Topic 1 - Business and Resources

Business & Business resources 2013
Learning Objectives
Basic knowledge of accounts and finance is increasingly recognized as a ‘must possess’

knowledge for anybody in business, irrespective of the role that one plays. The different roles
could be owners, management, employees etc. One may not handle accounts and finance
functions directly. However in order to take educated business decisions, one must know how
any business decision affects ultimately the profits of the organization, either positively or
negatively.
Keeping this in mind, the topic focuses on:

1. Business enterprise and forms of business organization
2. Financial resources for a business enterprise
3. Understanding application of basic finance concepts to business
Contents Index
1.1 Introduction to business and enterprise

1.2 Financial resources for a business enterprise
1.3 Basic finance concepts & their application to business
1.4 Solved Questions
1.5 Unsolved Questions
1.6 Summary
1.7 Handout
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1.1 Introduction to Business & Enterprise
1.1.1 Activities of a commercial business enterprise
A business enterprise is engaged in one or more of the following activities:

Trading – Buying a product in one form and selling the product in the same form without any
change:
Example – all retail merchants and wholesalers trading in various goods
Manufacturing – Converting materials into finished products with or without the help of
technology
Example – all manufacturing companies in various sectors, pharma, engineering, automobiles
etc.
Services – Engaged in one or more services that do not involve any tangible product
Example – any kind of service in the services sector including I.T. services
The enterprise can undertake more than one of these main activities or even all the activities,
trading, manufacturing or services
1.1.2 Different forms of business organization
Simply put, there are three different forms of business organization:

The forms depend upon the number of owners of the enterprise and the ‘Statutes’ or ‘Acts’
whose provisions are applicable to these different forms of business organizations.
Sole proprietorship firm – single owner
Partnership firm – multiple owners
Limited companies – Private limited and public limited companies
The characteristics of the three different forms of organization are given below:
Sole proprietorship firms
Characteristic features:
Formation: Easy as law does not recognize the firm but recognizes only the owner
Number of owners: One
Registration: None specifically; depending upon the nature of activity like manufacturing or
commercial enterprise within the precincts of a municipal corporation of metropolitan council,
required licence to operate is required. This is applicable to other forms of business
organizations too; this requirement should not be confused with the registration of the firm
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Financial resources: Mostly from the single owner. At times loans from lenders like banks, but
in small amounts.
Ownership, control and share in profits/loss: All to the sole proprietor with none else to share
with
Advantages: Easy to form

No direct statutory regulations to observe unlike partnership firms and limited companies.
Note: Not to confuse with the statutory requirements to comply with that depend upon the
activity of the enterprise, like manufacturing, trading or service enterprise etc. For example a
commercial enterprise in Pune city will require a ‘shop and establishment’ licence to run the
business. This is common requirement for all business enterprises within a town or a city or a
metropolitan city for all forms of business organization like proprietorship firms, partnership
firms and limited companies.
Suppose it is a manufacturing business enterprise, it has to register with the District Industries
Centre, a state government body. This is irrespective of the form of business organization, a
sole proprietorship firm, a partnership firm or a limited company.
Similarly if it is a restaurant, it has to register with the Food & Drug licensing authorities,
besides carrying ‘a shop and establishment’ licence. This is irrespective of the form of business
organization, a sole proprietorship firm, a partnership firm or a limited company.
100% ownership, control and share in profits
Disadvantages/demerits:
Much less credibility associated with this form, as no direct statutory requirements are
specified
Ability to raise resources from outside and hence growth constrained

100% liability for loss – sole liability of the single owner as the firm is not recognized by law.
Partnership firms
Formation: More difficult to form in comparison with sole proprietorship firms. The Indian law
recognizes both the firms and their partners jointly but not independently.
Number of owners: Two with a ceiling of 20 partners.
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Registration: Requires registration under The Partnership Act that is common to entire
dominion republic of India. The authority is known as ‘The registrar of firms’ and he is a state
authority.
A partnership firm is not allowed to have legally branches even within the same state. A sister
firm located at a different place even within the same state is required to be registered
separately as another partnership firm may be even with the same partners. However in
practice, it may be claimed as a branch with the authorities not enforcing the law strictly.
Licensing formalities: Common with all the forms of business organization, like sole
proprietorship firms, limited companies etc. depending upon the nature of activity like trading,
manufacturing or a service enterprise.
Statutory controls: The Partnership Act provisions are fairly strict and need 100% conformity.
They are legally enforceable throughout India.
Financial resources: Shared by the partners in the form of capital. Loans from lenders like banks
are fairly common and in large volumes too depending upon the scale of business. Cannot go
to members of public for raising funds in the form of equity or debentures or bonds or fixed
deposits unlike limited companies.
Ownership, control and share in profits/loss: All to the partners in the same proportion as
mentioned in the ‘Partnership agreement’. Profits after paying income tax (known as PAT) are
added to the capital of the partners in the proportion referred to in statement no. 1.
Advantages: Relatively easy to form in comparison with limited companies but more difficult
than sole proprietorship firms. Enjoys more credibility than sole proprietorship firms in general.
100% ownership, control and share in profits with the partners and nobody outside the firm
Less credibility associated with this form in comparison with a limited company, as the legal
requirements and statutory compliances for a limited company are more vast and demanding.
Ability to raise resources from outside limited and hence growth constrained
All partners liable for 100% loss; this is often referred to as ‘unlimited liability’, as for making
good the loss of the firms, in case the assets of the firms are not adequate to meet all its
liabilities, the personal assets of the partners can be attached and sold.
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Limited companies
Formation: Most difficult to form among the different forms of business organization. The
Indian law recognizes both the firms and the owners (also known as ‘shareholders’) individually
and not jointly. Formed under ‘The Companies Act’ of India.
Different kinds of limited companies: Private Limited Companies and Public Limited Companies
Private limited companies cannot go to public for finance like equity, debentures, bonds etc..,
while public limited companies can go to public for finance. This is the direct consequence of
the provisions in the ‘Memorandum and Articles of Association’ the governing document. This
spells out the purpose and objective of the limited company (Memorandum) and rules and
regulations governing the business enterprise (Articles). In the case of a private limited
company, there is a restriction on ‘share transfer’. Shares cannot be freely sold by the present
holders to anybody without the permission of all the other existing shareholders. This
restriction is absent in the case of public limited companies.
Number of owners: Private Limited Company – Minimum 2 and maximum 50. Public Limited
Company – Minimum 7 and maximum – nothing specified means there is no upper limit for the
number of shareholders of a public limited company.
Registration: Requires registration under The Companies Act that is common to entire
dominion republic of India. The authority is known as ‘The registrar of companies’ and he is a
Central government authority. Limited companies in India come under the ministry of Company
affairs.
A limited company is allowed to have legally branches within the country without any further
registration formalities. However it cannot have branches outside India and any subsidiary
outside India is required to be incorporated (formed) as a limited company in accordance with
the statutory requirements as prevalent in the country of registration. For example, Infosys
wants to open a subsidiary office in the USA; it has to form a separate limited company there
under the US laws and cannot operate it as its branch office of the Indian parent company. The
same requirement applies to Oracle US wanting to operate in India specifically or outside the
US in general.
Licensing formalities: Common with all the forms of business organization like sole
proprietorship firms, limited companies etc. depending upon the nature of activity like trading,
manufacturing or a service enterprise. Please refer to examples given under ‘Sole
proprietorship firms’.
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Statutory controls: The Indian Companies Act is very strict. Some of its provisions are common
for all limited companies, both public and private; some of the provisions are specific to private
limited and most of them are applicable to public limited companies. They are legally
enforceable throughout India.
Financial resources: Shared by the promoters in the case of a private limited company in the
form of share capital (also known as ‘equity’).
Shared by the promoters as well as members of public in the case of public limited companies
(this provision is an enabling provision but not compulsory thereby meaning that there could be
some public limited companies that have not gone to public for resources although they can go
as their registration name indicates). Besides, they can get loans from lenders like banks.
Further they can also go to public for other forms of loans like debentures, bonds etc. The
critical statutory requirement is that in case resources are taken from public, the company has
to list its shares, debentures etc. in stock exchanges for purpose of trading by the owners of
such instruments.
Ownership, control and share in profits/loss: All to the shareholders in the same proportion as
the number of shares held by them in the company. 100% of PAT cannot be distributed as
‘dividend’, as a part of PAT is required to be put back into business in the form of ‘Reserves and
surplus’. PAT cannot be added to the share capital of the owners unlike in the case of
partnership firms. PAT be it distributed (dividend) or retained (reserves and surplus) belongs to
the shareholders (owners) and not to the business enterprise.
Advantages: High credibility in view of statutory requirements.
Ability to raise resources without any constraint especially in the case of public limited
companies
Universal acceptability especially for joint ventures etc.
Limited liability to owners in the case of loss as their personal property is not affected.
Privileges like entitlement to further shares in the form of bonus and rights issues.
Most complex form of organization

A number of statutory requirements to comply with
A number of formalities to be complied with for going to public for resources
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Differences among the three different forms of business organizations are captured in the
following matrix
Parameter Sole proprietorship Partnership firms Limited companies

firms
Accounting system – No compulsion. The No compulsion under Under the provisions
Accrual or Cash firm can choose The Partnership Act. of The Companies’
either of them but The firm can choose Act, it is compulsory
once decided, will either of them but to adopt the Accrual
have to stick with it once decided, will basis of Accounting.
have to stick with it No choice
Cash transactions and If cash system is If cash system is The enterprise has to
credit transactions adopted, credit adopted, credit account for both cash
transactions will be transactions will be and credit
ignored ignored transactions
Final audited No specific formats No specific formats Specific formats as
statements – per Schedule VI of the
presentation in Companies’ Act
specific formats
Components of P&L Trading and Profit & Trading and Profit & Profit & Loss
Statement Loss components Loss components statement only
Retained profit in Transferred to the Transferred to the Transferred to
business capital of the owner capital accounts of Reserves & surplus as
(Profit After Tax as thereby increasing the owners thereby share capital of the
reduced by profit the investment of the increasing their owners cannot be
withdrawn from owner in the firm. investment in the firm altered by retained
business or profits in business
distributed in the
form of dividend)
Distribution of 100% Done Done Cannot be done.

profit to the owners’ Dividend is only after
capital transferring certain
minimum amount to
the General Reserve
that depends upon
the percentage of
Dividend on Share
capital
Statutory audit of Not compulsory. Tax Not compulsory. Tax Compulsory under
Accounts audit compulsory in audit compulsory in the provisions of the
case turnover is case turnover is Companies’ Act,
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beyond a specified beyond a specified besides Tax audit

limit limit
Depreciation on fixed Not compulsory in the Not compulsory in the Compulsory in terms
assets other than land books of accounts – books of accounts – of the Companies’ Act
claimed in the Income claimed in the Income – Schedule XIV and
Tax returns Tax returns the rates are different
from The Income Tax
provisions
1.1.3 Differences between private limited and public limited companies
A private limited company cannot go to public for raising money for business. The other details
have been given in the previous paragraphs like minimum number of share holders to be 2 and
the maximum number of share holders to be 50. This kind of limited company is registered so
with the Registrar of Companies under The Companies Act. If deemed necessary, this can be
modified to be a public limited company by the following steps:
1. Pass a board resolution at the board of directors’ meeting,

2. Place the resolution before the general body of equity shareholders,
3. Pass a general body resolution by the shareholders at the meeting called for this purpose,
Submit the required application to The Registrar of Companies &
4. Once his approval is received amend the ‘Memorandum & Articles’ of association of the
limited company.
A public limited company, on the other hand, can go to public for raising money for business.
The other details have been given in the previous paragraphs like minimum number of
shareholders to be 7 and no ceiling for the maximum number of shareholders. This kind of
limited company is registered so with the Registrar of Companies under The Companies Act.
Again here, if deemed necessary, this can be modified to become a private limited company by
the same steps as mentioned for a private limited company to become a public limited
company.
Public limited companies can go to public for resources for business. Does it mean that all of
them have gone to public for resources for business? No.
Just about 13,000 companies have gone to public in India at present and listed on the stock
exchanges, namely, Bombay Stock Exchange (BSE) & National Stock Exchange (NSE). The other
public limited companies that can go to public but have not gone to public are called ‘unlisted
public limited companies’.
Examples are: Tata Sons Limited, BSNL etc.
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Note:
Readers should note that whether to go to public or not entirely depends upon the
management policy and the requirement of funds. Suppose the enterprise wants more funds
for expansion of business and the owners have limitations of raising required resources, they
will be forced to go to public for resources for business.
Once they go to public for resources for business, they come under SEBI regulations. The
regulations require the limited companies that have gone to public for resources for business to
list the shares on stock exchanges. This is a mandatory requirement. The objective is to enable
the shareholders to sell and buy the shares freely.
The market in which the public limited companies issue shares to members of public and raise
resources for business is called ‘primary market’, while the market in which the shareholders
freely buy or sell shares is called ‘secondary market’. While primary market does not have any
specific market place, the secondary market has specific market place in the form of stock
exchanges.
1.1.4 Private sector & public sector
Most of the times, public sector and public limited companies are mistaken, one for the other.
Perhaps the common word ‘public’ could be the reason for this confusion. This note attempts
to put public sector and public limited companies in proper perspective.
Public or private sector:
This indicates whether the control over the enterprise is in the hands of Government or private.
Here the word private would include individuals, companies or other bodies. If the government,
either the central or state government in India has control over an enterprise, then it is a public
sector enterprise. As regards ownership of the government in such an enterprise, it has to be
51% (as recently clarified by the Central government spokesperson). For example, BHEL or
BEML are public sector companies. This means that these are under the control and direction of
the Union government of India; whereas Reliance Industries is in private sector. This is under
control and direction of Mukesh Ambani group.
Structure of a public sector enterprise:

It will either be a corporation like Life Insurance Corporation or a public limited company like
BHEL, ONGC etc.
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It is learnt that the principal officer under the Company Law Board (CLB which is responsible for
administration of ‘The Companies’ Act’) does not allow registration of a limited company, be it
in public sector or private sector with the word corporation as a part of its name. Please recall
the following to reinforce this point. Hindustan Petroleum Corporation has now become
Hindustan Petroleum Company Limited; similarly Bharat Petroleum Corporation has now
become Bharat Petroleum Company Limited.
The public sector undertakings or enterprises (PSUs or PSEs as they are known) which have not
been registered under the Companies’ Act as limited companies are often times referred to as
corporations. These enterprises could be at the centre such as LIC or at the state level. For
example in Maharashtra, we have the following corporations (these are only examples; they do
not form the exhaustive list of PSUs in Maharashtra which are not limited companies):
 Maharashtra state finance corporation
 State industry corporation of Maharashtra
 Maharashtra state road transport corporation
 Maharashtra state farming corporation
 Maharashtra Krishna valley development corporation
These PSUs are born mostly out of relevant Acts that have been passed in the Parliament or
state legislatures.
It is possible that among the PSUs, there are public limited companies which have not gone to
public at all for resources. A typical example is BSNL that is not listed. However the distinction
between a corporation and a limited company should be clear to the reader. While BSNL is not
a corporation and hence it is a public limited company, it has not yet gone to public. Please
recall Maruti Udyog Limited and ONGC before they became public in the year 2003.
It should be borne in mind that any government cannot start a private limited company as this
means that government’s wealth that is public can be owned by some private individuals or
corporations etc.
Examples of public sector public limited companies:
BHEL, BPCL, BEML, NTPC, IOCL, MUL & all public sector banks
Number of private sector public limited companies that are listed: Around 13,000, BSE & NSE
inclusive.
Besides the above, in the private sector there are unlisted public limited companies and private
limited companies. The write does not have the exact numbers of such companies.
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Summing up the different kinds of undertakings, both in public and private sectors, there are:
Public sector:
 Corporations that are not registered under The Companies’ Act, either at the centre or at
the state
 Public limited companies that have not gone to public for resources
 Public limited companies that have gone to public for resources and are listed
Private sector:
 Public limited companies that have gone to public for resources and are listed
 Public limited companies that have not gone to public for resources and hence are unlisted
&
 Private limited companies that cannot go to public for resources
Case lets:
1. Government of India wants to start a limited company in Electronics. It wants to give the
name of Bharat Electronics Private Limited. The government also wants to have branch
offices as sales offices of this limited company.
Examine the above and answer the following questions:
 What is fundamentally wrong with the choice of form of organization and name?
 Can a limited company have branches throughout India?
 Suppose it is not a limited company, which other form of organization can this public
sector undertaking called by? Give examples for the same.
 What is the difference in financial resources available for a government limited
company and the alternative form as relevant for the given case let?
2. There are public sector undertakings under the Union Government of India as well as under
the different states forming a part of the democratic Republic of India. They want to convert
some of the PSUs into limited companies.
 What is the first step towards the change in the form of organization?
 What are the formalities to be completed by the Government of India for this
conversion?
 Can the government company raise equity from the public?
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Class activity 1.1.1: To prepare a list of public sector and private sector companies in India, at
least 20 in number, both at the centre and at the state level
1.2 Financial resources for a business enterprise
1.2.1 Starting point for a business enterprise
For any form of business organization engaged in any of the three activities, the starting point
of business in terms of financial resources for business is owner’s/owners’ capital. The question
arises in a learner’s mind is that whether any enterprise can be established only with borrowed
funds and not owners’ capital? The answer is a firm ‘No’.
Let us study the following example to understand this:

Suppose we buy a car with the help of a loan from a bank. The bank will never give 100% loan.
It will insist on some contribution by the owner that is in India referred to as ‘margin’. This
means that even for purchasing an asset like a vehicle, the owner has to put in some money
with the balance coming from the lender in the form of ‘loan’. Scaling up this argument to a
business enterprise, a lender will never give 100% loan to any business enterprise. There should
always be some contribution by the owners in the business. This contribution is known by a
different name, ‘capital’.
What is the reason for this?

This is to ensure that the owners have financial interest in the enterprise so that their
commitment to the enterprise will be continuous. For example, if the owners are
technopreneurs, their continued contribution to the enterprise is a must for the success of the
enterprise. Suppose they withdraw from the business, the lenders will not be able to run the
business. They will have to look for alternative persons to run the enterprise. This could be
difficult and in some cases not possible also. In the absence of this financial commitment, the
persons who start business can arbitrarily withdraw from the business, thereby putting the
future of the enterprise to peril.
Are there different names given to this ‘capital’ from the owners?
Yes. The name depends upon the form of business organization.

It is called ‘capital’ in the case of sole proprietorship firms and partnership firms. The same is
called ‘share capital’ in the case of limited companies, as equity shares are issued to the owners
who are also known as shareholders.
Now the question arises: Can a business start with a mixture of capital and loans?
Yes. Once the capital of the owners is introduced into business, the request of the owners for a
loan can be considered by a bank on merits.
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Thus summing up:

 The starting point for any business is capital from the owners
 This capital is known by different names and the name depends upon the form of business
organization
 Owner’s/owners’ capital is a must for any enterprise so as to ensure financial commitment
 No lender will give 100% loan to an enterprise
 Once the owner’s/owners’ contribution comes in, a lender is prepared to give loans
1.2.2 Resources for business and resources of business
Having understood that without owner’s/owners’ contribution towards capital, no enterprise

can commence operations, the next learning is what the financial resources for a business are.
Further an attempt is made here to invoke the financial accounting terms of ‘liabilities’ and
‘assets’ to explain the concepts from a ‘finance perspective’.
In ‘financial accounting’ perspective, the liabilities are monies owed to others while assets are
monies owned by the enterprise. However, from the ‘finance perspective’, these terms could
be understood more appropriately as resources for business and resources of business. This
means that ‘resources for business’ are financial resources raised from owners and others.
Hence these have to be paid back. The accounting term ‘liabilities’ indicates this. On the other
hand, the term ‘resources of business’ indicates asset resources purchased by the enterprise
with the help of capital and loans. These resources are required by the business for running its
operations. Examples of assets – infrastructure, materials, goods, cash on hand, bank balance in
deposit accounts & monies receivables from debtors (who have taken goods on credit from the
enterprise).
Let us learn further on this topic. From the above, we understand that capital of the owners is
paid back to them in case the business enterprise closes down. Hence it is a liability. This brings
us to the fundamental accounting principle that is known as ‘business entity’ concept. Simply
put, this means that from the point of view of finance and accounts, the owner is different from
the enterprise.
Then what about profits earned by the enterprise? Does it belong to the owners of the
enterprise or the enterprise? Profits are due to capital introduced by the owners. Hence they
also belong to the owners. A student of finance and accounts should be clear as to what
belongs to whom, like assets, income, capital and profits. We will settle this issue immediately.
To the owners = capital and profit retained in business in the form of ‘Reserves & surplus’
To the enterprise = assets and income

The enterprise or the manager meets all expenses out of income and makes loan
repayment out of profits. After paying out installments of loans, whatever profits are
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retained in business belong to the owners. Thus, in a limited company, ‘Reserves and
surplus’ belong to the owners of the company and not the enterprise. The enterprise
has the right to use a portion of the profits for repayment of loans before declaring
dividends to the owners.
Then what about loss? Indirectly it belongs to the owners in the sense that so long as there is
loss there is no profit and hence dividend is not given to the owners. Dividend resumes only
after all the losses are recovered and the enterprise once again starts recording profits.
1.2.3 Equity (owners’ capital) & debt (borrowed funds)
Now let us see different kinds of resources for business through the following text:
Short-term, medium-term and long-term – explanation in terms of duration
Short-term
This is up to twelve months in duration. The shortest period could be as short as one day as in
the case of “call money markets” and/or ‘Repo contracts’. It is convention to take a year to
consist of 365 days even if the year under consideration were to be a leap year. The short-term
market is called “money market”. Hence short-term instruments are often referred to as
‘money market’ instruments. This is also referred to as ‘working capital’ resources or ‘current
liabilities’
Medium-term
This is beyond twelve months and the maximum duration is five to seven years. Some authors
and some markets consider the maximum duration for a medium-term instrument as ten years.
The students are well advised to be flexible in their understanding of different definitions of
medium-term. All the medium-term instruments are debt instruments.
Examples – Debentures, bonds, fixed deposits accepted from public etc.
Long-term
Anything beyond the medium-term period is long-term. There is no ceiling on the maximum
duration of long-term instruments.
Examples – long-term bonds, Equity share capital, Preference share capital, unsecured loans
from promoters, friends and relatives etc.
Objectives for different resources depend upon the duration
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What happens in case short-term resources are used for acquiring fixed assets?
Fixed assets require exclusive resources as they give benefits over a long period of time.
Medium and long term-loans are meant for this purpose. Hence the resources should be
matching in duration to the duration of receipt of benefits. The business enterprise will not be
able to recover the investment in a short time. Hence if short-term resources are used for fixed
assets, there will be shortage of funds required for working capital. The business of the
enterprise suffers for want of funds. Let us consider the following example:
Example no. 1
Let us assume that we require Rs. 100 lacs for day-to-day operations of the business enterprise.
We use Rs.30 lacs for acquiring capital assets. Hence we have only Rs.70 lacs for day-to-day
operations or working capital of the business enterprise. From where are we going to get the
shortfall of Rs. 30 lacs? It will take more than one year for recovering Rs. 30 lacs from the asset
in which we have invested by repeatedly using the asset. This is typical of any fixed asset like
land, building etc. We will appreciate another effect of reducing the working capital funds
employed in business. Suppose Rs. 100 lacs can give us sales volume of Rs. 500 lacs, Rs. 70 lacs
would give less than Rs. 500 lacs of sales. Thus by diverting funds from working capital, we
suffer on two counts:
Shortage of funds for day-to-day operations
Less revenues accruing to the business due to reduction of funds
Medium and long-term resources

Both medium and long-term resources, on the contrary, are primarily available for fixed assets
as the funds are in the business for periods longer than 12 months. Why primarily available for
fixed assets? Does it mean that the medium and long-term resources are available for working
capital also? Yes. Some of the resources like share capital, debentures and bonds are available
both for working capital and fixed assets. Some other resources like term loans are available
only for fixed assets, as we cannot use them for working capital. As we proceed further with the
chapter the concept behind this will be clear to the students. However we shall see one
example here just to show that capital of the owners in business is available both for fixed
assets and working capital.
Example no. 2
Stage 1 - Starting point for a business enterprise = introduction of capital into business by the
owners
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Stage 2 - The capital is used for purchase of business assets and business assets comprise fixed
assets and working capital. Only if needed, the business takes loans from outside and together
they constitute the funds required for business. This means that small business may not take
loans from outside in case the scale of operations or the nature of activity undertaken does not
warrant this. However most of the business enterprises would require funds from external
sources.
Thus we can see that a long-term resource like capital is available both for working capital and
fixed assets. Working capital assets are also known as “current assets”. Similarly fixed assets are
also known as “long-term” assets.
We keep talking of current assets of the business enterprise. What are these?
The type of current assets depends upon the type of activity undertaken by the business
enterprise. A manufacturing unit requires more funds than a trading enterprise, which in turn
requires more funds than a service enterprise.
Why?
Manufacturing enterprise requires conversion of material into finished goods and then sells it.
Hence it will require different kinds of current assets.
A trading unit does not convert material into finished goods and hence the variety of current
assets and investment in it will be less than in the case of a manufacturing unit.
A service unit does not deal in finished goods. Hence the requirement of current assets is still
less in this case.
Components of current assets in the case of a manufacturing unit

Raw materials
Components
Machinery spares
Consumables like oil, lubricant etc.
Work-in-process or semi-finished goods
Finished goods
Debtors representing credit sales
Cash balance for day-to-day operations and bank balances in current account (only where
short-term bank borrowing like cash credit or overdraft is absent)
Components of current assets in the case of a trading unit

Finished goods
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Components of current assets in the case of a service unit

Consumables (especially in the case of a car mechanic or repair unit) – amount invested will be
much less than in the case of finished goods of a trading unit
Securities
Let us note the difference between the term “security” and “securities”. The term security
refers to the legal claim on the assets of the business enterprise that it passes on to the lenders
for backing the loans taken by it from the lenders. The legal claim could be on current assets or
fixed assets or both as the case may be. The term “securities” however means financial
instruments issued by various users of resources to the investors of these resources
acknowledging their indebtedness to the investors. Typical examples of securities are – equity
shares, bonds and debentures.
The securities could be short-term, medium-term or long-term. Let us examine them in detail
now.
Example no.3
Suppose a limited company wants Rs. 1000 lacs from the public. It completes the necessary
formalities in this behalf including taking permission from the Securities Exchange Board of
India (SEBI). It proceeds to collect the funds through duly authorised agents and issues share
certificates denoting the number of shares invested in by the investors. Equity share capital is a
typical example of long-term source available to a limited company.
Bank borrowing for working capital

Commercial as well as co-operative banks give funds to business enterprise in the form of:
Overdraft – an extension of “current account” in which the borrowers are permitted to draw
cheques up to a predetermined limit against security like fixed deposit receipts, shares,
mortgaged property etc. Usually carries a rate of interest higher than the rate for cash credit.
Most of the private sector banks do not have cash credit system. They give only overdraft
facilities or loan facilities. These include foreign banks too. It is only the public sector banks in
India who have the distinction of overdraft and cash credit.
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Cash credit – given against inventory and receivables that form the bulk of current assets.
Borrowers are allowed to draw cheques up to a predetermined limit like in the case of
overdraft facilities.
Bills discounted – in which bills of exchange are discounted by seller’s banks. Bills of exchange
have been explained elsewhere at a footnote.
Export credit limit – given for specific purpose of exports. Split into pre-shipment (packing
credit facility) and post-shipment (bills finance). The rates of interest are less than for overdraft
or cash credit
Some of the readers will be wondering about what the differences are between Equity shares
and Preference shares and similarly between “debentures” and “bonds”. Here are the
differences.
Difference between Equity shares and Preference shares – for explanation of terms, ‘equity’
and ‘preference’, please refer to ‘glossary’ section
Equity share capital Preference share capital

Any limited company has to have this This is optional
If preference share capital is also there, ESC This forms a minor portion of the share capital
forms the bulk of the share capital
Equity shareholders are the owners of the Preference shareholders are not owners of the
company and have voting rights on all the company and do not have any voting rights on
administrative issues referred to the general the general administration issues. In short the
body of shareholders by the Board of Directors
preference shareholders do not constitute the
general body of shareholders
Dividend is paid only after paying dividend to Dividend is paid first on preference share
preference shareholders capital out of profit after tax (PAT)
Dividend rate is not fixed. There is no ceiling Fixed rate of dividend – current market
on the rate of dividend. There are instances in practice ranges between 9% and 14%.
India when even 1260% (Infosys – 2004-05) or
4000% (Hero Honda Limited - 2010/2011) on
the face value of Equity Share have been paid
At the time of liquidation of the company At the time of liquidation of the company,
money can be paid back to Equity money can be paid back to the preference
shareholders only after paying off the shareholders first before paying back to the
investment made by preference shareholders Equity shareholders
Different kinds of equity share capital like Different kinds of preference share capital like
cumulative and ordinary are absent cumulative and ordinary are possible.
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Cumulative means that in case during a year

dividend could not be paid for want of cash, as
and when the company starts paying dividend,
the cumulative preference shareholders get
dividend for the period during which dividend
has not been paid.
Equity shares can be issued either through private Preference shares are usually issued through
placement or public issue private placement
They are entitled to benefits like Bonus Issues They are not entitled to any of the benefits
(additional shares issued to the shareholders
without any funds) and Rights Issue (additional
shares issued to the shareholders by fresh
subscription)
Permanent share capital in business Cannot be permanent share capital in business. As
per provisions of the Companies’ Act, they are
either convertible (converted into equity shares
after a given period) or redeemable (paid back to
the investors after a specific period)
Differences between debenture and bond
Debentures Bonds
Medium term instrument – not exceeding ten This could be for longer periods – Reliance
years Industries in fact in 1997 had issued bonds for 100
years in the international market; Government of
India issues bonds for 30 years on a regular basis.
It is always a face value investment. This means This could be discounted value investment. This
that the amount invested by the debenture means take for example IDBI deep discounted
holders is the same as the face value of bond – The face value of the instrument is Rs. 1lac
debentures. payable after 15 years. The amount invested will
be the present value duly discounted by the
implied rate of interest.
Debenture certificates carry stamp charges as per Bond certificates carry stamp charges as per the
the Stamp Act of the state in which they are issued India Stamp Act
Bonds in India are slowly replacing debentures. As Bonds have come to stay in India. Before
it is, debentures are not very popular instruments 1996/1997 Indian private sector was not using this
internationally. instrument much. Nowadays bonds are becoming
more common
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Debentures could be convertible into equity shares Bonds are rarely convertible
like preference shares
Debentures are seldom issued by Governments or Bonds are issued by practically all the sectors:
Public Sector Undertakings or Banks or Financial Private sector companies, public sector
Institutions. They are issued by private sector undertakings, Financial Institutions, Commercial
companies Banks (SBI bonds and ICICI Bank bonds) and
Central Government/State Governments
Debentures issued by private sector companies Bonds issued by private sector companies carry an
carry preference over bonds issued by them at the inferior charge to the debentures. Bonds issued by
time of liquidation of the company (debenture Public Sector Undertakings, Financial Institutions,
holders get a superior charge – legal claim on Governments and Commercial Banks are not
assets of the company to bond holders) secured. There is no legal claim in favour of the
bondholders.
Term loans given by banks and financial institutions
Term loans or project loans are a complete source of funds for fixed assets. Term loan or project loan is
especially suitable for project assets, as all kinds of assets acquired under a project are eligible for
finance under “term loan”.
Why call it a term loan?
The repayment is as per terms agreed at the beginning and a fixed repayment schedule. Hence the term
“term loan” is used. This term is more often used in India rather than outside. Mostly it is referred to as
“project loan” as it more often than not used for creation of project assets.
Characteristic features of “term loan”
1. Finances all assets like land, building, plant and machinery, technical collaboration fees, effluent
treatment plant, patents, miscellaneous fixed assets including vehicles and furniture and
fixtures, electrical installations, stand-by power arrangement like Diesel Generating sets, for
projects in backward areas staff quarters etc.
2. Disbursement in stages as per requirement of funds by the borrowers
3. Extent of finance (Value of assets offered as security to the lender (-) owners’ contribution
towards margin) ranges between 70% and 90%.
4. Rate of interest could be fixed rate as agreed upon at the beginning of the loan or floating
interest rate (linked to the market rate and getting adjusted as per the movement of interest
rates in the market)
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5. There is non-repayment of principal amount or more popularly known as “moratorium period”

during which time there is no repayment of the principal amount. This period could be between
six months for small projects to two and a half years for very long gestation period1 projects.
6. The loan is secured by mortgage of immovable fixed assets and/or hypothecation of movable
fixed assets. Very rarely working capital assets are also offered as security.
7. The loan will be guaranteed by the owner directors especially for small and medium scale
borrowers. It is 100% applicable in the case of small limited companies like private limited
companies. Personal guarantees will not be insisted upon for large and professionally managed
companies whose stocks are listed on a stock exchange.
8. The arrangement could be that the interest charged on the loan on a monthly basis is paid
separately and the principal amount is also paid separately every month or every quarter.
Nowadays recovery on a half-yearly basis or annual basis is virtually absent especially in the
domestic market.
9. The installments need not be equal unlike in the past. These could be stepped up depending
upon how the cash flows occur or even larger in the initial period and less, later on. This means
that the arrangement with the lenders can be fully flexible.
Unsecured loans by promoters, friends and relatives
This could be an important source especially for private limited companies or public limited companies
that have not gone to the public for raising equity. The latter variety is referred to as “unlisted public
limited companies”.
1. It can be used for any purposes, either for fixed assets or working capital assets or for both
2. It is called “unsecured” as no tangible security like fixed assets or current assets can be offered
to the lender
3. Usually it carries higher rate of interest than for loans, debentures or bonds, as there is no
security.
4. These loans are usually paid off after the principal debt obligations like loans for fixed assets,
debentures or bonds have been paid off
Fixed Deposits accepted from public
Just like the fixed deposits we saw for short-term, we can issue fixed deposits in the medium-term also.
The maximum maturity period is 5 years. Other details have been given under short-term resources
Thus, summing up, the resources for business (other than working capital) are:
Equity share capital
Preference share capital
Bonds
1Gestation period for a project means the time lag between completion of the project for commercial production and generation of positive cash
flow by the project. Positive cash flow means total cash inflow is higher than total cash outflow. Till the business starts registering positive cash
flows repayment of the principal amount does not start.
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Debentures
Term loans
Unsecured loans and
Fixed deposits
Is debt compulsory?
The next question is whether loan or ‘debt’ is mandatory for an enterprise or not? The answer
is ‘No’. While ‘capital’ from the owner/owners is mandatory, loan is not mandatory. While any
enterprise cannot run with 100% loans and no capital from the owners, it can run entirely on
owners’ capital without any loans. The best example in this regard: Most of the I.T. companies
that do not require any loan at all. What could be the reasons for the same? The investment in
infrastructure, namely, land, building, plant & machinery, vehicles, furniture and fixture, is
much less in the case of I.T. companies. This is the main reason why their requirement of funds
is significantly low. Hence they do not take loans.
Thus, the factors primarily responsible for taking loans are:

1. The sector in which the enterprise operates - contrary to I.T. sector as explained above,
the manufacturing sector requires large investment in infrastructure. Hence, loans
would be required by manufacturing companies.
2. The scale of operations – suppose the business expands, then perhaps, the enterprise
may require more funds, compelling it to go for loans &
3. The corporate philosophy towards loans – some managements do not prefer loans and
want to be conservative while some others want to be aggressive and take more loans
Differences between equity and debt
As we recall, equity is compulsory while debt is optional. The differences between the two can
be captured in a matrix as under:
Equity Debt
Is compulsory Is optional
Long-term Short-term or long-term
Permanent in business To be repaid
Not repaid in the normal course of business; Repayment in normal course of business as
capital goes back to the owners in abnormal per repayment schedule
course of business, namely, closure of
business
Dividend on equity is profit distribution Interest on loans is business expense
Dividend is not compulsory; in the year of loss, Interest is compulsory; even in the year of
dividend is not paid loss, interest is to be paid
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Equity is not backed by security Usually loans for fixed assets are backed by
security *
* security is the legal claim of the lenders on the assets of the borrower conditionally to be exercised by
the lender at a future date through a legal process in the court, provided the borrower is a defaulter on
the loans.
Case lets:
1. The Ramchandanis want to take up a dealership for ‘Anchor’ switches and other electrical
equipments. The total investment is estimated to be around Rs. 5 million. They have family
property that is free and valued at Rs.10 million. They are prepared to give the entire land
as security to the bank. They are submitting a proposal to the bank accordingly asking for a
loan of Rs. 5 miilion against the property value of Rs.10 million.
 Will the bank accept this proposal for Rs. 5 million loan?
 If ‘no’ is the answer, state the reasons for the same
 Suppose the Ramchandanis are in a position to put in the entire money of Rs. 5 million,
can they run their business only with their money? Is there any restriction on this?
Explain.
 What could be the risk in the above to the owners?
2. Grover (India) Private Limited is enjoying bank borrowing to the extent of Rs. 250 lacs. This
borrowing is against inventory and receivables. On an average they utilise 60% of the limit.
The company’s operations are quite profitable. At present they are operating at 80% of the
capacity. The factory is located in Goa. The power supply is not reliable and hence the
company requires urgently a stand by power arrangement. The cost of a transformer of 250
KVA is around Rs.23lacs. Further they also require a CNC machine at a cost of Rs.65 lacs. The
total funds requirement would be in the region of Rs.93 lacs.
During 2009/10, the company’s operations resulted in a profit of Rs.200 lacs before tax,
against a sale of Rs. 1000 lacs. The monsoons of 2010 arrive and the frequency of power
tripping has increased tremendously. The management is worried about this aspect,
especially in view of export orders to the extent of Rs.250 lacs. This order is required to be
executed over the next 3 to 4 months.
At a meeting held with the Finance Manager, the management instructs the manager to
utilise the balance funds available with the bank immediately and ensure immediate
installation of DG set. The Finance Manager resists the proposal. He is requesting for some
more time to arrange for funds. He is very confident that in a month’s time, he will be in a
position to arrange for the funds. The management would not buy this and insists upon
immediate procurement of DG set.
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Examine the case and answer the following questions.

 What is the reason for the Finance Manager to resist?
 What is the correct practice of acquiring a fixed asset in a company?
 What are the considerations one should have before planning for capital expenditure?
 In your opinion, which are the sources for capital assets?
 What is diversion of funds?
 What is the impact of diversion of funds to business, both immediate and in the long-
term?
Class activity:
Study the short-term, medium-term and long-term resources available for a business enterprise
in India and list out the main characteristics of such resources, at least two for each resource.
1.3 Basic finance concepts and their application to business:
1.3.1 Financial stages in business:
Just like we have distinct steps in financial accounting, we have distinct stages in finance too.
These can be referred to as ‘financial stages in business’ from introduction of financial
resources to business to profit distribution in the form of dividend.
Let us see these steps:

Stage 1 = Introduction of funds in the form of capital and loans
Stage 2 = Purchase of business assets, long-term and short-term
Stage 3 = Operations of the business enterprise, trading, manufacturing or services
Stage 4 = Expenses for operations and income from sales
Stage 5 = Profit before tax (PAT) = Income (-) expenses
Stage 6 = Tax on profits
Stage 7 = Profit after tax (PAT)
Stage 8 = Profit distribution in the form of dividend
Stage 9 = Profit retention in the form of Reserves & surplus
Terms associated with the above:

Earnings before interest and tax = EBIT
Earnings before depreciation and tax = EBDT
Earnings before interest, depreciation and tax = EBIDT
Earnings before tax = Profit before tax = PBT
Earnings after tax = Profit after tax = PAT
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The numerical example starts from any of the above and ends in EPS (all figures are in Rs. in
millions)
EBIDT = 1000
Interest = 200
Depreciation = 150
Income Tax = 30%
Preference share capital = 10
Dividend on equity share capital 20% on 500
Face value of share = Rs.20/- per share
Detailed calculation as under:
Number of shares = 500 million/Rs.20 = 25 million
EBIDT 1000
Less:
Interest 200
Dep. 150
Total 350
Profit before tax 650
Tax @ 30% 195
Profit after tax 455
Less:
Dividend on preference shares 10
Dividend on equity shares 100
= Retained profits 345
EPS = PAT (-) Preference dividend = 455 (-) 10/25 = 445/25 = Rs.17.80
No. of equity shares
Suppose the market price is Rs. 150/- per share, can we determine the relationship between
EPS and the market price? Yes. This relationship is known as Price to Earnings ratio. In this case
it works out to Rs.150/-/Rs.17.80 = 8.43. This is a just a number and EPS is always in Rs. per
share.
1.3.2 Application of basic finance concepts to business:
Depreciation:
The fixed assets employed in business are subject to “wear and tear”. This requires
replacement on a regular basis, as the enterprise should not suffer for want of proper asset for
production, at a future date. Hence, it is only prudent that a certain amount by way of
depreciation, as permitted by laws of the country, is shown as expense in the P & L of a limited
company so that when the time comes for replacement of a fixed asset, you will have created
sufficient “cushion” in the business through the amount of “depreciation” invested back into
business.
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The importance of “depreciation” does not rest there. By claiming depreciation, we are
reducing the profit for the year and thereby tax.
As there is no “cash out flow” involved in depreciation, the entire funds are available with the
enterprise. Thus, depreciation is at once a “business expense” and a “fund”. It is a well-known
method of “tax plans” by acquiring fixed assets regularly, so that you reduce your tax liability.
This would be possible only if your level of income is sufficient to charge “depreciation” as
expenditure.
A limited company can claim depreciation either under ‘Straight Line Method’ (SLM) or ‘Written
down value method’ (W.D.V.) in the books, as per the provisions of the Companies Act. The
Income Tax rules permit only one method, i.e., the written down value method and the rates of
depreciation prescribed in the Income tax are different from the rates prescribed in the
Companies Act. These rates are the same for any form of business organisation, namely, firms
or limited companies or self-employed professionals.
Depreciation by straight line method and written down value method

Suppose we have an asset worth Rs.1lac at the beginning and we can claim depreciation either
by the straight-line method or by the written down value method. Further, let us assume the
rates are same for both the methods, say 10%. Then the depreciation schedule would look like:
(Straight-line method)
Year No. Opening value Depreciation Closing value
Zero 1,00,000/- ----- 1,00,000/-

1 1,00,000/- 10,000/- 90,000/-
2 90,000/- 10,000/- 80,000/-
3 80,000/- 10,000/- 70,000/-
4 70,000/- 10,000/- 60,000/-
5 60,000/- 10,000/- 50,000/-
6 50,000/- 10,000/- 40,000/-
7 40,000/- 10,000/- 30,000/-
8 30,000/- 10,000/- 20,000/-
9 20,000/- 10,000/- 10,000/-
10 10,000/- 10,000/- Nil
(Written down value method)
Year No. Opening value Depreciation Closing value
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Zero 1,00,000/- ----- 1,00,000/-

1 1,00,000/- 10,000/- 90,000/-
2 90,000/- 9,000/- 81,000/-
3 81,000/- 8,100/- 72,900/-
4 72,900/- 7,290/- 65,610/-
5 65,610/- 6,561/- 59,049/-
6 59,049/- 5,905/- 53,139/-
7 53,139/- 5,314/- 47,825/-
8 47,825/- 4,783/- 43,042/-
9 43,042/- 4,304/- 38,738/-
10 38,738/- 3,874/- 34,864/-
Note: The depreciation in the straight-line method is dependent on the original value and does
not vary from year to year. Under this method, an asset would be reduced to “zero” after a
period of time. The rate of depreciation is applied on the original value and not the closing
value.
The depreciation in the written down value method is dependent on the closing value only and
the rate of depreciation is applied to it. Hence, every year, the amount of depreciation varies.
If the rate of depreciation is the same under both the methods, then, while an asset gets
written off under the straight-line method, under the written down value method, it always
retains a positive value.
Hence, the rates of depreciation have been so arranged in the Schedule XIV of the Companies
Act, 1956, that under either method, over a period of time the closing value remains more or
less the same.
A limited company can claim depreciation either under S.L.M. or W.D.V. in the books, as per the
provisions of the Companies Act. The Income Tax rules permit only one method, i.e., the
written down value method and the rates of depreciation prescribed in the Income tax are
different from the rates prescribed in the Companies Act. These rates are the same for any
form of business organisation, namely, firms or limited companies.
Learning Points:
 Depreciation is at once an expense and a fund (resource). As it is a fund, it gets added to

PAT for determining the amount of cash available in the system.
 The main objectives of recording depreciation are:
o To account for diminution in the value of the fixed assets due to wear and tear as
per rates approved by statutory authorities
o To create sufficient cash over a period of time to be able to replace the old fixed
asset with a new one
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 Depreciation is a part of tax planning in companies. Please see the example below.
 In the books, you can claim depreciation either by SLM or WDV but in the income tax you
can claim only by WDV.
 In the books, only for limited companies, rates of depreciation have been prescribed by The
Companies’ Act.
 The rates of depreciation in the Income tax are uniform to all forms of business
organisation.
 In the SLM the value of the asset can reduce to “zero”, while in the WDV, this would not
happen.
 W.E.F. 1999, the Companies Act permits recording of depreciation on intangible fixed assets
like technology transfer fees, copyrights, patents, trademarks & franchisee fees
Example:
Let us consider two alternatives for the same enterprise, one with a higher depreciation
amount and the second one with a lower depreciation amount. Please recall the higher
depreciation is possible by keeping up the value of fixed assets high, which in turn is possible
due to continuous investment for replacement in fixed assets.
As the organization is not expanding, the earnings before depreciation and tax would be the
same, ignoring the higher cost of maintenance in the case of old plant (Alternative 2).
(All figures are in Indian Rs. in millions)
Parameter Alternative 1 Alternative 2
EBDT 100 100

Less: depreciation 30 20
PBT 70 80
Tax @ 30% 21 24
PAT 49 56
Add back depreciation 30 20
Cash accruals 79 76
Conclusion:
Although at PAT levels, alternative 2 is better, considering depreciation amount (which is the
correct method, as depreciation is a non-cash expense), alternative 2 turns out to be better.
The difference of 3 is due to less tax in alternative 1 due to higher amount of depreciation. This
is called ‘tax saving’ due to depreciation. That is the advantage of depreciation, at once saving
tax and increasing cash available.
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Amortization:
There are certain expenses incurred in a business enterprise that give the business long-term
benefits just as fixed assets but intangible in nature. For example, company formation expenses
and/or expenses relating to public issue of debt or equity, like debenture/share capital etc.
(also known as ‘Preliminary expenses’). These are called ‘deferred revenue expenditure’ (DRE).
What does a ‘deferred revenue expense’ mean? What is the relevance of the word ‘deferred’?
The details of the preliminary expenses mentioned above are given below:
Fees paid to the ROC (the Registrar of Companies)
Fees paid to the agents managing the public issue, especially in the first public offer
known as ‘Initial public offer’ (IPO)
Fees paid to the consultants who help in forming the company, like practicing company
secretary ETC.
The reader would realize that while preliminary expense is an expense, the benefits flow for a
long period of time just as in the case of fixed assets & unlike in the case of other revenue
expenditure like salary/wages. The Companies Act provisions and the ‘Accounting standards’ of
The Institute of Chartered Accountants of India (ICAI) permit booking only a part of such large
expenditure every year as expense in the ‘Profit & loss’ statement instead of booking the entire
amount in the first year itself. They are still referred to as ‘expenses’ as they are not fixed assets
in nature.
The word ‘deferred’ refers to the practice of accounting for the expense over a period of time
and not in one year.
Examples of other deferred revenue expenditure in business:
1. Research & development expenditure
2. Product development expenditure &
3. Product launch expenditure
The process of booking only a part of such expenditure is known as ‘amortization’.
This word also has another connotation in the international markets, meaning
redemption/repayment of a loan. How the entries are reflected in the books of accounts is
explained through an example at the end of this discussion.
There is a similarity between this and depreciation. It should be noted that both are “non-cash”
expenditure, as there is no cash outflow at the time of write-off. Take for example, preliminary
expenses paid to ROC and others. These are paid at the beginning itself and not deferred.
Hence at the time of recording such expenses in the ‘P&L’ statement, there is not cash outflow.
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Readers will appreciate that the agents giving required service are not going to take payments
in installments. This is an example of ‘accounting adjustment’ and not ‘deferring payment’.
Example of ‘recording’ of a deferred revenue expense say, ‘preliminary’ expense of Rs. 1

million. Let us assume a period of 5 years of recording.
(All figures in Indian Rupees in millions)
Year Profit & loss Balance sheet (Non-current & intangible)

1 0.2 0.8
2 0.2 0.6
3 0.2 0.4
4 0.2 0.2
5 0.2 nil
Learning points:
 Both depreciation and amortization are non-cash expenses

 They get added to the PAT to determine the exact amount of cash available in the
enterprise
 However amortization is not useful for saving tax unlike depreciation; it does not have any
role in ‘tax planning’ for saving tax
 Amortization is purely an accounting exercise having no involvement of cash that has gone
out at the beginning itself
Capital and revenue expenditure:
Please recall the terms revenue and capital. Revenue relates to operations and is recorded for a
period of 12 months. Capital means duration longer than 12 months.
Revenue receipt/expenditure and Capital receipt/expenditure

Revenue receipt is defined as an “inflow”, which is recurring like sales revenue, dividend
income etc. It is also referred to as “revenue income”. Revenue expenditure is also recurring
and hence all the operating expenditure is revenue expenditure. Revenue receipt and revenue
expenditure decide the profit for the year, whereas, capital receipt is outside the purview of the
profit and loss account.
Then, what is a capital receipt?
Any inflow of a capital nature, like increase in capital of the owners, fresh loans taken from
outside etc. is a capital receipt. The sources for capital receipts are as under:
Share capital
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Term loan
Debentures
Fixed deposits for more than 12 months
Unsecured loans from relatives, friends and promoters etc.
What is capital expenditure?
Purchase of any fixed asset

Repayment of any earlier capital receipt like term loan, debenture etc.
While operating expenditure can be met from operating income, capital expenditure can be met
only out of capital receipts and not out of revenue income.
In this connection, it should be noted that profit and depreciation are taken as capital receipt
even though profit arises out of the excess of revenue income over revenue expenditure and
depreciation is an operating expenditure. Once income tax is paid on the profits, the residual
amount with depreciation added back, known as “internal accruals” constitutes capital receipt
and forms the major source for repayment of term loans or debentures.
Learning points:
 Revenue income is meant for meeting revenue expenditure and not capital expenditure.
 Capital receipt is necessary to meet capital expenditure and if revenue receipt is used for
meeting capital expenditure, there will be liquidity problem. However, capital receipt like
capital from the owners, debentures, retained earnings, depreciation etc. can be used for
revenue expenditure.
 Depreciation as an expense is a part of the profit and loss account. Similarly, profit after tax
also forms part of the profit and loss account. However, once profit is taxed and retained in
business, it is reflected under “reserves” as a capital receipt. This is so, as profit retained in
business belongs to the equity shareholders. Similarly, depreciation is claimed on all fixed
assets, excluding land, and hence, as a fund, is treated as a capital receipt.
Case lets:
1. Kenilworth Private Limited had incurred an advertisement expenditure of extraordinary

nature (for launching a brand) of Rs.1 million in the financial year 2012-13. During the year,
the company had huge profits of Rs.8 million without considering the entire Rs.1 million as
expense. The auditors are in favour of observing the correct accounting practice of treating
this as ‘deferred revenue expenditure’; whereas the owners of the company are insisting
that this entire amount should be treated as business expenditure as the profits are quite
good.
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 What is the reason for the auditors to recommend the accounting practice of ‘deferred
revenue expenditure’?
 Can you explain the rationale for such an accounting practice?
 By treating the whole amount as expenditure in the P & L statement, does the company
save any tax?
 What are the examples of such deferred revenue expenditure in an organization?
2. ABC Limited has been in profitable business for the past 5 years in trading. It started with an
equity share capital of Rs.250 lacs and the present networth is Rs.580 lacs. It wants to
expand its business and the total capital outlay is Rs.1000 lacs. It has already paid off the
earlier loan of Rs.400 lacs. The bank is ready to finance them.
What could be the reasons for such favourable response from the bank? Examine this, both
from the point of management of finance by the enterprise as well as its financial position
due to its policy.
Class activity 1.3.1: To practice numerical exercises on application of finance concepts to

business as given in the handout
Numerical exercise 1 – Depreciation as a tax planning tool

Assuming EBDT of Rs. 2 million, create two alternatives to prove that one alternative is better
than the other due to higher depreciation. You can assume the different figures of depreciation.
Assume tax rate of 30%
Numerical exercise 2 – Booking amortization in the books of accounts

Assume product launch expenses of Rs.5 million to be amortized over 5 years. Show the details
of how accounting is done in the books during the 5-year period both in P&L and Balance sheet
Numerical exercise 3 – Use of debt to an enterprise

Assume total capital requirement of Rs.100 million; assume two alternatives, alternative 1 with
debt to equity of 3:5 while in the second alternative, the debt to equity ratio is 5:3. Take the
face value to be Rs.10/-. The rate of interest on loans is 16% p.a. You can assume EBIT to be
Rs.30 million and tax rate to be 30%.
Numerical exercise 4 – Financial stages in business

From the following find out the financial ratios as required:
- EBIDT = 1000 lacs
- Interest = 200 lacs
- Depreciation = 150 lacs
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- Income Tax = 30%

- Preference share capital = 100 lacs @ 10%
- Dividend on equity share capital 20% on 500 lacs
- Face value of share = Rs.20/-
You are required to determine the following:

- Profit before tax
- Income Tax payable
- Profit after tax
- Dividends paid
- Profit retained in business
- Earning per share
1.4 Solved questions

Question no. 1:
Compare and contrast between depreciation and amortization. How is depreciation useful to a
business enterprise?
Answer:
Both are non-cash expenses
Objectives are different:
Depreciation is to record the reduction in value of fixed assets due to usage
Depreciation is claimed on fixed assets, both tangible and intangible
It is useful for tax planning, being a non-cash expense throughout
Such cash is available to the enterprise for purchasing new fixed asset, as and when
required
Amortization on the other hand is a concept more related to accounts. It is an

accounting adjustment
Amortization occurs only in the case of intangible expenses
At the beginning, cash has gone out of the enterprise unlike in the case of depreciation
where cash does not go out throughout
Amortization is not useful for tax planning
Depreciation is useful to an enterprise provided the enterprise takes care to invest in its fixed
assets for replacing them in time, thereby increasing the value of fixed assets in its accounts.
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Hence it can claim higher depreciation and save tax and cash. This is possible only and only if a
prudent financial policy is adopted by the enterprise.
Question no. 2
Can a government, be it state government or central government in India start a private limited
company?
Answer:
No. In the case of a private limited company, the share capital is only from the shareholders. It
cannot go to public for financial resources. As India is a democratic republic, for the people, of
the people and by the people, government business has to be public limited company in which
members of public can participate in equity. Alternatively there can be public sector
corporations which are 100% owned either by state government or central government
Question no. 3
What is the concept of a ‘subsidiary’? Explain through a suitable example.
A subsidiary is another limited company in which the holding or a parent company has majority
shares. The subsidiary can either be 100% owned by the holding company or it is the majority
shareholder.
Example – Maruti Udyog Limited is a subsidiary of Suzuki Corporation, the largest shareholder
while some of its shares are being held by others also.
As per the provisions of The Companies Act, India, any company registered under The
Companies Act can have branches in India whereas it cannot have a branch outside India. This is
because in the case of a limited company established outside India, the local laws relating to
limited companies will apply and hence a new limited company there has to be established by
the Indian company.
Example – almost all major I.T. companies have subsidiaries abroad
Question no. 4:
What do you mean by the term ‘IPO’?
Answer:
IPO refers to ‘Initial Public Offer’. This means that a limited company comes out with offer of
equity shares or debentures or bonds to members of public. Subsequent offers are not called
‘IPOs’.
For this, the limited company has to be public limited company and not a private limited
company. Any public offer in India comes under SEBI rules & regulations.
34
IPOs are made in the primary market while sale of shares is in the secondary market.
IPO expenses are a part of ‘Preliminary expenses’ in a limited company.
Question no. 5:
Why do enterprises take debt? Is it compulsory? What are the factors influencing a debt
decision?
Answer:
Debt is not compulsory. Debt is largely dependent upon investment in fixed assets. The higher
the investment in fixed assets, the higher the chances of debt. Some sectors may require
heavier investment in fixed assets while some others can do with small amounts of investment.
For example, I.T. sector requires a minimum amount of investment in infrastructure. Hence its
requirement of funds is minimal.
Primarily debt is taken to share the risk between the equity shareholders and the lenders. The
lenders are also interested in giving debt due to certain reasons stated subsequently in the
answer.
The major drivers of debt are:

1. The sector
2. The scale of operations &
3. The management policy towards debt – could be conservative or aggressive.
Conservative means taking less risk and taking less debt. Aggressive means taking more
risk and taking more debt.
As a concept, debt has 3 different perspectives as under:

The manager’s perspective
The owners’ perspective &
The lenders’ perspective
The manager’s perspective:

Loans increase the funds available
Interest is a business expense before taxes while dividend on equity is after tax; hence loans
are cheaper than equity
However beyond a particular level, increasing loans is inviting risk as interest and
installments have to be paid regularly on them
35
It induces some discipline in the finances of the organization by and large, as the senior
management is always conscious of the enterprise’s obligations towards loans, both in the
form of interest and principal amount
The owners’ perspective:

Sharing risk with the lenders so that entire amount by way of equity need not be put in
Earnings per share increase due to less number of shares being issued
The lender’s perspective:

Interest is compulsory
Repayment of loans is during the course of business and not at the time of closure of
business only as is the case with equity
Usually loans are backed by security of assets of the borrower
1.5 Unsolved questions (with suggested answers in the teacher’s handbook)

1. What are the short-term resources for a business enterprise?
2. What are the long-term resources for a business enterprise?
3. Enumerate the differences between bond and debenture
4. Enumerate the differences between a partnership firm and a limited company
5. What is the significance of the term ‘limited’ in the case of companies? Explain through a
suitable example.
1.6 Summary:
As a student from an engineering background, he or she is not exposed to finance

fundamentals. Most of the times there is confusion about accounts and finance and the
differences between them. While this is being dealt with in the next chapter, the basics are
outlined and explained here.
The students are not aware of the fundamentals of business finance as under:
Different purposes of business enterprises
Differences between limited companies and other forms of business organization
Differences between private sector and public sector enterprises
Differences between resources for business & resources of business
Different resources for business &
Distinct stages of finance in a given business
36
1.7 Handouts
1. Glossary of accounting and finance terms – whether to give here or as a separate
handout??
2. Learning through questions:
Financial stages in a business enterprise
a) What is the starting point for a business enterprise – is it owners’ funds or loan?
b) Why can’t we start a business with loan?
c) Can we run our business entirely on equity?
d) What is the difference between what the owners get and what the lenders get?
e) What is the risk associated with 100% equity?
f) When does the lender get back his money?
g) When does the owner get back his money?
h) What are the financial stages in a business enterprise?
i) What is accrual?
j) What is EPS?
Short-term and long-term
a) What is the difference between revenue and capital?

b) Can the term ‘revenue’ be used to denote income as well as expense?
c) Are there specific resources for short-term and long-term assets in business?
d) Can we use short-term resource for a long-term purpose?
e) Can we use long-term resource for a short-term purpose?
f) What are the resources available to a business enterprise?
Critical finance concepts and their application to business
a) What is the usefulness of depreciation to business?

b) What is amortization and its usefulness to business?
c) What is the use of taking debt to share holders of a limited company?
d) What is the concept of leverage in business?
Case study covering all the objectives of the chapter
Story of M/S Vinod and Sons and its growth over a period of time
Phase 1
Vinod starts a small business with a capital of Rs. 1 lac for trading in electrical equipments as a sole
proprietorship firm. He did not take a loan as he was afraid of the risk of taking a loan. Further the
lender would insist on a guarantor and he did not want to approach any third person with a request for
giving personal guarantee.
37
At the end of the first year, the turnover was Rs. 6 lacs and the profit after expenses was Rs.1 lac. It was
quite a learning and rewarding experience. He had taken material on credit worth Rs.50,000/- and the
given material on credit worth Rs.1 lac. During the course of the year to finance its operations, Vinod
had to introduce further capital of Rs.50,000/-. He did not withdraw the profit of Rs. 1 lac that he had
reinvested. Hence at the end of the year, the total capital that he had invested in business stood at
Rs.2.5 lacs.
Without any financial assistance from any bank Vinod continued his business for another two years by
which time the business had grown to Rs.15 lacs and the profit to Rs.2lacs. Fortunately he did not have
bad debts and there was no need to introduce more capital. His capital stood at Rs. 4 lacs after
withdrawals for self at the end of this period.
Phase 2
By this time he had established himself reasonable reputation for consistent and quality supply of
electrical goods. Hence 2 national firms had approached him to take up dealership for their products in
one part of Pune. He had to think in terms of financial assistance as he could not put in more than 1 lac
additional capital.
The estimated annual sales would be in the region of Rs.30 lacs at the end of the first year and the bank
loan required would be Rs. 6 lacs in all to finance:
Working capital for stocking as dealers for 2 leading brands to begin with,
Rent deposit for a bigger place & Interiors in the shop for stocking etc.
The debt to equity ratio would work out 1.5:1. This was ok with the bank. Hence everything had gone off
smoothly. The operations continued for 3 years without any hitch. During this time the revenues had
grown to Rs.75 lacs and the profit was in the region of Rs. 12 lacs. The bank loan for interiors and vehicle
could be repaid in time and hence his credit rating was good.
Phase 3
By this time Vinod could acquire practical knowledge in electrical equipments besides completing his
AMIE diploma also.
He wanted to start a manufacturing firm for manufacture of testing equipments for LT transformers.
However he did not want to go alone this time. He had scouted for interested persons as partners in the
market and could succeed in roping in 2 partners. The bank was also insisting that they would give loan
to the new business only if more persons were inducted as partners.
Question 1 for discussion: Why should the bank insist on more partners to come into business?
38
Vinod before taking the new partners had taken stock of his assets and liabilities at the end of the 6-year
operations. His position was as under:
Revenues: Rs.75 lacs
Purchases: Rs.50 lacs
Closing stock: Rs.10 lacs
Opening stock: Rs.6 lacs
Operating expenses: Rs.17 lacs
Profit: Rs.12 lacs
Question 2 for discussion: Why there is no income tax considered here?
Liabilities Assets (all amounts in Indian Rupees in Lacs)
Item Amount Item Amount

Bank overdraft 4 Stock 10
Creditors 8 Debtors 12
Accrued expenses 1 Fixed assets 2
Bank loan 0.5 Investment in
Owner’s capital 12.5 Bank FD 1
Deposit for rent 1
Total 26 Total 26
Question 3 for discussion: What should be the approach of Vinod before inducting in new partners?
Should he sell off his existing business of dealing in electrical accessories?
The proposed partnership firm would be moving into a ready to occupy MIDC shed and the cost of
project and means of finance for starting the manufacturing unit was as under: (All figures are in Indian
Rupees in Lacs)
Cost of project Means of finance
Item Amount Item Amount
Capitation fee
For MIDC shed 5 Capital 33
Plant 50 Bank loan 50
Equipments 10
Vehicles 3
Office equipments 2
Furniture and fixtures 3
Margin money on working
Capital @ 25% 10
Total 83 Total 83
39
The other details of the project are:

Estimated sales and profit after tax for the first 3 years (amount in Indian Rupees in Lacs)
Revenues:
Year 1 – 100
Year 2 – 130
Year 3 - 180
Profit after tax:

Year 1 – 15
Year 2 - 18
Year 3 - 25
Questions for discussion:

4. Why are we considering here PAT?
5. What are the sources for repayment of bank loan?
6. How does a bank assess the viability of a project like this?
The partnership firm was formed and the manufacturing unit began its operations. The operations went
off smoothly and the bank had given a credit rating of A to the unit, A (+) being the best rating.
Phase 4 – Acquiring global technology for expansion and becoming all-India supplier of testing
equipment not only for LT transformers but also for MT transformers
On enquiries with international markets for supply of latest technology, the firm learnt that they would
have to form a private limited company.
Questions for discussion:

7. Why should this be the condition in the international market for selling technology?
8. Is it necessary for an Indian promoter to float a public limited company to attract foreign
investment?
40

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Business & Business resources 2013

Basic knowledge of accounts and finance is increasingly recognized as a ‘must possess’

Keeping this in mind, the topic focuses on:

1.1 Introduction to business and enterprise

1.1 Introduction to Business & Enterprise

1.1.1 Activities of a commercial business enterprise

A business enterprise is engaged in one or more of the following activities:

1.1.2 Different forms of business organization

Simply put, there are three different forms of business organization:

Number of owners: One

Advantages: Easy to form

100% ownership, control and share in profits

Ability to raise resources from outside and hence growth constrained

Number of owners: Two with a ceiling of 20 partners.

Advantages: High credibility in view of statutory requirements.

Universal acceptability especially for joint ventures etc.

Most complex form of organization

A number of formalities to be complied with for going to public for resources

Parameter Sole proprietorship Partnership firms Limited companies

Distribution of 100% Done Done Cannot be done.

beyond a specified beyond a specified besides Tax audit

1.1.3 Differences between private limited and public limited companies

1. Pass a board resolution at the board of directors’ meeting,

1.1.4 Private sector & public sector

Public or private sector:

Structure of a public sector enterprise:

1.2 Financial resources for a business enterprise

1.2.1 Starting point for a business enterprise

Let us study the following example to understand this:

What is the reason for this?

Yes. The name depends upon the form of business organization.

Thus summing up:

1.2.2 Resources for business and resources of business

Having understood that without owner’s/owners’ contribution towards capital, no enterprise

To the enterprise = assets and income

1.2.3 Equity (owners’ capital) & debt (borrowed funds)

Short-term, medium-term and long-term – explanation in terms of duration

Medium and long-term resources

Components of current assets in the case of a manufacturing unit

Components of current assets in the case of a trading unit

Debtors representing credit sales

Components of current assets in the case of a service unit

Bank borrowing for working capital

Equity share capital Preference share capital

Cumulative means that in case during a year

Differences between debenture and bond

Term loans given by banks and financial institutions

Why call it a term loan?

5. There is non-repayment of principal amount or more popularly known as “moratorium period”

Unsecured loans by promoters, friends and relatives

Fixed Deposits accepted from public

Thus, the factors primarily responsible for taking loans are:

Differences between equity and debt

Examine the case and answer the following questions.

1.3 Basic finance concepts and their application to business:

1.3.1 Financial stages in business:

Let us see these steps:

Terms associated with the above:

1.3.2 Application of basic finance concepts to business:

Depreciation by straight line method and written down value method

Year No. Opening value Depreciation Closing value

Zero 1,00,000/- ----- 1,00,000/-

(Written down value method)