is debt capital. As such, the phrase is often used that financial leverage magnifies both profits and losses'. However, though financial leverage magnifies the profits as well as EPS, the use of debt capital beyond a certain limit will not necessarily give a favourable impact. Use of financial leverage is useful as long as debt capital costs less than what it earns. It reduces profits or EPS if it costs more than what it earns. As such, financial leverage also acts as a guideline in setting maximum limit upto which the company should use the debt capital. However, the technique of financial leverage suffers from some limitations. Limitations : 1.

It ignores implicit cost of debt. It assumes that the use of debt capital may be useful so long as the company is able to earn more than the cost of debt, i.e. interest. But it is not always correct. Increasing use of debt capital makes the investment in the company a risky proposition, as such the market price of the shares may decline, which may not be maximizing the shareholders' wealth. Before considering the capital structure, the implicit cost of debt should be considered.

2.

It assumes that cost of debt remains constant regardless of degree of leverage which is not true. With every increase in debt capital, the interest rate goes on increasing due to the increased risk involved with the same.

3.

Combined Leverage :

The combined effect of operating leverage and financial leverage measures the impact of charge in contribution on EPS. It is computed as : Operating Leverage x Financial Leverage =

=

Sales - Variable Cost EBIT

x

EBIT EBIT - Interest

Sales - Variable Cost EBIT - Interest

EG. In the example cited above, in case of both A Ltd. and B Ltd., when sales are Rs. 20,000, contribution is Rs. 10,000 but earnings after interest and before tax are Rs. 4,100 and Capital Structure

269

Rs. 4,900 respectively. As such combined leverage can be computed as : Sales - Variable cost (i.e. contribution) EBIT - Interest A Ltd. =

Rs. 10,000 Rs. 4,100

=

2.44

B Ltd. = Rs. 10,000 Rs. 4,900 = 2.04

It means that in case of A Ltd. every 1% increase in contribution will increase EPS by 2.44% and vice versa, while in case of B Ltd. every 1% increase in contribution, will increase EPS by 2.04%. As such when contribution gets reduced from Rs. 10,000 to Rs. 9,000 i.e. 10% reduction, EPS of A Ltd. gets reduced from Rs. 20.50 to Rs. 15.50 (i.e. 24.4% reduction) and EPS of B Ltd. gets reduced from Rs. 2.72 to Rs. 2.16 (i.e. 20.4 reduction). Indications : The indications given by the combined effect of operating and financial leverages may be studied under the following possible situations. 1.

High Operating Leverage, High Financial Leverage : It indicates very very risky situation as a slight decrease in sales and/or contribution may affect the EPS to a very great extent. As far as possible, this situation should be avoided.

2.

High Operating Leverage, Low Financial Leverage : It indicates that a slight decrease in sales and/or contribution may affect EBIT to a very great extent due to existence of high fixed cost but this possibility is already taken care of by low proportion of debt capital in the overall capital structure.

3.

Low Operating Leverage, High Financial Leverage : It indicates that the decrease in sales/contribution will not affect EBIT to a very great extent as the component of fixed cost is negligible in the overall cost structure. As such, the company has accepted the risk of borrowing more debt capital in order to increase EPS to the maximum possible extent. This may be considered to be an ideal situation.

4.

Low Operating Leverage, Low Financial Leverage : It indicates that the decrease in sales/contribution will not affect EBIT to a very great extent as the component of fixed cost is negligible in the overall cost structure. But still, the company has not accepted the risk of having large component of debt capital in its capital structure. It may indicate very very cautious policy followed by the management which need not be necessary, as it will not maximise the shareholders' wealth. At the same time, it may also indicate that the company is not utilising its borrowing capacity properly and fully.

270

Financial Management

PART IV – THEORIES OF CAPITAL STRUCTURE

CAPITAL STRUCTURE AND COST OF CAPITAL In the previous pages we have seen that the introduction of debt capital in the capital structure increases the earning per share of equity shareholders. We have also seen that the introduction of debt capital increases the risk also which is the risk of insolvency due to non-availability of cash and variability of earnings available to equity shareholders. As such, increasing the debt component beyond a certain limit will not increase the earnings per share. If debt component crosses a particular limit, the expectations of the lenders of money also increase due to the risk factor involved. Similarly, the share holders also will demand a higher rate of return on their investment to compensate for the risk arising out of additional amount of debt capital in the capital structure. As such, introduction of a heavy amount of debt capital in the capital structure will not only reduce the valuation of the firm but will also increase the cost of capital. However, this view is not universally accepted. It is not an accepted principle that the valuation of a firm and its cost of capital may be affected by the change in financing mix. Different views have been expressed in this context. We will classify these views in the form of following four theories of capital structure. (1)

Net Income Approach

(2)

Net Operating Income Approach

(3)

Traditional Approach

(4)

Modigliani - Miller Approach

For this purpose, following assumptions have been made. (1)

Firms use only long term debt capital or equity share capital to raise funds.

(2)

Corporate Income Tax does not exist.

(3)

Firms follow policy of paying 100% of its earnings by way of dividend.

(4)

Operating earnings are not expected to grow.

Following definitions and symbols are also used. S

=

Market Value of equity shares

B

=

Market Value of debt

V

=

Total Market Value of firm

NOI =

Net Operating Income i.e. EBIT

I

=

Total Interest Payments

NI

=

Net Income available to equity shareholders. i.e. EBIT - I

Overall cost of capital = EBIT V Capital Structure

271

a)

Net Income Approach :

According to this approach as proposed by Durand, there exists a direct relationship between the capital structure and valuation of the firm and cost of capital. By the introduction of additional debt capital in the capital structure, the valuation of the firm can be increased and cost of capital can be reduced and vice versa. To explain the approach more precisely, we will consider the following example : Present Position Rs.

50% Increase in Debt Capital Rs.

50% Decrease in Debt Capital Rs.

8% Debentures

6,00,000

9,00,000

3,00,000

NOI i.e EBIT

1,50,000

1,50,000

1,50,000

48,000

72,000

24,000

1,02,000

78,000

1,26,000

10%

10%

10%

10,20,000

7,80,000

12,60,000

6,00,000

9,00,000

3,00,000

16,20,000

16,80,000

15,60,000

9.26%

8.93%

9.62%

I NI Equity Capitalisation Rate Market value of Equity Shares (S) Market value of Debentures (B) Total value of firm V = S + B Overall cost of capital

It can be seen from above, that by the increase in debentures, the total value of the firm increases and cost of capital reduces and vice versa. However, this will hold good only if the cost of debentures i.e. rate of interest is less than the equity capitalisation rate. b)

Net Operating Income Approach :

According to this approach, also proposed by Durand, the valuation of the firm and its cost of capital is independent of its capital structure. Any change in the capital structure does not affect the value of the firm or cost of capital, though the further introduction of debt capital may increase equity capitalisation rate and vice versa. To explain the approach, more precisely, we will consider the following example.

272

Financial Management

Present Position Rs.

50% Increase in Debt Capital Rs.

50% Decrease in Debt Capital Rs.

6,00,000

9,00,000

3,00,000

10%

10%

10%

1,50,000

1,50,000

1,50,000

Total value of firm (V)

15,00,000

15,00,000

15,00,000

Overall cost of capital

1,50,000

1,50,000

1,50,000

15,00,000

15,00,000

15,00,000

10%

10%

10%

Market value of Debentures (B)

6,00,000

9,00,000

3,00,000

Market value of Equity shares (S) i.e. V-B

9,00,000

6,00,000

12,00,000

48,000

72,000

24,000

EBIT - I

1,02,000

78,000

1,26,000

V-B

9,00,000

6,00,000

12,00,000

11.3%

13%

10.5%

8% Debentures Overall Capitalisation Rate EBIT

EBIT/V

I Equity Capitalisation Rate

It can be seen from the above that the market value of the firm remains unaffected by change in the capital structure. However, the introduction of additional debentures increases the equity capitalisation rate and vice versa. c)

Traditional Approach :

This is the mean between two extreme approaches of net income approach on one hand and net operating income on another. It believes the existence of what may be called 'Optimal Capital Structure'. It believes that upto a certain point, additional introduction of debt capital, inspite of increase in cost of debt capital and equity capitalisation rate individually, the overall cost of capital will reduce and total value of the firm will increase. Beyond the point, the overall cost of capital will tend to rise and total value of the firm will tend to reduce. Thus, for the judicious mix of debt and equity capital, it is possible for the firm to minimize overall cost of capital and maximize total value of the firm. Such a capital structure where overall cost of capital is minimum and total value of the firm is maximum is called :Optimal Capital Structure".

Capital Structure

273

To explain this approach, more precisely, we will consider the following example : No Debt 5% Debentures 8% Debentures Rs. 3,00,000 Rs. 6,00,000 EBIT

1,50,000

1,50,000

1,50,000

–

15,000

48,000

1,50,000

1,35,000

1,02,000

10%

11%

12%

15,00,000

12,27,273

8,50,000

0

3,00,000

6,00,000

15,00,000

15,27,273

14,50,000

10%

9.82%

10.34%

Less : Interest on debentures NI Cost of Equity Capital Market value of Equity Shares (S) Market value of Debentures (B) Total value of firm i.e. V = S + B Overall capital cost i.e. EBIT V

It can be seen from the above neither the no-debentures position nor the position where debentures are issued to the extent of Rs. 6,00,000 minimize the overall cost of capital or maximize the toal value of the firm. It is when debentures are issued to the extent of Rs. 3,00,000 that the overall cost of capital is minimum and total value of the firm is maximum, hence that is the Optimal Capital Structure. d)

Modigliani - Miller (M and M) Approach :

This approach closely resembles net operating income approach. According to this approach, value of the firm and its cost of capital are independent of its capital structure. It argues, that overall cost of capital is the weighted average of cost of debt capital and cost of equity capital. Cost of equity capital depends upon shareholders' expectations. Now, if shareholders expect 10% from a certain company, they already take into consideration debt capital in the capital structure. For every increase in debt capital the expectations of the shareholders also increase as in the eyes of shareholders, risk in the company also increases. Thus, each change in the mix of debt capital and equity capital is automatically offset by change in the expectations of the shareholders which in turn is attributable to change in risk element. As such, they argue that, leverage i.e. mix in debt capital and equity capital, has nothing to do with overall cost of capital and overall cost of capital is equal to the capitalisation rate of pure equity stream of a risk class. Hence, leverage has no impact on share market prices or cost of capital.

274

Financial Management

Illustrative Problems (1)

Assuming no taxes and given the earnings before interest and taxes (EBIT), interest (I), at 10% and equity capitalisation rate (K), below, calculate the total market value of each firm : Firms

EBIT Rs.

I Rs.

K

X

2,00,000

20,000

12,0%

Y

3,00,000

60,000

16,0%

Z

5,00,000

2,00,000

15,0%

W

6,00,000

2,40,000

18,0%

Also determine the weighted average cost of capital for each firm. Firm X

Firm Y

Firm Z

Firm W

EBIT

Rs.

2,00,000

3,00,000

5,00,000

6,00,000

I

Rs.

20,000

60,000

2,00,000

2,40,000

NI (Net Income available to the shareholders)

Rs.

1,80,000

2,40,000

3,00,000

3,60,000

12%

16%

15%

18%

Market value of Equity Shares (S) Rs. 15,00,000

15,00,000

20,00,000 20,00,000

Equity Capitalisation Rate

Market value of debt (B)*

Rs.

2,00,000

6,00,000

20,00,000 24,00,000

Total value of the firm V = S + B

Rs. 17,00,000

21,00,000

40,00,000 44,00,000

10.59%

11.43%

Overall cost of capital i.e. EBIT/V

7.50%

8.18%

*Note : As the rate of interest i.e. 10% and the amount of interest is known, the amount of debt capital can be calculated as : Amount of interest x 100 10 (2)

In considering the most desirable capital for a company, the following estimates of the cost of debt and equity capital (after tax) have been made at various levels of debt-equity mix.

Capital Structure

275

Debt as % of total capital employed

Cost of debt %

Cost of equity %

0

7.0

15.0

10

7.0

15.0

20

7.0

15.5

30

7.5

16.0

40

8.0

17.0

50

8.5

19.0

60

9.5

20.0

You are required to determine the optimal debt equity mix for the company by calculating composite cost of capital. Solution : Calculation of composite cost of capital Debt as % of total capital employed

Cost of debt

Cost of equity

Composite cost of capital %

0

7.0

15.0

7.0 x 0.1 + 15.0 x 1.0 = 15.00

10

7.0

15.0

7.0 x 0.1 + 15.0 x 0.9 = 14.20

20

7.0

15.5

7.0 x 0.2 + 15.5 x 0.8 = 13.80

30

7.5

16.0

7.5 x 0.3 + 16.0 x 0.7 = 13.45

40

8.0

17.0

8.0 x 0.4 + 17.0 x 0.6 = 13.40

50

8.5

19.0

8.5 x 0.5 + 19.0 x 0.5 = 13.75

60

9.5

20.0

9.5 x 0.6 + 20.0 x 0.4 = 13.70

It can be seen from the above that composite cost of capital is minimum i.e. 13.40% when capital structure is as below 40% debt 60% equity 100% Hence, that is the optimal debt-equity mix. (3)

276

Following items have been extracted from the liabilities side of XYZ company as at 31st December 1986

Financial Management

Rs. Paid-up Capital 4,00,000 Equity shares of Rs. 10 each

40,00,000

Reserves and Surplus

60,00,000

Loans 15% Non-convertible Debentures

20,00,000

14% Institutional Loans

60,00,000

Other information about the company as relevant is given below : Year ended 31st Dec.

Dividend per share Rs.

Earnings per share Rs.

Average market price per share Rs.

1986

4.00

7.50

50.00

1985

3.00

6.00

40.00

1984

4.00

4.50

30.00

You are required to calculate the weighted average cost of capital, using book values as the weights and Earnings/Price (E/P) ratio as the basis of cost of equity. Solution : Calculation of Cost of Capital Sources of Funds

Book Value (Weights)

Tax Adjusted Cost

Weighted Cost

Equity Shares

40,00,000

15%

6,00,000

Reserves & Surplus

60,00,000

15%

9,00,000

Non-convertible Debentures

20,00,000

7.5%

1,50,000

Institutional Loans

60,00,000

7%

4,20,000

1,80,00,000

20,70,000

Weighted average cost of capital 20,70,000

x 100

1,80,00,000 = 11.5% Capital Structure

277

Working Notes : (a)

It is assumed that the company is subjected to tax rate of 50%.

(b)

Cost of equity shares is calculated on E/P basis. Average EPS Average Market Price i.e.

Rs. 6.00

x 100

Rs. 40.00 = 15% (4)

A company needs Rs. 5,00,000 for the construction of a new plant. Following alternative capital structures are under consideration

a.

The company may issue 50,000 Equity Shares of Rs. 10 per share at par.

b.

The company may issue 2,500 debentures of Rs. 100 per debenture carrying the rate of interest of 12% p.a. and balance by way of Equity Shares of Rs. 10 per share issued at par.

c.

The company may issue 2,500 Preference Shares of Rs. 100 per share at par carrying the rate of dividend of 10% and balance by way of Equity Shares of Rs. 10 per share issued at par.

If the company's Profit Before Interest and Tax is Rs. 60,000 or Rs. 80,000 or Rs. 1,00,000 what will be the Earning Per Share under each of the above capital structures? If the objective of the company is to maximize the EPS, which of the capital structures will be recommended? Assume 50% as the corporate tax rate. Solution : It is assumed that the following three plans are possible for the company :

278

Plan 1 -

Only Equity Shares

Plan 2 -

Equity Shares and Debentures

Plan 3 -

Equity Shares and Preference Shares

Financial Management

a.

When Profit Before Interest and Tax is Rs. 60,000 Plan 1

Plan 2

Plan 3

60,000

60,000

60,000

–

30,000

–

Profit Before Tax

60,000

30,000

60,000

Tax

30,000

15,000

30,000

Profit After Tax

30,000

15,000

30,000

–

–

25,000

Distributable Profit

30,000

15,000

5,000

No. of Equity Shares

50,000

25,000

25,000

Re. 0.60

Re. 0.60

Rs. 0.20

Plan 1

Plan 2

Plan 3

80,000

80,000

80,000

–

30,000

–

Profit Before Tax

80,000

50,000

80,000

Tax

40,000

25,000

40,000

Profit After Tax

40,000

25,000

40,000

–

–

25,000

Distributable Profit

40,000

25,000

15,000

No. of Equity Shares

50,000

25,000

25,000

Re. 0.80

Rs. 1.00

Re. 0.40

Plan 1

Plan 2

Plan 3

100,000

100,000

100,000

–

30,000

–

100,000

70,000

100,000

Tax

50,000

35,000

50,000

Profit After Tax

50,000

35,000

50,000

–

–

25,000

Distributable Profit

50,000

35,000

25,000

No. of Equity Shares

50,000

25,000

25,000

Re. 1.00

Rs. 1.20

Re. 1.00

Profit Before Interest & Tax Interest

Preference Dividend

Earnings Per Share

b. When Profit Before Interest and Tax is Rs. 80,000 Profit Before Interest & Tax Interest

Preference Dividend

Earning Per Share

c. When Profit Before Interest and Tax is Rs. 1,00,000

Profit Before Interest & Tax Interest Profit Before Tax

Preference Dividend

Earning Per Share

Capital Structure

279

(5)

A company needs Rs. 12 lakhs for the installation of a new factory which would yield an annual EBIT of Rs. 2,00,000. The company has the objective of maximising the EPS. It is considering the possibility of issuing equity shares plus raising a debt of Rs. 2,00,000, Rs. 6,00,000 or Rs. 10,00,000. The current market price per share is Rs. 40 which is expected to drop to Rs. 25 per share if the market borrowings were to exceed Rs. 7,50,000. Cost of borrowings are indicated as under.

Upto Rs. 2,50,000

–

10% p.a.

Between Rs. 2,50,001 and Rs. 6,25,000

–

14% p.a.

Between Rs. 6,25,001 and Rs. 10,00,000

–

16% p.a.

Assuming a tax rate of 50%, work out the EPS and the scheme which would meet the objective of the management. Solution : On the basis of the information available, following are the alternative capital structures possible.

Equity Debt

Plan 1

Plan 2

Plan 3

2,00,000

6,00,000

10,00,000

10,00,000

6,00,000

2,00,000

12,00,000

12,00,000

12,00,000

Following is the calculation of EPS under each of the above capital structures Calculation of EPS Earnings Before Interest & Tax

2,00,000

2,00,000

2,00,000

20,000

84,000

1,60,000

1,80,000

1,16,000

40,000

Tax

90,000

58,000

20,000

Earnings After Tax

90,000

58,000

20,000

No. of Equity Shares

25,000

15,000

8,000

3.60

3.95

2.50

Interest Earnings Before Tax

Earnings Per Share

As Earnings Per Share is maximum in Plan 2, the company will go for the said plan. Notes : It is assumed that the company can issue the Equity Shares at the prevailing market price. The assumption will not be a valid assumption as the issue price will have to be lower than the market price. However, if we continue with the assumption, number of equity shares will be as below : 280

Financial Management

Plan 1 - Rs. 10,00,000 by Equity / Rs. 40 per share as issue price Plan 2 - Rs. 6,00,000 by Equity / Rs. 40 per share as issue price Plan 3 - Rs. 2,00,000 by Equity / Rs. 25 per share as issue price. (6)

Operating Leverage and Combined Leverage of a company is 2 and 3 respectively at the present level of sales of 10,000 units. The selling price per unit is Rs. 12 while its variable cost is Rs. 6. The company has no preference share capital. Applicable corporate income tax rate can be assumed to be 50%. The rate of interest on company's debt is 16% p.a. What is the amount of debt in the capital structure of the company?

Solution : As Sales are Rs. 1,20,000 and Variable Cost is Rs. 60,000, Contribution is known to be Rs. 60,000. As Operating Leverage is 2, Contribution / PBIT = 2 Hence, PBIT = Contribution / 2 i.e. Rs. 30,000 As Combined Leverage is 3, Contribution / PBT = 3 Hence, PBT = Contribution / 3 = i.e. Rs. 20,000. As PBIT is Rs. 30,000 and PBT is Rs. 20,000, Interest will be Rs. 10,000. Rate of Interest is known to be 16%. Hence, the amount of debt capital in the capital structures will be 10,000 x 100 = 62,500 16 (7)

The Capital Structure of a company is as below :

Equity Share Capital (Each Share of Rs. 10)

Rs. 60,000

10% Debentures

Rs. 80,000

Retained Earnings

Rs. 20,000

Sales of the company are Rs. 6,00,000. Its variable operating cost is 40% of sales and fixed operating cost is Rs. 1,00,000. Assuming the income tax rate of 50%. i.

Calculate different types of leverages

ii.

Determine the likely level of PBIT if EPS is (a) Re.1 (b) Rs. 3 and (c) Rs. 0.

Capital Structure

281

Profitability structure of the company will be as below :

–

–

–

–

Sales

Rs. 6,00,000

Variable Cost

Rs. 2,40,000

Contribution

Rs. 3,60,000

Fixed Cost

Rs. 1,00,000

EBIT

Rs. 2,60,000

Interest

Rs.

EBT

Rs. 2,52,000

Taxes

Rs. 1,26,000

Profit After Tax

Rs. 1,26,000

8,000

Calculation of Leverages : (a)

Operating Leverage : Contribution

=

EBIT (b)

= 1.38

2,60,000

Financial Leverage : EBIT

=

EBT (c)

3,60,000

2,60,000

= 1.03

2,52,000

Combined Leverage : Contribution EBT

=

3,60,000

= 1.43

2,52,000

Calculation of EBIT We know that, 50% of (EBIT - Interest) No. of Equity Shares

= EPS

We further know that Interest No. of Equity shares

282

= Rs. 8,000 = 6000

Financial Management

(a)

(b) . .. . .. . .. . .. (c) . .. . .. . .. . .. (8)

50% (EBIT - 8000) 6000

= 1

50% (EBIT - 8000)

= 6000

1/2 EBIT - 4000

= 6000

1/2 EBIT

= 10,000

EBIT

= 20,000

50% (EBIT - 8000) 6000

= 3

50% (EBIT - 8000)

= 18000

1/2 EBIT - 4000

= 18000

1/2 EBIT

= 22000

EBIT

= 44000

50% (EBIT - 8000) 6000

= 0

50% (EBIT - 8000)

= 0

1/2 EBIT - 4000

= 0

1/2 EBIT

= 4000

EBIT

= 8000

The following figures of Krish Ltd. are presented to you. Rs. EBIT Less :

23,00,000 Debenture interest @ 8% Long Term Loan interest @ 11%

80,000 2,20,000

3,00,000 20,00,000

Less : Income Tax

10,00,000

Earnings After Tax

10,00,000

No. of Equity Shares of Rs. 10 each EPS Market Price of Shares P/E Ratio

Capital Structure

5,00,000 Rs. 2 Rs. 20 10

283

The company has undistributed reserves and surplus of Rs. 20 lakhs. It is in need of Rs. 30 lakhs to pay the debentures and modernise its plant. It seeks your advice on the following alternative models of raising finance. Alternative I : Raising entire amount as term loan from banks @12%. Alternative II : Raising part of the funds by issue of 1,00,000 shares of Rs. 10 each at par and the rest by term loan @ 12%. The company expects to improve its rate of return on capital employed by 2% as a result of modernisation, but P/E ratio is likely to go down to 8 if the entire amount is raised as term loan. (a)

Advice the company on the financial plan to be selected.

(b)

If it is assumed that there will be no change in the P/E ratio, if either of the two alternatives are adopted, would your advice still hold good ?

Solution : Present Capital Employed

Rs.

Equity share capital

50,00,000

Reserves & Surplus

20,00,000

8% Debentures

10,00,000

11% Term Loan . . . Capital Employed

20,00,000 100,00,000

EBIT

23,00,000

Rate of EBIT on Capital Employed

23%

Alternative I : Term Loan Only

Rs.

EBIT Less :

30,00,000 Interest 11% Term Loan

2,20,000

12% Term Loan

3,60,000

EBIT

24,20,000

Taxes @ 50%

12,10,000

Profit After Taxes

12,10,000

E.P.S. P/E Ratio Market Price of the share 284

5,80,000

2.42 8 19.36 Financial Management

Alternative II : Term Loan and Equity Shares EBIT Less :

30,00,000 Interest 11% Term Loan

2,20,000

12% Term Loan

1,20,000

3,40,000

EBT

26,60,000

Taxes @ 50%

13,30,000

Profit After Taxes

13,30,000

E.P.S.

2.22

P/E Ratio

10

Market Price of the share

22.20

Conclusion : (a)

As the market price of the share in the second alternative is going to be more, the company will select that financial plan.

(b)

If it is assumed that there will be no chance in P/E ratio in either of these alternatives, the first alternative will be preferred as the market price of the share is going to be Rs. 24.20 in that situation.

(9)

The existing capital structure of XYZ Ltd. is as under : Equity shares of Rs. 100 each

Rs. 40,00,000

Retained Earnings

Rs. 10,00,000

9% Preference Shares

Rs. 25,00,000

7% Debentures

Rs. 25,00,000

The existing rate of return on the company's capital employed is 12% and the income tax rate is 50%. The company requires a sum of Rs. 25,00,000 to finance its expansion programme for which it is considering the following alternatives : (i)

Issue of 20,000 equity shares at a premium of Rs. 25 per shares.

(ii)

Issue of 10% preference shares.

(iii) Issue of 8% debentures. If it is estimated that the P/E ratios in the case of equity, preference and debenture financing would be 20, 17 and 16 respectively. Which of the above alternatives would you consider to be the best if objective of the company is to maximise market price of the shares.

Capital Structure

285

Chapter 9 CAPITAL MARKET

CAPITAL MARKET In simple words, Capital Market refers to the market available to the company for raising the long term requirement of funds. Last decade of the twentieth century has witnessed various liberalization measures and reforms taking place in various sectors of the economy. Capital Market is no exception to the rule. The changes which have taken place in the capital market are basically in two formsa.

Repeal of Capital Issues (Control) Act, 1947 and abolition of the office of Controller of Capital Issues. This came into effect from 29th May, 1992.

b.

Enactment of the Securities and Exchange Board of India Act, 1992 and formation of Securities and Exchange Board of India (SEBI).

As a result of this, the market for the long term securities of the companies has become more free and companies are now able to raise the funds in the market in a free manner. However, in order to protect the interests of investors, SEBI has been empowered to issue the directions from time to time. As such, at present, the only regulatory framework applicable to the companies trying to raise the funds by issuing their securities in the market is in the form of guidelines issued by SEBI from time to time for disclosure and investors’ protection. The extract of these SEBI guidelines are discussed in the following paragraphs. In the Capital Market (in technical words it is referred to as “Primary Market”), a company can raise the funds in following three mannersa.

Public Issue

b.

Rights Issue

c.

Private Placement of Securities

Public Issue indicates the sale of securities to the members of general public.

Capital Market

297

According to the provisions of Section 81 of the Companies Act, 1956, if a Public Limited Company wants to raise further capital by way of issuing additional shares, they are required to be offered to the existing equity shareholders first in the similar proportion. This is technically called as “Rights Issue” of shares. However, the existing shareholders are not compelled to buy those shares. The existing shareholder can buy those shares himself or he can renounce the right in favour of any other person. Private placement of Securities, as the name indicates, is the private placement made by the company to a selected few investors. SEBI guidelines for Public Issue and Rights Issue If the company wishes to collect the funds by making Public Issue or Rights issue of the Securities, following requirements of SEBI guidelines are required to be complied with by the company. Filling of Prospects or Letters of Offer A company cannot make the public issue of Equity Shares unless a draft prospects is filed with SEBI, through an eligible Merchant Banker, at least 21 days before it is filed with the Registrar of Companies (ROC). Contents of the prospectus are also prescribed in the guidelines. A listed company cannot make the rights issue of Equity Shares where aggregate value exceeds Rs. 50 Lakhs, unless the letter of offer is filed with SEBI, through an eligible Merchant Banker, at least 21 days before it is filed with the Regional Stock Exchange. Contents of the offer letter are also prescribed in the guidelines. Listing on Stock Exchange A company cannot make the public issue of Equity Shares unless it has made an application for listing of these equity shares in the stock exchange (s). Eligibility for an unlisted company for making public issue An unlisted company cannot make the public issue of equity shares unless the company has –

298

a.

a track record of distributable profits for at least three years out of immediately preceding five years and

b.

a pre-issue net worth of more than Rs. 1 Crore in three out of preceding five years, with the minimum net worth to be met during immediately preceding two years and

c.

the issue size not exceeding 5 times its net-worth.

Financial Management

If the unlisted company does not satisfy any of the above conditions, it can make the public issue only through the Book Building process. In the Book Building process, the company has to compulsorily allot at least 60% of the issue size to the Qualified Institutional Buyers, failing which the full subscription amount will have to be refunded. Eligibility for a listed company for making public issue A listed company can make the public issue if the issue size is less than 5 times its pre-issue net worth. If the issue size is more than or equal to 5 times of pre-issue net worth, the company has to take the route of Book Building and has to allot at least 60% of the issue size to the Qualified Institutional Buyers, failing which the full subscription amount will have to be refunded. Partly paid shares No company can make the pubic issue of Equity Shares unless all the partly paid shares have been fully paid up. Pricing of the issue A listed company can freely price its equity shares offered through the public issue or rights issue. An unlisted company making the Public Issue of Equity Shares and desirous of getting the shares listed on the stock exchange can freely price its equity shares. However, the company is required to give the justification of the price in the offer document. Any unlisted company or a listed company making issue of equity shares can issue them to applicants in the firm allotment category at a price different from the price at which offer is made to the public provided that the price at which the security is offered to the applicants in firm allotment category is higher than the price at which the security is offered to the public. Denomination of the shares Denomination of the equity shares in the public issue or rights issue can be freely decided by the company. Promoters’ Contribution In a public issue by an unlisted company, the promoters shall contribute not less than 20% of the post-issue capital. In a public issue by a listed company, the promoters shall participate to the extent of 20% of the proposed issue or ensure post-issue holding to the extent of 20% of the post-issue capital. Promoters shall bring full amount of the promoter contribution at least one day before the issue opens for public.

Capital Market

299

Lock-in period The lock-in period for the promoter contribution shall be three years from the date of commercial production or the date of allotment of shares whichever is later. If an unlisted company making the public issue of equity shares and desirous of getting the shares listed on the stock exchange has issued the shares to any person within six months prior to the opening of issue for the public at a price lower than the price at which shares are offered to the public, the entire share capital (except the shares of venture capitalist and employees of the company) shall have lock-in period of six months from the date of trading of shares on the stock exchange. Minimum application If the equity shares are being issued at par, the minimum number of shares for which an application is to be made is 200 shares of the face value of Rs. 10 per share. In other words, the minimum application money payable by the applicant shall not be less than Rs. 2,000. Minimum application money payable by the applicant along with the application shall not be less than 25% of the issue price. Tradable Lots Minimum tradable lot in case of shares having the face value of Rs. 10 per share can be decided by the company on the basis of offer price as stated below Offer Price per share Up to Rs. 100

Minimum tradable lot 100 shares

Rs. 101- Rs. 400

50 shares

More than Rs. 400

10 shares

However, minimum tradable lot shall not be more than 100 shares. Subscription List A public issue of shares shall be kept open for minimum three working days and not more than ten working days. Rights issue shall be kept open for at least 30 days and not more than 60 days. Underwriting Underwriting of the public issue of shares is at the option of the company making the issue.

300

Financial Management

Minimum Subscription If the company receives less than 90% of the issued amount from the public plus the shares taken over by the underwriters, the company must refund the subscription amount in full within 60 days from the date of closure of the issue. Utilization of funds The company can utilize the funds collected by way of rights issue after satisfying the stock exchange that minimum 90% subscription has been received. Retention of over subscription The quantum of issue shall not exceed the amount specified in the prospectus or the letter of offer. However, an oversubscription to the extent of 10% is permissible for the purpose of rounding off to the nearer multiple of 100 while finalising the allotment. SEBI GUIDELINES FOR THE ISSUE OF DEBT INSTRUMENTS Basic The company can not issue FCDs having a conversion period of more than 36 months unless conversion is made optional with “put” and “call” option. If the conversions take place after 18 months but before 36 months from the date of allotment of debentures, any conversion in part or in whole shall be optional at the hands of debentureholders. Rate of Interest, premium and period of conversion The rate of interest for the debentures can be freely decided by the company. The amount of premium on redemption and the period of conversion can be decided by the company and disclosed in the offer document. Credit Rating The company can not make the public issue of the FCDs/PCDs/NCDs unless credit rating is obtained from a credit rating agency and disclosed in the offer document. If the size of the issue is greater than Rs. 100 crores, two ratings from two different credit rating agencies are required to be obtained. When the rating is obtained from more than one credit rating agency, all the credit ratings, including the unacceptable ratings, shall be disclosed by the company. All the credit ratings obtained during the three preceding years for any listed securities of the company are required to be disclosed.

Capital Market

301

Debenture Trustees If the issue of debentures is having the maturity period of more than 18 months, the company shall appoint a Debenture Trustee. The name of the Debenture Trustee shall be disclosed in the offer document. A Trust Deed shall be executed by the company in favour of the Debenture Trustees within six months from the date of closure of the issue. The Debenture Trustee shall have the requisite powers for protecting the interests of the debenture holders including the right to appoint a nominee director. Debenture Redemption Reserve (DRR) If the company issues the debentures with the maturity of more than 18 months, it has to create DRR. DRR should be created out of the post-tax profits earned by the company. The company shall create the DRR to the extent of at least 50% of the amount of debenture issue before debenture redemption commences. Drawl from DRR is permissible only after 10% of the debenture liability has actually been redeemed by the company. DRR will be treated as free reserve while issuing the bonus shares. Security The company shall create the security within six months from the date of issue of debentures. INTERMEDIARIES IN CAPITAL MARKET If a company wants to raise the funds from various sources, services given by various intermediaries become essential in the process. Among all these intermediaries, probably the most important and significant intermediary is the Merchant Banker. In the area of Capital Markets, it is basic responsibility of the Merchant Banker to ensure that the issue is a success. To be more particular, Merchant Banker performs the following functions-

302

a.

Advise the company about the structuring of the issue after taking into consideration the overall economic conditions, expectations of the investors etc.

b.

Assist in getting the various statutory approvals.

c.

Drafting of the Prospectus and the Offer Document in consultation with the solicitors and others.

d.

Assist the company in the appointment of other intermediaries like underwriters, brokers, bankers, registrars, advertising agencies, printers etc.

e.

Develop the strategies for marketing the issue properly through the various techniques like advertisements, mailers, press conferences, investors’ conferences, broker conferences etc.

f.

Coordinate the efforts of all the intermediaries for the success of the issue.

g.

Monitor the issue during the period of subscription. Financial Management

h.

Assist in finalising the basis of allotment.

i.

Assist in securing the stock exchange listing

In addition to the Merchant Bankers, following intermediaries play a significant role in the process of raising the funds in Capital Market. Underwriters Underwriters provide a protection to the company in the situation of investors not fully subscribing to the issue of the securities. Thus, underwriting is a contract where the underwriter agrees to subscribe directly or to procure subscription for that portion of the issue which is not taken up by the pubic. As a result, when the issue is underwritten, the company making the issue is assured of getting the total requirement of funds, either from the investors or from the underwriters. The return received by the underwriters is in the form of underwriting commission which is based upon the amount underwritten by the underwriter. It has already been stated, that as per the SEBI regulations, underwriting is not obligatory. However, in case of every underwritten issue, the Lead Merchant Banker shall accept the minimum underwriting obligation of 5% of the total underwriting commitment or Rs. 25 Lakhs whichever is less. Bankers to the Issue Bankers to the issue collect the application money on behalf of the company. Bankers to the issue are the banks who provide the term finance or working capital finance to the company and who underwrite the issue. Registrars to the Issue Registrars to the Issue typically performs the following tasks–

Collecton of applications from the banks after the issue is closed.

–

Scrutiny of the application forms.

–

Classification and tabulation of information for allotment.

–

Finalisation of basis of allotment.

–

Preparation and dispatch of allotment letters, share certificates, debentures certificates and refund orders.

RECENT TRENDS IN CAPITAL MARKET We will study the recent trends in Capital Market mainly under the following headingsa.

Innovative instruments in Capital Market

b.

Credit Rating

Capital Market

303

c.

Buy Back of Shares

d.

Venture Capital

INNOVATIVE INSTRUMENTS IN CAPITAL MARKET During the last few years, the companies have entered the capital market with various innovative instruments to raise the funds from the public. We will discuss the following innovative instruments used by the companies. a.

Equity Warrants

b.

Floating Rate Bonds

c.

Zero Coupon Bonds

d.

Deep Discount Bonds

e.

Secured Premium Notes

Equity Warrants The holders of the warrants are entitled to purchase the equity shares at a specific price during the specified period (technically referred to as “exercise period”). However, the holder of the equity warrants has a right but not the obligations to purchase the equity shares. Naturally, the holder of the equity warrant will exercise the option to buy the equity shares if the prevailing market price of the equity shares is more than the specified price during the exercise period. The equity warrants are generally issued along with some other instrument with the intention to make the issue of that other instrument more attractive. Equity Warrants can be either detachable or non-detachable. Detachable Equity Warrants can be detached from the underlying instruments and can be traded independently. Non-detachable Equity Warrants can not be detached from the underlying instrument. Advantages of Equity Warrants The issuing company gets benefited with the help of Equity Warrants particularly when the requirement of funds of the company is staggered over a period of time. The company can decide the exercise period taking into consideration its requirement of funds. Risks associated with Equity Warrants If the market price of the equity shares is less than the exercise price during the exercise period, the company may not get the subscription for the shares. Once the exercise period is over, equity warrants are of no use to the company.

304

Financial Management

Floating Rate Bonds In case of floating rate bonds, the rate of interest paid by the company is not fixed. The rate of interest is tied up with some base rate say bank rate and the variations in base rate decide the actual rate of interest payable by the company on the bonds. E.g. State Bank of India issued the Floating Rate Bonds of the Face Value of Rs. 1,000 carrying the rate of interest of 3% over the maximum interest payable by the bank on the term deposits. If the rate of interest payable on the term deposits increases, the rate of interests on the floating rate bonds will increase and vice versa. At the same time, the company may prescribe some rate as the “Floor Rate” (indicating the minimum rate of interest payable by the company on the bonds even if the base rate falls below a certain limit) and as the “Cap Rate” (which indicates the maximum rate of interest payable by the company even if the base rate increases beyond a certain limit). Advantages of Floating Rate Bonds The Floating Rate Bonds avoid the risk of interest rate fluctuations in the economy both for the issuing company as well as for the investors. ZERO COUPON BONDS (ZCB) Zero Coupon Bonds do not have any explicit or coupon rate of interest payable by the company. E.g. ZCB can be issued on the following termsFace value

Rs. 100 per ZCB

Redemption Value

Rs. 125 per ZCB

Redemption Period

3 years

Difference between the redemption value and the face value is the gain to the investor. Advantages of ZCB The company does not require any periodical outflow of funds to service the borrowing during the currency of the borrowing. DEEP DISCOUNT BONDS (DDB) Deep Discount Bonds were issued by Industrial Development Bank of India (IDBI) in 1992 for the first time. The terms on which IDBI issued the DDB were as belowFace Value

Rs. 1,00,000

Issue Price

Rs. 2,700

Maturity Period

25 years

Capital Market

305

The investors were given the option to quit investment at the end of every 5 years period. E.g. the investors will be paid Rs. 5,700 after the end of 5 years and Rs. 50,000 at the end of 20 years etc. Advantages of DDB The company does not require any periodical outflow of funds to service the borrowing during the currency of the borrowing. Risks associated with DDB The redemption period is usually very long and hence, the investors accept the risk of nonpayment at the time of maturity. SECURED PREMIUM NOTES (SPN) Secured Premium Note was issued by TISCO in 1992 for the first time. The terms on which TISCO issued the SPN were as belowa.

Face Value of the SPN was Rs. 300 per SPN.

b.

SPN will not carry any interest during the first three years.

c.

Commencing from year 4, the investors were to be paid Rs. 75 towards the principal and another Rs. 75 towards the interest and redemption premium. The investors were given the following three options to choose the following mixes of the low interest/high premium or high interest/low premium.

d.

i)

Interest Rs. 37.50 and Redemption Premium Rs. 37.50.

ii)

Interest Rs. 50 and Redemption Premium Rs. 25

iii)

Interest Rs. 25 and Redemption Premium Rs. 50

Each SPN was attached with the warrant whereby the investor could buy one equity share of TISCO for Rs. 100 during the exercise period of one year to one and half years after the allotment of the SPN.

Advantages of SPN The company does not require any periodical outflow of funds to service the borrowing during the currency of the borrowing. CREDIT RATING After 1990, Indian capital market saw a lot of companies entering the capital market with the intention of raising the funds by issuing the shares and / or debentures. It is expected that

306

Financial Management

before an investor makes the investment in the instruments issued by the company, he should satisfy himself about the financial credentials of the company. While investing in the equity shares of a company, the investor is assumed to be knowing about the risk involved with the investment. However, in case of the debt instruments, the investors are expected to make the investment in these instruments after making the study of the various factors relating to the investment. However a small investor is not sufficiently equipped to make such a study. As such, the financial service in the form of credit rating has emerged as a tool to help the investor evaluate his investment portfolio. What is credit rating? Credit Rating is the expression of opinion, with the help of symbols, given by an independent credit rating agency, about the ability of the issuer of a debt instrument to make timely payments of principal and interest at the specified dates. The above description of credit rating reveals the following features of credit rating. a.

Credit rating is with respect to a particular instrument issued by the company. In other words, credit rating indicates the safety associated with the particular instrument issued by the company. It does not indicate the financial health of the company as a whole.

b.

Credit rating is not a recommendation for buying, selling or holding a security. Acutal investment made by the investor depends upon the other important factors like expectation of returns, risk taking capacity of the investor etc.

c.

For the purpose of deciding the rating about the particular instrument, the rating agency may use the various types of information. This information may be made available to the rating agency either by the company itself or it may be available to the agency from any other source. However, the rating agency does not perform the audit function. In the sense, the rating agency does not certify that the information available to it is true and correct.

d.

Credit Rating does not create any legal relationship between the rating agency and the investor. If an investor invests in particular security on the basis of high credit rating given by rating agency and the said investment turns out to be bad investment subsequently, the investor cannot hold rating agency responsible for the bad investment.

e.

The Credit rating once given is not a one-time phenomenon applicable during the entire tenure of the security. With the changing risk characteristics of the company, the credit rating should be reviewed and upgraded or downgraded accordingly.

Is credit rating obligatory? In the Indian circumstances, credit rating is not obligatory in case of equity shares. It is obligatory only in case of the debt instruments. To be more precise, credit rating is obligatory in case of the following debt instruments. Capital Market

307

a.

Convertible or Non-convertible Debentures/ Bonds irrespective of the period of maturity or redemption.

b.

Fixed Deposits issued by non-banking financial companies.

c.

Commercial Paper.

Recently amended SEBI guidelines provide that if the size of issue is more than Rs. 100 crores, the issue is required to be rated by at least two credit rating agencies. It should be noted that the requirement of credit rating in respect of the above instruments is not a part of any particular law or statute. It is included in the various guidelines applicable for the issue of above instruments. Who can do the credit rating? Presently there are four approved credit rating agencies who can do the credit rating of the various instruments. These agencies are : a.

Credit Rating and Information Services of India Ltd. (CRISIL)

b.

Investment Information and Credit Rating Agency (IICRA)

c.

Credit Analysis and Research Limited (CARE)

d.

FITCH Rating India Private Limited.

Advantages of credit rating

308

a.

In the developing capital market conditions, credit rating provides the investor with the reliable and superior information from an independent and professional source, about the company at no cost. This facilitates the investment on the part of investors on conscious basis instead of on some ad-hoc basis.

b.

With a satisfactory credit rating, it is comparatively easy for a company to market the instrument at less cost. Similarly, with a satisfactory credit rating, it is possible for the company to approach a wide audience of the investors.

c.

Credit rating provides a motivation to the companies to improve their performance. A company with a low credit rating with respect to a particular instrument, always strives to improve its performance.

d.

With the help of credit rating the investible funds of the investors are directed towards more productive investment portfolios. The possibility of investment failing is comparatively less.

Financial Management

Methodology of Credit Rating For this purpose, we will take into consideration the rating methodology followed by CRISIL. The rating procedure followed by CRISIL may be based upon the information available to it either directly from the company or from any other source. During this process, CRISIL considers the following aspects about the company. a.

b.

Business Analysis i)

Industry Risk – This indicates the overall demand/supply position in the industry as a whole, the existing as well as the potential competitors in the industry, various government policies affecting the industry etc.

ii)

Market Position – This indicates the market position of the company vis-à-vis that of the competitors in the industry in terms of the market share, competitive advantages and disadvantages, selling and distribution arrangements etc.

iii)

Operating efficiency – This involves the consideration of manufacturing process and operating efficiency of the company in relation to those of the competitors, availability of various infrastructural facilities, modernisation/expansion/diversification plans etc

Financial Analysis

This involves the consideration of the various factors like accounting policies followed by the company, analysis of the financial statements, adequacy of cash flows for fixed capital and working capital needs, ability to raise funds from the market etc.’ C.

Management Evaluation

This involves the consideration of the various factors like track record of the management, capacity to overcome the adverse business conditions, management targets/ objectives/ strategies etc.. Credit Rating Symbols CRISIL

IICRA

CARE

Highest Safety

AAA

LAAA

CARE AAA

High Safety

AA

LAA

CARE AA

Adequate Safety

A

LA

CARE A

Moderate Safety

BBB

LBBB

CARE BBB

Long Term (Debentures/Bonds)

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309

Inadequate Safety

BB

LBB

CARE BB

High Risk

B

LB

CARE B

Substantial Risk

C

LC

Care C

Default

D

LD

Care D

Highest Safety

FAAA

MAAA

CARE AAA (FD)

High Safety

FAA

MAA

CARE AA (FD)

Adequate Safety

FA

MA

CARE A (FD)

Inadequate Safety

FB

MB

CARE B (FD)

High Risk

FC

MC

CARE C (FD)

Default

FD

MD

CARE D (FD)

Highest Safety

P1

A1

PR1

High Safety

P2

A2

PR2

Adequate Safety

P3

A3

PR3

Inadequate Safety

P4

A4

PR4

Default

P5

A5

PR5

Medium Term (Fixed Deposits) :

Short Term (Commercial Paper) :

Note : a.

The above table indicates the comparison between the symbols used by the various rating agencies. The basic description for the use of symbols is as used by CRISIL. The exact description used by the remaining two rating agencies varies slightly from the description used by CRISIL.

b.

The rating agencies may add + or - signs to indicate the degree of variation.,

The Credit Rating Symbols used by Fitch Rating India Pvt. Ltd. are as below – For Long Term (12 months and more) AAA (ind) AA + (ind), AA (ind), AA-(ind) A+ (ind), A(ind), A- (Ind) BBB+(ind), BBB (ind), BBB- (ind) BB+ (ind), BB(ind), BB-(ind) B+(ind), B(ind), B-(ind) C(ind) D(ind)

310

Highest Credit Quality High Credit Quality Adequate Credit Quality Moderate Credit Quality Speculative Highly Speculative High Default Risk Default

Financial Management

Public Deposits tAAA (ind) tAA+(Ind), tAA(ind), tA-(ind) tA_(ind), tA(ind), tA-(ind) tBBB+(ind), tBBB(ind), tBBB-(ind) tBB+(ind), tBB(ind), tBB-((ind) tB+(ind), tB(ind), tB-(ind) tC (ind) tD(ind)

Highest Credit Quality High Credit Quality Adequate Credit Quality Moderate Credit Quality Speculative Highly Speculative High Default Risk Default

For Short Term (Less than 12 months) F1+(ind), F1(ind) F2+(ind), F2(ind) F3(ind) F4(ind) F5(ind)

Highest Credit Quality Good Credit Quality Fair Credit Quality Speculative Default

Limitations of Credit Rating a.

b.

c. d.

e.

Credit Rating is based upon the evaluation made by the agencies which is essentially a subjective evaluation which may vary depending upon the experience, knowledge and the individual opinion of the rators which may be biased in some cases. The various guidelines issued for regulating the various types of instruments for which credit rating is required, require the companies to get the credit rating done. However, these guidelines do not require the companies to publish these ratings. As such, in certain cases the companies may not publish the ratings, particularly when the ratings are not favourable to the companies. This defeats the basic purpose of credit rating. The approved credit rating agencies prevailing in the country are promoted by the government controlled organisations. This may involve its own consequences. It is usually observed that the ratings given by the credit rating agencies is primarily based upon the past performance of the companies, whereas the future prospects of the companies should be given more importance while deciding the credit rating. Moreover, if a particular company or a particular industry is passing through the temporary adverse conditions, it may get a low credit rating if judged on temporary basis. Multiplicity of the rating agencies can be considered to be the limitation of the credit rating. If a company is not satisfied with the rating given by one agency, the company can approach another rating agency with the hope to get better rating from that agency. The recently introduced guidelines issued by SEBI provide that if the company has approached more than one rating agency, it is required that the ratings given by all the agencies are made known to the investors. If there is a vast difference between the ratings awarded by the different agencies, it may be a point of concern for the investor.

Capital Market

311

f.

In the recent past, some cases were observed that the ratings given by the agencies were either upgraded or downgraded within comparatively a very short span of time. The question arises what went wrong to such an extent that the ratings were required to be upgraded or downgraded to such an extent. In the whole process, the basic rating given by the agencies gets challenged. Effectively, the credibility of the agency is at stake.

BUY BACK OF SHARES As per the provisions of Companies (Amendment) Act, 1999, the company is now authorised to buy back its own shares. This is one of the exceptions to the rule that no company can reduce the amount of its share capital during its life time. The provisions in respect of buy back of own shares are contained in Section 77A of the Companies Act, 1956 which are as below: a.

Articles of Association of the company should authorise the company to buy back its own shares. If there is no authorisation in the Articles of Association, they need to be amended first.

b.

The buy back of the shares should be approved by passing a special resolution in the general meeting of the Company. The explanatory statement enclosed to such notice should contain the details like disclosure of all material facts, necessity for buy back, the class of shares proposed to be bought back, amount required for such buy back of shares and time required for completion of buy back. After the special resolution is passed but before the buy back of shares, the company shall file with the Registrar of Companies of the respective state and with SEBI, if shares of the Company are listed on a recognized stock exchange, a declaration that the company is capable of meeting its liabilities and will not be insolvent within a period of one year from such declaration. Such declaration shall be signed by atleast two directors, one of whom should be the managing director. This special resolution should be filed with the Registrar of Companies of the respective state in Form No. 23. The procedure of buy back should be completed within 12 months from passing such special resolution.

c.

The shares can be bought back out of the following amounts: i)

Free Reserves of the company.

ii)

Share Premium Account of the company.

iii)

Proceeds of issue of any shares or other specified securitites. However, proceeds of earlier issue of shares or other specified securities can not be used for buy back of shares.

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Financial Management

Similarly, the shares can be bought backi)

From the open market.

ii)

Form the existing shareholders on a proportionate basis.

iii)

By purchasing the shares issued to the employees under the employees stock option scheme or issued to them as sweat equity.

d.

The amount of shares bought back should not be more than 25% of total paid-up capital of the company and its free reserves. A company may be able to buy back its own shares every year, however, the amount of shares bought back in any financial year shall not be more than 25% of its paid up equity capital in that financial year.

e.

The debt equity ratio of the company after such buy back of shares should not be more than 2:1 except where the Central Government allows a higher ratio in case of certain companies.

f.

The shares which are proposed to be bought back should be fully paid up shares.

g.

When the company buys back its own shares, it shall extinguish and physically destroy securities so bought back within a period of 7 days from the last date of completion of buy back.

h.

If the company buys back its own shares, it shall not make further issue of same kind of shares (including rights shares) within a period of 24 months. However, this provision shall not apply toi)

Issue of bonus shares.

ii)

Conversion of preference shares/debentures into the equity shares.

iii)

Fulfillment of obligations in respect of conversion of equity warrants, employees stock options or sweat equity.

i.

After the process of buy back of shares is complete, the company shall file necessary particulars with Registrar of Companies of the respective state and with SEBI if shares of the company are listed on a recognized stock exchange.

j.

Where a company buys back its own shares, it shall maintain a registrar of the shares so bought back, consideration paid for such shares bought back, date of cancellation of these shares, date of extinguishing/ physical destruction of these shares etc.

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313

VENTURE CAPITAL In the recent past, Ventures Capital has become one of the best possible sources for raising the funds for the companies involving more amount of business risks and for whom the normal avenues for raising the funds are unavailable as the common investors are unwilling to invest their funds into such ventures. Venture capital as a source of funds has become a necessity for the organizations who have good growth opportunities. Venture Capitalist or Venture Capital Fund (VCF) is interested in investing in these projects (i.e. Venture Capital Undertaking) as his investment is likely to generate huge amount of returns. These returns may not be in the form of recurring returns like dividend, but also in the form of capital gains over a longer span of time. A venture capitalist investing in the project is aware of the fact that the project is in the untested area, involving more amount of risk. He is also aware that the projects are likely to involve larger gestation period. As such, a venture capitalist is not worried about the failure of the project in which he invests his funds. This is because of the fact that he knows that the project which succeeds will give huge returns which will compensate for the losses incurred by other projects. This is the reason why the venture capitalist is not only the investor of funds or the lender of the funds. A conventional lender of funds is not directly involved in the operations and management of the company. He keeps away from managing the company and is bothered about the safety of the funds lent by him, A conventional investor only trades in the shares of the company without any relationship with the management of the company. As against this, before investing in the project, Venture Capital Company or Venture Capital Fund scrutinizes the project carefully and studies the merits of the project. He takes active participation in the management of the project providing the benefit of his expertise and experience to the Venture Capital Undertaking. Before investing in the project, Venture Capitalist is interested in ensuring thata.

The project is technically feasible.

b.

The project is commercially viable.

c.

The entrepreneurs are technically competent.

d.

The project has a competitive advantage over a longer span of time.

Types of Venture Capital Financing The venture capital funding can be either in the form of equity financing or debt financing. However, equity financing is more preferred route for venture capital funding. This is due to the following facts –

314

Financial Management

a.

Projects for venture capital financing are more risky in nature and involve larger gestation period. Hence, the project will require the long term funds on which it may not be able to pay the returns during the initial period. At the same time, venture capitalist is not interested in interfering in the project. Hence, the investment of the venture capitalist does not exceed 49% so that the effective control of the project remains with the entrepreneur.

b.

Venture capitalist is not interested in keeping his investment in the project on a permanent basis. He wishes to quit his investment as early as possible. He can do so when the project becomes successful and profitable and he is able to sell off his equity shares.

Exit Routes available to VCF As stated earlier, the VCF is not interested in remaining associated with the Venture Capital Undertaking on a permanent basis. He is interested in quitting his investment at a suitable point of time. In the Indian circumstances, following two options may be available to VCF for the purpose of quitting his investment. a.

Purchase of VCF stake by the promoters

b.

Initial Public Offering (IPO)

Purchase of VCF stake by the promoters This exit route is very popular in the Indian circumstances where the promoters of the Venture Capital Undertaking purchase the equity stake of VCF within the agreed period at a pre decided price. This enable the promoters to maintain their stake in the Ventures Capital Undertaking intact. The limitation of this exit route lies in the fixation of the price which the promoters will be required to pay to the VCF for buying the equity stake of the VCF. Initial Public Offering (IPO) The first public offering of equity shares of company to be followed by listing of the shares on stock exchange is known as Initial Public Offering (IPO). Once the Venture Capital Undertaking becomes profitable, it can make the public issue of its shares. After the abolition of the office of Controller of Capital Issues, it is possible for the companies to decide the premium on the issue of its shares. After the shares of the company are listed on the stock exchange, the VCF can sell its stake on the stock exchange earning the capital appreciation in return. The limitation of this exit route is the restricted scope of IPO for the Venture Capital Undertaking as the venture promoted by comparatively unknown promoters may be viewed as an unattractive proposition by the investors. Further, complexities in getting the securities listed on the stock exchange and the efficiency of the secondary markets in India restrict the scope of this exit route available to the VCFs.

Capital Market

315

Ventures Capital in India The history of venture capital in India can be traced back to the establishment of Technology Development Fund (TDF) in the year 1987-88, through the levy of cess on all technology import payments. TDF was for providing financial assistance to innovative and high risk projects through Industrial Development Bank of India (IDBI). In 1988, Industrial Credit and Investment Corporation of India (ICICI) promoted Technology Development and information Company of India (TDICI) as the first venture capital company under the Companies Act, 1956. In 1996, Securities and Exchange Board of India issued the guidelines for the operations of Venture Capitalists to carry out their operations in India. This has made the entry of foreign venture capital funds more easy in the Indian situations At present, the venture capital funds (VCFs) operating in India can be classified in the following categories. a.

VCFs promoted by All India Development Financial Institutions like IDBI, ICICI and IFCI. E.g. TDICI promoted by ICICI.

b.

VCFs promoted by State level Financial Institutions. E.g. Gujrat Venture Finance Company Limited or Andhra Pradesh Venture Capital Limited.

c.

VCFs promoted by the Commercial Banks. Eg. Can Bank Venture Capital Fund or State Bank Venture Capital Fund etc.

d.

Private Sector Venture Capital Funds. Eg. Indus Venture Fund, 20th Century Venture Capital Company, Infrastructure Leasing and Financial Services Limited etc.

In order to promote the venture capital, Section 10 (23FB) was inserted in Income Tax Act, 1961 which provides that any income earned by a VCF will be exempt from tax. To get this exemption, following two conditions are required to be satisfied. a.

Venture Capital Company or Venture Capital Fund should have been given the certificate of registration by SEBI and such Venture Capital Company or Venture Capital Fund should have fulfilled all the conditions as specified by SEBI.

b.

Venture Capital Company or Venture Capital Fund is set up to raise the funds for investment in a Venture Capital Undertaking which essentially means a company whose shares are not listed in a recognised stock exchange.

If the above conditions are satisfied, any income of such Venture Capital Company or Venture Capital Fund will be exempt from income tax even if the shares of such company are subsequently listed in recognized stock exchange.

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Financial Management

QUESTIONS 1.

State the guidelines for the public issue and rights issue of shares.

2.

Write a short note on various intermediaries in capital market.

3.

Write a short note on various innovative instruments used by the companies for raising the funds in capital market.

4.

Write short notes on a)

Credit Rating

b)

Venture Capital

c)

Buy Back of shares

Capital Market

317

NOTES

318

Financial Management

Chapter 10 CAPITAL BUDGETING

As discussed in the earlier chapters, the finance function has to deal with one of the most important decisions regarding the amount to be invested in fixed assets and the decision is technically in the form of ‘Capital Budgeting’. Thus, the capital budgeting decisions are decisions as to whether or not money should be invested in long term projects. It includes analysis of various proposals regarding capital expenditure to evaluate their impact on the financial situation of the company and to choose the best out of the various alternatives. The function of finance in this area is to enable the management to take a proper capital budgeting decision. IMPORTANCE OF CAPITAL BUDGETING Capital budgeting decisions are the most crucial and critical decisions for a business to take. This is the fact due to the various reasons. (1)

Capital budgeting decisions have long term implications on the operations of the business.A wrong decision may affect the long term survival of the Company. The investment in fixed assets more than required, may increase the operating costs of the Company. The inadequate investment in fixed assets may make it difficult for the Company to compete and may affect its market share.

(2)

Capital budgeting decisions involve large amount of the funds. As such, it is necessary to take the decision very very carefully and to make the arrangement of the funds for the procurement of these assets.

(3)

The capital budgeting decisions are irreversible due to the fact that it is difficult to find the market for such capital goods. The only alternative is to scrap these assets which involves huge losses.

(4)

Capital budgeting decisions are difficult to make because it involves the assessment of future events which are difficult to ascertain. The investments are required to be made immediately but the returns are expected over a number of years.

Capital Budgeting

319

THE PROCESS OF CAPITAL BUDGETING The process of capital budgeting involves generally the following steps. (1)

Project Generation : The generation of the proposals may fall under any of the following categories. (a)

Additions to the present product line.

(b)

Expansion of the capacity of the existing product line.

(c)

Proposals to reduce costs of the existing product line without affecting the scale of operations.

The generation of the projects may take place at the levels of top management or at the level of workers also. E.g. Proposal to replace on old machine or to improve the production techniques may originate at the worker’s level also. (2)

Project Evaluation : As in case of any types of decision makings, the capital budgeting decisions also have two faces. Firstly, estimation of the benefits and costs measured in terms of cash flows and Secondly, selection of an appropriated criterian to judge the desirability of the projects. It is necessary that the evaluation of the projects is done by impartial group and experts in the field. Care must be taken to choose the criteria to judge the desirability of the projects and it should be consistent with the company’s basic objective to maximize the wealth.

(3)

Project Selection : There is no fixed and laid down procedure to select the final criteria among the various available alternatives. Generally, the selection of the final project is done by the top management though it may be scrutinized at various levels. In many cases, top management may delegate the authority to approve certain projects to lower management also.

(4)

Project Execution : After the final selection of the project is made, the funds are appropriated and the execution of the project is carried on. However, there has to be a proper system to check that the execution of the project is being made as per the predecided plans and scheldules.

EVALUATION OF THE PROJECTS As discussed earlier, the process of evaluation of the projects necessarily involves the cost benefit analysis. This cost benefit analysis will generally be made in financial terms, though in some cases non-financial considerations may also come into play. E.g. Some times a project may be undertaken to get established in the market or to satisfy certain legal requirements or for some social welfare benefits or just for some emotional reasons. However financial cost benefit analysis will be the basic evaluation criteria. 320

Financial Management

There are many techniques and tools to evaluate the various investment proposal. But before going into the details of these various techniques, one most important aspect of the evaluation has to be studied and that is ‘how to compute the cash flows?’ HOW TO COMPUTE THE CASH FLOWS? As the estimation of cash flows – both outflows as well as inflows – is the crux for evaluating the projects, this estimation should be made as carefully as possible. The following stages should be considered for this purpose. (1)

Following items constitute the cash outflow. (i)

Cost of new equipment.

(ii)

Cost for demolition of old equipment (similarly, if there is some scrap value receivable from the disposal of the old equipment, the outflow on account of the new equipment should be suitably adjusted.)

(iii) Cost of preparing site and installation charges incurred with respect to the new equipment. Following factors should also be taken into consideration. (i)

If the cost of the new equipment is not to be incurred in one single instalment, but is to be paid over a period of years, it will involve the cash outflow not only in the first year but in the subsequent years also. Similarly, if the cost of the equipment/ project is met by raising the term borrowing, the cash outflow will come into consideration as and when the instalment of term borrowings and interest on the same are paid.

(ii)

If the new equipment/project brings certain scrap value after the useful life is over, the amount realised as scrap value will constitute the cash inflow, but in relation to the year in which the amount is actually received.

(iii) In some cases, implementation of the project may involve investment in the form of additional working capital due to increased inventory, increased debtors etc. This additional investment in working capital constitutes cash outflow. Similarly, after the useful life of the project is over, this investment in the working capital is released and hence should be considered as inflow but only with respect to the year in which it is so released. Further, if the company resorts to some outside source of funds for financing working capital requirements, the cash outflow on account of investment in working capital will be the amount invested by the company itself. The amount received from the outside source of working capital finance constitute the cash inflow. Capital Budgeting

321

(iv)

(2)

If a new asset is intended to be purchased in order to replace an existing asset, the sale proceeds of the old asset should be considered as the cash inflow and the cash outflow required to purchase new asset should be adjusted accordingly.

Following factors should be considered while computing cash inflows. (i)

Computation of cash inflows highly depends upon correct estimation of production and sales. On the basis of the additional production units which can be sold and the price at which they can be sold, the gross revenue from the project can be worked out. However, while doing so, the possibility of reduction in selling price, introduction of a cheaper product by competitiors, etc. should also be considered.

(ii)

Second stage in deciding the cash inflows is to estimate the costs attached to the project. These costs may be in the form of fixed costs or variable costs or depreciation.

(iii)

The difference between the gross revenue and the costs give the result of the net revenue which should be adjusted for taxation factor for computation of cash inflows as it involves the actual payment of cash. However, the amount of depreciation, if it is already included in the cost to consider the taxation factor should be added back while computing the cash inflow as depreciation does not involve the cash outflow. In simple words, the cash inflows should be computed in the following stages. Sales Revenue Less :

Costs (including depreciation) Net Revenue

Less :

Tax Liability Revenue after taxes.

Add :

Depreciation Net cash inflow

322

(iv)

Care should be taken not to include the cost of interest and dividends while considering the costs attached to the project. This is due to the fact that for evaluating the proposals if cost of capital is considered as the discounting factor (as discussed in details later), the amounts of interest and dividend are already given due consideration while computing the cost of capital.

(v)

Sometimes the cash inflows may be considered in terms of net savings in costs rather than in terms of excess of sales over the additional cost. Thus, for computing the cash inflows these savings in costs will be the starting point which will have to be adjusted further for taxation and depreciation factor. The cash inflows will be computed as below. Financial Management

Saving in costs (Other than Depreciation) Less :

Depreciation Net Savings in costs.

Less :

Tax liability Savings after tax

Add :

Depreciation Net cash inflows.

TIME VALUE OF MONEY It has already been discussed that the evaluation of capital expenditure proposals involves the comparison between cash outflows and cash inflows. The peculiarity of evaluation of capital expenditure proposals is that it involves the decisions to be taken today whereas the flow of funds, either outflow or inflow, may be spread over a number of years. It goes without saying that for a meaningful comparison between the cash outflows and cash inflows, both the variables should be on comparable basis. As such, the question which arises is that “is the value of flows arising in future the same in terms of today?” E.g. If a proposal involves the cash inflow of Rs. 10,000 after one year, is the value of this cash inflow really Rs. 10,000 as on today when the capital expenditure proposal is to be evaluated? The ideal reply to this question is ‘no’. The value of Rs. 10,000 received after one year is less than Rs. 10,000 if received today. The reasons for this can be stated as below: (1)

There is always an element of uncertainty attached with the future cash flows.

(2)

The purchasing power of cash inflows received after the year may be less than that of equivalent sum if received today.

(3)

There may be investment opportunities available if the amount is received today which cannot be exploited if the equivalent sum is received after one year.

E.g. If Mr. X is given the option that he can receive an amount of Rs. 10,000 either today or after one year, he will most obviously select the first option. Why? Because, if he receives Rs. 10,000 today he can always invest the same say in the fixed deposits with a bank carrying the interest of say 10% p.a. As such, if the choice is given to him, he will like to receive Rs. 10,000 today or Rs. 11,000 (i.e. Rs. 10,000 plus interest @ 10% p.a. on Rs. 10,000) after one year. If he has to receive Rs. 10,000 only after one year, the real value of the same in terms of today is not Rs. 10,000 but something less than that. This concept is called time value of money.

Capital Budgeting

323

In the capital budgeting decisions, if there has to be a meaningful comparison between the cash outflows and cash inflows which may arise in future at different points of time whereas the evaluation is required to be done as on today, both the future cash outflows and cash inflows are required to be expressed in terms of today. There are two techniques available for this. (a)

Compounding

(b)

Discounting

(a)

Compounding :

In this technique, the interest is compounded and becomes a part of initial principal at the end of compounding period. E.g. If Mr. X invests Rs. 10,000 in fixed deposit carrying interest @ 10% p.a. compounded annually, at the end of first year, Rs. 10,000 will be worth Rs. 11,000 (i.e. Rs. 10,000 + interest on Rs. 10,000 @ 10% p.a.). If Rs. 11,000 are reinvested in the same fixed deposit, at the end of second year Rs, 11,000 will be worth Rs. 12,100 (i.e. Rs. 11,000 + interest on Rs. 11,000 @ 10% p.a.) In other words, the value of today’s Rs. 10,000 if received after two years becomes Rs. 12,100. The compounding of interest can be calculated with the help of following equation. A

=

P (1 + i)n where

A

=

Amount at the end of the period.

P

=

Amount of principal at the beginning of the period.

i

=

Rate of interest

n

=

Number of years

E.g. In the above example, after two years, the value of today’s Rs. 10,000 if invested in the investment carrying the interest of 10% p.a. can be computed as A

(b)

=

10,000 x (1 + 0.10)2

=

10,000 x 1.21

=

Rs. 12,100

Discounting :

These techniques involve the process which is exactly opposite to that involved in the technique of compounding. This technique tries to find out the present value of Re. 1 if received or spent after n years, provided that the interest rate of i can be earned on investment. The present value is calculated with the help of following equation. 324

Financial Management

A

where,

P

=

P

=

Present value of sum received or spent

A

=

Sum received or spent in future

i

=

Rate of interest

n

=

Number of years.

n

(1 + i)

E.g. If Mr. X is given the opportunity to receive Rs. 10,000 after two years, when he can earn interest of 10% p.a. on his investment, what should be the amount which he should invest today so that he may be able to receive Rs. 10,000 after two years. It can be computed as : P

=

= =

A (1 + i)n 10,000 (1 + 0.10)2 Rs. 8,264.46

In other words, if Mr. X invests Rs. 8,264.46 today in the investment carrying interest rate of 10% p.a. he may be able to receive Rs. 10,000 after two years or the present value or Rs. 10,000 if received after two years is only Rs. 8,264.46 as on today if investment opportunities are available to earn the interest of 10% p.a. PRESENT VALUE TABLES To simplify the computation of present value, use can be made of Table A given in the Appendix which gives the present value of rupee one for the various interest rates (i) and years (n) for computing the present value of a future lump sum, the said sum can be multiplied by choosing the interest factor/discounting factor/present value factor for the relevant combination of i and n. E.g. To find out the present value of Rs. 4,000 received after 7 years, assuming interest rate to be 15%, we ascertain the present value factor to be 0.513. We ascertain the present value to be Rs. 4000 x 0.513 = Rs. 2,052. PRESENT VALUE OF SERIES OF CASH FLOWS In capital budgeting decisions, the cash flows, either cash outflow or cash inflow, may occur at various points of time. For finding out the present value of this series of cashflows, it is necessary to find out the present value of each future cash flow and then aggregate them. Capital Budgeting

325

Illustration I A project involves cash inflows as below. Year Cash

Inflows Rs.

1

10,000

2

12,000

3

15,000

4

20,000

Assuming interest rate to be 15%, find out the present value of cash inflows. Solution : Calculation of present value of cash inflows. Year

Cash inflows Rs.

Present Value Factor 15%

Total Present Value Rs.

1

10,000

0.870

8,700

2

12,000

0.756

9,072

3

15,000

0.658

9,870

4

20,000

0.572

11,440 39,082

Illustration II : A machine costing Rs. 1,00,000 is to be purchased as below : Rs. 20,000 –

Down payment out of own contribution.

Rs. 80,000 –

Borrowing by way of term loan. To be paid in 4 equal annual instalment along with the interest @ 15% p.a. The interest being computed on opening outstanding balance.

Calculate present value of the cash outflow.

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Financial Management

Solution : Calculation of present value of cash outflows Year

Principal sum/ Own Contribution Rs.

Interest Total outflow Rs. Rs.

PV. Factor 15%

Total PV Rs.

0

20,000

-

20,000

1.000

20,000

1

20,000

12,000

32,000

0.870

27,840

2

20,000

9,000

29,000

0.756

21,924

3

20,000

6,000

26,000

0.658

17,108

4

20,000

3,000

23,000

0.572

13,156 1,00,028

If a project involves uniform cashflows, the present value of the cashflows can be calculated by a short cut method. Instead of calculating present value for each cashflow and then summing up the present values, the discounting factors (interest factor or present value factors) themselves can be summed up to find out the Accumulated Discounting Factor for the various interest rates (i) and years (n) and the multiplication of Accumulated Discounting Factor and cashflow will give present value of cashflow. Illustration III A project involves the cash inflow of Rs. 20,000 per year for 4 years. Assuming interest rate of 15%, find out the present value of cash inflows. Accumulated Discounting factor at 15% for 4 years is 2.855. Present value of cash inflows Rs. 20,000 x 2.855 =

Rs. 57,100.

RELEVANCE IN CAPITAL BUDGETING DECISIONS As discussed earlier, to make the value of cash outflows and cash inflows comparable, it is necessary to reduce future cash outflows or cash inflows to their present value by discounting them by proper discounting factor or interest factor or present value factor. Usually, weighted average cost of capital is considered as the discounting factor in capital budgeting decisions.

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327

TECHNIQUES FOR EVALUATION OF CAPITAL EXPENDITURE PROPOSALS Various techniques are available for evaluation of capital expenditure proposals. They can be broadly catagorised under two heads. (a)

Techniques not considering time value of money.

(b)

Techniques considering time value of money.

(a)

Techniques not considering time value of money :

(1)

Pay back period :

Pay back period indicates the period within which the cost of the project will be completely recovered. In other words, it indicates the period within which the total cash inflows equal to the total cash outflows. Thus, Pay back period

=

Cash outlay Annual cash inflow

Illustration I : A project requires an outlay of Rs. 5,00,000 and earns, an annual cash inflow of Rs. 1,00,000 for 8 years. Calculate pay back period. Pay back period for the project is Rs. 5,00,000 = 5 years Rs. 1,00,000 If the project involves unequal cash inflows, the payback period can be computed by adding up the cash inflow till the total is equal to cash outlay. Illustration II A project requires an outlay of Rs. 1,00,000 and earns, the annual cash inflow or Rs. 25,000, Rs. 30,000, Rs. 20,000 and Rs. 50,000. Calculate pay back period. If we add up cash inflows, we find that in the first 3 years, an amount of Rs. 75,000 of the cash outlay is recovered. Fourth year generates the cash inflow of Rs. 50,000, whereas the amount of Rs. 25,000 only remains to be recovered. Assuming that the cash inflows occur evenly during the year, the time which will be required to recover Rs. 25,000 will be Rs. 25,000 x 12 months = 6 months. Rs. 50,000

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Financial Management

Thus, the pay back period is 3 years and 6 months. Acceptance Rule : Payback period method can be used as an accept or reject criteria or as a method of ranking the project. If the payback period computed for a project is more than maximum pay back period estimated by the management it would be rejected or vice versa. As a ranking method, the projects having shortest pay back period will be ranked highest. Advantages : (1)

It is quite simple to calculate and easy to understand. It makes it quite clear that there are no profits on a project unless pay back period is over.

(2)

It costs less.

(3)

It may be a suitable technique where risk of absolescence is high. In such cases, projects with shorter pay back period may be preferred as the changes in technology may make other projects obsolete before their costs are recovered.

Disadvantages : (1)

It does not consider the returns from a project after its pay back period is over. Thus, one project A may have a pay back period of 5 years while another project B may have a pay back period of 3 years, thus making project B more preferable. But it is quite possible that project A may generate good cash inflows after 5 years till the end of 10 years, while project B may stop generating cash inflows after 3 years only. In such cases, project A may prove to be more advantageous.

(2)

It may not be a suitable method to evaluate the projects if they involve uneven cash inflows.

(3)

It ignores time value of money.

(4)

To decide the acceptable payback period is a difficult task. There is no rational basis for deciding the maximum payback period. It is a subjective decision.

(2)

Accounting Rate of Return :

Accounting rate of return (ARR) computes the average annual yield on the net investment in the project. ARR is computed by dividing the average profits after depreciation and taxes by net investments in the project. Thus ARR can be computed as. Total Profits x 100 Net investment in project x No. of years of profits

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Illustration : A project involves the investment of Rs. 5,00,000 which yields profits after depreciation and tax as stated below. Years

Profits after depreciation and tax

1

Rs.

25,000

2

Rs.

37,500

3

Rs.

62,500

4

Rs.

65,000

5

Rs.

40,000

Rs. 2,30,000 At the end of 5 years, the machineries in the project can be sold for Rs. 40,000. Find the ARR. The total profits after depreciation and taxes are Rs. 2,30,000. The net investment in the project will be Original cost Less salvage value i.e. Rs. 5,00,000 – Rs. 40,000 = Rs. 4,60,000 ARR will be Rs. 2,30,000 x 100 = 10% Rs. 4,60,000 X 5 years Acceptance Rule : As pay back period method, ARR also can be used as accept or reject criteria or as a method for ranking the projects. As accept or reject criteria, the projects having the ARR more than minimum rate prescribed by the management will be accepted and vice versa. As a ranking method, the projects having maximum ARR will be ranked highest. Advantages :

330

(1)

It is simple to calculate and easy to understand.

(2)

It considers the profits from the project throughout its life.

(3)

It can be calculated from the accounting data.

Financial Management

DISADVANTAGES : (1)

It uses profits after depreciation and taxes and not the cash inflows for evaluating the projects.

(2)

It ignores time value of money.

(b)

Techniques considering time value of money

(1)

Discounted Pay back period :

This is an improvement over the pay back period method in the sense that it considers time value of money. Thus, discounted pay back period indicates that period within which the discounted cash inflows equal to the discounted cash outflows involved in a project. Illustration : A project requires an outlay of Rs. 1,00,000 and earns the annual cash inflows of Rs. 35,000, Rs. 40,000, Rs. 30,000 and Rs, 50,000. Calculate discounted pay back assuming the discounting rate of 15%. Years

Cash inflows Rs.

Discounting Factor @15%

Discounted Cash Inflow Rs.

Cummulative Discounted Cash inflows Rs.

1

35,000

0.870

30,450

30,450

2

40,000

0.756

30,240

60,690

3

30,000

0.658

19,740

80,430

4

50,000

0.572

28,600

1,09,030

Thus, pay back period is after 3 years but before 4 years. Assuming that cash inflows accrue evenly during year, Pay Back Period will be 3 years 8 months (Approx.). Acceptance rule, advantages and disadvantages They are the same as in case of pay back period method except the fact that it considers time value of money (2)

Net Present Value :

Net present Value (NPV) is a method of calculating present value of cash inflows and cash outflows in an investment project, by using cost of capital as the discounting rate, and finding out net present value by subtracting present value of cash outflows from present value of cash inflows. Thus,

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331

NPV =

cash { ∑ Discounted } Inflows

Less

Discounted Cash { ∑Outflows }

Illustration : Calculate net present value of a project involving initial cash outflow Rs.1,00,000 and generating annual cash inflows of Rs. 35,000, Rs. 40,000 Rs, 30,000 and Rs. 50,000 Discounting rate is 15%. Years

Cash inflows Rs.

Discounting factor 15%

Present Value of cash inflows Rs.

1

35,000

0.870

30,450

2.

40,000

0.756

30,240

3.

30,000

0.658

19,740

4.

50,000

0.572

28,600 1,09,030

Less :Investment outlay Net Present Value (NPV)

1,00,000 9,030

Accceptance Rule : As accept or reject criteria, all the projects which involve positive NPV i.e. NPV > 0 will be accepted and vice versa. As a ranking method, the projects having maximum positive NPV, will be ranked highest. Advantages : (1)

It considers time value of money.

(2)

It considers cash inflows from the project throughout its life.

Disadvantages :

332

(1)

It is difficult to use, calculate and understand.

(2)

It presupposes that the discounting rate, i.e. cost of capital is known. But cost of capital is difficult to measure in practice.

(3)

It may give dissatisfactory results if the alternative projects involve varying investment outlay. A project involving maximum positive NPV may not be desirable if it involves huge investment. Financial Management

(4)

(3)

It presupposes that the cash inflows can be reinvested immediately to yield the return equivalent to the discounting rate, which may not be possible always. Internal Rate of Return :

Internal Rate of Return (IRR) is that rate at which the discounted cash inflows match with discounted cash outflows. The indication given by IRR is that this is the maximum rate at which the company will be able to pay towards the interest on amounts borrowed for investing in the projects, without loosing anything. Thus, IRR may be called as the “break even rate” of borrowing for the company. In simple words, IRR indicates that discounting rate at which NPV is zero. If by applying 10% as the discounting rate, the resultant NPV is positive, while by applying 12% discounting rate, the resultant NPV is negative, it means that IRR, i.e. the discounting rate at which NPV is zero, falls between 10% and 12%. Thus, by applying the trial and error method, one can find out the discounting rate at which NPV is zero. The process to compute IRR will be to select any discounting rate and compute NPV. If NPV is negative, a lower discounting rate should be tried and the process should be repeated till the NPV becomes zero. Following illustration explains the process to calculate IRR. Illustration : A project cost Rs. 1,00,000 and generates annual cash flows of Rs 35,000, Rs. 40,000, Rs. 30,000 and Rs. 50,000 over its life of 4 years. Calculate the Internal Rate of Return. Using 15% as discounting rate, the present value of cash inflows can be calculated as below. Year

Cash inflows Rs.

PV factor 15%

Total PV Rs.

1 2 3 4

35,000 40,000 30,000 50,000

0.870 0.756 0.658 0.572

30,450 30,240 19,740 28,600 1,09,030

Using 18% as discounting rate, the present value of cash inflows can be calculated as below : Year

Cash inflows Rs

PV factor 18%

Total PV Rs.

1 2 3 4

35,000 40,000 30,000 50,000

0.847 0.718 0.609 0.516

29,645 28,720 18,270 25,800 1,02,435

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333

Using 20% as discounting rate, the present value of cash inflows can be calculated as below. Year

Cash inflows Rs

PV factor 20%

Total PV Rs.

1 2 3 4

35,000 40,000 30,000 50,000

0.833 0.694 0.579 0.482

29,155 27,760 17,370 24,100 98,385

Thus, at 18% discounting rate, NPV, is Rs. 2,435 and at 20% discounting rate, NPV is (-) Rs. 1615. Hence, IRR is between 18% and 20%, i.e. more than 18% but less than 20%. Difference between PV at 18% and 20% is Rs. 4050 (i.e. Rs. 1,02,435 – Rs. 98,385) and the negative NPV of Rs. 1615 has to be covered by this amount to arrive as IRR. Thus IRR will be

=

20% –

1615 X 2 4050

= 19.2% (Appr.) Acceptance Rule : The computed IRR will be compared with the cost of capital. If the IRR is more than or at least equal to the cost of capital the project may be accepted (IRR > Cost of Capital – Accept). If the IRR is less than cost of capital, the project may be rejected. (IRR < Cost of Capital – Reject) Advantages : (1)

It considers time value of money.

(2)

It considers cash inflows from the project throughout its life.

(3)

It can be computed even in the absence of the knowledge about the firm’s cost of capital. But in order to draw the final conclusion, the comparison with the cost of capital is a must.

Disadvantages :

334

(1)

It is difficult to use, calculate and understand.

(2)

It presupposes that the cash inflows can be reinvested immediately to yield the return equivalent to the IRR. NPV method, on the other hand, presupposes that the cash inflows can be reinvested to yield the return equivalent to the cost of capital, which is more realistic.

Financial Management

(4)

Profitability Index (PI)/Benefit Cost Ratio (B/C Ratio)

It is the ratio between total discounted cash inflows and total discounted cash outflows. Thus the Profitability Index can be computed as : PI =

∑ Discounted cash inflows ∑ Discounted cash outflows

PI can be computed as gross one as stated above or as net one which means gross minus one. Illustration A project requires an outlay of Rs. 1,00,000 and earns the annual cash inflows of Rs. 35,000 Rs. 40,000, Rs. 30,000 and Rs. 50,000. Calculate, Profitability Index assuming the discounting rate of 15%. Year

Cash flows Rs.

Discounting factor @15%

Discounted Cash Inflows Rs.

1

35,000

0.870

30,450

2

40,000

0.756

30,420

3

30,000

0.658

19,740

4

50,000

0.572

28,600 1,09,030

Profitability Index can be calculated as : = ∑ Discounted cash inflows ∑ Discounted cash outflows Rs. 1,09,030 Thus, PI (Gross)

= 1.09 Rs. 1,00,000

PI (Net)

1.09 – 1.00

= 0.09

Acceptance Rule : As accept or reject criteria, the projects having the Profitability Index of more than one will be accepted and vice versa. As a ranking method, the projects having highest profitability index will be ranked highest.

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335

FINAL CHOICE OF EVALUATION METHOD Between the basic two types of techniques as described above, the techniques considering time value of money are generally preferred for the obvious reasons. However, the choice of the evaluation technique depends upon the objective of the management in the investment decisions. The objective is naturally in the form of maximization of wealth of the shareholders. As such, only those projects will be in the interest of the shareholders which can earn more rate of return than other alternative investment opportunities. LIMITATIONS OF CAPITAL BUDGETING The basic limitation of the capital budgeting process lies in this fact that it involves various estimations . These estimations are specifically in respect of (a)

Cash outflow.

(b)

Revenues / Saving and costs attached with projects.

(c)

Life of the projects.

Whereas the cash outflows can be estimated with a reasonable accuracy, the cash inflows and life of the projects can’t be estimated accurately. Further, the changes in fiscal and taxation policies of the Government also have the impact on determination of cash inflows. If the techniques use the discounted flows to evaluate the projects, the cost of capital is used as discounting rate. Difficulties in deciding the cost of capital, prove to be the limitation of capital budgeting process. EVALUATION CRITERIA IN CERTAIN TYPICAL SITUATIONS (a) In certain cases, the capital expenditure may not involve any specific inflow of funds, but only outflow of funds. E.g. If a machine manufactures such products which themselves cannot be marketed, there may not be any specific inflow of funds associated with such machines. Under such situations, if the company is required to make the choice between two machines, the company should choose that machine which involves less amount of present value of outflow of funds. Illustration : A company has to make a choice between buying of two machines. Machine A would cost Rs. 1,00,000 and require cash running expenses of Rs. 32,000 p.a. Machine B would cost Rs. 1,50,000 and its cash running expenses would amount to Rs. 20,000 p.a. Both the machines have a life of 10 years with zero salvage value. The company follows straight line depreciation and is subject to 50% tax on its income. The company’s required rate of return is 10%. Which machine should it buy?

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Financial Management

Note : Present value of Re. 1 p.a. for 10% discount rate is Rs. 6.1446. Solution : Machine A Particulars Cost of Machine Running Expenses Depreciation

Pre-tax Amt.

Post-tax Amt.

Years

PV factor @10%

Total PV

1,00,000 32,000 (-)10,000

1,00,000 16,000 (-) 5,000

0 1-10 1-10

1.0000 6.1446 6.1446

1,00,000 98,314 (-) 30,723 1,67,591

Machine B Particulars

Pre-tax Amt. Rs.

Post tax Amt. Rs.

Years

PV factor @10%

Total PV Rs.

Cost of Machine

1,50,000

1,50,000

0

1.0000

1,50,000

20,000

10,000

1-10

6.1446

61,446

(-) 15,000

(-) 7,500

1-10

6.1446

(-) 46,085

Running Expenses Depreciation

1,65,361 As the PV of net outflow of funds is less in case of Machine B, investment in Machine B will be accepted. (b) In certain cases, the capital expenditure may involve replacement of an existing machinery or equipments which is likely to result into the savings of costs. As such, under such situations, the inflow of funds is in the form of savings arising from the investment which will be required to be considered in the light of costs and benefits associated with new proposal vis-à-vis the costs and benefits associated with existing proposal which will not be available in future. Illustration : Shree Prakash Co. has been using a machine costing Rs. 15,000 for the past 5 years. The machine has 15 years of life. The current salvage value would be Rs. 2,000 and the company has been paying 50% of its profits as taxes (i.e. it is subjected to 50% flat tax rate) Now, the management desires to replace it by new machine costing Rs. 10,000 with salvage value of Rs. 2000. The new machine has life of 10 years. Cost of capital is 10% and the expected savings are likely to be Rs. 3,000 per annum.

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337

(a)

Should be company go for a new machines?

(b)

What would be your advice if expected savings increase by 50% per annum and expected life descreases by 5 years?

Solution : Part A : Calculation of Cash Outflow : Rs. Purchase Price of new Machine

10,000

Less : Salvage value of old machine

2,000

Less : Tax saving @ 50% on the loss on sale of old machine

4,000

Net Cash Outflow

4,000

Note : Loss on the sale of old machine is calculated as below : Cost of Old machine

15,000

Less : Depreciation for 5 years

5,000

∴ Written down value (WDV)

10,000

Less : Salvage value

2,000

∴ Loss on sale of old machine

8,000

Calculation of Cash Inflows : Particulars

Savings Difference in amount of depreciation Salvage value

pre-tax Amt. Rs.

Post-tax Amt. Rs.

Years

PV factor @10%

Total PV Rs.

3,000

1,500

1-10

6.145

9,218

(-) 200

(-) 100

1-10

6.145

(-) 615

2,000

2,000

10

0.386

772 9,375

Hence NPV i.e. Rs. 9375 – Rs. 4,000

5,375

As NPV is positive, the company should go for new machine. Note : Assuming that the depreciation is calculated on straight line basis which is acceptable for income tax purposes and that the slavage value of old machine at the end of its life was Rs. Nil, difference in the amount of depreciation is calculated as below :

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Financial Management

Old Machine (Rs.) Cost price Less : Salvage value

Life in years Annual depreciation

New Machine (Rs.)

15,000

10,000

–

2,000

15,000

8,000

15

10

1,000

800

Hence, amount of depreciation will be reduced by Rs. 200 if new machine is purchased. Part B Calculation of cash outflow will remain the same. Calculation of cash inflows : Particulars

Pre-tax Amt. Rs.

Post-tax Amt. Rs.

Years

PV factor @10%

Total PV Rs.

4,500

2,250

1-5

3.791

8,530

Depreciation on new machine

1600

800

1-5

3.791

3,033

Depreciation on old machine

(-) 1,000

(-) 500

1-10

6.145

(-) 3,073

2,000

2,000

5

0.621

1,242

Savings

Salvage value

9,732 Hence NPV is Rs. 9732- Rs. 4,000

5,732

As NPV is positive, the company should go for new machine in the second case also. PLANNING, ORGANIZATION AND CONTROL OF CAPITAL EXPENDITURE It has already been discussed that the various proposals for incurring capital expenditure may be generated either at top management level or even at lower management level though latter is the rare possibility. The various proposals generated are evaluated with the help of various techniques as discussed above. The ultimate selection for proposals depends upon the evaluation made by these techniques, however the factors like urgency or availability of funds may also play important role. The ultimate power to reject or accept various capital expenditure proposals rests with the top management which may be in the form of Board of Directors or Executive Committee or Management Committee. In some cases, the power may rest with the Chairman or Managing Capital Budgeting

339

Director. The proposals involving the outlay to a certain extent may fall within the powers of chief executive also and the proposals involving the outlay beyond that extent will have to be referred to top management as described above. If the actual implementation of the selected proposals involve the arrangement of funds from the financial institutions or require certain Government approvals, it is the responsibility of middle management to arrange for the same. If it is intended to exercise proper control on the capital budgeting process, an organization may be required to take the following steps.

340

(1)

Planning : The capital expenditure has to be planned properly taking into consideration the present and future needs of the business. It should be planned in such a way as to ensure the balanced development of all the sections of the organization individually as well as of the organisation as a whole. Usually, the plans in respect of capital expenditure are prepared in the form of capital expenditure budget. Care should be taken to select the period for which capital expenditure budget should be prepared. Too long a period may not be useful.

(2)

Evaluation : Utmost care should be taken while evaluating the capital expenditure proposals. As the capital expenditure proposals involve long term and irreversible decisions, a wrong decision may disturb the entire financial structure of the organization. The evaluation of various proposals should be done as rationally as possible. Proper weightage should be given to the elements of risk and uncertainly.

(3)

Control over progress : Usually, the implementation of capital expenditure proposals are spread over more than one year. As such proper control is required to be exercised over issue of work orders/purchase orders, acquisition of material, labour force and other assets, supply of funds etc.

(4)

Periodic and post completion audit : These are required to be conducted in order to confirm whether the proposal has been implemented as per the original plan or not. If some faults are pointed out regarding planning process, they may be corrected while considering future projects. If some faults are pointed out during mid-term review of the projects, corrective actions may be taken during the remaining period of implementation.

(5)

Forms and procedures : In order to ensure proper control over capital expenditure, certain forms and procedures may be prescribed. Care should be taken that the said forms are used and procedures are followed at each and every stage of implementation of the capital expenditure proposals.

Financial Management

APPENDIX - I CAPITAL RATIONING The various techniques available with the company for evaluating the capital expenditure proposals facilitate the company to decide which of the projects may be accepted. If the company has sufficient funds to invest in all the acceptable projects, the problem is very simple. However, it may not be the situation in practice. The company may not have enough funds to invest in all the acceptable projects. Or the company may not be willing to acquire necessary funds to invest in all acceptable projects due to the external or internal reasons (E.g. Fixed budget for capital expenditure). Thus, capital rationing refers to a situation where the company has more acceptable proposals requiring a greater amount of funds than is available with the company. As such, under capital rationing, it is not only necessary to decide profitable investments, but it is also necessary to rank the acceptable proposals according to their relative profitabilities. With limited funds, the company must obtain the optimum combination of acceptable investment proposals. The normal process which may be followed under the capital rationing situations may be – (1)

To rank the projects according to some measure of profitability.

(2)

To select projects in the descending order of profitability till the available funds are exhausted.

However, the situation of capital rationing may involve the consideration of other problems also. (1) Project Indivisibility : There may be some projects which cannot be divided while execution. They can be either accepted or rejected in its entirety. These projects cannot be undertaken partially or in pieces. Consider the following situation. The company has the following four acceptable proposals ranked according to Profitability Index Method with the ultimate capital expenditure budget ceiling of Rs. 10,00,000. Project

Projet Cost Rs.

Profitability Index

Ranking

A

5,00,000

1.25

1

B

3,50,000

1.20

2

C

2,50,000

1.18

3

D

1,00,000

1.15

4

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341

According to capital rationing process, projects A and B can be executed completely. Project C is costing Rs. 2,50,000 whereas funds available after the execution of projects A and B is only Rs. 1,50,000. if project C can be either accepted or rejected completely, the problem is how to face such situation? (2) Avoidance of smaller projects : If the process of capital rationing is strictly followed it may result into the exclusion of various smaller projects by larger projects though the smaller projects may be competitively profitable when compared with the larger projects. Consider the following situation. The company has the following four acceptable proposals ranked according to Profitability Index Method with the ultimate capital expenditure budget ceiling of Rs. 10,00,000 Project

Projet Cost Rs.

Profitability Index

Ranking

A

6,50,000

1.26

1

B

3,50,000

1.25

2

C

50,000

1.24

3

D

40,000

1.23

4

If capital rationing process is to be applied strictly, projects A and B will be selected for execution, whereas projects C and D will be rejected though they are equally profitable like projects A and B. (3) Mutually Dependent Project : The projects available before the company may be basically of two types. Firstly, projects may be mutually exclusive i.e. the execution of one project rules out the possibility of execution of other projects e.g. Five different machines are available for a company to carry out a job. If the company decide to purchase one machine, the possibility of purchasing other four machines is ruled out. Secondly, projects may be mutually dependent i.e. the execution of one project depends upon the execution of another project. Now under the capital rationing situation, if sufficient funds are available to invest only in machine A but not in B when investment in both the machines is mutually dependent, then the problem is how to face such situation? (4) Multi Period Projects : There may some projects the execution of which cannot be completed in one accounting period, but their execution is spread over in various accounting periods. In such situations, the constraints of capital rationing are required to be considered over all the subsequent periods also which are required for the execution of the project.

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Financial Management

APPENDIX II CAPITAL BUDGETING AND RISK The various techniques, as discussed above, for evaluating the capital expenditure proposals may be ideally applied in a riskless situation which is a rare possibility. As stated above, the capital budgeting process involves the estimation of various future aspects regarding future cash inflows, life of the project etc. The accuracy of these estimates and hence reliability of investment decisions mainly depends upon the precision in the forecasting of these aspects. Howsoever carefully these aspects are forecast, there is always the possibility that the actual situations may not correspond with these estimates. As such, the term risk with reference to investment decisions may be defined as the variability in the actual returns emanating from a project in future over its working life in relation to the estimated return as forecast at the time of the initial capital budgeting decision. Several mathematical and non-mathematical methods have been developed to consider the risk in capital budgeting decisions. We will consider mainly three methods which are commonly used. (1)

Informal Method :

This method does not follow any mathematical or statistical model to consider the risk factor. This is surely an informal or subjective method, which depends on the knowledge and experience of the evaluator. The standard fixed to consider a project to be risky is strictly internal and is not specified. Illustration : A company has under consideration two mutually exclusive projects for increasing its plant capacity, the management has developed pessimistic, most likely and optimistic estimates of the annual cash flows associated with each project. The estimates are as follows : Project A (Rs.)

Project B (Rs.)

30,000

30,000

Pessimistic

1,200

3,700

Most likely

4,000

4,000

Optimistic

7,000

4,500

Net Investment Cash flow estimates :

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343

(a)

Determine the NPV associated with each estimate given for both the projects. The projects have 20 years life each and the company’s cost of capital is 10%.

(b)

Which project do you consider should be selected by the company and why?

P.V. Factor is 8.514 Solution : Calculation of NPV Pessimistic

Most

Optimistic

1,200

4,000

7,000

Present value of Annual cash flows (At PV factor for 20 years)

10,217

34,056

59,598

Outflow

30,000

30,000

30,000

(-)19,783

4,056

29,598

3,700

4,000

4,500

Present value of Annual cash inflows (At PV factor for 20 years)

31,502

34,056

38,313

Outflow

30,000

30,000

30,000

1,502

4,056

8,313

Project A : Annual cash inflows

NPV Project B : Annual cash inflows

NPV CONCLUSION :

It can be seen from the above calculations that in case of most likely cash inflows, both the projects are equally profitable. However, Project A involves more risk as the variation of NPV in pessimistic conditions and optimistic conditions is more in case of Project A. As such, if risk involved with the projects is considered as the criteria, Project B will be selected. (2)

Risk adjusted discounting rate :

According to this method, the discounting rate is used not only to consider the futurity of the returns from the project but also to consider the risk involved with the project. As such, in this method, the discounting rate is increased in case of projects involving greater risk whereas it is reduced in case of projects involving lesser risk. This can be explained with the help of following illustration.

344

Financial Management

Suppose that following two projects involving outflow of cash of Rs. 1200 generate the cash inflows as below. Year

Project A (Rs.)

Project B (Rs.)

1

800

500

2

700

500

3

300

500

4

150

500

Obviously, Project A is more risky than Project B. As such, the discounting rate of 14% is applied in case of Project A whereas the discounting rate of 10% is applied in case of Project B, the difference of 4% being to take care of risk involved in case of Project A. Thus, the computations of net present value are made as below : Project A : Year

Cash inflows Rs.

PV factor 14%

Total PV Rs.

1

800

0.877

701.60

2

700

0.769

538.30

3

300

0.675

202.50

4.

150

0.592

88.80 1531.20

Less: Outflow NPV

1200.00 331.20

Project B : Years

Cash Inflow

PV factor 10%

1 to 4

500 per year

3.169

Less : Outflow NPV

Total PV Rs. 1,584.50 1,200.00 384.50

As project B involves greater NPV, it will be accepted. This method is advantageous in this sense that it is simple to understand and incorporates the risks attached with the future returns in case of capital expenditure proposals. However, this method certainly suffers from some limitations.

Capital Budgeting

345

(1)

Additional discounting rate is considered to compensate for the risk attached to a project as compared to any other riskless project. How much additional discounting rate will be sufficient to take care of this risk cannot be decided accurately, say with the help of any statistical or mathematical formula. Charging additional discounting rate is a subjective concept to be decided by the evaluator of the proposals.

(2)

This method takes into consideration the risk factor by considering additional discounting rate, however the cash inflows forecasted for the future period are considered without taking into consideration the risk factor. E.g. if the cash inflows of Rs. 50,000 are estimated to be received in a riskless situation, this method assumes that the amount of cash inflows will be the same even in a risky situation. As such, only the discounting rate is increased to take care of risk factor.

(3)

This method presupposes that the investors are not willing to take the risk and may demand the compensation for assuming the risk. However, it ignores the possibility of existence of risk-seekers who may be willing to pay premium for taking the risk.

(3)

Certainty-Equivalent Approach :

According to this method, rather than adjusting the discounting rate to take care of the risk factor, the future cash inflows themselves are adjusted by using the certainty equivalent coefficient which can be calculated as – Certainty Cash Inflows Risky Cash Inflows E.g. cash inflows from a project are expected to be Rs. 25,000, however generation of cash inflow of Rs. 20,000 is most certain. As such, the certainty equivalent coefficient can be computed as Rs. 20,000 = 0.80 Rs. 25,000 Accordingly, depending upon the degree of risk, the certainty equivalent coefficient is decided. Higher the risk, lower the certainty equivalent coefficient and vice versa.

346

Financial Management

To explain this approach, following illustration may be considered. Year

Cash Inflows Rs.

Certainty Equivalent Coefficient

Adjusted Cash Inflows Rs.

PV factor @10%

Total PV Rs.

1

6,000

0.90

5,400

0.909

4,908.60

2

4,000

0.80

3,200

0.826

2,643.20

3

2,000

0.70

1,400

0.751

1,051.40

4

4,000

0.60

2,400

0.683

1,639.20 10,242.40

Less : Outflow NPV

10,000.00 242.40

Illustrative Problems (1)

One of the two machines – A and B – is to be purchased. From the following information, find out which of the two will be more profitable? The average rate of tax may be taken at 50%. Machine A (Rs.)

Machine B (Rs.)

50,000

80,000

4 years

6 years

Rs.

Rs.

1

10,000

8,000

2

15,000

14,000

3

20,000

25, 000

4

15,000

30,000

5

–

18,000

6

–

13,000

Cost of machine Working life Earnings Before Tax: Year

Solution : As the discounting rate is not available, the evaluation of the projects can be made with the help of following methods. (1)

Pay Back Period

(2)

Accounting Rate of Return

Capital Budgeting

347

(1)

Pay Back period Machine A

Machine B

Rs. Cumulative Rs. Cash Outflow

Rs.

Cumulative Rs.

50,000

–

80,000

–

Year 1

10,000

10,000

8,000

8,000

2

13,750

23,750

13,667

21,667

3

16,250

40,000

19,167

40,834

4

13,750

53,750

21,667

62,501

5

–

–

15, 667

78,168

6

–

–

13,000

91,168

Cash Inflows

As such, Pay Back Period for : Machine A – 3 years 9 months (Appr.) Machine B – 5 years 2 months (Appr.) Hence, machine A will be profitable. Working Notes : The cash flows are computed as below. Inflows : before tax Less : Depreciation Less Tax @ 50% Add : Depreciation Depreciation is computed as, Cost of machine Working life in years

348

Financial Management

credit bills/invoices raised by the company. The bank holds the bills as a security till the payment is made by the customer. The entire amount of bill is not paid to the company. The company gets only the present worth of the amount of the bill, the difference between the face value of the bill and the amount of assistance being in the form of discount charges. However, on maturity, bank collects the full amount of bill from the customer. While granting this facility to the company, the bank inevitably satisfies itself about the credit worthiness of the customer and the genuineness of the bill. A fixed limit is stipulated in case of the company, beyond which the bills are not purchased or discounted by the bank. (5)

Working Capital Term Loans : To meet the working capital needs of the company, banks may grant the working capital term loans for a period of 3 to 7 years, payable in yearly or half yearly instalments.

(6)

Packing Credit : This type of assistance may be considered by the bank to take care of specific needs of the company when it receives some export order. Packing credit is a facility given by the bank to enable the company to buy/manufacture the goods to be exported. If the company holds a confirmed export order placed by the overseas buyer or an irrevocable letter of credit in its favour, it can approach the bank for packing credit facility. Basically, packing credit facility may take two forms : i)

Pre-shipment Packing Credit : To take care of needs of the company before the goods are shipped to the overseas buyer.

ii)

Post-shipment Packing Credit : To take care of needs of the company from the shipment of goods to the overseas buyer till the date of collection of dues from him.

Necessarily, both these facilities are short-term facilities. The company may be required to repay the same within a predecided span or out of the export proceeds of the goods exported. (c)

Security for Assistance :

The bank may provide the assistance in any of the modes as stated above. But normally no assistance will be available unless the company offers some security in any of the following forms. 1)

Hypothecation :

Under this mode of security, bank extends the assistance to the company against the security of movable property, usually inventories. Under this mode of security neither the property not the possession of the goods hypothecated is transferred to the bank. But the bank has the right to sell the goods hypothecated to realise the outstanding amount of assistance granted by it to the company.

Working Capital Management

385

2)

Pledge :

Under this mode of security, bank extends the assistance to the company against the security of movable property, usually inventories. But unlike in case of hypothication, possession of the goods is with the Bank and the goods pledged are in the custody of the bank. As such, it is the duty of the bank to take care of the goods in its custody. In case of default on the part of company to repay the amount of assistance, the bank has the right to sell the goods to realise the outstanding amount of assistance. 3)

Lien :

Under this mode of security, the bank has a right to retain the goods belonging to the company until the debt due to the bank is paid. Lien can be of two types. i)

Particular Lien : It is valid till the claims pertaining to specific goods are fully paid.

ii)

General Lien : It is valid till all the dues payable to the bank are paid.

Normally, banks enjoy general Lien. 4)

Mortgage :

This mode of security pertains to immovable properties like land and, buildings. It indicates transfer of legal interest in a specific immovable property as security for the payment of debt. Under this mode, the possession of the property remains with the borrower while the bank gets full legal title there, subject to borrower’s right, to repay the debt. The party who transfers the interest (i.e. the company) is called mortgager and the party in whose favour the interest is so transferred (i.e. the bank) is called mortgagee. CONTROL OVER WORKING CAPITAL : It can be seen from the preceding discussions that the commercial banks play a very significant role in financing working capital needs. These working capital needs used to be met mainly in the form of cash credit facilities and these advances used to be totally security oriented rather than end-use oriented. As such, the units which were able to provide securities to the banks were able to get main chunk of the finances provided by the banks whereas others experienced shortage of inputs, lower capacity utilisation, high cost of production and ultimately threat of closure. Reserve Bank of India has attempted to identify major weaknes in the system of financing of working capital needs by Banks in order to control the same properly. These attempts were mainly in the form of appointment of following committees.

386

(a)

Dahejia committee

(b)

Tandon committee

(c)

Chhore Committee

(d)

Marathe Committee

(e)

Nayak Committee and Vaz Committee Financial Management

(a)

Dahejia Committee :

This committee was appointed in October 1968 to examine the extent to which credit needs of industry and trade are likely to be inflated and how such trends could be checked. Findings : The committee found out that there was a tendency of industry to avail of short term credit from Banks in excess of growth rate in production for inventories in value terms. Secondly, it found out that there was a diversion of short-term bank credit for the acquisition of long term assets. The reason for this is that generally banks granted working capital finance in the form of cash credit, as it was easy to operate. Banks took into consideration security offered by the client rather than assessing financial position of the borrowers. As such, cash credit facilities granted by the banks was not utilised necessarily for short-term purposes. Recommendations : The committee, firstly, recommended that the banks should not only be security oriented, but they should take into consideration total financial position of the client. Secondly, it recommended that all cash credit accounts with banks should be bifurcated in two categories. (i)

Hard core which would represent the minimum level of raw materials, finished goods and stores which any industrial concern is required to hold for maintaining certain level of production and

(ii)

Short-term component which would represent of funds for temporary purposes i.e. Shortterm increase in inventories, tax, dividend and bonus payments etc.

It also suggested that hard core part in case of financially sound companies should be put on a term loan basis subject to repayment schedule. In other cases, borrowers should be asked to arrange for long term funds to replace bank borrowings. In practice, recommendations of the committee had only a marginal effect on the pattern and form of banking. (b)

Tandon Committee :

In August 1975, Reserve Bank of India appointed a study group under the Chairmanship of Mr. P. L. Tandon, to make the study and recommendations on the following issues : (i)

Can the norms be evolved for current assets and for debt equity ratio to ensure minimum dependence on bank finance?

(ii)

How the quantum of bank advances may be determined?

(iii) Can the present manner and style of lending be improved? (iv)

Can an adequate planning, assessment and information system be evolved to ensure a disciplined flow of credit to meet genuine production needs and its proper supervision?

Working Capital Management

387

The observations and recommendations made by the committee can be considered as below : (1)

Norms : The committee suggested the norms for inventory and accounts receivables for as many as 15 industries excluding heavy engineering industry. These norms suggested, represent maximum level of inventory and accounts receivables in each industry. However if the actual levels are less than the suggested norms, it should be continued. The norms were suggested in the following forms : –

For Raw Materials : Consumption in months.

–

For Work in Progress : Cost of production in months.

–

For Finished Goods : Cost of Sales in months.

–

For Receivables : Sales in months.

It was clarified that the norms suggested cannot be absolute or rigid and the deviations from the norms may be allowed under certain circumstances. Further, it suggested that the norms should be reviewed constantly. It was suggested that the industrial borrowers having an aggregate limits of more than Rs. 10/- Lakhs from the Banks should be subjected to these norms initially and later it can be extended even to the small borrowers. (2)

Methods of Borrowings : The committee recommended that the amount of bank credit should not be decided by the capacity of the borrower to offer security to the banks but it should be decided in such a way to supplement the borrower’s resources in carrying a reasonable level of current assets in relation to his production requirement. For this purpose, it introduced the concept of working capital gap i.e. the excess of current assets over current liabilities other than bank borrowings. It further suggested three progressive methods to decide the maximum limits according to which banks should provide the finance. Method I : Under this method, the committee suggested that the Banks should finance maximum to the extent of 75% of working capital gap, remaining 25% should come from long term funds i.e. own funds and term borrowings. Method II : Under this method, the committee suggested, that the borrower should finance 25% of current assets out of long term funds and the banks provide the remaining finance. Method III : Under this method, the committee introduced the concept of core current assets to indicate permanent portion of current assets and suggested that the borrower should finance the entire amount of core current assets and 25% of the balance current assets out of long term funds and the banks may provide the remaining finance.

388

Financial Management

To explain these methods in further details, let us consider the following data : Current Assets

Rs. 400

Core Current Assets

Rs. 100

Current Liabilities

Rs. 80

(Except bank borrowings) The maximum amount of bank finance can be decided as below : Method I Current Assets

400

Less : Current Liabilities (except bank borrowings) Working Capital Gap

80 320

25% of above from Own Sources

80

Maximum Permissible Bank Finance (MPBF) Current Ratio

240 1.25

Method II Current Assets

400

25% of above from Own Sources

100 300

Less : Current Liabilities (except bank borrowings)

80

Working Capital Gap

220

Maximum Permissible Bank Finance (MPBF)

220

Current Ratio

1.33 Method III

Current Assets

400

Less : Core Current Assets from Own Sources

100

Other Current Assets

300

25% of above from Own Sources

75 225

Less : current Liabilities (except bank borrowings) Maximum Permissible Bank Finance (MPBF) Current Ratio

Working Capital Management

80 145 1.77

389

It can be observed from above that the gradual implementation of these methods will reduce the dependence of borrowers on bank finance and improve their current ratio. The committee suggested that the borrowers should be gradually subjected to these methods of borrowings from first to third. However, if the borrower is already in second or third method of lending, he should not be allowed to slip back to first or second method of lending respectively. It was further suggested that if the actual bank borrowings are more than the maximum permissible bank borrowings, the excess should be converted into a term loan to be amortized over a suitable period depending upon the cash generating capacity.

390

(2)

Style of Lending : The committee suggested changes in the manner of financing the borrower. It suggested that the cash credit limit should be bifurcated into two components i.e. Minimum level of borrowing required throughout the year should be financed by way of a term loan and the demand cash credit to take care for fluctuating requirements. It was suggested that both these limits should be reviewed annually and that the term loan component should bear slightly a lower rate of interest so that the borrower will be motivated to use least amount of demand cash credit. The committee also suggested that within overall eligibilities, a part of the limits may be in the form of bill limits (to finance the receivables) rather than in the form of cash credit.

(3)

Credit Information Systems : In order to ensure the receipt of operational data from the borrowers to exercise control over their operations properly, the committee recommended the submission of quarterly reporting system, based on actual as well as estimations, so that the requirements of working capital may be estimated on the basis of production needs. As such, borrowers enjoying total credit limits aggregating Rs. 1 Crore and above were required to submit certain statements in addition to monthly stock statements and projected balance sheet and profit and loss account at the end of the financial year. The working capital limits sanctioned were to be reviewed on annual basis. Within the overall permissible level of borrowing, the day to day operations were to be regulated on the basis of drawing power.

(4)

Follow up, Supervision and Control : In order to assure that the assumptions made while estimating the working capital needs still hold good and that the funds are being utilised for the intended purpose only it was suggested, that there should be proper system of supervision and control. Variations between the projected figures and actuals may be permitted to the extent of 10%, but variations beyond that level will require prior approval. After the end of the year, credit analysis should be done in respect of new advances when the banks should re-examine terms and conditions and should make necessary changes. For the purpose of proper control, it suggested the system of borrower classification in each bank within credit rating scale. Financial Management

(5)

Norms for Capital Structure : As regards the capital structure or debt equity ratio, the committee did not suggest any specific norms. It opined that debt equity relationship is a relative concept and depends on several factors. Instead of suggesting any rigid norms for debt equity ratio, the committee opined that if the trend of debt equity ratio is worse than the medians, the banker should persuade the borrowers to strengthen the equity base as early as possible.

Action Taken by RBI According to the notification of RBI dated 21st August, 1975, RBI accepted some of the main recommendations of the committee. (1)

Norms for Inventories and Receivables : Norms suggested by the committee were accepted and banks were instructed to apply them in case of existing and new borrowers. If the levels of inventories and receivables are found to be excessive than the suggested norms, the matters should be discussed with the borrower. If excessive levels continue without justification, after giving reasonable notice to the borrowers, banks may charge excess interest on that portion which is considered as excessive.

(2)

Coverage : Initially, all the industrial borrowers (including small scale industries) having aggregate banking limits of more than Rs. 10/- Lakhs should be covered, but it should be extended to all borrowers progressively.

(3)

Methods of Borrowing : RBI instructed the banks that all the covered borrowers should be placed in method I as recommended by the committee. However, all those borrowers who are already complying with requirements of Method II should not slip back to Method I. As far as Method III is concerned, RBI has not taken any view. However, in case of the borrowers already in Method II, matter of application of Method III may be decided on case to case basis.

(4)

Style of Credit : As suggested by the committee, instead of granting entire facility by way of cash credit, banks may bifurcate the limit as (i) Term loan to take care of permanent requirement and (ii) fluctuating cash credit. Within the overall limits, bill limits may also be considered.

(5)

Information system : Suggestions made by the committee regarding the information system were accepted by RBI and were made applicable to all the borrowers having the overall banking limits of more than Rs. 1 crore.

(c)

Chhore Committee :

In April 1979, Reserve Bank of India appointed a study group under the chairmanship of Mr. K.B. Chhore to review mainly the system of cash credit management policy by banks.

Working Capital Management

391

The observations and recommendations made by the committee can be discussed as below : (1)

The committee has recommended increasing role of short-term loans and bill finance and curbing the role of cash credit limits.

(2)

The committee has suggested that the borrowers should be required to enhance their own contribution in working capital. As such, they should be placed in Second Method of lending as suggested by Tandon Committee. If the actual borrowings are in excess of maximum permissible borrowings as permitted by Method II, the excess portion should be transferred to Working Capital Term Loan (WCTL) to be repaid by the borrower by half yearly instalments maximum within a period of 5 years. Interest on WCTL should normally be more than interest on cash credit facility.

(3)

The committee has suggested that there should be the attempts to inculcate more discipline and planning consciousness among the borrowers, their needs should be met on the basis of quarterly projections submitted by them. Excess or under utilisation beyond tolerance limit 10% should be treated as irregularity and corrective action should be taken.

(4)

The committee has suggested that the banks should appraise and fix separate limits for normal non-peak levels and also peak levels. It should be done in respect of all borrowers enjoying the banking credit limits of more than Rs. 10 Lakhs.

(5)

The committee suggested that the borrowers should be discouraged from approaching the banks frequently for ad hoc and temporary limits in excess of limits to meet unforeseen contingencies. Requests for such limits should be considered very carefully and should be sanctioned in the form of demand loans or non-operating cash credit limits. Additional interest of 1% p.a. should be charged for such limits.

(d)

Marathe Committee

In 1982, Reserve Bank of India appointed a study group known as Marathe Committee to review the Credit Authorization Scheme (CAS) which was in existence since 1965. Under CAS, the banks were required to take the prior approval of RBI for sanctioning the working capital limits to the borrowers. As per Marathe Committee recommendations, in the year 1988, CAS was replaced by Credit Monitoring Arrangement (CMA) according to which the banks were supposed to report to RBI, sanctions or renewals of the credit limits beyond the prescribed amounts for the post-sanction scrutiny. (e)

Nayak Committee and Vaz Committee :

Recently, RBI has accepted the recommendations made by Nayak Committee. This was with the intention to recognize the contribution made by the SSI Sector to the economy.

392

Financial Management

According to Nayak Committee recommendations, for evaluating working capital requirements of village industries, tiny industries and other SSI units having the total fund based working capital limits up to Rs. 50 Lakhs, the norms for inventory and receivables as suggested by Tandon Committee will not apply. The working capital requirement of these units will be considered to be 25% of their projected turnover (for both new as well as existing units), out of which 20% is supposed to be introduced by the units as their margin money requirements and remaining 80% can be financed by the bank. In other words, there are 4 working capital cycles assumed in every year. Vaz Committee has extended the recommendations of Nayak Committee to all the business organisations. This has also been accepted by RBI. As a result of Nayak Committee and Vaz Committee recommendations, projected turnover of the borrowers is the basis for evaluating the working capital requirement. Out of the projected turnover, 5% is supposed to be introduced by the borrower in the form of own contribution and remaining 20% can be financed by the bank. The requirement of working capital has nothing to do with the level of current assets and current liabilities, which was the basis of Tandon Committee and Chhore Committee recommendations. EVALUATION OF WORKING CAPITAL REQUIREMENTS BY THE BANKS RELAXED With the intention to give greater autonomy to the banks while evaluating working capital requirement, RBI has officially withdrawn the concept of MBPF with effect from 15th April, 1997. As a result of this, now the banks are free to have their own methods for evaluating the working capital requirement of the borrowers. Illustrative Problems ( 1 ) A proforma cost sheet of a company provides the following particulars Elements of cost

Amount per unit

Raw material

80

Direct Labour

30

Overheads

60

Total Cost

170

Profit Selling Price

30 200

The following further particulars are available. Raw materials are in stock for one month. Credit allowed by suppliers is one month. Working Capital Management

393

Credit allowed to customers is two months. Lag in payment of wages 1.5 weeks. Lag in payment of overheads one month. Materials are in process for an average of half month. Finished Goods are in stock for an average of one month. 1/4th of output is sold against cash. Cash in hand and at bank is expected to be Rs. 25,000. You are requested to prepare a statement showing the working capital needed to finance a level of activity of 1,04,000 units of product. You may assume that production is carried on evenly throughout the year. Wages and overheads accrue similarly and a period of 4 weeks is equivalent to a month. Solution : Estimates of Working Capital

Rs.

(A) Current Assets 1)

Raw Material

2000 units X Rs. 80 X 4 weeks

6,40,000

2)

Work in Process

2000 units X Rs. 170 X 2 weeks

6,80,000

3)

Finished Goods

2000 units X Rs. 170 X 4 weeks

13,60,000

4)

Debtors (Cost Equivalent)

1500 units X Rs. 170 X 8 weeks

20,40,000

5)

Cash Balance

25,000 47,45,000

(B) Current Liabilities 1)

Creditors

2000 units X Rs. 80 X 4 weeks

2)

Outstanding wages

2000 units X Rs. 30 X 1.5 weeks

3)

Outstanding Overheads

2000 units X Rs. 60 X 4 weeks

6,40,000 90,000 4,80,000 12,10,000

(C) Net Working Capital Required (A-B)

35,35,000

Working Notes : (1)

394

It is assumed that the total units during the year are distributed over total number 52 weeks. As total units sold during the year are 1,04,000, weekly sales work out to 2,000 units. Financial Management

(2)

Calculation of Debtors : 1/4th of total units are sold in cash. As such, out of weekly sales of 2,000 units, only 1500 units are sold on credit, each unit having the cost of Rs. 170 and the balance is outstanding for 2 months i.e. 8 weeks. As such, amount blocked in debtors works out to 1500 Units X Rs. 170 X 8 weeks i.e. Rs. 20,40,000.

(2)

Calculate the working capital from the following particulars :

(1)

Annual Expenses Wages Stores and Materials Office Salaries

(2)

(3)

(5)

Rs. 12,480 Rs. 2,000

Other Expenses

Rs. 9,600

Average amount of stocks to be maintained Finished goods stock

Rs. 1,000

Material/stores stock

Rs. 1,600

Expenses paid in Advance Rs. 1,600

p.a.

Annual Sales Home Market

Rs. 62,400

Foreign Market

Rs. 15,600

Lag in Payment of Wages

1.5

weeks

Stores and material

1.5

months

Office Salaries

0.5

months

6

months

1.5

months

Rent Other Expenses (6)

Rs. 9,600

Rent

(Quarterly advance) (4)

Rs. 52,000

Credit Allowed to Customers Home Market Foreign Market

Working Capital Management

6

weeks

1.5

weeks

395

Solution : Estimates of Working Capital (A) Current Assets

Rs.

(1)

Finished goods stock

1,000

(2)

Material/Stores stock

1,600

(3)

Debtors : Home Market

Foreign Market

(4)

62400 X 6 52 15600 X 1.5 52

Prepaid Expenses

7,200

450

400 10,650

(B) Current Liabilities Outstanding Expenses Wages

1.5 weeks

1,500

Stores and Material

1.5 months

1,200

Office Salaries

0.5 months

520

Rent Other Expenses

6 months

1,000

1.5 months

1,200 5,420

(C) Net working capital Required (A-B)

5,230

Notes : It is assumed that 52 weeks constitute the year. (3)

Raju Brothers Private Limited sells goods on a gross profit of 25%. Depreciation is considered in cost of production. The following are the annual figures given to you. Rs. Sales (Two month’s credit) Materials consumed (one month’s credit)

4,50,000

Wages paid (one month lag in payment)

3,60,000

Administration expenses (one month lag in payment)

1,20,000

Sales Promotion expenses (paid quarterly in advance) 396

18,00,000

60,000 Financial Management

Rs. Income tax payable in 4 equal instalments of which one falls in the next year.

1,50,000

Cash manufacturing exp. (one month lag in payment)

4,80,000

The company keeps one month’s stock each of raw materials and finished goods. It also keeps Rs. 1,00,000 in cash. You are required to estimate the working capital requirements of the company on cash basis assuming 15% safety margin. Solution : Estimated Working Capital Requirements of Raju Brothers Pvt. Ltd. Rs. (A) Current Assets Sundry Debtors (1/6th of cash cost)

2,45,000

Sales Promotion Expenses (Paid in Advance)

15,000

Stock of Raw Material (Rs. 450,000/12)

37,500

Stock of Finished Goods (Rs. 12,90,000/12)

1,07,500

Cash in hand

1,00,000 5,05,000

(B) Current Liabilities Sundry Creditors (Rs. 4,50,000/12)

37,500

Outstanding Expenses - Wages

30,000

- Manufacturing Expenses

40,000

- Administrative Expenses

10,000

Income Tax Payable

37,500 1,55,000

(C) Working Capital (A-B) Add : 15% Safety Margin Working Capital Requirement

Working Capital Management

3,50,000 52,500 4,02,500

397

Working Notes (1)

Manufacturing Expenses Rs. Sales

18,00,000

Less Gross Profit @ 25% . . . Manufacturing Cost

4,50,000 13,50,000

…A

Known Components of Manufacturing cost are Material

4,50,000

Wages

3,60,000

Cash Manufacturing Expenses . . . Cash Manufacturing Cost

4,80,000 12,90,000

...B

Hence,

(2)

Manufacturing Cost (A)

13,50,000

Less : Cash Manufacturing Cost (B) . . . Depreciation

12,90,000 60,000

Total Cash Cost : Cash Manufacturing Cost (As per B above)

12,90,000

Administrative Expenses

1,20,000

Sales Promotion Expenses . . . Total cash cost

60,000 14,70,000

(3)

Income Tax liability of the company will not be considered as a part of the cost.

(4)

From the following information, make an assessment of working capital required by a firm X & Co. The firm has approached bank A who have agreed to sanction the working capital limits based on the data furnished by the firm. Retaining margins are as under. Raw Materials

–

25%

Stocks in Process

– 33.33%

Finished goods

–

25%

Debtors

–

20%

You are also required to work out the working capital limits proposed to be sanctioned by the bank.

398

Financial Management

Estimates for 1987

Rs.

Monthly Sales

1,00,000

Monthly cost of production

72,000

(including raw material consumption) Monthly raw material consumption

50,000

Envisaged stocking pattern : Raw material

– 1 month

Stock in process

– 15 days

Finished goods

– 15 days

While the firm may extend a credit of 1 month to its customers, it is hopeful of getting 15 days credit from its suppliers. Solution : Statement Showing Requirement of Working Capital (A)

Current Assets

Rs.

Raw Material

50,000

Work in Process

36,000

Finished Goods

36,000

Sundry Debtors

1,00,000 2,22,000

(B)

Current Liabilities Sundry Creditors

(C)

25,000

Working Capital (A - B)

1,97,000

Working Capital Limits Proposed from Bank Security Margin

Margin %

Margin Rs.

Bank Finance Rs.

25%

12,500

37,500

33.33%

12,000

24,000

Finished Goods

25%

9,000

27,000

Sundry Debtors

20%

10,000

40,000

Raw Material Stocks in Process

Working Capital Management

399

(5)

The management of Royal Industries has called for a statement showing the working capital needs to finance a level of activity of 1,80,000 units of output for the year. The cost structure for the company’s product for the above mentioned activity level is detailed below. Cost per Unit (Rs.) Raw Materials

20

Direct Labour

5

Overheads (including depreciation of Rs. 5 per unit)

15 40

Profit

10

Selling Price

50

Additional Information : (a)

Minimum desired cash balance is Rs. 20,000.

(b)

Raw materials are held in stock on an average for two months.

(c)

Work in progress (assume 50% completion stage) will approximate to half a month’s production.

(d)

Finished goods remain in warehouse on an average for a month.

(e)

Suppliers of materials extend a month’s credit and debtors are provided two month’s credit. Cash sales are 25% of total sales.

(f)

There is a time-lag in payment of wages of a month and half and a month in case of overheads.

From the above facts, you are required to

400

(i)

Prepare a statement showing working capital needs.

(ii)

Determine the maximum working capital finance available under first two methods suggested by Tandon Committee :

Financial Management

Solution : Estimated Requirement of Working Capital Rs. (A)

Current Assets Raw Materials

15000 units x Rs. 20 x 2 Mths.

6,00,000

Work-in-Progress

15000 units x Rs. 35 x 1/2 mth.x 1/2

1,31,250

Finished Goods

15000 units x Rs. 35 x 1 Mth.

5,25,000

Sundry Debtors

15000 units x Rs. 35 x 2 Mths. x 75%

7,87,500

Cash Balance

20,000 20,63,750

(B)

Current Liabilities : Sundry Creditors‘

15000 units x Rs. 20 x 1 Mth.

3,00,000

Outstanding Wages

15000 units x Rs. 5 x 1 Mth.

75,000

Outstanding Overheads

15000 units x Rs. 10 x 1/2 Mth.

75,000 4,50,000

(C)

Working Capital (A - B)

16,13,750

Calculation of Maximum Permissible Bank Borrowing (A) Method I : Current Assets Less : Current Liabilities Working Capital Gap Own contribution (i.e. 25% of Working Capital Gap) Maximum Permissible Bank Finance

20,63,750.00 4,50,000.00 16,13,750.00 4,03,437.50 12,10,312.50

(B) Method II : Current Assets Less : Own Contribution (i.e. 25% of Current Assets)

20,63,750.00 5,15,937.50 15,47,812.50

Less : Current Liabilities Maximum Permissible Bank Finance

Working Capital Management

4,50,000.00 10,97,812.50

401

Means of Finance

Current Liabilities Bank Finance Own Contribution

Method I

Method II

4,50,000.00

4,50,000.00

12,10,312.50

10,97,812.50

4,03,437.50

5,15,937.50

20,63,750.00

20,63,750.00

Working Notes : (1)

It is assumed that the year consists of 360 days and that sales are evenly distributed throughout the year. As such, monthly sales will be 15000 units.

(6)

Hi-Tech Ltd. plans to sell 30,000 units next year. The expected cost of goods is as follows. Rs. per unit Raw Material

100

Manufacturing Expenses

30

Selling, Administration and Financial Expenses

20

Selling Price

200

The duration of various stages of the operating cycle is expected to be as follows : Raw Materials Stage Work in Process Stage Finished Goods Stage Debtors Stage

2 months 1 month 1/2 month 1 month

Assuming the monthly sales level of 2500 units :

402

(a)

Calculate the investment in various current assets.

(b)

Estimate the gross working capital requirement if the desired cash balance is 5% of the gross working capital requirement.

Financial Management

Solutions : Calculation of various current assets Rs. (a) (b)

(c)

(d)

Raw Material 2500 units x Rs. 100 x 2 Mths.

5,00,000

Work in Progress (Valued on manufacturing cost only, assuming 50% completion) 2500 units x Rs. 65 x 1 Mth.

1,62,500

Finished Goods (Valued on total cost) 2500 units Rs. 150 x 1/2 Mth.

1,87,500

Sundry Debtors : (Valued on total cost) 2500 units x Rs. 150 x 1 Mth.

3,75,000 12,25,000

Calculation of Gross Working Capital Rs. Raw Material

5,00,000

Work in Progress

1,62,500

Finished Goods

1,87,500

Sundry Debtors

3,75,000

Sub-total Cash Balance

12,25,000 64,474 12,89,474

Working Capital Management

403

QUESTIONS

404

1.

What do you mean by working capital? Why the need for working capital arises for a manufacturing company? State the various factors affecting the requirement of working capital.

2.

How do you calculate the amount of working capital needed by a company? Explain the various sources for financing these working capital needs.

3.

Explain the main recommendations of various committees appointed by Reserve Bank of India to regulate the banks financing working capital needs of a company.

Financial Management

PROBLEMS 1.

Estimate working capital required from the data of Delhi Ltd. Cost price per unit Raw Material

Rs. 40

Labour

Rs. 10

Overheads

Rs. 30

Projected sales

75000 units at

Debtors pay after

Rs. 100 per unit

10 weeks

Creditors are paid after

4 weeks

Raw Material in stock

6 weeks

Finished stock

8 weeks

Production and processing time

4 weeks

Wages are paid once in

4 weeks

Contingency 10% of working capital Assume Cash and Bank Balance 2.

Rs. 1,87,500

You are required to calculate average amount of working capital from the following information. Estimates for year Rs. (a)

(b)

Average amount locked up for — Stock of finished goods

Rs. 5,000

Stock of stores/materials

Rs. 8,000

Average Credit given — Inland sales — 6 weeks credit Export sales — 1.5 week’s credit

3,12,000 78,000

Estimates for year Rs. (c)

Lag in payment of — Wages - 1.5 weeks Stores/materials etc. — 1.5 months

48,000

Rent, Royalties etc. — 6 months

10,000

Staff Salary — 1/2 month

62,400

Manager’s Salary – 1/2 month Miscellaneous Expenses – 1.5 months (d)

2,60,000

4,800 48,000

Payment in advance – Sundry Expenses (Paid Quarterly in advance)

Working Capital Management

8,000

405

3.

Following is the Balance Sheet of M/s Fairdeal & Co. as on 31.3.1970 Liabilities

Rs.

Capital Trade Creditors Profit & Loss A/c

10,00,000 1,40,000 60,000

Assets Fixed Assets Stock Debtors Cash and bank

12,00,000

Rs. 4,00,000 3,00,000 1,50,000 3,50,000 12,00,000

Estimates upto 31.3.1971 are (i)

Purchases

Rs. 15,20,000

(ii)

Sales

Rs. 21,20,000

(iii) Additions to Fixed Assets (Subjected to depreciation @ 10%)

Rs. 1,00,000

Time lag for payment to trade creditors for purchase and receipts from sales is one month. The business earns a gross profit of 30% on turnover. The expenses against gross profits amount to 10% of turnover. The amount of depreciation is not included in these expenses. Draft a Balance Sheet as on 31.3.1971 assuming that creditors are all trade creditors for purchases and debtors for sales and there is no other item of current assets and liabilities other than stock and Cash/Bank balances. 4.

Following details are available in case of a company. Projected Profitability Statement Sales Cost of Sales Material Consumed Wages & Expenses Depreciation Less : Stock of Finished Goods Gross Profit Administration Expenses Selling Expenses

Rs. 21,00,000 Rs. 8,40,000 Rs. 6,25,000 Rs. 2,35,000 Rs. 17,00,000 Rs. 1,70,000 Rs. 15,30,000 Rs. 5,70,000 Rs. 1,40,000 Rs. 1,30,000 Rs. 2,70,000

Profit before tax Provision for tax 406

Rs. 3,00,000 Rs. 1,00,000 Financial Management

The above figures relate only to finished goods and not to work in progress which is equal to 15% of the year’s production in terms of physical units. Work in progress constitutes 100% of material cost and 40% of other expenses. Raw material in stock is for 2 months’ consumption. All expenses are paid one month in arrears. Suppliers of material give 1.5 month’s credit. 20% sales are in cash, rest are at 2 months’ credit. 70% of the income tax to be paid in advance in quarterly instalments. You are required to compute working capital requirements after adding 10% for contingencies. 5.

From the following details, prepare an estimate of the requirement of working capital. Production Selling Price per unit Raw Materials Direct Wages Overheads Materials in hand Production time Finished goods in stores Credit for material Credit allowed to customers Average cash balance

- 60,000 units - Rs. 5 - 60% of selling price - 10% of selling price - 20% of selling price - 2 months’ requirements - 1 month - 3 months - 2 months - 3 months - Rs. 20,000

Wages and overheads are paid at the beginning of the following month. In production, all the required materials are charged in the initial stage and wages and overheads accrue evenly. 6.

From the following details, you are required to make an assessment of the average amount of working capital requirement of Fine Drinks Limited. Average Period of credit Purchase of material Wages Overheads Rent, Rates etc. Salaries Other overheads Sales Credit sales Average amount of stock and work in progress Average amount of undrawn profits

Working Capital Management

Estimate for first year Rs.

6 weeks 1/2 week

26,00,000 19,50,000

6 months 1 month 2 months Cash 2 months

1,00,000 8,00,000 7,50,000 2,00,000 60,00,000 4,00,000 3,00,000

407

It is to be assumed that all expenses and income were made at an even rate for the year. 7.

PQR & Co. have approached their bankers for their working capital requirement who have agreed to sanction the same by retaining the margins as under : Raw Materials

- 20%

Stock-in-process

- 30%

Finished goods

- 25%

Debtors

- 10%

From the following projections for 89-90, you are required to work out – (a)

The working capital required by the company.

(b)

The working capital limits likely to be approved by bankers.

Estimates for 89-90

Rs.

Annual Sales

14,40,000

Cost of Production

12,00,000

Raw Material Purchases Monthly Expenditure

7,05,000 25,000

Anticipated Opening Stock of Raw Materials

1,40,000

Anticipated Closing Stock of Raw Materials

1,25,000

Inventory Norms Raw Material

2 months

Work in Progress

15 days

Finished Goods

1 month

The firm enjoys a credit of 15 days on its purchases and allows one month’s credit on its supplies. On sales orders, the company has received an advance of Rs. 15,000. State your assumptions if any.

408

Financial Management

8.

Following Annual figures relate to XYZ & Co. Rs. Sales (at two months’ credit)

36,00,000

Materials consumed (suppliers extend two months’ credit)

9,00,000

Wages paid (Monthly in areas)

7,20,000

manufacturing expenses outstanding at the end of the year (Cash expenses are paid one month in arrear)

80,000

Total administrative expenses paid as above

2,40,000

Sales promotion expenses, paid quarterly in advance

1,20,000

The company sells its products on gross profit of 25% counting depreciation as part of cost of production and keeps one month’s stock each of raw material and finished goods and a cash balance of Rs. 1,00,000 Assuming 20% safety margin, work out the working capital requirements of the company on cash basis. Ignore work in process.

9.

You are supplied with the following information in respect of XYZ Ltd. for the ensuing year. Production of the year

–

69,000 units

Finished goods in store

–

3 months

Raw material in store

–

2 months’ consumption

Production process

–

1 month

Credit allowed by creditors

–

2 months

Credit given to debtors

–

3 months

Selling price per unit

–

Rs. 50

Raw material

–

50% of selling price

Direct wages

–

10% of selling price

Overheads

–

20% of selling price

There is a regular production and sales cycle and wages and overheads accrue evenly. Wages are paid in the next month of accrual. Material is introduced in the beginning of production cycle.

Working Capital Management

409

You are required to find out :

10

(a)

Its working capital requirement.

(b)

Its permissible bank borrowing as per 1st and 2nd method of lending.

XYZ Cements Ltd. sells its products on a gross profit of 20% on sales. The following information is extracted from its annual accounts for the year ended 31st December, 1989. Rs. in lacs Sales at 3 months’ credit

40.00

Raw Material

12.00

Wages paid - 15 days in arrears

9.60

Manufacturing Expenses paid - One month in arrears

12.00

Administrative Expenses paid - One month in arrears

4.80

Sales Promotion Expenses - Payable half yearly in advance

2.00

The company enjoys one month credit from the suppliers of raw materials and maintains 2 months’ stock of raw materials and one and half months’ finished goods. Cash balance is maintained at Rs. 1,00,000 as a precautionary balance. Assuming a 10% margin, find out the working capital requirements of XYZ Cements Ltd. 11.

The management of Gayatri Ltd. has called for a statement showing the working capital needed to finance a level of activity of 3,00,000 units of output for the year. The cost structure for the company’s product for the above mentioned activity level is detailed below.

Raw materials Direct Labour Overheads

410

Cost per unit Rs. 20 5 15

Total Profit

40 10

Selling Price

50

Financial Management

(a)

Past experience indicates that raw materials are held in stock, on and average, for two months.

(b)

Work in progress (100% complete in regard to materials and 50% for labour and overheads) will approximately be half a month’s production.

(c)

Finished goods remain in warehouse on and average for a month.

(d)

Suppliers of materials extend a month’s credit.

(e)

Two month’s credit is allowed to debtors. Calculation of debtors may be made on selling price.

(f)

A minimum cash balance of Rs. 25,000 is expected to be maintained.

(g)

The production pattern is assumed to be even during the year. Prepare the statement of working capital requirement.

12. Mr. Fairdas wishes to commence a new trading business and has given the following information. (a)

(b)

(c) (d)

(e)

(f)

Annual Expenses (Rs.) Wages Stores & Materials Office salaries Rent Other Expenses Average amount of stock to be maintained (Rs.) Stock of finished goods Stock of materials and stores Expenses paid in advance (Rs.) Quarterly advance Annual sales (Rs.) In the region Out of the region Lag in payment of expenses Wages Stores and materials Office salaries Rent Other expenses Credit allowed to customers In the region Out of the region

78,000 14,400 18,720 3,000 14,400 1500 2400 2400 p.a. 93,600 23,400 1.5 weeks 1.5 months 0.5 months 6 months 1.5 months 6 weeks 1.5 weeks

Calculate his working capital requirement Working Capital Management

411

13. From the following information, prepare a statement in columnal form showing the working capital requirement. Budgeted sales (Rs. 10 per unit) Rs. 2,60,000. Analysis of one rupee of sales

Raw Materials Direct Labour Overheads

Rs. 0.30 0.40 0.20

Total cost Profit

0.90 0.10

Sales

1.00

It is estimated that – (a)

Raw materials are carried in stock for three weeks and finished goods for two weeks.

(b)

Factory processing will take two weeks.

(c)

Suppliers will give full five weeks credit.

(d)

Customers will require eight weeks credit.

It may be assumed that production and overheads accrue evenly throughout the year.

412

Financial Management

NOTES

Working Capital Management

413

NOTES

414

Financial Management

Chapter 12 MANAGEMENT

OF

CASH

Management of cash is one of the most important areas of overall working capital management. This is due to the fact that cash is the most liquid type of current assets. As such, it is the responsibility of the finance function to see that the various functional areas of the business have sufficient cash whenever they require the same. At the same time, it has also to be ensured that the funds are not blocked in the form of idle cash, as the cash remaining idle also involves cost in the form of interest cost and opportunity cost. As such, the management of cash has to find a mean between these two extremes of shortage of cash as well as idle cash. MOTIVES OF HOLDING CASH : A company may hold the cash with the various motives as stated below : (1)

Transaction Motive : The company may be required to make various regular payments like purchases, wages/salaries, various expenses, interest, taxes, dividends etc. for which the company may hold the cash. Similarly, the company may receive the cash basically from its sales operations. However, receipts of the cash and the payments by cash may not always match with each other. In such situations, the company will like to hold the cash to honour the commitments whenever they become due. This requirement of cash balances to meet routine needs is known as transaction motive.

(2)

Precautionary Motive : In addition to the requirement of cash for routine transactions, the company may also require the cash for such purposes which cannot be estimated or foreseen. Eg. There may be a sudden decline in the collection from the customers, there may be a sharp increase in the prices of the raw materials etc. The company may like to hold the cash balance to take care of such contingencies and unforeseen circumstances. This need of cash is known as precautionary motive.

(3)

Speculative Motive : The company may like to hold some reserve kind of cash balance to take the benefit of favourable market conditions of some specific nature. Eg. Purchases of raw material available at low prices on the immediate payment of cash, purchase of securities if interest rates are expected to increase etc. This need to hold the cash for such purposes is known as speculative motive.

Management of Cash

415

ESTIMATING THE CASH REQUIREMENTS As has been discussed in the preceding paragraphs, the company should hold adequate cash balance but should necessarily avoid the excessive balances. For this purpose, basically the company is required to assess its need for cash properly. For this purposes, one of the best tools available with the company is to prepare the cash budget. A cash budget is the statement showing the various estimated sources of cash receipts on one hand and the various applications of cash on another hand. Thus, by preparing the cash budget, the company may predict whether at any point of time there is likely to be excess or shortage of cash. If the shortage of cash is estimated, the company has to arrange the cash from some other source. If the excess of cash is estimated, the company may explore the possibility of investing the cash balance profitably. Before preparing the cash budget, following principles must be kept in mind. (1)

The period for which the cash budget is to be prepared should be selected very carefully. There is no fixed rule as to the period to be covered by the cash budget. It depends on company and individual circumstances. As a general rule, the period to be covered by cash budget should neither be too long nor too short. If it is too long, it is possible that the estimates will be inaccurate. If it is short, the areas which are beyond the control of the company will not be given due consideration.

(2)

The items which should appear in the cash budget should be carefully decided. Naturally, all those items which do not have bearing on the cash flows will not be considered while preparing the cash budget. Eg. As the cost in the form of depreciation does not involve any cash outflow, it does not affect the cash budget, though the amount of depreciation affects the determination of the tax liability which involves cash outflow. While preparing the cash budget, the various items appearing in the same may be classified under the following two categories.

416

(i)

Operating cash flows : These are the items of cash flow which arise as the result of regular operations of the business.

(ii)

Non-Operating cash flows : These are the items of cash flow which arise as the result of other operations of the business.

Financial Management

The standard items which may appear on a standard cash budget may be stated as below. Cash Inflow

Cash Outflow

Operating

Operating

Cash Sales

Payment to creditors

Collection from debtors

Purchases of raw material

Interest/Dividend Received

Wages/Salaries Various kinds of overheads

Non-Operating

Non-Operating

Issue of shares/debentures

Redemption of shares/debentures

Receipt of loans/borrowings

Loan Instalments

Sale of Fixed Assets

Purchase of Fixed Assets Interest Taxes Dividends

PRINCIPLES OF CASH MANAGEMENT : The basic objective of cash management is to reduce the operating cash requirement to the minimum possible extent without affecting the routine transactions. In particular, the objectives of cash management can be stated as below : (a)

Accelerate the cash collections.

(b)

Delay the cash payments.

(c)

Maintenance of optimum cash balance.

(d)

Investment of excess cash available.

CONCEPT OF FLOAT In absolutely non-technical language Float indicates the difference between the bank balance as per the bank book and as per the bank pass book/bank statement. This float arises mainly due to the fact that there is always a time gap between the time a cheque is written by the company and the time when it is presented to the bank for payment or there is a time gap between the time when a cheque is deposited by the company in the bank and the time when the credit is actually given by the bank to the company. This time gap may arise due to various reasons. (a)

Time required for receiving the cheque from the customer through the post office. This is called postal float.

Management of Cash

417

(b)

Time required by the company to process the received cheque and deposit the same in the bank. This is called deposit float.

(c)

Time required by the banker of the company to collect the payment from the customers’ bank. This is called bank float.

This concept of float can be illustrated with the help of the following example. Suppose that company A of Calcutta has to make a payment to company B of Pune for Rs. 10,000 towards certain purchases made by company of A from company B. Accordingly, company A draws a cheque in favour of company B on 1st June, 1993. This cheque is sent by company A by Registered A.D. and it is physically received by company B on 8th June, 1993. After company B receives the cheque, it completes the various administrative formalities and deposits the cheque in its bank account on 12th June, 1993. Company B’s bank sends the cheque to company A’s bank for collection and after getting the advice from company A’s bank, finally credits company B’s account with Rs. 10,000 on 20th June, 1993. Now, the various concepts of float can be stated as below. 1st June, 93 to 8th June, 93

– Postal Float

8th June, 93 to 12th June, 93

– Deposit float

12th June, 93 to 20th June, 93

– Bank Float

From the paying company’s point of view, attempts should be made to increase these various types of floats as much as possible. From the receiving company’s point of view, attempts should be made to decrease these various types of floats as much as possible. Now, in the light of discussions regarding the concept of float, we will discuss the principles of cash management. (a)

Accelerate Cash Collections : This can be done with the help of following techniques.

418

(1)

As far as possible insist upon the payment from the customer in the safe modes like demand drafts, letters of credit, preaccepted hundies/bills of exchange etc. This may reduce the bank float.

(2)

In order to ensure the prompt payment from customers, self-addressed envelope can be sent along with the bill/invoice itself. Allowing the cash discounts is the best possible way to induce the customer to make prompt payments.

(3)

In case of the outstation customers, faster means of communications can be used so as to reduce the postal float to the minimum possible extent. Eg. Courier Services, Speed Post etc.

Financial Management

(4)

Decentralised Collection : In case of the company which has the branches at different places, the company can establish the decentralised collection centres. The customers in a certain area are required to make the payment at the local collection centre and the cheques collected by the local collection centre are deposited in the local bank account. The balance in the local bank account beyond a predetermined level may be transferred to the central or head office bank account at periodic intervals. The decentralised collections may be useful for reducing the postal float as well as bank float.

(5)

Lock Box System : Under this arrangement, the company hires a post office box at important collection centres. The customers are instructed to make the payment directly to the lock box. The local bankers of the company are authorised to pick up the cheques from the lock box. After crediting the cheques to the company’s account, the bank informs the company about the details of cheques credited. The lock box systems reduces the postal float as well as bank float. The clerical work of handling the cheques before deposits is performed by the banker and the process of collection of cheques can be started immediately on the receipt of cheque from the customer.

It should be noted in this connection that both the above systems of decentralised collections as well as lock box system, help to reduce deposit float but at the same it involves cost. Before taking any decision in this connection, it is necessary to carry out a cost-benefit analysis to ensure that the funds released due to speedy collections justify the additional costs. (b)

Delay cash payments : This can be done with the help of following techniques. (1)

Payments can be made from a bank which is distant from the bank of the company to which payment is to be made. This may increase the postal float and bank float.

(2)

Attempts should be made by the company to get the maximum credit for the goods or service supplied to it. Eg. In case of wages payable to the workers, the company gets the services in advance which are to be paid for later. Thus, they provide the credit to the company for the period after which they are paid, say a week or a month. As such, if the company can make monthly payment of wages rather than weekly payment of wages, it can enjoy extended credit, slow down the payments and reduce the requirement of operating cash balance.

(3)

Avoid Early Payments : If according to the terms of credit available to the company, it is required to make the payment within the stipulated period, it should not make the payment before the specified date unless the company is entitled to cash discounts. The delay in making the payment beyond the stipulated time may affect the credit standing of company.

Management of Cash

419

(c)

(4)

Centralised Disbursements : Under this methods, the payments are made by the Head Office of company from its central bank account. This involves the benefits mainly in three respects as compared to decentralised payments. Firstly, it increases the transit time. Eg. If the creditor at Madras is to be paid out of the Central bank account of the company in Delhi, it increases the postal float as well as the bank float, which is ultimately beneficial for the company. Secondly if the company decides to make decentralised payments by maintaining various bank accounts at various branches, it will be necessary for it to maintain minimum cash balance at all these bank accounts, whereas in case of centralised disbursement system, the problem of maintaining minimum cash balance will be only in case of central bank account. Thirdly, to maintain the bank accounts at different branches may prove to be administratively difficult.

(5)

In case of a company operating on decentralised basis, the arrangements can be made in such a way that the local branches are authorised to deposit the cheques in the local bank accounts but are not authorised to withdraw the amounts from there. This facilitates speedy collections as well as ensures proper control over the disbursements from the bank accounts.

(6)

It may not be necessary for the company to arrange for the funds immediately after it issues the cheque. If it is possible to analyse the time lag in the issue of cheque and their presentation for payment, which is possible on the basis of past experience, the company may make arrangements for funds only on the expected date of presentation of cheque for payment.

Maintenance of optimum cash balance : As stated earlier, maintenance of cash balance which is more than requirement as well as less than requirement involves the consequences. As such, one of the basic objectives of cash management is to maintain the optimum cash balance. One of the tools available to the company to ensure the maintenance of optimum cash balance is to prepare the cash budget. By preparing the cash budget in a proper way, the company can have an idea in advance of the timing and quantum of excess availability of cash or shortage of cash. Accordingly, the company can take the decision of investment of excess cash on short term basis (in case of excess cash available) or to meet the shortfall (in case of shortage of cash).

(d)

Investment of excess cash balance : As stated earlier, one of the basic objectives of cash management is to optimise the investment in cash. The company cannot afford to keep the excess cash balance idle as it involves the opportunity cost. As such, one of the basic objectives of cash management requires the company to think about the possibility of investing the excess cash balance on short term basis.

420

Financial Management

The avenues available to the company to invest the excess cash balance on short term basis may be in various forms. Eg. Inter-corporate loans/deposits, inter-corporate bills discounting, stock market operations, commercial paper, bank deposits etc. However, the final selection of the avenue for investing the cash balance may depend upon various factors. (1)

Return – The basic factor affecting any investment decision is essentially in the form of return on investment. Higher the return, better the investment.

(2)

Risk – Risk and return always go hand in hand. High return investments may involve high risk. While selecting the investment yielding high return, the company should take into consideration the risk involved with the proposition.

(3)

Liquidity – In some cases, due to unexpected cash needs, it may be necessary to sell the investment before maturity. Under these circumstances, liquidity associated with the investment becomes an important criteria to formulate the investment policy.

(4)

Legal requirements – Some organisations may be subjected to certain legal requirements before they can select their investment portfolio. Eg. Public charitable trusts, co-operative societies etc. These organisations are required to invest their funds in certain specified forms.

ILLUSTRATIVE PROBLEMS (1)

A Private Limited Company is formed to take over a running business. It has decided to raise Rs. 55 lakhs by issue of Equity Shares and the balance of the capital required in the first six months is to be financed by a financial institution against an issue for Rs. 5 lakhs, 8% Debentures (Interest payable annually) in its favour. Initial outlay consists of : Freehold premises

Rs. 25 Lakhs

Plant & Machinery

Rs. 10 Lakhs

Stock

Rs. 6 Lakhs

Vehicle & Other items

Rs. 5 Lakhs

Payments on the above items are to be made in the month of incorporation. Sales during the first 6 months ending on 30th June are estimated as under : January

Rs. 14 Lakhs

April

Rs. 25 Lakhs

February

Rs. 15 Lakhs

May

Rs. 26.50 Lakhs

March

Rs. 18.50 Lakhs

June

Rs. 28 Lakhs

Lag in payment

– Debtors 2 Months – Creditors 1 Month

Management of Cash

421

OTHER INFORMATION : (1)

Preliminary expenses Rs. 50,000 (Payable in February)

(2)

General Expenses Rs. 50,000 p.m. (Payable at the end of each month).

(3)

Monthly wages (Payable on 1st day of next month) Rs.80,000 p.m. for first 3 months and Rs. 95,000 p.m. thereafter.

(4)

Gross profit rate is expected to be 20% on sales.

(5)

The shares and debentures are to be issued on 1st January.

(6)

The stock levels throughout is to be the same as the outlay.

Prepare cash budget for the 6 months ended 30th June. Solution : Cash Budget (For 6 months ending 30th June) Rs. In Lakhs Jan.

Feb.

Mar.

Apr.

May

June

55.00

–

–

–

–

–

5.00

–

–

–

–

–

–

–

14.00

15.50

18.50

25.00

60.00

–

14.00

15.00

18.50

25.00

Fixed Assets

40.00

–

–

–

–

–

Stock (Initial)

6.00

–

–

–

–

–

Preliminary Expenses

–

0.50

–

–

–

–

Sundry Creditors

–

10.40

11.20

14.00

19.05

20.25

0.50

0.50

0.50

0.50

0.50

0.50

–

0.80

0.80

0.80

0.95

0.95

46.50

12.20

12.50

15.30

20.50

21.70

13.50

(12.20)

1.50

(0.30)

(2.00)

3.30

–

13.50

1.30

2.80

2.50

0.50

+ Surplus for the month

13.50

(12.20)

1.50

(0.30)

(2.00)

3.30

Closing Balance

13.50

1.30

2.80

2.50

0.50

3.80

(A) Cash Inflow Issue of shares Issue of Debentures Collection from Debtors

(B) Cash Outflow

General Expenses Wages

(C) Net Cash Inflows i.e. (A – B) Opening Balance

422

Financial Management

Working Notes : (1)

It is assumed that the company is incorporated in January.

(2)

Assuming that the company is carrying on manufacturing operations, the purchases say for the month of January are computed as below: Sales of January

14.00

Less Gross Profit @ 20%

2.80

Cost of goods sold

11.20

Less wages for January

0.80

Purchases (3)

10.40

A newly started company ‘Green Co. Ltd.’ wishes to prepare cash budget from January. Prepare a cash budget for the first 6 months from the following estimated revenue and expenditure. Overheads Production Month

Selling Distribution Rs.

Total Sales Rs.

Material Rs.

Wages Rs.

Rs.

Jan.

20,000

20,000

4,000

3,200

800

Feb.

22,000

14,000

4,400

3,300

900

Mar.

24,000

14,000

4,600

3,300

800

Apr.

26,000

12,000

4,600

3,400

900

May

28,000

12,000

4,800

3,500

900

June

30,000

16,000

4,800

3,600

1,000

Cash balance on 1st January was Rs. 10,000 A new machine is to be installed at Rs. 30,000 on credit, to be repaid by two equal instalments in March and April. Sales Commission @ 5% on total sales is to be paid within the month following actual sales. Rs. 10,000 being the amount of second call may be received in March. Share premium amounting to Rs. 2,000 is also obtainable with 2nd call. Period of credit allowed by suppliers

2 months

Period of credit allowed to customers

1 month

Delay in payment of overheads

1 month

Delay in payment of wages

½ month

Assume cash sales to be 50% of total sales. Management of Cash

423

Solution : Cash Budget of Green Co. Ltd. Jan.

Feb.

Mar.

Apr.

May

June

10,000

11,000

12,000

13,000

14,000

15,000

Collection from Debtors

–

10,000

11,000

12,000

13,000

14,000

Share Capital (2nd Call)

–

–

10,000

–

–

–

Share Premium

–

–

2,000

–

–

–

10,000

21,000

35,000

25,000

27,000

29,000

–

–

20,000

14,000 14,000

12,000

2,000

2,200

2,300

2,300

2,400

2,400

For last month

–

2,000

2,200

2,300

2,300

2,400

Production overheads

–

3,200

3,300

3,300

3,400

3,500

–

800

900

800

900

900

Purchased

–

–

15,000

15,000

–

–

Sales Commission

–

1,000

1,100

1,200

1,300

1,400

2,000

9,200

44,800

38,900 24,300

22,600

8,000

11,800

10,000

18,000

29,800

8,000

11,800

18,000

29,800

(A) Cash Inflow Cash sales

(B) Cash Outflows Sundry Creditors Wage For current month

Selling & Distribution overheads Instalment for Machine

(C) Net Cash Inflows or Outflows (A-B) Opening Cash balance + Surplus for month Closing cash balance (3)

2,700

6,400

20,000

6,100

8,800

(-)9,800

(-)13,900

2,700

6,400

20,000

6,100

8,800

15,200

Prepare a cash budget for the quarter ended 30th September, 1987 based on the following information. Cash at bank on 1st July, 1987

Rs. 25,000

Salaries and Wages estimated monthly

Rs. 10,000

Interest Payable – August 1987

424

(-)9,800 (-) 13,900

Rs. 5,000

Financial Management

June Rs.

July Rs.

August Rs.

September Rs.

–

1,40,000

1,52,000

1,21,000

Credit Sales

1,00,000

80,000

1,40,000

1,20,000

Purchases

1,60,000

1,70,000

2,40,000

1,80,000

–

20,000

22,000

21,000

Estimated cash sales

Other expenses (Payable in same month)

Credit sales are collected 50% in the month of sales made and 50% in the month following. Collection from credit sales are subject to 5% discount if payment is received in the month of sales and 2.5% if payment is received in the following month. Creditors are paid either on a prompt or 30 days basis. It is estimated that 10% of the creditors are in the prompt category. Solution : Cash Budget (For Quarter ending September 1987) July Rs.

August Rs.

September Rs.

1,40,000

1,52,000

1,21,000

Last Month

48,750

39,000

68,250

Current Month

38,000

66,500

57,000

2,26,750

2,57,500

2,46,250

17,000

24,000

18,000

1,44,000

1,53,000

2,16,000

Salaries & Wages

10,000

10,000

10,000

Other Expenses

20,000

22,000

21,000

–

5,000

–

1,91,000

2,14,000

2,65,000

35,750

43,500

(18,750)

Opening Balance

25,000

60,750

1,04,250

+ Surplus for the month

35,750

43,500

(18,750)

Closing Balance

60,750

1,04,250

85,500

(A) Cash Inflows Cash Sales Collection from Debtors

(B) Cash Outflows Sundry Creditors Prompt Basis Others

Interest (C) Net Cash Inflows (A-B)

Management of Cash

425

WORKING NOTES : It is assumed that salaries and wages are paid in the same month. (4)

From the following information you are required to prepare a cash budget for six months from January 1987 to June 1987, month by month, showing also the cash credit facility available from the Bank. Opening overdrawn balance is Rs. 1,50,000. Wages

Sales Rs.

Materials Purchases Rs.

January

1,44,000

50,000

20,000

12,000

8,000

3,000

February

1,94,000

62,000

24,200

12,600

10,000

3,400

March

1,72,000

51,000

21,200

12,000

11,000

4,000

April

1,77,200

61,200

50,000

13,000

13,400

4,400

May

2,05,000

74,000

44,000

16,000

17,000

5,000

June

2,17,400

77,600

46,000

16,400

18,000

5,000

Month

Rs.

Production Selling Expenses Expenses Rs. Rs.

Office Expenses Rs.

Following further information is available.

426

(1)

Out of total sales 50% are cash sales and balance 50% is received in the month following month of sale.

(2)

Payment for purchase of assets is to be made of Rs. 16,000 in February, Rs. 25,000 in March and Rs. 50,000 in April.

(3)

Proceeds from sale of scrap are to be received in May, amounting to Rs. 6,000.

(4)

Dividend of Rs. 90,000 is to be paid in June.

(5)

Sales commission is to be paid at 3% of total sales in same month in which sales are made.

(6)

Suppliers for materials are paid in the month following the month of purchases of materials.

(7)

Cash credit facility granted is Rs. 2,00,000.

(8)

Wages are paid in the same month.

(9)

Creditors of Production, Selling and Office Expenses are given one month’s credit period.

Financial Management

Solution : Cash Budget for six months ending June 1987 Jan. 87

Feb. 87

Mar. 87

Apr. 87

May 87

June 87

72,000

97,000

86,000

88,600

1,02,500

1,08,700

Collection from debtors

–

72,000

97,000

86,000

88,600

1,02,500

Sale of Scrap

–

–

–

–

6,000

–

72,000

1,69,000

1,83,000 1,74,600

1,97,100

2,11,200

–

50,000

62,000

51,000

61,200

74,000

20,000

24,200

21,200

50,000

44,000

46,000

Production Expenses

–

12,000

12,600

12,000

13,000

16,000

Selling & Dist. Expenses

–

8,000

10,000

11,000

13,400

17,000

Admn. Expenses

–

3,000

3,400

4,000

4,400

5,000

Purchases of Assets

–

16,000

25,000

50,000

–

–

Dividend

–

–

–

–

–

90,000

4,320

5,820

5,160

5,316

6,150

6,522

24,320

1,19,020

1,39,360 1,83,316

1,42,150

2,54,522

47,680

49,980

43,640

(-)8,716

54,950

(-)43,322

1,50,000

1,02,320

52,340

8,700

17,416

(-)37,534

+ Surplus/Deficit for the month 47,680

49,980

43,640

(-)8,716

54,950

(-)43,322

Closing overdrawing

52,340

8,700

17,416 (-)37,534

5,788

(A) Cash Inflow Cash Sales

(B) Cash Outflow Creditors Materials Wages

Sales Commission

(C) Net Cash Inflows/ Outflows (A-B) Opening overdrawing

Management of Cash

1,02,320

427

Note : Even though, the cash credit facility is granted to the extent of Rs. 2,00,000 the company is not likely to utilise it fully. At the end of June 1987, the overdrawn balance is likely to be only Rs. 5,788. (5)

ABC Co. Ltd. wishes to arrange overdraft facilities with its bankers during the period April to June 1987 when it will be manufacturing mostly for stock. Prepare a cash budget for the above period from the following data, indicating the extent of the bank facility the company will require at the end of each month. Month

Sales Rs.

Purchases Rs.

Wages Rs.

February

1,80,000

1,24,800

12,000

March

1,92,000

1,44,000

14,000

April

1,08,000

2,43,000

11,000

May

1,74,000

2,46,000

10,000

June

1,26,000

2,68,000

15,000

Additional Information : (1)

All sales are credit sales, 50% of credit sales are realised in the month following the sales and the remaining 50% in the second month following.

(2)

Creditors are paid in the month following the month of purchases.

(3)

Cash at Bank on 1.4.87 (Estimated) Rs. 25,000.

Solution : Cash Budget of ABC Co. Ltd. April 87

May 87

June 87

First 50%

96,000

54,000

87,000

Second 50%

90,000

96,000

54,000

1,86,000

1,50,000

1,41,000

(A) Cash Inflows Sundry Debtors

428

Financial Management

April 87

May 87

June 87

1,44,000

2,43,000

2,46,000

11,000

10,000

15,000

1,55,000

2,53,000

2,61,000

31,000

(-) 1,03,000

(-) 1,20,000

Opening cash balance

25,000

56,000

(-) 47,000

+ Surplus/Deficit for the month

31,000

(-) 1,03,000

(-) 1,20,000

Closing cash balance

56,000

(-) 47,000

(-) 1,67,000

(B) Cash Outflows Sundry Creditors Wages

(C) Net Cash Inflows or Outflows (A-B) (D) Estimated Cash surplus or shortage

Note : It can be seen that the company will be required to arrange for the bank finance of Rs. 47,000 at the end of May 1987 and an additional amount of Rs. 1,20,000 at the end of June 1987.

Management of Cash

429

QUESTIONS

430

1.

Explain the various motives for holding the cash.

2.

Explain the various principles to be followed for managing the cash in a very big size organisation having the branches all over the country.

Financial Management

PROBLEMS (1)

From the following budgeted data of ABC Ltd. prepare cash budget for the quarter ending 31st December, 1984. Month

Sales

Purchases

Wages

Misc. Exp.

August

1,20,000

84,000

10,000

7,000

September

1,30,000

1,00,000

12,000

8,000

80,000

1,04,000

8,000

6,000

November

1,16,000

1,06,000

10,000

12,000

December

88,000

80,000

8,000

6,000

October

Additional Information : Cash on hand on 1.10.84 : Rs. 5,000 Sales : 20% realised in the month of sale, discount allowed 2%, balance realised in 2 subsequent months. Purchases : These are paid in the following month of supply. Wages : 25% in arrears paid in the following month Misc. expenses : paid a month in arrears Rent : Rs. 1000 per month paid quarterly in advance due to October. Income Tax : Instalments of Rs. 25,000 due on or before 15.12.84 Income from investment : Rs. 5,000 received quarterly April, July, Oct. etc. Insurance claim : Rs. 72,936 receivable in December. (2)

A firm expects to have Rs. 30,000 in Bank on 1.10.86 and requires you to prepare an estimate of cash position during the three months October 86 to December 86. The following information is supplied to you. Wages Month

Sales Purchases Rs.

Factory

Office

Selling

Exp.

Exp.

Exp.

Rs.

Rs.

Rs.

Rs.

Rs.

August

40,000

24,000

6,000

3,000

4,000

3,000

September

46,000

28,000

6,500

3,500

4,000

3,500

October

50,000

32,000

6,500

4,000

4,000

3,500

November

72,000

36,000

7,000

4,000

4,000

4,000

December

84,000

40,000

7,250

4,250

4,000

4,000

Management of Cash

431

Other information :

(3)

(1)

25% of the sales are for cash, remaining amount in the month following that of sale.

(2)

Suppliers supply goods at 2 months’ credit.

(3)

Delay in the payment of wages and all other expenses is one month.

(4)

Income Tax of Rs. 10,000 is due to be paid in December.

(5)

Preference shares dividend of 10% on Rs. 1,00,000 is to be paid in October.

Following details are available in case of Pam Industries Ltd. Actual Sales (Rs.)

Estimated Sales (Rs.)

January

75,000

May

1,05,000

February

80,000

June

1,20,000

March

90,000

July

1,50,000

August

1,60,000

April

1,00,000

Consider the following additional information : (1)

Cash sales are 50 per cent of the total sales. The remaining 50 per cent will be collected equally during the following two months.

(2)

Cost of goods manufactured is 70 per cent of sales. 90 per cent of this cost is paid during the first month after incurrence and the balance is paid in the following month.

(3)

Sales and administrative expenses are Rs. 15,000 per month plus 10 per cent of sales. All these expenses are paid during the month of incurrence.

(4)

Half-yearly interest of 6 per cent on Rs. 4,50,000 debenture is paid during July.

(5)

Rs. 60,000 are expected to be invested in fixed assets during June.

(6)

A dividend of Rs. 15,000 will be paid in July.

(7)

An Income tax of Rs. 15,000 will be paid in July.

It is the policy of the company to have a minimum cash balance of Rs. 30,000/-. Accordingly as on 30th April the actual cash balance was Rs. 30,000/-. The Management wishes to know whether it will be required to borrow during the quarter ending on 31st July and if so when and how much?

432

Financial Management

(4)

A company has its cost of goods of 70% of its sales, 70% of this cost is paid in the month of the sale and the balance in the next month. Salary and administrative expenses amount to Rs. 40,000 per month plus 5% of sales. These expenses must be paid during the month following the month when expenses are actually incurred. The company has also 10% Debentures of Rs. 1,50,000 and interest has to be paid in 4 quarters from January onwards. The company gives its actual and forecast sales as below. Actual Sales

Rs.

Forecast Sales

Rs.

January

2,00,000

May

2,00,000

February

2,00,000

June

2,50,000

March

3,00,000

July

2,50,000

April

3,00,000

August

3,00,000

You are required to prepare a cash budget for six months from March onwards. (5)

Prepare a cash budget for the three months ending 30th June, 1986 from the information given below. (a)

(b)

Month

Sales

Materials

Wages

Overheads

February

14,000

9,600

3,000

1,700

March

15,000

9,000

3,000

1,900

April

16,000

9,200

3,200

2,000

May

17,000

10,000

3,600

2,200

June

18,000

10,400

4,000

2,300

Credit terms are : Sales/Debtors – 10% of sales are on cash, 50% of the credit sales are collected next month and balance in the month following. Creditors –

Materials

–

2 months

Wages

–

1/4 month

Overheads

–

½ month

(c)

Cash and Bank balance on 1st April, 1986 is expected to be Rs. 6,000.

(d)

Other relevant information : (i)

Plant and Machinery will be installed in February 1986 at a cost of Rs. 96,000. The monthly instalments of Rs. 2,000 is payable from April onwards.

Management of Cash

433

(ii)

Dividend @5% on preference share capital of Rs. 2,00,000 will be paid on 1st June.

(iii) Advance to be received for sale of vehicle Rs. 9,000 in June.

(6)

(iv)

Dividends from investment amounting to Rs. 1,000 expected to be received in June.

(v)

Income Tax advance is to be paid in June – Rs. 2,000.

Anand & Co. has furnished the following information. Based on this, prepare a cash budget for three months – June 87, July 87 and August 87. Month

Sales

Materials

Wages

Production Exp.

Office & Selling Exp.

June 87

72,000

25,000

10,000

6,000

5,500

July 87

97,000

31,000

12,100

6,300

6,700

August 87

86,000

25,500

10,600

6,000

7,500

Assumptions : (a) (b) (c) (d) (e) (f) (7)

Lal and Company has given the forecast sales of January 1989 to July 1989 and actual sales for November and December 1988 as under. With the other particulars given, prepare a cash budget for the five months i.e. from January 1989 to May 1989. (1)

434

Cash balance in hand on 1.6.87 – Rs. 72,500. 50% of sales are cash sales. A fixed asset has to be purchased for Rs. 8,000 in July 87. Debtors are allowed one month’s credit. Creditors for materials grant one month’s credit. Sales commission @3% on sales is paid to the salesman each month.

Sales

Rs. in lakhs

1988 –

November December

1.60 1.40

1989 –

January February March April May June July

1.60 2.00 1.60 2.00 1.80 2.40 2.00

Financial Management

(2)

Sales 20% cash, 80% credit, payable in the third month (January sales in March etc.)

(3)

Variable expenses 5% on turnover, time lag half month.

(4)

Commission 5% of credit sales, payable in the third month.

(5)

Purchases, 60% of the sales of the third month, payment will be made on 3rd month of purchases.

(6)

Rent and other expenses Rs. 6,000 paid every month.

(7)

Other payments : Fixed assets purchases Taxes

(8)

– –

March April

– –

Rs. 1,00,000 Rs. 40,000

Opening cash balance Rs. 50,000.

Management of Cash

435

NOTES

436

Financial Management

Chapter 13 MANAGEMENT OF RECEIVABLES

Receivables or Debtors as Current Assets get created on account of the credit sales made by the company i.e. the company makes the sales to the customers but the customers do not make the payment immediately. Even if the customers do not pay the cash immediately, the company has to make credit sales to the customers in order to face the competition and also to attract the new and potential customers to buy the goods or services from the company. OBJECTS OF MANAGEMENT OF RECEIVABLES As in case of general objective of working capital management, the receivables management is also to achieve a trade off between the risk and profitability. The aim of receivables management is to ensure optimum investment in receivables i.e. the investment in receivables should be neither less nor more. If the objective of the company is to reduce the investment in receivables to the minimum extent, the company will not make any credit sales at all, as receivables is the result of credit sales made by the company. This will reduce the investment in receivables, but the company will suffer in terms of profitability as the customers will not buy from the company, particularly if the competitors offer the credit to the customers. On the other hand, if the company makes credit sales to the customers in order to increase the sales and profitability, the company may be accepting the risk of bad debts, more collection efforts etc. As such, the objective of receivables management is to increase the credit sales to such an extent that the risk of non-recoverable dues is reasonable and within control. As in case of any other financial decisions, decisions regarding the receivables management also involve the cost benefit analysis. Costs associated with the receivables management may be in the form of credit administration costs, cost of bad debts and opportunity cost of funds blocked in receivables. Benefits associated with the receivable management are naturally in the form of profits from the sales made on credit basis. An effective receivables management policy tries to increase the credit sales to such an extent that the profits arising therefrom are more than the costs attached to it.

Management of Receivables

437

FLOAT IN RECEIVABLES MANAGEMENT The concept of float can be extended to the receivables management as well. The time gaps in the receivables management can be in the following forms – a)

Frequency of period of service at which invoices or bills are raised in favour of the customers.

b)

Administrative delay for raising the invoices or bills in favour of the customers.

c)

Period of credit offered to the customers.

An effective receivables management will target at reducing these time gaps to the maximum possible extent. From this angle, following propositions should be remembered – a.

If the bills or invoices are raised in favour of the customers at the periodic intervals, attempts should be made to reduce this time interval. E.g. If the bills are raised in favour of the customers on monthly basis, raising the bills on customers on fortnightly basis may be an effective way of managing the receivables. This will reduce the first time gap.

b.

Bills or invoices should be raised in favour of the customers immediately after the dispatch of material or rendering the services. Documentation for this purpose should be completed as early as possible. This will reduce the second category of time gap.

c.

Period of credit offered to the customers gets affected due to many other factors which are discussed later on.

AREAS COVERED BY RECEIVABLES MANAGEMENT Receivables Management may be concerned with the following aspects – a.

Credit Analysis.

b.

Credit Terms

c.

Financing of Receivables

d.

Credit Collection

e.

Monitoring of Receivables.

(a)

Credit Analysis :

Even though the intention of the company will be to increase the profits by increasing the sales, the company will not like to sell its products to any customer who comes its way. For this purpose the company has to decide the customers to whom it should sell its products on credit. The credit should be extended only to those customers whose creditworthiness is established. For deciding the credit worthiness of the customers, the company may consider various factors viz. analysis of the financial status of the customer, reputation of the customer, record of previous dealing of the customer with the company, quality and character of the

438

Financial Management

management running the business of the customer etc. For deciding the credit worthiness of the customer, the company may need information which may be available from the following sources. (1)

Trade References : The company can ask the prospective customer to give trade references. The company may insist that the references should be given of those names who are currently dealing with the company. The company in turn can obtain the information from these references, either by personal interview or by sending short questionnaires. While doing this, honesty, seriousness and integrity of the references should be examined.

(2)

Bank Reference The company can ask the prospective customer to instruct its banker to give the relevant information to the company. In this case, there may be two problems. Firstly, the banker of the prospective customer may not give clear answers to the enquiries made by the company. Secondly, even though the Bank of prospective customer certifies the proper conduct of the account, it may not mean that he will settle his dues of the company in time. As such, along with Bank reference, other ways of obtaining the information should also be used.

(3)

Credit Bureau Reports : The sources of trade references and bank references may be biased in some cases. In such cases, the credit bureau reports may be considered. In some cases, the associations for some specific industries maintain credit bureau that may give useful and authentic information about their members.

(4)

Financial Statements : This is one of the easiest ways to obtain the information about the creditworthiness of the prospective customer. If the prospective customer is a public limited company, there may not be any difficulty in getting the financial statements in the form of Profit and Loss Account and Balance Sheet. However, getting the financial statements, may be difficult in case of private limited companies or partnership firms.

(5)

Past Experience : This can be considered to be the most reliable source of getting the information about the creditworthiness of the customer who is dealing with the company presently. If there is the question of extending further credit to the existing customer, the company should inevitably consider the past experience while dealing with that customer.

Management of Receivables

439

(6)

Salesmans’ Interviews and Reports : Many a times, companies may depend upon the reports given by the sales personnel for evaluating the creditworthiness of the customers.

After the creditworthiness of the customer is ascertained, the next question is to decide the limit on the credit to be allowed to them, both in terms of amount and duration. The decision depends upon the amount of anticipated sales, increased cost of monitoring and servicing the receivables and the financial strength of the customer. If the customer is a frequent buyer of the goods of the company, a line of credit for selling may be established which means the maximum amount of credit which the company may extend. In such case, the company need not investigate every order of the customer so long as it is within the limit of line of credit. The line of credit granted for the customer should be reviewed periodically in the light of the collection of the previous dues, specific requirements of the customer for the future and so on. (b)

Credit Terms :

Credit terms indicate the terms on which the company should extend the credit to the customer. This involves the consideration of following aspects, –

Credit Period

–

Credit Limit

–

Discount Policy.

Credit Period : Credit period is the time allowed by the company to the customers to pay their dues. The duration of this credit period may depend upon various factors. One, in case of the products having inelastic demand, the credit period may be small, however if the demand is elastic, small credit period may affect quantum of sales. Two, credit period may depend upon the nature of industry. In the buyer’s market, the company may be required to offer more credit period. In the seller’s market, the company may afford to offer smaller credit period. Further, it also depends upon the policies followed by the competitors. Three, decisions regarding the credit period may be affected by the management attitudes. If the management attitude is aggressive, it may offer more credit period to increase sales and profits. However, if management attitude is conservative, it will like to restrict the credit period. Lastly, the credit period may depend upon the amount of funds available and also upon possible bad debts losses. Naturally, the company will like to have credit period as short as possible, whereas the customers will like to have longer credit period. As such, by liberalising its credit period, the company can attract new customers. However, the proposition of liberalising the credit period may involve the consequences in the form of more investment in receivables, possibility of bad debts losses, increased cost of monitoring and servicing the receivables etc. As such, policy to liberalise the credit period should be viewed from this angle.

440

Financial Management

Illustration: A company is currently selling 12000 units at Rs. 50 per unit. Variable cost per unit is Rs. 40. At present, the company gives credit of one month which is proposed to be extended to two months, whereby it will be able to increase sales by 25%. If the required rate of return is 18% and average cost per unit is Rs. 45, should the new credit policy be implemented? Solution : Calculation of incremental profits Present Costs Structure Rs.

Proposed Costs Structure Rs.

Differences

Sales

6,00,000

7,50,000

1,50,000

Variable cost

4,80,000

6,00,000

1,20,000

Contribution

1,20,000

1,50,000

30,000

Fixed Costs

60,000

60,000

__

Profit

60,000

90,000

30,000

Rs.

Thus, the new credit policy will result into increased profits of Rs. 30,000. The costs involved with the new credit policy will be as below.

Variable cost Fixed Cost Total Cost Average Debtors Investment in Debtors

Present Policy Rs.

New Policy Rs.

4,80,000 60,000 5,40,000 (1 month) 45,000

6,00,000 60,000 6,60,000 (2 months) 1,10,000

As such, incremental investment in debtors is Rs. 65,000 i.e. 1,10,000 – Rs. 45,000. As the required rate of return is 18% p.a., costs attached with incremental debtors will be Rs. 11,700 i.e. 18% of Rs. 65,000. As the increased profits of Rs. 30,000 are more than increased costs of Rs. 11,700 the new credit policy will be desirable. However, before liberalising the credit period, following factors should also be considered. (i)

Liberalising the credit period is likely to increase the demand. It should be verified whether the company has the capacity to meet this additional demand. If the company is operating

Management of Receivables

441

at its full capacity and it is necessary to increase the capacity to meet the additional demand, the effect of this possibility on the cost structure of the company is required to be considered. (ii)

Liberalising the credit period may increase the demand which in turn may call for the additional investment in working capital say inventory. While evaluating the proposal to liberalise the credit period, cost associated with the additional investment in working capital is also required to be considered.

Discount Policy : Discounts are usually allowed to speed up the collection process, and to induce the customers to pay the dues early. The decisions regarding the rate of discount and period of discount depends upon the usual cost benefit considerations i.e. The cost of carrying the debts on one hand and on another hand, the benefits received from getting the amount released from the debtors immediately, which may be available for some different and beneficial use. Proposal to liberalise the discount policy should be evaluated in terms of loss of revenue on one hand and the benefits arising out of released investment in receivables on another hand. Illustration : A Ltd. Is considering to introduce cash discount policy of “3/10 net 30” i.e. if the customer pays his dues within 10 days, he will be entitled to a cash discount of 3%, otherwise he has to pay the dues within 30 days. The company expects that 60% of the sales will opt for this facility which will improve the Average Collection Period from 30 days to 18 days. If sales of the company amount to Rs. 50 lakhs and if required rate of return is 15%, should the proposal be accepted? Solution : (a)

Loss of Revenue 60% of Rs. 50,00,000 X 3%

(b)

Receivables before discount 50,00,000 360

(c)

X 30

Rs. 4,16,666

Receivables after discount 50,00,000 360

442

Rs. 90,000

X 18

Rs. 2,50,000

Financial Management

(d)

Investment in receivables released i.e. b – c

(e)

Rs. 1,66,666

Return on investment released 15% on Rs. 1,66,666

Rs. 25,000

As the return on investment released is likely to be less than loss of revenue, the proposal of cash discount should not be accepted. (c)

Financing the Receivables :

Whichever sources are available to the company for financing the working capital requirement, are equally the sources available for financing the receivables. This is due to the fact that receivables is a part of working capital. However, following sources may be identified as the sources available for financing the receivables particularly. a)

Bills Discounting

b)

Cash Credit against hypothecation of book debts as the security.

c)

In the recent past, factoring has become one of the sources available for financing the receivables. The mechanism of factoring is discussed in the following paragraphs.

(d)

Credit Collection :

This indicates the steps taken by the company to collect the dues from the customer. For this purpose, the company may follow the standard practices of reminding the customer just before the due date. This can be done by sending the reminder letters, or making telephone calls or by paying the personal visits. The customers who are slow paying ones should be handled property. If they are permanent customers, they may object to harsh collection procedure and the company may loose them ultimately. If the slow paying customer is facing some temporary funds problem, the company should understand the same. If there are some defaulting customers, the company should decide as how many reminders should be sent and how each of them should be drafted. If these measures fail, the next step taken may be the personal call to these customers or the personal visit by the company’s representative. If all these above courses of action fail, the company may decide to take the legal action against the defaulting customer as a last resort. It is a very regular practice to offer cash discounts to the customers in order to speed up the credit collection process. While designing the credit collection policy, following propositions should be remembered.

Management of Receivables

443

(a)

Before deciding collection policies and procedures, it is essential to make a cost benefit analysis. The costs are the administrative expenses associated with the collection policies and the benefits are the reduced bad debts losses and interest on released investment in debtors. As a financial management proposition, it is necessary that the cost should be justified by the benefits.

(b)

Before deciding collection policies and procedures, provisions of the Indian Limitation Act should be kept in mind. In spite of the repeated reminders, if the customer fails to pay the amount due from him, the legal action should be initiated against the customer before the limitation period is over.

(e)

Monitoring the Receivables :

It may be necessary to ensure that the outstanding receivables are within the framework of the credit policy decided by the company. For this, the company may be required to apply regular checks and have a regular system to monitor the receivables property. For this, the company may use the following techniques. Techniques available on Macro Basis : One of the most common methods to monitor the receivables on macro basis is to calculate the Average Collection Period (ACP) which effectively indicates the period taken by the customers to make payment to the company or the average period of credit allowed by the company to the customers. Average Collection Period may be calculated in two stages described below : a.

Calculation of daily or monthly sales – Credit Sales during the year No. of days / No. of months

b.

Calculation of Average Collection Period – Sundry Debtors in Balance Sheet Daily/Monthly Sales

For the purpose of proper interpretation of ACP, it needs to be compared with the NCP, i.e. the Normal Credit Period offered by the company to customers for making the payment. If ACP works out to be more than the NCP, it indicates inefficiency on the part of marketing department or sales department or collection department of the company in collecting the dues from the customers. If ACP works out to be less than the NCP, it indicates efficiency on the part of marketing department or sales department or collection department of the company in collecting the dues from the customers. However, calculation of ACP as a tool to monitor the receivables involves some limitations – 444

Financial Management

a.

Calculation of ACP assumes that the credit sales are evenly spread throughout the year. In practical circumstances, credit sales are not evenly spread throughout the year. In such situations, ACP may give wrong indications.

b.

Calculation and interpretation of ACP as a tool to judge the efficiency or inefficiency of the company in collecting the dues from the customers is not possible based upon the published financial statements of the company due to non-availability of sufficient data for the same. Eg. The amount of credit sales made by company or the normal credit period offered by the company are not available in the published financial statements.

Techniques available on Micro Basis : Considering the limitations associated with the calculation of ACP, it may not be a tool available to monitor the receivables on micro basis. For this, the calculation of age-wise analysis of receivables may be made. Age-wise analysis of the receivables involves the classification of outstanding receivables at any given point of time (say at the end of every month) into the different age groups (age of the receivables indicating the number of days since the date receivables become outstanding). Percentage of receivables falling under each age group may also be calculated. For example, Age Group (No. of days)

Amount Rs.

%

Less than 30 days 31-60 days 60-90 days More than 90 days Now, if the normal credit period offered by the company to the customers is 30 days, any amount which is outstanding for more than 30 days is definitely indicating the inefficiency on the part of collection department of the company in collecting the receivables. Thus age-wise analysis of the receivables may provide superior information about the quality of receivables and the company can concentrate its collection efforts on those receivables which are outstanding for a longer period of time. FACTORING In the recent past, factoring has emerged as one of the major financial service in the Receivables Management area. What is Factoring? Factoring indicates the relationship between a financial institution (called as the “factor”) and a business organisation (called as the “client”) who in turn sells the goods/services to its Management of Receivables

445

customers (called as the “customer”), whereby the factor purchases book debts of the client, either with recourse or without recourse, and in relation thereto controls the credit extended to the customers and administers the sales ledger of the client. In non-technical language, the financial service in the form of factoring tries to provide the services which the marketing department of an organisation will be undertaking. Eg. The factor may provide the following services to the client : a.

Factor may undertake the credit analysis of the customers of the client. Factor may also help the client in deciding the credit limit upon each customer and the other credit terms like period of credit, discount to be allowed etc. It should be noted that the factor need not factor all the debts of the client. He may have his own assessment of the customers of the client and accordingly, he will factor the debts of the client.

b.

Factor will undertake the various bookkeeping and accounting activities in relation to the receivables management. This will consist of maintenance of debtors’ ledger and generation of the various periodical reports on behalf of the client (like outstanding from the customers, age wise analysis of the outstandings etc.)

c.

The factor undertakes the responsibility of following up with the customers for the purpose of making the collection from the customers. For this it will be necessary that the client informs its customers about the fact that the debts have been factored by the factor and that the customers should make the payments to the factor directly.

d.

Factor can purchase the debts of the client making the immediate payment of these debts to the client after maintaining about 20% to 30% margin. This reduces the strain on the working capital requirements of the client and the client can concentrate on the manufacturing and other activities. After the customer makes the payment to the factor on the due date, the factor passes on the funds to the client after adjusting the funds advanced by him to the client. If the factor purchases the debt of the client, it will be involving the cost and the cost is slightly higher than the interest which the client would have paid had he borrowed the funds from the bank. If some of the debts are not purchased by the factor, the client can borrow from the bank against these debts.

e.

Factor can assume the risk of non-payment by the customers if the factoring is without recourse factoring and in such cases, the factor is not able to recover the money from the client. If the factoring is with recourse factoring, the risk of non-payment by the customers is assumed by the client and not by the factor. As such, the factor is entitled to recover the funds advanced by him to the client.

Factoring Vs. Bills Discounting : Factoring is different from the bills discounting in two ways. One, Bills Discounting is essentially a financial function whereby the client gets the finance against the book debts, whereas the 446

Financial Management

factoring is a financial as well as administrative function. The factor is engaged not only in financing the book debts of the client, but he is engaged in the various administrative activities as well like the maintenance of sales ledger, generation of the various reports, follow up with the customers, collection of dues from the customers etc. Secondly, in case of Bills Discounting, the risk of non-payment of dues by the customers is essentially assumed by the client, whereas in the case of factoring the risk of non-payment by the customers may be assumed by the factor if the factoring is without recourse factoring. Procedure of Factoring : a.

After the careful evaluation of customers and setting the credit limits upon the customers, the factoring firm enters into the agreement with the selling company.

b.

Sales invoices raised by the selling company in favour of its customers consists of an indication to the customer that the amount is being factored with the factor and on the due date, the customer should make the payment to the factor directly.

c.

The factor makes the prepayment of the invoice to the selling company after keeping the margin as stipulated.

d

On the due date, when the customer makes the payment, the factoring firm recovers its fees/charged as agreed upon and also the amount already advanced to the selling company and passes on the balance amount to the selling company.

The various steps involved in the factoring operations may be explained with the help of following figure. MECHANICS OF FACTORING 1

CLIENT (SELLER)

8 5 4 2

Management of Receivables

CUSTOMER (BUYER)

3

6

FACTOR

7

447

Description of Numbers in above figure 1.

Places the order

2.

Fixes the limit

3.

Delivers the goods and instructs the customer to make payment to the factor

4.

Sends the invoice copy

5.

Makes the prepayment of invoice

6.

Follows up

7.

Makes the payment

8.

Pays the balance amount

Types of Factoring : On the basis of above features of factoring, factoring can be classified in the following ways : a.

Without Recourses Factoring : In case of this type of factoring, the risk on account of non-payment by the customer is assumed by the factor. The factor is not entitled to recover the amount from the selling company. Thus, without Recourse Factoring results into the outright buying of selling company’s receivables by the factor. This type of factoring is also referred to as full factoring.

b.

With Recourse Factoring : In case of this type of factoring, the risk on account of nonpayment by the customer is assumed by the selling company and the factor is entitled to recover the funds advanced by him the selling company.

Advantages of Factoring :

448

a.

Factoring is the way in which the company can finance its requirement of working capital in respect of receivables. Immediate availability of cash reduces the strain on working capital of the company. As the financing in the form of factoring moves with the level of receivables directly, the company need not worry about financing the additional requirement of working capital due to the increased amount of sales.

b.

Factoring orgainsation is a professional specializing in the various fields. The company can take the advantage of the expertise of the factor in the areas of credit evaluation, credit analysis, deciding the credit limits upon the customers etc.

c.

With the help of factoring as a financial service, the company can be relieved of the administrative responsibilities of maintaining the debtors’ ledger, periodical report generations and following up with the customers for collecting the dues etc. This not

Financial Management

only results in the cost saving for the company, but the company is able to concentrate its efforts on business development. Disadvantages of Factoring : a.

As the amount charged by the factoring organisation, consists of the components towards the administrative services rendered by the factor as well as the cost of finance provided by the factor, the effective financial burden on the company increases.

b.

the Indian circumstances, Factoring is mainly with-recourse factoring. This means that the risk of non-payment on the part of customer is not borne by the factor. It is borne by the selling firm. This has restricted the popularity of factoring services in the Indian circumstances.

c.

While making the credit evaluation, if the factor adopts a very conservative approach with the intention to minimize the risk of delay and default, it may restrict the sales growth of the selling company.

d.

Factoring may be considered to be a symptom of financial weakness on the part of the selling company. It may indicate that the selling company is not able to manage its receivables effectively on its own and is required to take the help of an outside agency in the form of factor.

Factoring in Indian situations : Factoring services in Indian circumstances started on the basis of the recommendations of Kalyanasundaram Committee which was appointed in the year 1989 with the intention of studying the scope of starting factoring services in India. The committee recommended the factoring in India. Reserve Bank of India demarcated the zones for the banks who wished to get involved in the factoring business. The distribution of zones bank wise was as below : Western Zone

–

State Bank of India

Southern Zone

–

Canara Bank

Northern Zone

–

Punjab National Bank

Eastern Zone

–

Allahabad Bank

Recently, Export Credit Guarantee Commission (ECGC) has been authorised to start the Export Factoring business. Out of the above banks, State Bank of India started its factoring services in 1991 by forming a separtate subsidiary viz. SBI Factors Limited.

Management of Receivables

449

Generally the factoring in India is with recourse factoring i.e. the risk of non-payment by the customer is not accepted by the factor but by the client. That may be the reason that the experience of factoring in India is not very encouraging. ILLUSTRATIVE PROBLEMS (1)

A firm is proposing strict collection policies. At present the firm sells 36,000 units with the average collection period of 60 days. Collection charges amount to Rs. 10,000 and bad debts are 3% of sales. If collection procedures are tightened, it will reduce the collection period to 40 days and bad debts losses to 1% of sales. However it involves additional collection charges of Rs. 20,000 and the sales decline by 500 units. If selling price is Rs. 32, average cost is Rs. 28 and variable cost is Rs. 25, whether the firm should implement the policy? Assume 20% rate of return.

Solution : Costs attached to proposal (1)

(2)

Loss of contribution (500 units X Rs. 7)

Rs. 3,500

Additional Collection Expenses

Rs. 20,000 Rs. 23,500

Benefits attached to proposal (1)

Saving in bad debts losses 3% of old sales Rs. 11,52,000

Rs. 34,560

1% of revised sales Rs. 11,36,000

Rs. 11,360 Rs. 23,200

(2)

Reduced investment in Receivables

Rs. 57,444

Assuming 20% rate of return, the firm will save due to this reduced investment.

Rs. 11,489 Rs. 34,689

As the benefits attached to the proposal to tighten the collection procedures exceeds the costs attached to the same, the firm should implement the proposal.

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Financial Management

WORKING NOTES : Cost Structure

Sales (Rs. 32/- per unit) Variable cost (Rs. 25/- per unit) Fixed cost Total cost Average collection period Average outstanding (on the basis of cost of sales) Reduced average outstanding (2)

36000 Units

35500 Units

Rs. 11,52,000

Rs. 11,36,000

Rs. 9,00,000

Rs. 8,87,500

Rs 1,08,000

Rs. 1,08,000

Rs. 10,08,000

Rs. 9,95,000

60 days

40 days

Rs. 1,68,000

Rs. 1,10,556

Rs. 57,444

XYZ Corporation is considering relaxing its present credit policy and is in the process of evaluating two proposed policies. Currently, the firm has annual credit sales of Rs. 50 lakhs and accounts receivable turnover ratio of 4 times a year. The current level of loss due to bad debts is Rs. 1,50,000. The firm is required to give a return of 25% on the investment in new accounts receivables. The company’s variable costs are 70% of the selling price. Given the following information, which is the better option?

Annual Credit Sales (Rs.)

Present Policy

Policy Option I

Policy Option II

50,00,000

60,00,000

67,50,000

4 times

3 times

2.4 times

1,50,000

3,00,000

4,50,000

Accounts Receivable Turnover Ratio Bad Debts Losses (Rs.)

Management of Receivables

451

Solution : Evaluation of credit policy options Option I

Option II

Benefits (a)

Sales (Rs.)

60,00,000

67,50,000

(b)

Incremental Sales (Rs.)

10,00,000

17,50,000

(c)

Additional contribution (30% of sales)

3,00,000

5,25,000

60,00,000

67,50,000

3

2.4

20,00,000

28,12,500

Costs (a)

Sales (Rs.)

(b)

Accounts Receivables Turnover Ratio (No. of times)

(c)

Accounts Receivables (Rs.)

(d)

Incremental Receivables (Rs.)

7,50,000

15,62,500

(e)

Investment in incremental Receivables (70%) (Rs.)

5,25,000

10,93,750

Return on investment in Receivables (25%)

1,31,250

2,73,438

(g)

Incremental Bad Debt losses

1,50,000

3,00,000

(h)

Total Costs (i.e. f + g)

2,81,250

5,73,438

18,750

(48,438)

(f)

Net Benefits Conclusion :

As credit policy option no. II generates the incremental loss of Rs. 48,438, the company should reject the same. Credit policy option no. I generates the incremental profit of Rs. 18,750, which can be accepted by the company. (3)

452

STS Ltd. which sells on credit basis has ranked its customers in categories 1 to 5 in order of credit risk.

Financial Management

Category

% bad debts

ACP

1

0.0

30 days

2

1.0

45 days

3

2.0

60 days

4

5.0

90 days

5

10.0

120 days

The company’s current policy is to allow unlimited credit to firms in categories 1 to 3, limited credit to firms in category 4 and no additional credit to firms in category 5. As a result, orders amounting to Rs. 25,00,000 from category 4 and Rs. 75,00,000 from category 5 customers are rejected every year. If the STS Ltd. makes a 10% gross profit on sales and has an opportunity cost on investment in receivables of 12% what would be the effect on profits of allowing full credit to all categories of customers? Should credit be extended to all categories of customers? Solution : Evaluation of Credit Policies Category 4

Category 5

25,00,000

75,00,000

2,50,000

7,50,000

25,00,000

75,00,000

90

120

(c ) Receivables (Rs.)

6,25,000

25,00,000

(d)

Investment in receivables i.e. 90%(Rs.)

5,62,500

22,50,000

(e)

Return on investment in receivables 67,500

2,70,000

Benefits (a)

Loss of sales (Rs.)

(b)

Loss of profit (10% of sales (Rs.)

Costs (a)

Loss of sales (Rs.)

(b)

Average collection Period – days

@ 12% (Rs.) (f)

Bad debt losses

1,25,000

7,50,000

(g)

Total Costs (i.e. e + f)

1,92,500

10,20,000

57,500

(2,70,000)

Net Benefits

Management of Receivables

453

Conclusion : As extending credit to the customers in category 5 results into the loss, the company should not extend credit to them. However, it can extent the credit to category 4 customers, as it results into a plus. (4)

A trader whose current sales are in the region of Rs. 6 lakhs per annum and an average collection period of 30 days wants to pursue a more liberal policy to improve sales. A study made by a management consultant reveals the following information : Credit Policy

Increase in collection period (Days)

Increase in sales

%default anticipated

A

10

30,000

1.5%

B

20

48,000

2%

C

30

75,000

3%

D

45

90,000

4%

Selling price per unit is Rs. 3, average cost per unit is Rs. 2.25 and variable cost per unit is Rs. 2 Current bad debt loss is 1%. Required return on additional investment is 20%. Assume 360 days a year. Which of the above policies would you recommend for adoption.

Solution : Evaluation of credit policies Benefits (a)

Credit Policy

(b)

Credit Period (days)

(c) (d) (e)

454

A

B

C

D

40

50

60

75

Additional Sales (Rs.)

30,000

48,000

75,000

90,000

Contribution generated by additional sales (Rs.)

10,000

16,000

25,000

30,000

6,30,000

6,48,000

6,75,000

Total Sales (Rs.)

6,90,000

Financial Management

A

B

C

D

(f)

Bad Debts (Rs.)

9,450

12,960

20,250

27,600

(g)

Additional Bad Debts (Rs)

3,450

6,960

14,250

21,600

(h)

Net Additional

6,550

9,040

A

B

C

D

40

50

60

75

6,30,000

6,48,000

6,75,000

6,90,000

Contribution (Rs.) i.e. d minus g

10,750

8,400

Costs : (a)

Credit Policy

(b)

Credit Period (days)

(c)

Total Sales (Rs.)

(d)

Average Debtors (Rs.)

70,000

90,000

1,12,500

1,43,750

(e)

Investment in Receivables (Rs.) 46,667

60,000

75,000

95,833

(f)

Additional investment in receivables (Rs.)

13,334

26,667

41,667

62,500

Investment

2,667

5,333

8,333

12,500

Net Benefit :

3,883

3,707

2,417

(-) 4,100

(g)

Return on additional

Conclusion : As the benefit is maximum in case of credit policy A, the company should adopt that policy. Note : (a)

Additional bad debts will be considered as excess of anticipated bad debts as compared to the existing bad debts.

(b)

Additional investment in receivables in calculated as below Existing sales – Rs. 6,00,000 Average Collection Period – 30 days Average Debtors – Rs. 50,000 As variable cost is 2/3rd of selling price, investment in debtors is – 50,000 X 2/3 = 33,333

The investment in debtors under all the proposed credit policies should be considered on the basis of the existing investment in debtors as stated above i.e. Rs. 33,333.

Management of Receivables

455

QUESTIONS

456

1.

How would you manage the credit policy in a company where the amount locked up in receivables (debtors) is equal to six month’s sales?

2.

What is meant by a firm’s credit terms? What are the expected effects of (a) A decrease in the firm’s cash discounts and (b) A decrease in credit period.

3.

“The credit policy of a company is criticised because bad debt losses have increased considerably and collection period has also increased”. Discuss under what conditions the criticism may not be justified.

4.

What are the important dimensions of a firm’s credit policy? Discuss the consequences of a liberal credit policy.

5.

Write a detailed essay on “factoring”.

Financial Management

PROBLEMS (1)

XYZ Corporation is considering relaxing its present Credit policy and is in the process of evaluating two proposed policies. Currently, the firm has annual credit sales of Rs. 50 Lakhs and accounts receivable turnover ratio of 4 times a year. The current level of loss due to bad debts is Rs. 1,50,000. The firm is required to give a return of 25% on the investment in new accounts receivables. The company’s variable costs are 70% of the selling price. Given the following information, which is the better option? Present Policy

Policy Option I

Policy Option II

Annual credit sales

Rs. 50 Lakhs

Rs. 60 Lakhs

Rs. 67.5 Lakhs

Accounts receivable turnover ratio

4 times

3 times

2.4 times

Rs. 1.5 Lakhs

Rs. 3 Lakhs

Rs. 4.5 Lakhs

Bad debt losses

(2)

The credit manager of ABC Company had to decide on a proposal for liberal extention of credit which will result in a slowing process of average collection period from one month to two months. The company’s product was sold for Rs. 20 per unit of which Rs. 15 represented variable cost (including credit department cost). The current actual sales amounted to Rs. 24 Lakhs, represented entirely by credit sales. The average total costs was Rs. 18. The extention in credit policy was expected to result in a 25% increase in sales i.e. Rs. 30 Lakhs annually. The corporate management aimed at a return of 25% on additional investment. You are required to make relevant calculations to help the credit manager in examining the financial implications of liberalising the credit policy.

(3)

Pune Sandals Ltd. is planning a strategy to increase its sales in the domestic market and one of its strategy is to extend its credit terms to various classes of customers. The company has ranked its customers in categories 1 to 5 in the Ascending order of risk. Category

% Bad Debts

Average Collection Period

1

Nil

30 days

2

2.00

45 days

3

4.00

60 days

4

7.00

90 days

5

10.00

180 days

Management of Receivables

457

The Company’s current policy is to allow unlimited credit to customers in category 1 to 3, limited credit to customers in category 4 and no additional credit to customers in category 5. As a result of the existing policy, the company lost orders of Rs. 50 lakhs from customers in category 4 and Rs. 100 lakhs from customers in category 5. As the Finance Manager, would you recommend that credit should be extended to all categories of customers. Your analysis should contain the effect on profits. (4)

MNQ Ltd. wants to relax its credit on sales from the current level of 1 month to 2 months. Due to this , the sales would increase to Rs. 72 lakhs from the present level of Rs. 60 lakhs per annum but the percentage of bad debts losses is likely to go up by 2 % of sales which, is now at 3% of sales. The company’s variable cost is 75% of sales and fixed expenses are Rs. 12 lakhs per annum. Advice the company on the implications of revising the credit policy. Interest on the additional funds required to extend credit need not be considered.

(5)

A firm sells 40,000 units of its product per annum @ Rs. 35 unit. The average cost per unit is Rs. 31 and the variable cost per unit is Rs. 28. The average collection period is 60 days. Bad debts losses are 3% sales and the collection charges amount to Rs. 15,000. The firm is considering proposal to follow a stricter collection policy which would reduce bad debts losses to 1% of sales and the average collection period to 45 days. It would, however reduce sales volumes by 1000 units and increase collection expenses Rs. 25,000. The firm’s required rate of return is 20%. Would you recommend the adoption of the new collection policy? Assume 360 days in a year for the purpose of your calculation.

(6)

Agro Products Ltd. is considering the following credit policy alternatives : Existing Policy

Option I

Option II

Credit Period (days)

30

14

60

Sales (Rs. in lakhs)

10

9.60

12

5

3.33

.6

20,000

12,000

25,000

45

51

72

Bad debts (% of sales) Cost of credit administration (Rs.) Average effective collection period (Days)

458

Financial Management

The average effective collection period differs from the credit period as all debtors don’t strictly adhere to the condition stipulated . The company achieves a contribution of 40% on sales and the firm requires a 20% p.a. return on investment. You are required to suggest which credit period is more suitable to the company. Do you have any further suggestions to the management in the context of your finding. (7)

Premier Steels Limited has a present annual sales turnover of Rs. 40,00,000. The unit sales price is Rs. 20. The variable costs are Rs. 12 per unit and fixed costs amount to Rs. 5,00,000 per annum. The present credit period of one month is proposed to be increased to either 2 or 3 months whichever will be more profitable. The following additional information is available. On the basis of credit period of 1 Mth.

2 Mths.

3 Mths.

Increase in sales (Rs)

–

10%

30%

% of bad debts to sales

1

2

3

Fixed cost will increased by Rs. 75,000 when sales will increase by 30%. The company requires a pretax return on investment of 20%. Evaluate the profitability of the proposals and recommend best credit period for the company.

Management of Receivables

459

NOTES

460

Financial Management

NOTES

Management of Receivables

461

NOTES

462

Financial Management

To conclude, it can be said that the objective of inventory management is to minimise the investment in inventory without affecting the production or sales operations. TECHNIQUES OF INVENTORY MANAGEMENT : (1)

Economic Order Quantity :

It indicates that quantity which is fixed in such a way that the total variable cost of managing the inventory can be minimised. Such cost basically consists of two parts. First, Ordering Cost (which in turn consists of the costs associated with the administrative efforts connected with preparation of purchase requisitions, purchase enquiries, comparative statements and handling of more number of bills and receipts). Second, Carrying Cost i.e. the cost of carrying or holding the inventory. (which in turn consists of the cost like godown rent, handling and upkeep expenses, insurance, opportunity cost of capital blocked i.e. interest etc.) There is a reverse relationship between these two types of costs i.e. if the purchase quantity increases, ordering cost may get reduced but the carrying cost increases and vice versa. A balance is to be struck between these two factors and it is possible at Economic Quantity where the total variable cost of managing the inventory is minimum. It is possible to fix the Economic Order Quantity with the help of mathematical formula. The following assumptions may be made for this purpose. Let Q

be Economic Order Quantity.

A

be Annual Requirement of material in units.

O

be cost of placing an order (which is assumed to remain constant irrespective of size of order).

C

be cost of carrying one unit per year.

Now, if A is the annual requirement and Q is the size of one order, the total number of orders will be A/Q and the total ordering cost will be : A/Q x O. Similarly, if the size of one order is Q and if it is assumed that the inventory is reduced at a constant rate from order quantity to zero when it is repurchased, the average inventory will be Q/2 and the cost of carrying one unit per year being C, the total carrying cost will be Q/2 x C. Thus, Total cost = Ordering Cost + Carrying Cost, =

A x Q

O +

Management of Inventory

Q x 2

C

465

The intention is that the value of Q should be such that the total cost should be minimum. Hence, taking the first derivative of the equation with respect to Q and setting the result to zero. do 1 C = AO (– 2 ) + dq Q 2 =0 or

Q=

Where

2 x A x O C

Q = Order Quantity A = Annual Requirement in Units O = Cost of Placing an Order C = Cost of Carrying One Unit Per Year

Illustration : A manufacturer uses 200 units of a component every month and he buys them entirely from outside supplier. The order placing cost is Rs. 100 per order and annual carrying cost per unit is Rs. 12. From this set of data, calculate Economic Order Quantity. Solution : EOQ

=

2 x A x O C

=

2 x 2400 x 100 12

=

200 units

In some cases, the carrying cost may be expressed as an annual percentage of the unit cost of purchases. In which case, the calculation of Economic Order Quantity takes the following form. EOQ where

A

=

2 x A x O C x i

= Annual requirement in units

O = Cost of placing an order

466

C

= Unit purchase price

i

= Carrying cost expressed as a percentage of unit purchase price. Financial Management

Illustration : From the following data, work out the EOQ of a particular component, Annual Demand

:

5000 Units

Ordering Cost

:

Rs. 60 per Order

Price Per Unit

:

Rs. 100

Inventory Carrying Cost

:

15% on average inventory.

Solution : EOQ

2 x 5000 x 60 15% of 100

=

= 200 units. The total cost of managing inventory will be Ordering Cost

=

500 200

Carrying Cost

=

200 2

x 60 i.e. 25 x 60

= Rs. 1,500

x 15% of 100

= Rs. 1,500 Rs. 3,000

(Based on average inventory) Now, the next question is whether the purchases in Economic Order Quantity really reduce the total cost of managing inventory to the minimum. We can verify this, by trial and error method, by considering the above results. Order Quantity

No. of Orders A/Q

Ordering Cost A/Q x O Rs.

Carrying Cost Q/2 x Ci Rs.

Total Cost Rs.

50

100

6,000

375

6,375

100

50

3,000

750

3,750

200

25

1,500

1,500

3,000

250

20

1,200

1,875

3,075

1,000

5

300

7,500

7,800

1,250

4

240

9,375

9,615

2,500

2

120

18,750

18,870

Management of Inventory

467

It can be observed from the above, that the order size of 200 units proves to be the most economic one in terms of minimum total cost. If the purchases are made in any other way, the same may not necessarily result into minimum total cost. Illustration : Kapil Motors purchase 9,000 motor spare parts for its annual requirements, ordering one month usage at a time. Each spare part costs Rs. 20. The ordering cost per order is Rs. 15 and the carrying charges are 15% of the average inventory per year. You have been asked to suggest a more economical puchasing policy for the company. What advice would you offer and how much would it save the company per year? Solution : Present Policy : Number of Orders

=

Annual Requirement Order size

= 9000 = 12 750 Ordering Cost

= 12 x 15 = 180 Order Size = x Cost Price 2 = 750 x 15% of Rs. 20 2

Carrying Cost

…(1) x Carrying cost in %

= 375 x 3 = 1,125 Total cost i.e. 1 + 2

…(2)

= 180 x 1125 = 1,305

…(3)

Proposed Policy : To purchase in Economic Order Quantity EOQ

468

=

2xAxO Cxi

=

2 x 9000 x 15 15% of 20

=

300 units Financial Management

Now, the revised total cost will be Number of Orders

=

9000 300

= 30 Ordering Cost

= 30 x 15 = 450

Carrying Cost

=

…(4)

300 x 15% of 20 2

= 150 x 3 = 450 Total Cost i.e. 4 + 5

…(5)

= 450 + 450 = 900

…(6)

Thus, purchases in Economic Order Quantity will result into the yearly saving of Rs. 405 (i.e. Rs. 1305 - Rs. 900) (2)

Fixation of Inventory Levels :

Fixation of various inventory levels facilitates initiating of proper action in respect of the movement of various materials in time so that the various materials may be controlled in a proper way. However, the following propositions should be remembered. (i)

Only the fixation of inventory levels does not facilitate the inventory control. There has to be a constant watch on the actual stock level of various kinds of materials so that proper action can be taken in time.

(ii)

The various levels fixed are not fixed on a permanent basis and are subject to revision regularly.

The various levels which can be fixed are as below : (1)

Maximum Level :

It indicates the level above which the actual stock should not exceed. If it exceeds, it may involve unnecessary blocking of funds in inventory. While fixing this level, following factors are considered.

Management of Inventory

469

(i)

Maximum usage.

(ii)

Lead time

(iii) Storage facilities available, cost of storage and insurance etc. (iv)

Prices for material

(v)

Availability of funds

(vi)

Nature of material e.g. If a certain type of material is subject to Government regulations in respect of import of goods etc. maximum level may be fixed at a higher level.

(vii) Economic Order Quantity. (2)

Minimum Level :

It indicates the level below which the actual stock should not reduce. If it reduces, it may involve the risk of non-availability of material whenever it is required. While fixing this level, following factors are considered.

(3)

(i)

Lead time

(ii)

Rate of consumption

Re-order Level :

It indicates that level of material stock at which it is necessary to take the steps for procurement of further lots of material. This is the level falling in between the two existences of maximum level and minimum level and is fixed in such a way that the requirements of production are met properly till the new lot of material is received. (4)

Danger Level :

This is the level fixed below minimum level. If the stock reaches this level, it indicates the need to take urgent action in respect of getting the supply. At this stage, the company may not be able to make the purchases in a systematic manner but may have to make rush purchases which may involve higher purchases cost. CALCULATION OF VARIOUS LEVELS : The various levels can be decided by using the following mathematical expressions. (1)

Re-order level : Maximum Lead Time x Maximum Usage.

(2)

Maximum Level Re-order Level + Re-order Quantity - (Minimum Usage x Manimum Lead Time)

470

Financial Management

(3)

Minimum Level : Reorder Level - (Normal Usage + Normal Lead Time)

(4)

Average Level : Minimum Level + Minimum Level 2

(5)

Danger Level : Normal Usage x Lead time for emergency purchases

Note : It should be noted that the expression of the Re-order Quantity in the calculation of Maximum Level indicates Economic Order quantity. Illustration : Two components X and Y as used as follows: Normal usage

–

50 units per week each

Minimum usage

–

20 units per week each

Maximum usage

–

75 units per week each

Re-order quantity

–

X - 400 units Y - 600 units

Re-order period

–

X - 4 to 6 weeks Y - 2 to 4 weeks

Calculate for each component : (a)

Reorder level

(b)

Minimum level

(c)

Maximum level

(d)

Average stock level

Solution : (1)

Re-order Level : Maximum Lead Time x Maximum Usage X

= 6 weeks x 75 units = 450 units.

Management of Inventory

471

Y

= 4 weeks x 75 units = 300 units

(2)

Minimum Level : Re-order Level - (Normal Usage x Normal Lead Time) X

= 450 units - (50 units x 5 weeks) = 200 units.

Y

= 300 units - (50 units x 3 weeks) = 150 units.

(3)

Maximum Level : Re-order Level + Re-order Quantity - (Minimum Usage x Minimum Lead time) X

= 450 units + 400 units - (25 units x 4 weeks) = 750 units

Y

= 300 units + 600 units - (25 units x 2 weeks) = 850 units

(4)

Average Stock Level : Maximum Level + Minimum Level 2 X

=

200 units + 750 units 2

= 475 units Y

=

150 units + 850 units 2

= 500 units As stated above, the expression of the Re-order Quantity in the calculation of Maximum level indicates Economic Order Quantity. Hence, in some cases, it may be necessary to decide the Economic Order Quantity before fixing the inventory levels.

472

Financial Management

Illustration : Shriram Enterprises manufactures a special product ‘ZED’. The following particulars are collected for the year 1986. (a)

Monthly demand of ZED – 1000 units.

(b)

Cost of placing an order – Rs. 100.

(c)

Annual carrying cost per unit – Rs. 15.

(d)

Normal Usage – 50 units per week.

(e)

Minimum Usage – 25 units per week.

(f)

Maximum Usage – 75 units per week.

(g)

Re-order period – 4 to 6 weeks.

Compute from the above : (1)

Re-order Quantity.

(2)

Re-order Level.

(3)

Minimum Level.

(4)

Maximum Level.

(5)

Average stock Level.

Solution : (1)

Re-order Quantity : 2xAxO C

Where,

A

= Annual Requirement

O

= Ordering cost per order

C

= Carrying cost per unit per year

EOQ =

2 x 12000 x 100 15

= 400 units

Management of Inventory

473

(2)

Reorder Level : Maximum Lead Time x Maximum Usage . . . 6 weeks x 75 units = 450 units

(3)

Minimum Level : Re-order Level - (Normal Usage x Normal Lead Time) . . . 450 units - (50 units x 5 weeks) =

(4)

200 units

Maximum Level : Re-order Level + Re-order Quantity/- (Minimum usage x Minimum Lead time) . . . 450 units + 400 units - (25 units x 4 weeks) =

(5)

750 units

Average Stock Level : Minimum Level + Minimum Level 2 200 units + 750 units 2

= 475 units

There may be one more way in which the various inventory levels may be fixed and for this, determination of the safety stock (also called as minimum stock or buffer stock) is essential. Safety stock is that level of stock below which the actual should not be allowed to fall. The safety stock may be calculated as : (Maximum Usage x Maximum Lead time) less (Normal Usage x Normal Lead time) According to this method, the various inventory levels as discussed above may be fixed as below : (1)

Minimum Level : It is equal to safety stock.

(2)

Maximum Level : It can be calculated as - Safety Stock + EOQ

474

Financial Management

(3)

Re-order Level : It can be calculated as : Safety Stock + (Normal Usage x Normal Lead time)

(4)

Average Stock Level : It can be calculated as : Minimum Level + Maximum Level 2 =

Safety Stock + Safety Stock + EOQ 2 Safety Stock +

EOQ 2

Illustration : You have been asked to calculate the following levels for part No. 007 from the information given thereunder : (a)

Re-ordering level.

(b)

Maximum level.

(c)

Minimum level.

(d)

Danger level.

(e)

Average level.

There ordering quantity is to be calculated from the following data : (i)

Total cost relating to one order : Rs. 20.

(ii)

Number of units to be purchased during the year : 5,000.

(iii) Purchase price per unit : Rs. 50. (iv)

Annual cost of storage of one unit : Rs. 5.

Lead Times :

Average

…10 days

Maximum

…15 days

Minimum

…6 days

Maximum for emergency purchases Rate of consumption :

Management of Inventory

… 4 days

Average

… 15 units per day

Maximum

… 20 units per day 475

Solution : Working Notes : (a)

Calculation of Safety Stock :

(Maximum Usage x Maximum Lead Time ) – (Normal Usage x Normal Lead time)

(b)

=

(20 units x 15 days) - (15 days x 10 days)

=

300 units - 150 units

=

150 units

Calculation of EOQ : 2 x A x O C Where

A

=

Annual requirement

O

=

Ordering cost per order

C

=

Carrying cost per unit per year

=

2 x 500 x 20

Hence, EOQ

5 = (1)

200 units.

Re-ordering Level : It can be calculated as Safety Stock + (Normal Usage x Normal Lead time)

(2)

=

150 units + (15 units x 10 days)

=

150 units + 150 units

=

300 units.

Maximum Level : It can be calculated as Safety Stock + EOQ

476

=

150 units + 200 units

=

350 units Financial Management

(3)

Minimum Level : It is equal to Safety Stock =

(4)

150 units.

Danger Level : Normal Usage x Lead time for emergency purchases

(5)

=

15 units x 4 days

=

60 units

Average Stock Level : It can be calculated as Safety Stock +

(3)

=

150 units +

=

250 units

EOQ 2

200 units 2

Inventory Turnover :

Inventory turnover indicates the ratio of materials consumed to the average inventory held. It is calculated as below : Value of material consumed Average inventory held where value of material consumed can be calculated as : Opening Stock + Purchases – Closing Stock. Average inventory held can be calculated as : Opening Stock + Closing Stock 2 Inventory turnover can be indicated in terms of number of days in which average inventory is consumed. It can be done by dividing 365 days (a year) by inventory turnover ratio.

Management of Inventory

477

Illustration : From the following data for the year ended 31st December 1986, calculate the inventory turnover ratio of the two items and put forward your comments on them. Material A Rs.

Material B Rs.

Opening Stock 1.1.86

10,000

9,000

Purchases during the year

52,000

27,000

6,000

11,000

Material A 56,000

Material B 25,000

8,000

10,000

=

7

2.5

Inventory Turnover Period =

365

365

7

2.5

52 days

146 days

Closing Stock 31.12.86 Solution : Inventory turnover ratio

=

Value of material consumed Average Inventory held

Inventory turnover ratio

=

=

A high inventory turnover ratio or low inventory turnover period indicates that maximum material can be consumed by holding minimum amount of inventory of the same, thus indicating fast moving items. Thus, high inventory turnover ratio or lower inventory turnover period will always be preferred. Thus, knowledge of inventory turnover ratio or inventory turnover period in case of various types of material will enable to reduce the blocked up capital in undesirable types of stocks and will enable the organisation to exercise proper inventory control. (4)

ABC Analysis :

This technique assumes the basic principle of “Vital Few Trivial Many” while considering the inventory structure of any organisation and is popularly known as “Always Better Control”. It is an analytical method of inventory control which aims at concentrating efforts in those areas where attention is required most. It is usually observed that, in practice, only a few number of items of inventory prove to be more important in terms of amount of investment in inventory or value of consumption, while a very large number of items of inventory account for a very 478

Financial Management

meagre amount of investment in inventory or value of consumption. This technique classifies the various inventory items according to their importance. Eg. A class consists of only a small percentage of total number of items handled but are most important in nature. B class items include relatively less important items. C class items concists of a very large number of items which are less important. The importance of the various items may be decided on the basis of following factors. (i)

Amount of investment in inventory.

(ii)

Value of material consumption.

(iii) Critical nature of inventory items. An example of ABC Analysis can be given as below : Class

No. of items

% of total no. of items

Value/Consumption Rs.

% of Total Value Consumption

A

300

6

5,60,000

70

B

1,500

30

1,60,000

20

C

3,200

64

80,000

10

5,000

100

8,00,000

100

In order to exercise proper inventory control, A class items are watched very closely and control is exercised right from initial stages of estimating the requirements, fixing minimum level/lead times, following proper purchase/storage procedures etc. Whereas in case of C class of items, only those inventory control measures may be implemented which are comparatively simple, elaborate and inexpensive in nature. Advantages of ABC Analysis : (a)

A close and strict control is facilitated on the most important items which constitute a major portion of overall inventory valuation or overall material consumption and due to this, costs associated with inventories may be reduced.

(b)

The investment in inventory can be regulated in proper manner and optimum utilisation of the available funds can be assured.

(c)

A strict control on inventory items in this manner helps in maintaining a high inventory turnover ratio.

However it should be noted that the success of ABC analysis depends mainly upon correct categorisation of inventory items and hence should be handled by only experienced and trained personnel.

Management of Inventory

479

(5)

Bill of Materials :

In order to ensure proper inventory control, the basic principle to be kept in mind is that proper material is available for production purpose whenever it is required. This aim can be achieved by preparing what is normally called as “Bill of Materials”. A bill of material is the list of all the materials required for a job, process or production order. It gives the details of the necessary materials as well as the quantity of each item. As soon as the order for the job is received, bill of materials is prepared by Production Department or Production Planning Department. The form in which the bill of material is usually prepared is as below : BILL OF MATERIALS No.

Date of Issue

Production/Job Order No.

Department authorised S.No.

Description of Material

Code No.

Qty.

For Department Use only Material Date Quantity Requisition Demanded No.

Remarks

The function of bill of materials are as below :

480

(1)

Bill of materials gives an indication about the orders to be executed to all the persons concerned.

(2)

Bill of materials gives an indication about the materials to be purchased by the Purchase Department if the same is not available with the stores.

(3)

Bill of material may serve as a base for the Production Department for placing the material requisition slips.

(4)

Costing/Accounts Department may be able to compute the material cost in respect of a job or a production order. A bill of material prepared and valued in advance may serve as base for quoting the price for the job or production order.

Financial Management

(6)

Perpetual Inventory System :

As discussed earlier, in order to exercise proper inventory control, perpetual inventory system may be implemented. It aims basically at two facts. (1)

Maintenance of Bin Cards and Stores Ledger in order to know about the stock in quantity and value at any point of time.

(2)

Continuous verification of physical stock to ensure that the physical balance and the book balance tallies.

The continuous stock taking may be advantageous from the following angles : (1)

Physical balances and book balance can be compared and adjusted without waiting for the entire stock taking to be done at the year end. Further, it is not necessary to close down the factory for Annual stock taking.

(2)

The figures of stock can be readily available for the purpose of periodic Profit and Loss Account.

(3)

Discrepancies can be located and adjusted in time.

(4)

Fixation of various levels and bin cards enables the action to be taken for the placing the order for acquisition of material.

(5)

A systematic maintenance of perpetual inventory system enables to locate slow and non-moving items and to take remedial action for the same.

(6)

Stock details are available correctly for getting the insurance of stock.

ILLUSTRATIVE PROBLEMS (1)

A company uses annually 50,000 units of an item each costing Rs. 1.20. Each order costs Rs. 45 and inventory carrying costs 15% of the annual average inventory value. (a)

Find EOQ

(b)

If the company operates 250 days a year, the procurement time is 10 days, and safety stock is 500 units, find reorder level, maximum, minimum and average inventory.

Management of Inventory

481

Solution : (a)

Economic Order Quantity 2xAxO Ci =

2 x 50,000 x 45 15% of 1.20

= 5,000 units (b)

(1)

Reorder Level :

Safety Stock + (Normal Usage x Normal Lead time)

(2)

=

500 units + (200 units x 10 days)

=

2,500 units

Maximum Level : Safety stock + EOQ

(3)

=

500 units + 5,000 units

=

5,500 units

Minimum Level It is equal to safety stock i.e. 500 units

(4)

Average Level Safety Stock +

= 500 units + = (2)

482

EOQ 2

5000 units 2

3000 units.

M/s. Kailas Pumps Ltd. uses about 75,000 valves per year and the usage is fairly constant at 6,250 per month. The value costs Rs. 1.50 per unit when purchased in quantities and inventory carrying cost is 20% of the average inventory investment on annual basis. The cost to place an order and to process the delivery is Rs. 18. It takes 45 days to receive from the date of an order and minimum stock of 3,250 valves is desired. You are required to determine : Financial Management

(a)

The most economical order quantity and the number of orders in year.

(b)

The reorder level.

(c)

The most economic order quantity if value costs Rs. 4.50 each instead of Rs. 1.50 each.

Solution : (a)

Economic Order Quantity : EOQ

=

2 x A x O Ci

=

2 x 75,000 x 18 20% of 1.50

=

3,000 units

Number of Orders : Annual Consumption EOQ =

75,000 units 3,000 units

= (b)

25

Reorder Level : Safety stock + (Normal Usage x Normal Lead time)

(c)

=

3,250 unts + (6,250 units x 1.5 months)

=

12,625 units

Revised EOQ (If unit cost is Rs. 4.50 instead of Rs. 1.50) EOQ

=

2 x A x O ci

=

2 x 75,000 x 18 20% of 4.50

= Management of Inventory

1,732 units 483

(3)

The Purchase Department of your Organisation has received an offer of quantity discounts on its orders of materials as under. Price Per Tonne Rs.

Tonnes

1,200

Less than 500

1,180

500 and less than 1000

1,160

1000 and less than 2000

1,140

2000 and less than 3000

1,120

3000

and above

The annual requirement for the material is 5000 tonnes. The delivery cost per order is Rs. 1,200 and the stock holding cost is estimated at 20% of material cost per annuam. You are required to advice the Purchase Department the most economic purchase level. Solution : As the price discount varies with lot size, EOQ will have to be decided by Trial and Error Method. Lot Size (Units) Q

Price per Tonne Rs. P

Purchase Cost for 5,000 Tonnes Rs.

Ordering Cost 5000 x 1200 Q

Q x P x 20% 2

2

3

4

5

6(3+4+5)

100

1200

60,00,000

60,000

12,000

60,72,000

250

1200

60,00,000

24,000

30,000

60,54,000

500

1180

59,00,000

12,000

59,000

59,71,000

625

1180

59,00,000

9,600

73,750

59,83,350

1,000

1160

58,00,000

6,000

1,16,000

59,22,000

1,250

1160

58,00,000

4,800

1,45,000

59,49,800

2,000

1140

57,00,000

3,000

2,28,000

59,31,000

2,500

1140

57,00,000

2,400

2,85,000

59,87,400

3,000

1120

56,00,000

2,000

3,36,000

59,38,000

4,000

1120

56,00,000

1,500

4,48,000

60,49,500

1

Carrying Cost

Total Cost Rs.

It will be observed, that if the purchases are made in the lot size of 1,000 units, it proves to be most economical.

484

Financial Management

(4)

A company needs 24,000 units of raw materials which costs Rs. 20 per unit and ordering cost is expected to be Rs. 100 per order. The company maintains safety stock of 1 month’s requirements to meet emergency. The holding cost of carrying inventory is supposed to be 10% per unit of average inventory. Find out : 1.

Economic lot size.

2.

Ordering cost.

3.

Holding cost.

4.

Total cost.

The supplier of raw material has agreed to supply the goods at a discount of 5% in price on a lot size of 4,000 units. Find where the concession price should be availed. Solution : (a)

(1)

Economic Lot Size 2xAxO Ci =

2 x 24,000 x 100 10% of 20

= 1,550 units (Approx.) (2)

Ordering Cost Annual requirement EOQ

x Ordering cost per order = 24,000 1550

x 100

= Rs. 1,548 (Approx.) (3)

Holding Cost :

As the company maintains safety stock of one month’s requirement, the average inventory held at any point of time will not only be EOQ/2 but safety stock + EOQ/2. Assuming that the usage of raw material is steady throughout the year i.e. 2,000 units per month, holding cost will be : (Safety Stock + EOQ/2) Carrying cost per unit per year)

Management of Inventory

485

(4)

1,550 units

=

(2,000 units +

=

2,775 units x Rs. 2

=

Rs. 5,550

2

) x 10% of Rs. 20

Total Cost : Cost of material 24,000 x 20

=

Rs. 4,80,000

Ordering Cost

=

Rs.

1,548

Holding Cost

=

Rs.

5,550

Total Cost

=

Rs. 4,87,098

(b)

Revised Total Cost : (with 5% discount)

(1)

Ordering Cost : As order size is going to be 4,000 units, total 6 orders will be placed. Hence total ordering cost will be : 6 orders x Rs. 100 per order i.e. Rs. 600

(2)

Holding Cost : The holding cost will be as below : (Safety Stock +

(3)

486

Order Size ) x Carrying cost per unit per year. 2

=

(2,000 units +

=

Rs. 7,600

4,000 units ) x 10% of Rs. 19 2

Total Cost : Cost of material – 24,000 x 19

=

Rs. 4,56,000

Ordering Cost

=

Rs.

600

Holding Cost

=

Rs.

7,600

Total Cost

=

Rs. 4,64,200

Financial Management

Conclusion : If purchased in Economic Lot Size, total cost (including material cost) is Rs. 4,87,098. If purchased in Lot Size of 4,000 units with 5% discount, total cost (including material cost) is Rs. 4,64,200. As purchases in Lot Size of 4,000 units result in the saving of Rs. 22,898 (i.e. Rs. 4,87,098 Rs. 4,64,200) that alternative will be preferred. PROBLEMS (1)

XYZ Ltd. requires 20,000 units of product A per annum. The purchase price is Rs. 4 per unit. The inventory carrying cost is 20% per annum and the cost of ordering is Rs. 100 per order. Advise the company, on how many times they should order in a year, so as to minimise the cost of product A?

(2)

A manufacturer buys certain essential spares from outside suppliers at Rs. 40 per set. Total annual requirements are 45000 sets. The annual cost of investment in inventory is 10% and costs like rent, stationery, insurance, taxes etc. per unit per year work to Re. 1, cost of placing an order is Rs. 5. Calculate the Economic Order Quantity.

(3)

Following information relating to a raw material is available. Annual Demand

2,400 units

Unit Price

Rs. 2.40

Ordering cost per order

Rs. 4.00

Storage cost

2% p.a.

Interest Rate

10% p.a.

Lead Time

Half month

Calculate Economic Order Quantity and total annual inventory cost in respect of the particular raw material. (4)

From the particulars given below, your are required to compute. (a)

Economic Order Quantity.

(b)

Maximum Level.

(c)

Minimum Level.

(d)

Re-ordering Level.

(e)

Average stock level.

Management of Inventory

487

(i)

Quantity required annually 3,000 units @Rs. 5 per unit.

(ii)

Interest and cost of carrying one unit - 10%

(iii)

Cost of placing an order at Rs. 30 per order.

(iv)

Consumption per week

Normal 60 units. Maximum 70 units. Minimum 50 units.

(v)

Lead time (in weeks)

Normal 5 Maximum 6 Minimum 4

(5)

Following information is available in respect of two components A and B. Particulars

A

B

Normal Usage

units

50

50

Minimum Usage

units

25

25

Maximum Usage

units

75

75

Week

4–6

2–4

Units

9,000

6,250

Ordering cost per year

Rs.

45

100

Carrying cost per unit per year

Rs.

9

5

Lead Time Annual Consumption

Calculate for each component (i)

Re-order level.

(ii)

Minimum level

(iii) Maximum level (iv) (6)

488

Average level

P. Ltd. uses three types of materials A, B and C for production of X, the final product. The relevant monthly data for the components are as given below. A

B

C

Normal Usage (Units)

200

150

180

Minimum Usage (Units)

100

100

90

Maximum Usage (Units)

300

250

270

Re-order Quantity (Units)

750

900

720

Re-order period (Months)

2 to 3

3 to 4

2 to 3

Financial Management

Calculate for each component.

(7)

(1)

Reorder Level.

(2)

Minimum Level

(3)

Maximum Level

(4)

Average Stock Level

The Following data are available from the records of M/s. Naveen Industries Ltd., using two types of materials A and B for the manufacture of their product. A

B

Normal Usage (units per month)

250

200

Minimum Usage (Units per month)

100

200

Maximum Usage (Units per month)

350

400

Reorder Quantity (Units)

900

1000

Reorder Period (Months)

3

4

Compute for each type of material, the following levels.

(8)

(1)

Reorder Level.

(2)

Minimum Level.

(3)

Maximum Level

(4)

Average Stock Level.

Following details are available in respect of a material. (i)

Ordering cost per order Rs. 45

(ii)

Annual consumption 9,000 units.

(iii) Carrying cost per unit per year Rs. 9 (iv)

Lead Times

Average – 10 days Minimum – 6 days Maximum –15 days Maximum for emergency purchases – 4 days.

Management of Inventory

489

Calculate (i)

Re-ordering Level

(ii)

Maximum Level.

(iii) Minimum Level. (iv) (9)

Average Level.

Certain purchased part of which annual requirements are 8,000 units, involves ordering cost equal to Rs. 12.50 per order, cost per piece Re. 1 and the annual carrying cost 20%. In addition, average daily usage is 32 units (based on 250 operating days per year), lead time is 10 days and safety stock has been calculated to be 100 units. Calculate : a)

Economic Order Quantity

b)

Re-order point.

(10) (i)

(ii)

XYZ company buys in the lots of 500 boxes which is a 3 months supply. The cost per box is Rs. 125 and the ordering cost is Rs. 150. The inventory carrying cost is estimated at 20% of unit value. What is the total annual cost of the existing inventory policy? How much money could be saved by employing the economic order quantity?

(11) To decide to buy an item, the following data are given. Annual Demand – 600 units. Ordering Cost – Rs. 400 Holding Cost – Rs. 40% Cost per unit – Rs. 15. Discount 10% if the order quantity is 500 What should be the decision? Justify your answer. (12) A manufacturer requires 10 lakhs components for use during the next year which is assumed to consist of 250 working days. The cost of storing one component for one year is Rs. 4 and the cost of placing order is Rs. 32. There must always be a safety stock equal to two working days usage and the lead time from the supplier, which has been guaranteed, will be 5 working days throughout the year. Assuming usage takes place steadily throughout the working days, delivery takes place at the end of the day and orders placed at the end of working days, you are required to calculate.

490

Financial Management

(i)

Economic Order Quantity

(ii)

Re-order Point

(13) Anil Company buys its annual requirement of 36,000 units in six instalment. Each unit costs Re. 1 and the ordering cost is Rs. 25. The inventory carrying cost is estimated at 20% of the unit value. Find the total cost of existing inventory policy. How much money can be saved by using Economic Order Quantity? (14) A company for one of the A class items, placed 6 orders each of size 200 in a year. Given ordering cost Rs. 600, holding cost 40% cost per unit Rs. 40, find out the loss to the company in not operating scientific inventory policy. What are your recommendations for the future? (15) A manufacturer has to supply his customers 600 units of his product per year. Shortages are not allowed and the inventory carrying cost amounts to Rs. 0.60 per unit per year. The set up cost per unit run is Rs. 80. Find. (a)

The Economic Order Quantity

(b)

The minimum average yearly cost.

(c)

The optimum number of orders per year.

(16) A purchase manager has decided to place order for minimum quantity of 500 numbers of a particular item in order to get a discount of 10%. From the records, it was found that in the last year, 8 orders each of size 200 numbers have been placed. Given ordering cost Rs. 500 per order, Inventory carrying cost 40% of the inventory value and cost per unit Rs. 400, is the purchase manager justified in his decision. What is the effect of his decision to the company? (17) A publishing house purchases 200 units of a particular item per year at a unit cost of Rs. 20, the ordering cost per order is Rs. 50 and the inventory carrying cost is 25%. Find the optimal order quantity and minimum total cost including purchase cost. If a 3% discount is offered by the supplier for purchase in lots of 1000 or more, should the publishing house accept the proposal? (18) Calculate for each component A and B the following : (a)

Re-order Level

(b)

Maximum Level.

(c)

Minimum Level

(d)

Average Stock Level

Management of Inventory

491

Normal Usage

–

300 units per Week each.

Maximum Usage

–

450 per Week each.

Minimum Usage

–

150 units per Week each.

Reorder Quantity

–

A - 2,400 units. B - 3,600 units.

Reorder Period

A - 4 to 6 Weeks B - 2 to 4 Weeks.

(19) Economic Enterprises require 90,000 units of certain item annually. The cost per unit is Rs. 3, the cost per purchase order is Rs. 300 and the inventory carrying cost is Rs. 6 per unit per year. (i)

What is Economic Order Quantity?

(ii)

What should the firm do if the supplier offers discounts as below viz.

Order Quantity

492

Discount in %

4500 – 5999

2

6000 and above

3.

Financial Management

NOTES

Management of Inventory

493

NOTES

494

Financial Management

Chapter 15 DIVIDEND POLICY

Profits earned by a company may be handled by it basically in two ways. (1)

To distribute the profits among the shareholders by way of dividend.

(2)

To retain the profits in the business to be used in future.

There are no strict rules and guidelines available to decide as to what portion of the profits should be distributed by way of dividend and what portion should be retained in the business. As such, to decide the dividend policy may be one of the most tricky and delicate decisions which the management of the company may be required to take. If the management decides to retain a large portion of the profits in the business, funds required for future expansion and modernisation needs of the company may be available to it on long term basis, without any obligations to repay the same. The expansion or modernisation programmes may improve the earning capacity of the company in future which may carry forward the growth of the company. The company may be able to absorb the shocks of business fluctuations and adverse situations boldly. A strong and stable company may earn the confidence of the investors and creditors and funds may be available to it at reasonable rates conveniently. As a result, the share prices and the value of the company will increase. Thus, though the shareholders are required to forego the dividends in the short run, they get benefit in the long run. On the other hand, if the management decides to distribute a large portion of profits by way of dividend, the company may be able to earn the confidence of the shareholders and may be able to attract the prospective investors to invest in the securities of the company. Shareholders are necessarily interested in getting larger dividends immediately due to the time value of money and also due to uncertainty regarding the future. Shareholders are thus attracted to the companies paying high dividends, due to which prices of the shares and value of the company increases.

Dividend Policy

495

Thus, it can be seen that both high retentions and high dividends may be desirable, but there is necessarily a reciprocal relationship between the retentions and dividends – Higher the retentions, lower the dividends, Lower the retentions, higher the dividends. The skill of the Finance Manager lies in striking the balance between these two extremes. The Finance Manager has to decide the dividend policy very carefully. A wrong dividend policy may put the company into financial troubles and the capital structure of the company may get unbalanced. The growth of the company may get hampered if sufficient resources are not available to implement growth programmes. This may affect earnings per share adversely. The stock market may react to this immediately and the share prices and the value of the company may decline. As such, the Finance Manager has to formulate the dividend policy in such a way which coincides with the ultimate object of the finance function of maximizing the wealth of shareholders and value of the firm. However, there are conflicting opinions regarding the impact of dividend policy on the valuation of the firm. According to one school of thought, dividends are irrelevant, so the dividends have no impact on value of the firm. According to second school of thought, dividends are relevant to the value of the firm measured in terms of market prices of the shares. (A) Irrelevance Approach: This approach is suggested mainly by Modigliani and Miller. According to this approach, the value of the company remains unaffected by the dividend policy of the company. It is the earnings potential and the investment opportunities available to the company which affects its value and not the dividend policy. Suppose, that a company wants to invest in a project, it has the two options open before it. (i)

Pay the earnings and raise the funds from market.

(ii)

Retain the earnings to be used to finance the project.

If the company pays the dividend, it will have to go to the market for raising the funds. Acquisition of the funds from the market will dilute the shareholding which results in reduced share values. As such, whatever the shareholders receive by way of cash dividends, they loose in terms of reduced share values. As such, they are not concerned with the fact whether the earnings are retained or are distributed by way of dividend. The market price of the shares and as such value of the company remains the same in both the situations. It is worth recollecting here the Modigliam Miller approach in relation to capital structure which suggests that the value of firm and its cost of capital are independent of its capital structure. As such, in relation to dividend policy also, the source from which the funds required to finance the investment programme are raised does not affect the value of the company.

496

Financial Management

(B) Relevance Approach : This approach is suggested mainly by Walter and Gordon. They hold that there is a direct relationship between the dividend policy of the company and its value in terms of market price of its shares. The propositions of the above approach can be stated, in most simple words as below. The investors prefer current dividend income to future dividend income as it does not involve any risk. As such, increasing payout ratio increases the share prices under normal circumstances. However, if the company has the investment opportunities open before it where expected rate of return is more than cost of capital, the share prices may increase even with the declining payout ratio which is due to the anticipated and future dividend income. Factors determining Dividend Policy Before formulating the dividend policy of the company, the Finance Manager is required to take into consideration various factors which may be classified as below – a.

External Factors

b.

Internal Factors

External Factors 1.

Phase of Trade Cycles : The company’s dividend policy depends upon the phase of trade cycles through which the company may be moving. During the phase of boom and prosperity, the company may not like to distribute huge amount of profits by way of dividends though the earning capacity of the company may permit it to do so. The company will like to retain more profits which can be used during the depression which is likely to follow. Further, the company will like to take the benefits of investment opportunities prevailing during the period of boom. Similarly, during the period of depression, the company will like to withhold the dividend payments to retain the profits in the business in order to preserve its liquidity position. At all the times, though it may be necessary to declare higher dividends to increase marketability of its shares.

2.

Legal Restrictions: The Company can formulate its dividend policy within the overall legal framework. If the company wants to pay the dividend in cash, relevant provisions of Companies Act, 1956 are required to be followed by the company. If the company wants to issue the bonus shares with the intention to capitalise its reserves, relevant SEBI guidelines are required to be followed by the company. The relevant provisions of Companies Act, 1956 and SEBI guidelines are discussed later.

3.

Tax Policy: Tax policy as a factor affecting the dividend policy of the company needs to

Dividend Policy

497

be considered from the point of view of company as well as the shareholders. From company’s point of view, dividend can be paid out of profit after tax. As such, tax policy of the government necessarily affects the dividend policy of the company. From the shareholder’s point of view, dividend received by them is considered to be a taxable income which increases their individual tax liability. 4.

Investment Opportunities : Formulation of dividend policy of the company depends upon the investment opportunities available to the company. If the investment opportunities involve a higher rate of return than the cost of capital of the company, the company will like to retain the profits to be invested in these projects.

5.

Restrictions imposed by the lending institutions : In practical circumstances, the lending banks or financial institutions impose certain restrictions on the company preventing the payment of dividend entirely or limiting the amount of dividend or disallowing the payment of dividend if certain conditions are not fulfilled. This is due to the fact that the payment of dividend amounts to the withdrawal of profits from the business and company paying the dividend may be against the interest of the lending banks or financial institutions so long as the loans are still unpaid to them.

Internal Factors

498

1.

Attitude of the Management : If the attitude of the management is aggressive, it may decide to pay more dividend as the management be interested in increasing the recurring income of the shareholders. Whereas if the attitude of the management is conservative, the company will like to retain more profits in the business to take care of the contingencies.

2.

Composition of Shareholding : The composition of the shareholding may play an important role in the dividend policy formulation of the company. If the company is a private limited company having less number of shareholders, the company will like to retain more profits and restrict the payment of dividend in order to reduce the tax liability of the individual shareholders, as the dividend received by the shareholders is a taxable income in their hands. If the company is a public limited company, tax brackets of the individual shareholders may not have a significant impact on the dividend policy of the company.

3.

Age of the Company : A young and growing concern will like to retain maximum profits in the business in order to finance its growth and expansion needs as it may be difficult for it to raise the funds from the open market whenever the need arises. On the other hand, an old or established company having reached the saturation point, may follow a high dividend policy.

4.

Nature of Business / Earnings : The nature of business of the company inevitably affects its dividend policy. A company having stability of earnings may be able to formulate Financial Management

long term dividend policy and may even follow a high dividend policy if the earnings so permit. On the other hand, a company having unstable income may like to retain its profits during boom to ensure that dividend policy is not affected by cyclical variations. 5.

Growth Rate of Company : The growth rate of the company closely affects its dividend policies. A rapidly growing company may like to retain majority of its profits in order to take care of its expansion needs. However, care should be taken by the management to invest only in those projects which yield more returns than its cost of capital.

6.

Liquidity Position : Profitability and Liquidity are separated from each other. In spite of existence of high profitability or huge reserves, the company may not have sufficient funds to pay cash dividends. As such, before formulating the dividend policy, due considerations should be given to the liquidity positions of the company. At the same time, future commitments affecting the liquidity should also be considered. E.g. At present, company’s cash position may be comfortable, but it may need cash within a short time to pay instalments of term loans or to pay creditors for materials. In such case, Finance Manager may not like to impair its liquidity for making dividend payment.

7.

Customs and Traditions : In some cases, the customs and traditions built by the company may affect its dividend policy. E.g. If the company is following the stable dividend policy for 20 years, it may like to maintain the trend in 21st year also, inspite of adverse profitability or liquidity situations.

Choosing the Dividend Policy : As discussed above, a host of factors are required to be considered by the company before formulating its dividend policy. The selection of ultimate dividend policy varies from industry to industry. There may be various pattern in which a company may pay dividends. (1)

Stable Dividend Policy :

According to this policy, the company pays a fixed amount of dividend irrespective of the fluctuations in income. During the periods of prosperity, the company withholds extra income to be used for paying dividends in lean years. Stable dividend policy does not indicate stagnation in dividend payout. If the company is assured about permanent increase in earnings, amount of dividend per share may be increased. Stable dividend policy helps the company in following respects : (i)

The credit standing of the company in market increases. The investors are assured of a stable income and the company can raise as much funds as required in the market.

(ii)

The share prices of the company increase. The marketability of the shares increase and the investors are ready to pay high premium for these shares.

Dividend Policy

499

(iii) The management of the company enjoys confidence of the shareholders. This may enable the company to raise the funds whenever required and it also improves the morale of management. (iv)

The company following stable dividend policy can formulate financial plan on long term basis as future demand and supply of capital can be correctly estimated.

While formulating stable dividend policy, care should be taken not to fix the dividend payout ratio at a very high level which can not be maintained in lean period. For this purpose, correct estimations of earnings capacity and future earnings of the company should be made. 2.

No Immediate Dividend Policy :

According to this policy, the company does not pay any dividend despite the huge earnings. The company retains the earnings to be used in future for its growth and expansion programmes if it is feared that the access to capital market will be difficult or costly in future. The main drawback with this policy is that the shareholders do not get immediate cash income by way of dividend and hence shareholders who invest in the shares with the view to get regular income may not be in favour of this policy. However, this policy may attract the shareholders who are willing to devote short term dividend income for long term capital gains and share in the increased prosperity of the company. 3.

Regular and Extra Dividend Policy :

This policy may be used as supplement to stable dividend policy. In case of a stable dividend policy, the dividend pay out its maintained at a constant rate. However, if in a particular year, the earnings of the company increase abnormally, the additional earnings may be distributed by way of extra dividends rather than increasing the dividend payout rate itself. The advantage attached with the policy is that the shareholders are aware of the fact the extra dividends are solely due to the abnormal earnings which may be dropped if there are no abnormal earning in a particular year. However, if a company follows a policy of regular and extra dividends for years together, a wrong impression may be created in the minds of shareholders who may treat the extra dividends as a part of regular dividends and the omission to pay extra dividend in some year may result into loss of confidence of the shareholders with the adverse effect on share prices and credit standing of the company. 4.

Regular Stock Dividend Policy :

According to this policy, the company may decide to pay dividends in the form of stock rather than in the form of cash i.e. by issuing bonus shares. This policy may be useful to the company as it does not involve the effect on liquidity position of the company. However, following its policy on a regular basis may prove to be disadvantages due to two reasons.

500

Financial Management

Firstly, if the company is not in the position to increase future earnings on a permanent basis, issue of Bonus shares may reduce the earnings per share which may adversely affect the share prices and credit standing of the company. Secondly, the shareholders who are interested in getting cash income on regular basis may not approve of this policy on a permanent basis and may demand cash dividends. 5.

Irregular Dividend Policy :

According to this policy, the dividend payout rate is not fixed by the company. The dividend per share varies according to the level of earnings. As such, high earnings may result into high dividends whereas less earnings may result into less or no dividends. As such, this policy believes that the shareholders are entitled to dividends only when the earnings and liquidity position of the company justify the payment of dividends. This policy may be followed by the companies having unstable income. This policy may be advantageous for the company as it does not commit itself to any fixed and regular payment of dividend. However, it may not be approved by the shareholders as it does not assure any fixed or regular dividend income. Forms of dividend payment If a company wants to distribute the profits among the shareholders by way of dividend, it can do so in two forms – a.

Payment of dividend in cash

b.

Issue of Bonus Shares

Cash Dividend If the company wants to distribute the dividend by way of cash i.e. by issuing the dividend warrants, the company is required to fulfill various procedural and legal formalities. a.

The rate of dividend to be paid needs to be decided by the Board of Directors. However, the capacity of the Board of Directors is only the recommendary capacity. The dividend is declared by the shareholders in their meeting i.e. Annual General Meeting. However, the shareholders can not increase the rate of dividend recommended by Board of Directors. According to the provisions of Section 205-1(B) of the Companies Act, 1956, the Board of Directors can declare the interim dividend. The term interim dividend refers to the dividend declared in between two Annual General Meetings.

b.

The dividend is payable out of the current year’s profit after providing for sufficient amount of depreciation as per the provisions of Schedule XIV of the Companies Act, 1956.

Dividend Policy

501

c.

d.

e.

Before any dividend is paid in cash, the company is required to transfer a certain minimum amount to reserves from the profits earned in the current year. This provision is made to ensure that the company does not withdraw the entire amount of profits from the business. The rates at which the profits needs to be transferred to reserves, are stated below : Rate of dividend To be paid

% of current profits to be transferred to reserves

More than 10% but less than 12.5%

2.5%

More than 12.5% but less than 15%

5%

More than 15% but less than 20%

7.5%

More than 20%

10%

Generally, the company will not be able to pay the dividend unless the company has the profits in the current year. However, in some cases, the company can pay the dividend out of the profits earned by the company in the past and retained as reserves. If the company pays the dividends out of the retained profits, the company needs to comply with following conditions: (i)

The rate of dividend declared shall not exceed the average rate at which the dividend was declared during 5 immediately preceding years or 10% of its paid up capital.

(ii)

The total amount to be drawn from the reserves shall not exceed an amount equal to 10% of its paid up capital and free reserves.

Any amount of dividend declared including interim dividend shall be deposited in a separate bank account within five days from the date of declaration of such dividend and the amount so deposited shall be used for the payment of interim dividend. If the dividend has been declared but has not been paid or the dividend warrants are not posted within 30 days from the declaration of dividend to any shareholder entitled to the payment of dividend, every director of the company who is knowingly a party to the default, shall be punishable with simple imprisonment upto three years and also to a fine of Rs. 1000 for every day during which the default continues. Further, the company shall be liable to pay simple interest @18% p.a. during the period for which the default continues.

f.

502

Any dividend which has been declared by the company but which remains to be paid or claimed within 30 days from its declaration, the company shall, within 7 days from the expiry of such 30 days, transfer this amount of unpaid or unclaimed dividend to a separate account opened with a scheduled bank. If any amount remains pending in this account for a period of 7 years, such amount will be transferred by the company to a fund

Financial Management

established by the Central Government as “Investor Education and Protection Fund” which is supposed to be used for promotion of investors’ awareness and protection of the interests of the investors. Bonus Shares : Bonus Shares indicate the payment of dividend in the form of shares of the same company in proportion to their existing shareholding. This form of paying the dividend does not involve any outflow of cash, but involves only transfer of retained earnings to share capital. Profits earned by a company in the previous years effectively belong to the equity shareholders as they are the ultimate owners of the company. However, so long as the reserves appear on the balance sheet of the company, the legal ownership of the reserves remain with the company. By issuing the bonus shares, the company transfers ownership of reserves to the shareholders legally. As such, issue of bonus shares is technically referred to as the capitalisation of reserves. When a company issues bonus shares, reserves of the company get reduced and share capital of the company increases. Advantages : (1)

To the Company : (i)

Conservation of Cash : The company can satisfy the desire of shareholders for dividend without affecting its cash position. Thus, issuing of bonus shares may be a best remedy for a company having deficiency of the funds inspite of the huge earnings.

(ii)

Remedy for Undercapitalisation : As discussed earlier, the conditions of undercapitalisation indicate huge amount of earnings per share. By issuing bonus shares, the company increases number of shares thereby reducing the amount of earnings per share and the amount of dividends per share. Thus bonus shares can be a best remedy for overcoming the situation of undercapitalisation.

(iii) Transferring Ownership of Reserves : Existence of huge reserves may tempt a company to indulge itself in the speculative activities and manipulation of market value of shares. Issuing the bonus shares prevents the company from doing so. (iv) Increased Marketability : Bonus shares may increase the marketability of the shares. Increased number of shares and reduced earnings per share may keep the market price of the shares within the reach of an ordinary investor. Thus, the market for the shares of the company may become wide. (v)

Increased Prestige : Issuance of bonus shares increases the credit standing of the company in the eyes of the lending financial institutions and it can arrange for the funds at a reasonable cost.

Dividend Policy

503

(vi) Proper Presentation of Earning Capacity : Issuance of bonus shares results into proper presentation of earning capacity of the company. If bonus shares are not issued, the accumulated reserves go on increasing with no change in shares capital which may create a false idea about the profitability and earning capacity of the company. To Shareholders : Due to bonus shares, shareholders are benefited from two angles. First, their equity holding in the company increases. Though they may get dividend per share at a reduced rate, their total income is not affected. Second, the increased prestige of the company in the eyes of probable investors creates a ready market for their shareholding. To Creditors : Creditors react favourably as company’s liquidity position is not affected and the margin of safety available for the creditors increases. But if the company continues to pay dividend at old rates on increased capital, it increases the strain on liquidity position of company. Disadvantages : (1)

Issue of bonus shares presupposes that the earnings of the company will increase proportionately, otherwise the increased capital may not be justified. If the earnings per share are not increased with respect to the increased capital, it may suggest low profitability of the company and its poor management. This may prove to be fatal to the company.

(2)

The stock dividends are more expensive to administer as compared to cash dividends.

Guidelines for the issue of Bonus Shares : Earlier, the companies issuing bonus shares were governed by the guidelines issued by Controller of Capital Issues (CCI), After the abolition of office of CCI, these guidelines were replaced by SEBI guidelines. Whereas the guidelines issued by CCI were restrictive in nature, the guidelines issued by SEBI are more administrative in nature. Eventhough the guidelines issued by SEBI are more particularly applicable to the companies listed on the recognised stock exchanges, they equally apply to non-listed companies as well. The SEBI guidelines in respect of issue of bonus shares are as below :

504

a.

Articles of Association of the company should permit the issue of bonus shares. If there is no provision in the Articles of Association, they need to be amended first.

b.

The authorised share capital of the company should be sufficient to absorb the share capital of the company after the issue of bonus shares. If the authorised share capital is not sufficient, the same needs to be increased first.

Financial Management

c.

The bonus shares can not be issued in respect of partly paid shares.

d.

The issue of bonus shares needs to be approved by the board of directors and the company should issue the bonus shares within a period of six months from the date of approval given by the board of directors. Approval given by the board of directors can not be reversed.

e.

Bonus shares can be issued out of the free reserves appearing on the balance sheet and the share premium amount collected in cash. It is made very clear in the SEBI guidelines that revaluation reserve can not be used for issue of bonus shares.

f.

The company can not issue the bonus shares if it has defaulted i)

in respect of payment of interest or repayment of principal amount, either in case of debentures or in case of public deposits. This provision is to protect the interests of debenture holders or depositors.

ii)

in respect of payment of employee dues, like provident fund, gratuity, bonus etc. This provision is to protect the interests of employees.

g.

Pending the conversion of Fully Convertible Debentures (FCDs) or partly Convertible Debentures (PCDs) into the shares of the company, no company can issue the bonus shares unless the same benefit is extended to holders of these FCDs or PCDs by reserving a part of shares for them. Such shares can be actually issued when the conversion into shares takes place.

h.

A company which is a listed company shall forward a certificates duly signed by the company and countersigned by its statutory auditor or a company secretary in practice, certifying that the company has compiled with all the terms and conditions in respect of issue of bonus shares.

When CCI guidelines were applicable, no company could issue the bonus shares in the proportion of more than 1:1 i.e. for every one share held in the company, maximum one bonus share could be issued by the company. This restriction was removed by SEBI guidelines. First company to take the advantage of these revised SEBI guidelines was Cipla Ltd., which issued the bonus shares in the proportion of 5:1, i.e. for every one shares held in the company, the shareholders got five bonus shares.

Dividend Policy

505

QUESTIONS

506

1.

Discuss the significance of dividend policy decisions. Which factors affect dividend policy decisions of a company? What are the different dividend policies a company can follow?

2.

Discuss various legal and procedural formalities to be complied with by a company while paying the dividend in cash.

3.

What do you mean by Bonus shares? What are the advantages of Bonus shares. Discuss SEBI guidelines for the issue of Bonus shares.

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NOTES

Dividend Policy

507

NOTES

508

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LIST OF REFERENCE BOOKS

1.

Financial Management

–

Prasanna Chandra

2.

Financial Management

–

I.M. Pandey

3.

Financial Management

–

S.C. Kucchal

4.

Financial Management

–

Khan & Jain

5.

Financial Management

–

R.M. Shrivastava

Reference Books

509

NOTES

510

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NOTES

Reference Books

511

NOTES

512

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