Financial Management

FINANCIAL MANAGEMENT
Vipul V. Shah
M.B.A., M.COM, AICWA, EXIM Contact : 9881 236 536
saraswaticlasses.in vipulshah701@yahoo.co.in
INDEX
SR. No.
1 2 3 4 5 6 7
CHAPTER NAME
INTRODUCTION TO FINANCIAL MANAGEMENT ANALYSIS OF FINANCIAL STATEMENT WORKING CAPITAL MANAGEMENT OF RECEIVABLES CAPITAL BUDGETING DECISIONS CAPITALISATION DIVIDEND DISTRIBUTION THEORIES QUESTION BANK
PAGE NO
4 14 45 66 71 83 101 110
Instruction Notes are designed from syllabus point of view. Strictly for private circulation
SARASWATI CLASSES
FOR
CA, CS & CWA
CHAPTER 1
INTRODUCTION TO FINANCIAL MANAGEMENT
SARASWATI CLASSES FOR CA, CS & ICWA
www.saraswaticlasses.in
CHAPTER 1
INTRODUCTION TO FINANCIAL MANAGEMENT
1. FINANCE Finance is lifeblood of every business organization. It is a foundation of all economic activity. Business needs finance to make more money. Only money can earn more money. Therefore efficient management of business is closely linked with efficient management of finance. 2. BUSINESS FINANCE This is a one of the most important Management function Business finance is defined as procurement of fund & their effective utilization. It is also defined as Activity concern with planning, raising controlling and administrating of the funds used in business. 3. MEANING OF FINANCIAL MANAGEMENT It concern with proper management of fund. The finance manager must see that the funds are procured in a manner that the risk, cost and control consideration are properly balanced in a given situation and there is optimum utilization of fund. Financial Management can be defined as: The management of the finances of a business / organisation in order to achieve financial objectives Taking a commercial business as the most common organisational structure, the key objectives of financial management would be to:
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Chapter : 1 Introduction to Financial Management / 4
Create wealth for the business Generate cash, and Provide an adequate return on investment bearing in mind the risks that the business is taking and the resources invested There are three key elements to the process of financial management: (1) Financial Planning Management need to ensure that enough funding is available at the right time to meet the needs of the business. In the short term, funding may be needed to invest in equipment and stocks, pay employees and fund sales made on credit. In the medium and long term, funding may be required for significant additions to the productive capacity of the business or to make acquisitions. (2) Financial Control Financial control is a critically important activity to help the business ensure that the business is meeting its objectives. Financial control addresses questions such as: Are assets being used efficiently? Are the businesses assets secure? Do management act in the best interest of shareholders and in accordance with business rules? (3) Financial Decision-making The key aspects of financial decision-making relate to investment, financing and dividends: Investments must be financed in some way - however there are always financing alternatives that can be considered. For example it is possible to raise finance from selling new shares, borrowing from banks or taking credit from suppliers A key financing decision is whether profits earned by the business should be retained rather than distributed to shareholders via dividends. If dividends are too high, the business may be starved of funding to reinvest in growing revenues and profits further. 4. BASIC OBJECTIVES/GOALS OF FINANCIAL MANAGEMENT (1) Maintenance of liquid asset Liquid assets are required to meet firms obligation at all times. Liquid assets are those assets, which can be converted into cash with minimum loss. Liquid assets have to be adequate. (Neither too low not too excessive) finance manager has to maintain balance between profitability & liquidity as Profitability increases liquidity decreases Profitability decreases liquidity increases (2) Goal of Profit maximization. Maximization of profits is generally regarded as the main objective of a business enterprise. Each company collects its finance by way of issue of shares to the public. Investors in shares purchase these shares in the hope of getting medium profits from the
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company as dividend It is possible only when the company's goal is to earn maximum profits out of its available resources. If company fails to distribute higher dividend, the people will not be keen to invest their money in such firm and persons who have already invested will like to sell their stocks. On the other hand, higher profits are the barometer of its efficiency on all fronts, i.e., production, sales an management. A few replace the goal of 'maximization of profits' to 'fair profits'. 'Fair Profits' means general rate of profit earned by similar organisation in a particular area. Concept of profit maximisation has come under serve criticism in recent time due to following reason. I) It is vague It dose not clarify which profit dose it mean; whether short term or long term, PBT OR PAT profit from shareholders point of view or from capital employed point of view. Profit in the short term may be quite different from those in the long run. For e.g. if a firm continues to run its business without having adequate maintenance of machinery, the firm profit in the short run may increase because of saving in expenditure. However in the long run firm may suffer heavy loss/expenditure since machine may have to be replaced or it may require heavy expenditure. ii) If ignores timing The concept ignores the importance of the fact that the rupee recovered today is much more valuable than a rupee recovered tomorrow for. e.g. If company is having 2 project i.e. A & B The expected rate of return is 14% & 13% respectively returns are expected for 4 & 6 years respectively Now in order to decide which project should be accepted, It is not only enough to see the rate of return, but the present value of cash flow available from both the project. By comparing returns project A is acceptable, but it will stop giving returns after 4 years. It will be more profitable than B if firm is having investment option after 4 years otherwise project B is better as returns are available for 6 years. iii) It ignore financial aspect & risk associated with particular decision (3) Goal of Return Maximization. The second goal of financial management is to safeguard the economic interest of the persons who are directly or indirectly connected with the company, i.e.,shareholders, creditors and employees. The all such interested parties must get the maximum return for their contributions. But this is possible only when the company earns higher profits or sufficient profits to discharge its obligations to them. Therefore, the goal of maximization of returns are inter-related. (4) Goal of Wealth Maximization. Frequently, Maximization of profits is regarded a the proper objective of the firm but it is not as inclusive a goal as that of maximising it value to its shareholders. Value is represented by the market price of the ordinary share of the company over the long run which is certainly a reflection of company's investment and financing decisions. The log run means a considerably long period in order to work out a normalized market price. The management can
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make decision to maximize the value of its shares on the basis of day-today fluctuations in the market price in order t raise the market price of shares over the short run at the expense of the long fun by temporarily diverting some of its funds to some other accounts or by cutting some of its expenditure to the minimum at the cost of future profits. This does not reflect the true value of the share because it will result in the fall of the share price in the market in the long run. It is, therefore, the goal of the financial management to ensure its shareholders that the value of their shares will be maximized in the long-run. In fact, the performances of the company can well be evaluated by the value of its share. Steps for wealth maximization Avoid high level of risky projects Pay dividend regularly by considering Market value of share & share holders expectation Maintain growth in sales. Maintain price of firms share Social Responsibility (5) Other objectives Fair return to share holder Building up reserves Efficient & effective utilisation of available resources 5) SCOPE OF FINANCE FUNCTION I) Traditional Approach This approach limited the role of finance manager He was expected to raise fund and administration of fund needed by organisation This approach broadly covers 3 aspects I) Procurement of fund from financial institution ii) Procurement of funds from financial institution Such as Shares, bonds. iii) Looking after legal and accounting relations between a corporation and its sources of funds Role of finance manager To keep accurate financial records. Prepare reports on corporation status and performance. Manage cash in order to pay bill on time. The term corporate finance was used in place of present terms financial management. Criticism against traditional approach i) Outsider looking in approach It has treated finance function from suppliers point of view i.e. investors & bankers. (As finance function deals with raising and administration of fund) It completely ignored the viewpoint of those who had to take decision.
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SARASWATI CLASSES FOR CA, CS & ICWA ii)
Ignored routine problems It gives importance to event, which dose not happen frequently i.e. merger amalgamation. It ignore routine & day to day finance problems iii) Ignored working capital financing. It gives more importance to long-term loan rather then short-term loan, which is required finance working capital. iv) No emphasis on allocation of funds It gives more importance to raising of fund rather then allocation of funds. II) Modern Approach Traditional approach lost its utility due to changed business situation since 1950. Technological development widened market operation, Development of strong capital structure, healthy competition. These changes require efficient use of available financial resources. Computer helped manager to give more information to take decision. Era of high inflation Interest rates rise dramatically Thus it was important for Manager to raise loans on suitable basis which needs proper analysis
1950 :
1960 : 1980 :
According to modern approach Finance manager's Job is to acquire fund and allocation of fund by keeping in mind org. objective. Under modern approach finance manager is expected to take following decision i) Financing decision The financing of capital investment proposals are done in two forms of finances in general i.e. equity and debt. The finance decision should consider the cost of finances available in different forms and risk associated with it. The reduction in the cost of capital will increase profit. Before selecting any particular source of finance. It is necessary to understand advantages & risk associated with it. The main task of finance manager is to minimize cost of capital & maximizing returns available to the shareholders. The finance manager involve in following finance decision Determination of financing pattern of fund Analyse different sources of finances Arrangement of funds form financial institutions Consideration of impact of interest on profitability & liquidity Calculating component as well as composite cost of capital Decide appropriate debt -equity mix. Evaluation of alternative use of funds. ii) Investment decision Investment decision are those which determine how scare resources in terms of funds available for projects. The investment decision should aim at investment in assets only when they are expected to earn greater than minimum acceptable return. It is the function of finance manager to carefully
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analyse different capital proposal & select the best proposal. Investment in current assets will demand upon credit policy and inventory policy of firm. The investment decisions of a finance manager cover the following areas Funds allocation & its rationing. Buy or lease decisions Asset replacement decisions Ascertainment of total volume of a funds, a firm can commit. Measurement of risk and uncertainty in the investment proposals. iii) Dividend decision. Dividend decision involves the determination of the % of profit earned by enterprises, which is to be paid to shareholders and frequency of such payments. The profit available to shareholders is divided in two ways Amt payable to shareholders as divided Amt to be retained for internal finance The finance manager will involve in taking the following dividend decisions Determination of amount of divided & retention policies of firm. How divided decision will affect market value of share ? Considering the impact of legal and cash flow constraints on dividend decisions. 6) IMPORTANCE / SIGNIFICANCE OF FINANCIAL MANAGEMENT i) Sound financial Management It is necessary for efficient utilization of funds in fixed assets & in working capital. ii) To borrow money Finance manager estimate total requirement of fund both short term and long term & accordingly loan is taken. He assesses various ratios such as return on capital debts equity ratio to determine requirement. iii) To minimize cost of borrowing Finance manager evaluates various sources of borrowing & select best source, which will minimize cost of borrowing. iv) Helps in planning Management helps in profit planning, investment analysis, controlling inventories, capital spending & measuring cost. v) Determination of future activity Finance manager also helps is ascertaining how the company would perform in future. It helps in indicating whether firm will generate enough funds to meets it various obligation like repayment of installment due on loan, redemption of liabilities. 7) ROLE & KNOWLEDGE OF FINANCE MANAGER Initially finance manager was called upon wherever company needs fund. His role was limited to procurement of fund i.e. once funds were procured his function was over but now days role of finance manager has changed.
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SARASWATI CLASSES FOR CA, CS & ICWA Functions
Capital procurement To provide adequate finance as when require. Investor relations To maintained proper relationship with bankers, lending institutions. Short term financing To meet short funds requirement of firm. Reporting & interpretation To provide necessary report to the management as and when required & to compare standard performance with actual performance. Allocation To allocate funds available as per the requirement of each department. Administrative function To provide necessary reports to the government agencies. To assess impact of economic, social & government policies on business environment. 8) FORMS OF BUSINESS ORGANISATION I. PRPPRIETORY FIRMS/ SOLE TRADING CONCERN Meaning This form of organisation is called as One-man business. One person invests capital. Profit & loss shared by one person only. Advantages Flexibility Quick decision Less Government Intervention Personal touch with customers Easy to form Direct relationship between efforts and rewards Easy to adopt Market changes Limitation Limited Capital Risk bear by one person Useful for small business only No legal status Unlimited Liability Existence of organization depends on existence of proprietor Limited loan raising capacity
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SARASWATI CLASSES FOR CA, CS & ICWA II. PARTNERSHIP FIRM Meaning
Firm which is formed by minimum 2 or more person and maximum 20 members. Registration under partnership act 1932 is required. Advantages Capital contribution by partners Risk is shared by partners Sharing of expertise and knowledge by partners Better decision can be taken Division of work according to specialization Capacity to handle complex business problems Less government intervention Limitation Difficult to fix up responsibility for common work Conflict between partners No legal status Loan raising capacity is comparatively less but more than sole trading organizations. Unlimited Liability Transfer of ownership involves change in the constitution of business No direct relation between efforts and rewards Death of one partner affects existence of firm III. JOINT STOCK COMPANY Advantages Large capital collection Separate legal existence Division of risk Large scale operations Skilled professional can be hired Transferability of ownership Capital appreciation Dividend income Repayment of capital at the time of Liquidation Provides employment opportunities Separation of ownership and management Limited liability of shareholders
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SARASWATI CLASSES FOR CA, CS & ICWA Limitations
Decision making takes time Difficult to adopt changes Lack of flexibility Government intervention in the form of various rules and regulations Types of Joint Stock company Public Limited A organization which has got Separate Legal existence independent of its members Shareholders enjoy voting rights Minimum 7 members required to from and no limit on maximum members Capital contribution by issuing shares Private Limited Minimum 2 members required to form and maximum 50 members Can not issue shares to public that means capital contribution by members only Minimum paid up capital of Rs 1 crore is required Can not invite or accept deposit from public Restriction on transfer of ownership
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CHAPTER 2
ANALYSIS OF FINANCIAL STATEMENTS
CHAPTER 2
ANALYSIS OF FINANCIAL STATEMENTS
RATIO ANALYSIS 1. INTRODUCTION & MEANING: Profit & loss A/c & balance sheet are 2 basis parameters to judge the financial health of a company. By looking to these statements one can know gross profit, net profit, current asset, current liabilities etc. However making decision based on absolute figure without relating them to some other figure becomes meaning less. Meaning Ratio analysis is a technique by which various figures in the profit & loss a/c & b/s are related to each other to give a meaningful conclusion got interpreting & deciding the line of action for decision making & control. 2. IMPORTANCE/ADVANTAGES OF RATIO ANALYSIS It revels inter-relationship that may exist among different items in financial statement. It is a powerful tool majoring, liquidity, Solvency, profitability & efficiency of business. Ratio analysis is useful to management of company, investors, creditors, government, banks & other outside parties. Ratio analysis is useful to reduce expenditure & increased rate of profit. It is useful for planning & formulating future policies. It is useful for control purposes. Standard ratios are compared with actual ratios & if there is difference correct actions are taken. Analysis reflects utilization of asset employed in business. It is useful to locate trouble areas of business.
Chapter : 2 Analysis of Finacial Statements / 14
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It is useful for compression between different units of same firm or between two firms. 3. LIMITATIONS OF RATIO ANALYSIS It communicates only a relative picture. Every organization in one way or other is unique and comparison may not be valid. Ratios are only a tool. Their ultimate use depends upon management who use it. They only pass guiding signals. Sometimes attempts are made to window dress the accounts, i.e. efforts are made to manipulate the accounts in a manner, that the picture being better than what actually it is. Inflation distorts financial ratio analysis. Changes in the reported performance of a company may be entirely due to inflation and not due to management. Following Parties are interested in Ratio analysis. Party I) Shareholder 1. 2. 3. 4. II) Creditors 1. 2. 3. III) Government 1. 2. 3. IV) Management 1. Interested in which Ratio Return on Capital employed. Rate of dividend. Long term solvency. Earning per share. Current ratio. Liquidity ratio. Debts equity ratio. G.P. ratio. N.P. ratio. Capacity utilisation. All turn over ratio.
4. TYPES OF RATIO i) Liquidity Ratios Means ability of company to make cash available as & when required. The liquidity ratios study the firm's short term solvency and ability to pay off the liabilities. Consequently, these ratios focus on current assets and current liabilities. Some of the common liquidity ratios are 1) Current Ratio 2) Quick Ratio/Acid Test Ratio 3) Absolute Quick ratio
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SARASWATI CLASSES FOR CA, CS & ICWA ii) The Activity/ Turnover/ Performance Ratios
These ratios measure the effectiveness with which the firm uses its resources. It shows how efficiently and effectively the assets of the firm being utilized. Some of the important activity ratios are as follows 1) Working Capital Turnover Ratio 2) Inventory/Stock Turnover Ratio 3) Debtors Turnover Ratio 4) Creditors Turnover Ratio 5) Fixed Assets Turnover Ratio 6) Capital Turnover Ratio 7) Total asset turnover Ratio iii) Leverage/Solvency Ratios The term leverage in general refers to a relationship between two interrelated variables. In financial analysis it represents the influence of one financial variable over some other related variable. It is an ability of the firm to use fixed costs to magnify the returns to the shareholders. 1) Debt-Equity Ratio 2) Interest Coverage Ratio 3) Fixed Charge Coverage Ratio 4) Total debt ratio/ Debt-Asset Ratio 5) Fixed Assets Ratio iv) Profitability Ratios Profits are the ultimate test of the management. It can be measured by variety of ways. Profitability ratios communicate the profitability of events that have already taken place. Important profitability ratios are as follows 1) GP Ratio 2) NP Ratio 3) Operating Profit Ratio 4) Operating Ratio 5) Return on Asset 6) Return on Capital Employed 7) Return on Equity 8) Proprietary Ratio v) Valuation Ratios/Miscellaneous Group 1) 2) 3) 4) Earning Per Share Dividend Payout Ratio Price Earning Ratio Capital gearing Ratio
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SARASWATI CLASSES FOR CA, CS & ICWA LIQUIDITY RATIOS SR 1 RATIO Current Ratio Current Assets Current Liabilities DETAILS Current assets = Debtors. + Cash or Bank + Bills receivable + Prepaid Expenses + Closing Stock + Advances + Marketable security Current Liabilities = Creditors + Bills payable + Outstanding expenses + Bank Overdraft
PURPOSE The ratio tells us about the about the capabilities of a company to discharge its short term liabilities. Ideally the ratio should be 2:1 i.e. current asset should be double that of current liability. CR of 1.33:1 is considered by banks as the minimum acceptable level for providing working capital finance. This ratio indicates immediate liquidity of company; ideally this ratio should be 1:1 that means immediate & quick liabilities can be repaid by collecting money from sundry Drs. & cash available with company. If ratio goes below one it indicate that liquidity of company is disturbed. This ratio indicates abilities of company to fulfill its immediate commitments on time. Ideal ratio 1:2.
Liquid /Acid Test / Ratio Quick /Liquid Assets Current Liabilities Quick Ratio Quick /Liquid Assets Quick liabilities
Liquid Assets = CA - Stock Prepaid exp. Quick Liabilities = CL - Bank o/d If bank overdraft is usually availed by the firm on more or less regular basis, and is not payable in real sense, is therefore, deducted from the amount of total current liabilities.
Absolute Liquid Ratio
This ratio is also called as Super Quick / Cash/ cash reservoir Cash + Mkt. Securities Ratio. Quick Liabilities Mkt. Investment means short term investments.
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SARASWATI CLASSES FOR CA, CS & ICWA TURNOVER RATIOS SR. RATIO 4 Inventory / Stock Turnover Ratio Cost of Goods Sold Average Inventory OR Cost of Goods Sold Closing Inventory 5 Debtors Turnover Ratio Net Credit Sales Avg. Accounts Receivable DETAILS Cost of goods sold = Sales - Gross Profit Average Inventory = Opening Stock + Closing stock 2
PURPOSE This ratio indicates the efficiency of inventory management when inventory turnover ratio is goes down management has to review its inventory policies & inventory stock levels.
Net Credit Sales This ratio indicates = Credit Sale - Sales return efficiency of recovery Accounts receivable department. = Bills Receivable + Debtors Avg. Accounts receivable = Op. Receivable + Cl. Receivable / 2 This ratio indicate collection period in moths or days.
Debt Collection Period 12 months DTR OR 365 days DTR 6 Creditors Turnover Ratio Net Credit Purchase Avg. Accounts Payable
Net Credit Purchase This ratio indicates credit = Credit Purchase - Purchase return given by suppliers. Accounts payable = Bills Payable + Creditors Avg. Accounts payable = Op. payable+ Cl. payable / 2 This ratio indicate payment period in moths or days.
Debt Payment Period 12 months CTR OR 365 days CTR Fixed Assets Turnover Net Sales = Sales - Sales returns Ratio Fixed assets after depreciation Net Sales Fixed Assets OR COGS Fixed Assets
This ratio indicate how efficiently fixed assets have been utilized in the business. Every company will try to maximise this ratio.
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SARASWATI CLASSES FOR CA, CS & ICWA 8 Capital Turnover Ratio Capital Employed= share Capital + Net Sales Reserve & Surplus + Long term Loans + Capital Employed Debentures - Fictitious assets Accumulated losses OR Fixed Assets + Working Capital Total Assets turnover Total assets = Fixed assets ratio + Current assets Net Sales Total Assets Working Capital Turnover Ratio Net Sales Working Capital Net Sales = Sales Sales returns Working Capital = Current Assets - Current Liabilities
www.saraswaticlasses.in This ratio indicates the efficiency of the organization with which capital employed is being utilized to generate revenue.
This ratio compares sales generated with available assets.
10
Ratio indicates efficiency of working capital management of the company. Higher the ratio better is the efficiency better is the utilization of working capital.
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SARASWATI CLASSES FOR CA, CS & ICWA PROFITABILITY RATIOS SR. 11 RATIO Gross Profit Ratio DETAILS GP = Sales - cost of goods sold Sales = Cash and Credit Sales sales returns Sales = Cash and Credit Sales sales returns
PURPOSE Indicate efficiency of production department.
GP X 100 Sales
12 Net Profit Ratio
NP X 100 Sales
13 Return on assets
This ratio shows overall efficiency of business
PAT X 100 Total Assets

14 Return on Capital Employed / Return on Investments Capital Employed = share Capital + Reserve & Surplus + Long term Loans + Deben tures - Fictitious assetsaccumulated losses
This ratio indicates how firm has used assets to maximise profit. ROC Emeasures profitability of the capital employed in the business
PBIT Capital Employed

15
X 100
Return Shareholder Funds PAT X 100 Total Shareholders' funds OR Return on Equity PAT - Pref. dividend X 100 Total Shareholders' funds - Pref. Share Capital Operating Profit Ratio
Shareholders funds = Equity This ratio indicates the capital +Pref. Capital + Reserves profitability of a firm in & surplus - accumulated losses relation to the funds supplied by the shareholders or owners.
16
Operating profit X 100 Net Sales
Operating Profit = Gross profit operating expenses
Operating profit indicates pure profit generated by the operation of the firm hence it is calculated on the basis of EBIT.
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LEVERAGE/CAPITAL STRUCTURE RATIOS SR RATIO DETAILS 17 Interest Coverage Ratio PBIT = Profit before depreciation, PBDIT interest and tax Interest = Interest on long term Interest Charges loans only. 18 Debt- Equity Ratio Debt Net Worth/ Shareholder Fund/ Proprietors Fund Debts = Debentures + Long term loans payable after year Shareholder's funds= Equity & Preference capital + Reserves & surplus- Fictitious assets-Accumulated losses PURPOSE This ratio indicates funds available to pay interest. An interest cover of more than 7 times is regarded as safe & more than 3 is desirable. Debt equity ration of 2:1 is the norms accepted by financial institution for financing the projects. It indicates the cushion available to the creditors on liquidation of the organisation. High debt equity ratio is maintained to maximize returns given to shareholders. The Total debt ratio depicts the proportion of total assets financed by the shareholders.
19
Total Debt Ratio (Debt-Asset Ratio) Total Debts Total Assets Capital gearing ratio Fixed Income Bearing Securities Equity Capital
Total debts = Long Term Debts + Current Liabilities Total Assets = Fixed Asset + Current Assets Fixed income bearing Security = Preference share capital and Debentures Equity Capital = Equity Share Capital + reserve & Surplus
20
A high gearing ratio indicate that in the capital structure; fixed income bearing securities are more in comparison to the equity share capital and in that case company is said to be highly geared and vice versa.
21
Proprietary Ratio Shareholders Fund Total Assets
Shareholders Funds = Capital It expresses the relationship employed - Long term Loans- between shareholders funds to Fictitious assets total assets. Total Assets = Fixed assets + Current assets - Fictitious assets This ratio is the key indicator to the lender to assess the extent of ability of the borrower to service the loan in regard to timely payment of interest & loan. A ratio of 2 considered satisfactory by the financial institutions.
22
Debt service coverage Ratio PAT + Dep +Int Interest + Loan repayment in a year
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SARASWATI CLASSES FOR CA, CS & ICWA VALUATION RATIO SR RATIO 23 Earning Per Share PAT - Preference Dividend No. of Equity Shares 24 Price Earning Ratio Market Price Per Share Earning Per Share DETAILS No of equity share = Paid up capital Face value per share
PURPOSE This ratio is used to measure profit available to shareholder. Higher EPS indicate increasing trend of profit. This ratio indicates the expectations of the equity investors about the earnings of the firm. The investor's expectations are reflected in the market price of the share. The ratio indicates how much an investor is prepared to pay per rupee of earnings. This ratio explains relationship between earnings belonging to shareholder and amount finally paid to them in the form of Dividend. The ratio reflects the % yield that an investor receives on this investment at the current market price of the share
25
Dividend Payout Ratio Dividend Per Share Earning Per Share
26
Dividend yield ratio Dividend per share X 100 Market price
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STEPS INVOLVED IN THE FINANCIAL STATEMENT ANALYSIS The analysis of the financial statements requires: (1) Methodical classification of the data given in the financial statements. Methodical classification. In order to have a meaningful analysis it is necessary that figures should be arranged properly. Usually instead of the two-column (T form statements as ordinarily prepared, the statements are prepared in single (vertical) column form "which should throw up significant figures by adding or subtracting." This also facilitates showing the figures of a number of firms or number of years side by side for comparison purposes. OPERATING (INCOME) STATEMENT For the year ending Gross Sales Sales Returns Sales Tax/Excise Net Sales (or sales) for the year Cost of Goods sold : Raw Materials consumed (Op. stock of R.M + Purchase of R.M. + Expenses on Purchases - Cl. Stock R.M) Direct Wags Manufacturing Expenses Opening Stock of Finished Goods Closing Stock of Finished Goods Gross Profit Operating Expenses : Administration Expenses Selling and Distribution Expenses Depreciation Net Operating Profit (OPBIT) Non-trading Income (Such as dividends, interest received, etc.) Non-trading Expenses (such as discount on issue of shares written off) Income or Earning before Interest and Tax (EBIT) Interest on Loans and Debentures Income or Profit Before Tax (PBT) Provision for Tax Profit after Tax Preference Dividend Profit Available to Shareholders Equity Dividend Retained Earnings Rs. *** *** *** Rs.
Less :
........
Less :
*** *** ***
Add : Less : = Less :
........ ........ ........ ****
*** *** ***
= Add: Less : = Less: = Less = Less = Less =
... **** ........ ........ ........ **** ........ **** ........ **** ........ **** ........ ****
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SARASWATI CLASSES FOR CA, CS & ICWA BALANCE SHEET AS ON PARTICULARS Preference Share Capital Equity Share Capital Total Share Capital (1) Add Capital reserve General reserve Share Premium Capital Redemption Reserve Profit & Loss A/c Preliminary Expenses Accumulated Losses Shareholders fund / Proprietors Funds / Net Worth (2) Long Term Funds Debentures Capital Employed (3) Represented By Fixed Assets Land & Building Plant & Machinery Furniture & Fixtures Gross Block Depreciation Net Fixed Assets (4) Current Assets (5) Cash & Bank Debtors Bills Receivables Closing Stock Pre-paid Expenses etc Current Liabilities (6) Trade Creditors Bills Payable Bank Overdraft Outstanding Expenses Provision for Tax Net Working Capital (7) = (5) - (6) Total Assets (4) + (7)
RS . .
RS
****** . . . . . . . ****** ****** . . ****** ****** . . . . . .
Less
= Add
Less = Add
****** ******
. . . . . . . . . . .
Less
= =
****** ****** ******
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SARASWATI CLASSES FOR CA, CS & ICWA FUND FLOW STATEMENT
The profit & loss a/c and balance sheet statements are the common important accounting statement of a business organization. These statement dose not provide information about movement of funds which is equally important for shareholders. To provide this information Funds flow statement is prepared. The statement is divided into two parts , sources and application. The sources of funds shows The funds generated from operation internally The reasons for liquidity problems even though it is earning profits. It helps the efficient working capital management It indicate ability of firm in servicing its long term liabilities The application of funds shows How much amount is paid towards paying dividend & tax payment ? How long term & short term funds utilized by the company? What are the sources of funds available during the year ? This statement shows difference between two balance sheet. The term fund means working capital i.e., difference between current assets & current liabilities. The flow means movement of funds which cause a change in working capital. Benefits of fund flow statement Fund flow statement helps in taking decisions regarding allocation of limited financial resources. It helps in securing new laon. It may allow company to declare dividend inspite of losses or low profits. Drawbacks The fund flow statement is historical in nature like any other financial statement. It dose disclose the major policy decisions with regards to investment in current assets & fixed assets. Funds flow statement are depends upon correctness of financial statements.
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How to prepare Fund Flow statement?

1) Prepare fund flow statement. Source 1. Issue of shares 2. Issue of debentures 3. Loan taken from bank 4. Sale of assets 5. Decrease in working capital 6. Operating profit Rs Application 1. Redemption of shares 2. Redemption of debentures 3. Payment of loan 4. Purchase of assets 5. Incerase in working capital 6. Operating loss 7. Dividend paid 8. Tax paid TOTAL TOTAL Rs
2) Prepare statement showing changes in Working Capital. Particular A. Current Assets 1.Bank 2.Drs 3.Stock 4.Pre-paid expenses 5.Bills receivables 6.Short term investment B. Current Liabilities 1.Credits 2.Bank overdrafts 3.Bills payable 4.Proposed Dividend* 5.Provision for Tax* TOTAL Increase/Decrease in working capital NET TOTAL ** ** * Proposed dividend & provision for Tax can be treated as current liability as well as non-current liability (open separate ledger account). ** ** Year 1 Year 2 Increase Decrease
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SARASWATI CLASSES FOR CA, CS & ICWA Rules to decide increase or decrease in working capital Increase or decrease in CA or CL Working Capital
CA - CL = WC 100 - 50 = 50
Increase in Current Assets Decrease in Current Assets Increase in Current Liabilities Decrease in Current Liabilities
Increase in WC Decrease in WC Decrease in WC Increase in WC
120 - 50 = 70 80 - 50 = 30 100 - 80 = 20 100 - 30 = 70
3) Prepare necessary ledger account for adjustments and P&L account. 4) Record all adjustments with the help of journal entries & ledger posting. I. Sale of Asset. Cash or bank a/c Dr To Asset a/c. Cr II. Purchase of Asset. Asset a/c Dr. To bank a/c. Cr III. Profit on sale of Asset. Asset a/c Dr. To P&L a/c. Cr IV. Loss on sale of asset. P&L a/c Dr. To asset a/c. Cr V. Depreciation on Assets. P&L (depreciation) a/c Dr. To Asset a/c. Cr VI. Dividend paid. P&L (Dividend) a/c Dr. To cash a/c. Cr VII. Dividend paid when proposed dividend is given (Treated as non-Current Liability). Provision of dividend a/c Dr. To Bank a/c Cr VIII. Tax paid. P&L (Tax) a/c Dr. To bank a/c. Cr IX. Tax paid when provision for tax account is given (Treated as non-Current Liability). Provision for Tax a/c Dr. To bank. Cr
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SARASWATI CLASSES FOR CA, CS & ICWA X. Issue of share capital. Cash a/c Dr. To share capital. Cr XI. Redemption of share capital. Share capital a/c Dr. To cash a/c. Cr XII. Redemption of share capital/debenture at a premium Share capital /Debenture a/c Dr P&L (Premium on redemption) a/c Dr. To bank a/c. Cr XIII. Entry for creating provision. P&L a/c Dr. To respective provision. Cr XIV. Assets purchased by issuing shares. Assets a/c Dr. To share. Capital a/c Cr 5) Balancing of ledger account except P&L account Dr Particulars To balance b/d To Bank a/c TOTAL Dr Particulars To Bank a/c (Redemption/Repayment) To balance c/d TOTAL Asset a/c Rs Particulars By depreciation a/c
Cr Rs
By bank a/c (Sale of Assets) By balance c/d TOTAL Loan / Share capital a/c Rs Particulars By balance b/d By bank a/c (Issue of share/ Loan Taken) TOTAL Cr Rs
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SARASWATI CLASSES FOR CA, CS & ICWA Dr Particulars To Bank a/c (Payment) To balance c/d TOTAL 6) 7) Provision/Reserve a/c Rs Particulars By balance b/d
www.saraswaticlasses.in Cr Rs
By P&L a/c (current year provision) TOTAL
Consider assets & liabilities (other than considered in working capital statement & adjustment). Balance P&L account. Differences will be treated as operating profit or operating loss which is to be transferred to fund flow statement.
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SARASWATI CLASSES FOR CA, CS & ICWA PROBLEMS ON RATIO ANALYSIS Illustration 1 Given below the balance sheet of X ltd. Balance sheet of X Ltd Liabilities Equity share capital Retained earnings Long term debt Creditors Bank overdraft TOTAL Rs 15,00,000 6,00,000 5,00,000 12,00,000 2,00,000 40,00,000 Assets Fixed Assets Inventories Debtors Cash
Rs 16,50,000 9,10,000 12,40,000 40,000 1,60,000 40,00,000
Short term investments TOTAL
Annual sales Rs 74,40,000, GP Rs 7,44,000 Calculate 1) 2) 3) 4) 5) 6) 7) 8) 9) Debt-equity ratio Current ratio Quick ratio Fixed asset turnover ratio Debtors turnover ratio Stock turnover ratio Capital turnover ratio Total asset turnover ratio Gross profit ratio
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Illustration 2 Certain items of the annual accounts of ABC Ltd. are missing as shown below: TRADING AND PROFIT & LOSS ACCOUNT for the year ended 31st March, 2005 Particulars To Opening stock To Purchase To Direct Expenses To Gross Profit c/d Amount Rs. 3,50,000 _______ 87,500 _______ Particulars By Sales By Closing Stock Amount _______ _______
To Office and other Expenses To Interest on Debentures To Provision for Taxation To Net Profit for the year
Rs. 2,13,421 30,000 _______ _______
By Gross Profit b/d By Commission
_______ 50,000
To Proposed Dividends To Transfer to General reserve To Balance transferred to BS
_______ _______ _______
By Balance b/d By Net Profit for the year
70,000
BALANCE SHEET As on 31st March, 2005 Liabilities Paid up Capital General Reserve: Balance at the beginning Of the year Proposed Addition Profit and Loss A/c 10% Debenture Current Liabilities Total _______ _______ _______ _______ _______ Amount 5, 00,000 Assets Fixed Assets: Plan and Machinery Other Fixed Assets: Current Assets: Stock-in-trade Sundry Debtors Bank Balance Total _______ _______ 62,500 Rs. 7, 00,000 _______ Amount
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You are required to supply the missing figures with the help of the following information: i) Current ratio 2:1 ii) Closing Stock is 25% of sales. iii) Proposed dividends are 40% of the Paid up capital. iv) Gross Profit ratio is 60% v) Ratio of Current liabilities to Debentures 2:1. vi) Transfer to General reserve is equal to proposed dividends. vii) Profit carried forward are 10% of the Proposed dividend. viii) Provision for taxation is 50% of profit after tax. ix) Balance to the credit of General reserve at the beginning of the year is twice the mount transferred to that account from the current profits. Illustration 3 As on 31st March, 2003, the paid up capital of Navroj Ltd. was Rs. 1, 00, 00,000. The ratios as on that date were as under: Current debt to Total debt Total debt to Equity Fixed assets to Equity Total assets turnover (based on sales) Inventory turnover (based on sales) Draw the balance sheet of Navroj Ltd. (C.S., Final, Dec. 2003) Illustration 4 From the following details, prepare a Statement for Proprietary Funds with as many details as possible. a) Stock turnover b) Capital turnover c) Fixed assets turnover d) Gross profit ratio e) f) Debtors turnover Creditors turnover 6 2 4 20% 2 Months 73 days 0.40 0.60 0.60 2 times 8 times
The Groff profit was Rs. 60,000; Reserves and Surplus amounted to Rs. 20,000; Closing stock was Rs. 5,000 in excess of Opening stock.
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SARASWATI CLASSES FOR CA, CS & ICWA Illustration 5
The following are the Ratios extracted from the Balance Sheet of a company as at 31st December, 2005. Draw up the Balance sheet of the firm. Current liabilities Current Assets Working Capital Liquidity Ratio Stock Turnover Ratio Gross Profit Ratio Debt Collection period Shareholders' Capital Reserve and Surplus Fixed Asset Turnover (on cost of sales) Illustration 6 From the following information, prepare a summarized Balance Sheet s at 31st March, 2002 : Working Capital Bank Overdraft Fixed Assets to Proprietary ratio Reserves and Surplus Current ratio Liquid ratio Illustration 7 ABC Ltd has made plan for the next year. It estimated that the company will employ total assets of Rs 8, 00,000, 50% of the assets being financed by borrowed capital at an interest @ 16% p.a. The direct costs for the year estimated at Rs 4, 80,000 and all other operating expenses are estimated at Rs 80,000. The goods will be sold to customers at 150% of the direct costs. Income-tax is assumed to be 50%. You are required to calculate 1. Income statement of ABC Ltd 2. Net Profit Margin 3. Assets Turnover 4. Return on Assets 5. return on owner's equity Rs. 2, 40,000 Rs. 40,000 0.75 Rs. 1, 60,000 2.5 1.5 1.0 2.5 Rs. 3, 00,000 1.5 6 20% 2 months Rs. 5, 00,000 Rs. 2, 50,000 2
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The following figures extracted from the book of XYX Ltd as on 30.09.2000 Particulars Net Sales (-)Operating Expenses Gross Profit (-)Non operating expenses Net profit Current Assets Inventories Fixed Assets Total Assets Net Worth Debts Current Liabilities Total Liabilities Working Capital Calculate 1. GP Ratio 2. NP Ratio 3. Return on Assets 4. Inventory Turnover 5. Working Capital Turnover 6. Net worth to Debts Rs 24, 00,000 18, 00,000 6, 00,000 2, 40,000 3, 60,000 7, 60,000 8, 00,000 14, 40,000 30, 00,000 15, 00,000 9, 00,000 6, 00,000 30, 00,000 9, 60,000
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SARASWATI CLASSES FOR CA, CS & ICWA Illustration 9 Using the following information prepare balance sheet. Sales 36lacs Sales/Total assets 3 Sales/Fixed assets 5 Sales/Current assets 7.5 Sales/Inventories 20 Sales/Debtors 15 Current ratio 2 Total asset/Net worth 2.5 Debt/Equity 1 Balance sheet Liabilities Net worth Long term debt Current liabilities Rs Assets Fixed Assets Inventories Debtors Liquid assets TOTAL TOTAL
Rs
Illustration 10 Using the following data prepare balance sheet. Gross profit (20% of sales) Shareholders equity Credit sales to total sales Total assets turnover Inventory turnover ACP (360days a year) Current ratio Long term debt to equity Rs 60,000 Rs 50,000 80% 3 times 8 times 18 days 2 times 40%
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Using the following information prepare balance sheet. Long term debt to net worth Total assets turnover Average collection period Inventory turnover GP ratio Acid test ratio 0.5 to 1 2.5 times month 9 times 10% 1:1 Balance sheet of XYZ Ltd Liabilities Equity share capital Retained earnings Long term debt Creditors TOTAL Illustration 12 The following is the balance sheet of Amit Ltd. Balance sheet of AMIT Ltd Liabilities Equity share capital of Rs.10 each Retained earnings Long term debt Creditors Profit & loss a/c Other current liabilities Rs. 5,00,000 3,50,000 17,50,000 2,50,000 5,50,000 2,50,000 Assets Fixed Assets 30,00,000 25,50,000 5,00,000 4,00,000 1,00,000 Rs. Rs 100000 100000 ........... 100000 Assets Fixed Assets Inventories Debtors Cash TOTAL Rs ........... ........... ........... ...........
Less: Depreciation 4,50,000 Inventories Debtors Cash
TOTAL Additional information
35,50,000
TOTAL
35,50,000
1) Profit during the year Rs 4,00,000 2) The company has declared 25% dividend 3) Market price of share is Rs 500
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SARASWATI CLASSES FOR CA, CS & ICWA Calculate
Debt equity ratio, Current ratio, Acid test ratio, EPS, P/E ratio, Divided payout ratio, Dividend yield ratio Illustration 13 The following is the balance sheet of Aditi Ltd. Balance sheet of ADITI Ltd Liabilities Equity share capital of Rs 100 each Retained earnings Creditors Bills payable Other current liabilities TOTAL 3,68,000 1,04,000 2,00,000 20,000 16,92,000 Prepaid insurance TOTAL Rs 10,00,000 Assets Plant & machinery Land Inventories Cash Debtors 4,00,000 Less: RDD 40,000 Rs 6,40,000 80,000 4,80,000 1,60,000
3,60,000 12,000 16,92,000
Income statement for the year ended 31st December Sales Less: Cogs Gross profit Less: op. exp Net profit before tax Less; tax 50% PAT 40, 00,000 30, 80,000 9, 20,000 6, 80,000 2, 40,000 1, 20,000 1, 20,000
Sundry debtors & stock at the beginning of the year were Rs 3, 00,000 & Rs 4,00,000 respectively. Calculate CR, LR, STR, DTR, GP, NP, Operating profit ratio, EPS, ROCE, Market value if P/E ratio is 10 times.
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From the following information prepare balance sheet of Shri Mohan. Current ratio Working capital Net worth + Deb to current assets Fixed assets to turnover Cash sales / Credit sales Creditor's velocity Stock velocity Debtors' velocity Net profit Reserves Debenture / Share capital GP ratio Illustration 15 The actual ratios of a company compared to the industry standard are given below. Comment on each ratio and indicate in one or two sentences the nature of action to be taken by the company. RATIO Current ratio Debtors turnover ratio Stock turnover ratio Net profit ratio Total debt to total assets INDUSTRY STANDARD 2.2 6 10 5% 7.5% ACTUAL FOR THE YEAR 2.7 8 3 2.4% 40% 2 Rs 4, 00,000 3:2 1:3 1:2 2 months 2 months 3 months 10% of turnover 2.5% of turnover 1:2 25%
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PROBLEMS ON FUND FLOW STATEMENT Problem 1 : From the following balance sheets of X ltd prepare fund flow statement as on 31.03.2006. Rs in thousand LAIBILITIES Share capital General reserve P & L a/c Long term loan Creditors Provision for tax 158 45 31.03.2005 500 200 40 31.03.2006 500 220 32 100 172 30 ASSETS Land & building Plant machinery Other fixed assets Investments Stock Debtors Cash at bank TOTAL Adjustments: 1) 2) 3) 4) 5) Dividend amounting to Rs 30,000 was paid during the year. Provision for taxation made Rs 12,000. Machinery worth Rs 15,000(book value) was sold at a loss of Rs 3,000. Investment costing Rs 10,000 was sold for Rs 12,000. Depreciate land & building by Rs 5,000 & machinery by Rs 20,000. 943 1054 TOTAL 31.03.2005 31.03.2006 180 210 30 50 200 170 103 943 200 276 45 50 190 195 98 1054
Problem 2: From the following information, prepare a statement showing sources and application of the funds for the year ended 31.12.84. Rs in lakhs LAIBILITIES Share capital General reserve P&L account Creditors Provision for tax Mortgage loan TOTAL 31.121983 4.50 3.00 0.56 1.68 0.75 10.49 31.12.1984 4.50 3.10 0.68 1.34 0.10 2.70 12.42 TOTAL 10.49 12.42 ASSETS Fixed assets Investments Inventories Debtors Bank 31.12.1983 4.00 0.50 2.40 2.10 1.49 31.12.84 3.20 0.60 2.10 4.55 1.97
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SARASWATI CLASSES FOR CA, CS & ICWA Adjustments
1) Investment costing Rs 8,000 were sold during 1984 for Rs 8,500. 2) Provision for taxation was 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. 4) Dividend paid during the year amounted to Rs 40,000. Problem 3: Given below are the balance sheets of Liquid Ltd. LAIBILITIES Equity capital 9% pref.capital Debentures Reserves RDD Current liabilities TOTAL Adjustments 1) 2) 3) 4) A machine costing Rs 7,000(book value Rs 4,000) was sold for Rs 2,500. 15% dividend was paid on equity capital in addition to preference dividend on opening balance of capital. The preference shares were redeemed at the end at 5% premium. Depreciation written off Rs 7,000 on fixed assets. 31.121974 30,000 20,000 10,000 11,000 1,000 7,000 79,000 31.12.1975 35,000 10,000 20,000 27,000 1,500 14,500 1,08,000 79,000 1,08,000 ASSETS Fixed assets Investment Current assets Preliminary exp 31.12.1974 51,000 3,000 24,000 1,000 31.12.1975 62,000 8,000 37,500 500
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SARASWATI CLASSES FOR CA, CS & ICWA Problem 4:
From the following adjustments & balance sheets given prepare fund flow statement. 1) 2) 3) 4) 5) 6) During the year 2008 fixed assets values at Rs 20,000(book value) was sold for Rs 16,000. The proposed dividend of the last year was paid in 2008. During 2008, investment costing Rs 1,60,000 were sold and later in the year investments of the same cost were purchased. Debentures were redeemed at a premium of 10% in 2008. Tax paid during the year 1,10,000. Bad debts written off against provision Rs 30,000. Balance sheets LAIBILITIES Share capital General reserve Profit on sale of investment P & L a/c 7% debentures Crs for expenses Proposed div. Prov. for tax Dep. Provision Creditors TOTAL 2,00,000 6,00,000 20,000 60,000 1,40,000 4,00,000 3,20,000 33,40,000 4,00,000 4,00,000 24,000 70,000 1,50,000 5,00,000 5,00,000 39,64,000 TOTAL 33,40,000 39,64,000 Debtors Bills receivables Pre paid exp Misc. exp 4,50,000 80,000 20,000 30,000 4,90,000 1,30,000 24,000 20,000 2007 12,00,000 4,00,000 2008 14,00,000 5,00,000 20,000 ASSETS Fixed assets Investments Stock 2007 20,00,000 3,60,000 4,00,000 2008 24,00,000 3,60,000 5,40,000
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SARASWATI CLASSES FOR CA, CS & ICWA Problem 5: From the following information prepare fund flow statement. Balance sheets LAIBILITIES Share capital General reserve P & L account Debentures Creditors Proposed div. TOTAL 2005 10,00,000 5,00,000 1,00,000 5,00,000 9,00,000 1,00,000 31,00,000 2006 12,00,000 6,00,000 1,50,000 5,00,000 10,50,000 1,50,000 36,50,000 TOTAL ASSETS Fixed assets Investments Stock Debtors Cash
2005 18,00,000 2,00,000 5,00,000 5,85,000 15,000
2006 20,50,000 2,50,000 7,00,000 6,40,000 10,000
31,00,000
36,50,000
Additional information: 1) During the year 2006 depreciation was charged on fixed assets amounted to Rs 2,50,000. 2) Final dividend for the year 2005 was paid in the year 2006 mounting to Rs 1,00,000. Problem 6: Given below are the balance sheets of Lucky Ltd. LAIBILITIES Capital Debentures Tax payable Creditors Interest payable 31.121974 10,00,000 7,40,000 1,54,000 1,92,000 14,000 31.12.1975 10,00,000 9,00,000 86,000 3,84,000 90,000 70,000 25,30,000 ASSETS Fixed assets Investments WIP Stock Debtors Cash TOTAL 31.12.1974 12,00,000 4,00,000 1,60,000 3,00,000 1,40,000 60,000 22,60,000 31.12.1975 14,00,000 2,00,000 1,80,000 4,50,000 2,80,000 20,000 25,30,000
Dividend payable 1,00,000 TOTAL 22,60,000
Prepare fund flow statement.
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SARASWATI CLASSES FOR CA, CS & ICWA Problem 7:
Following are the summarised Balance shees of the Ganges Ltd. as on 31st December, 2005 & 2006 Balance Sheet (Rs.000) Liabilities Share capital General reserve Profit and loss account Bank Loan Sundry creditors Provisions for taxation 2005 200 50 30.5 70 150 30 2006 250 60 30.6 135.2 35 Assets Land and building Plant and machinery Stock Sundry debtors Cash balance Bank balance Goodwill 530.5 510.8 2005 200 150 100 80 0.5 530.5 2006 190 169 74 64.2 0.6 8 5 510.8
The following additional information is available I) During the year ended 31st December, 2006 i) ii) Dividend of Rs. 23,000 was paid. Assets of other company were purchased for Rs. 50,000 payable in shares. Assets purchased were : stock Rs. 20,000; and machinery Rs. 25,000.
iii) Machinery of Rs. 8,000 was purchased in addition to that of (ii) above. II) Depreciation written off during the year, 2006 Building Rs. 10,000; and machinery Rs. 14,000. III) The net profit for the year 2006 was Rs. 66,100 IV) Income-tax paid during the year 2006 was Rs. 28,000 and provision of Rs. 33,000 was made to Profit and Loss Account. Prepare statement of sources and application of funds for the year ended 31st December, 2006 and a schedule setting out the changes in working capital.
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CHAPTER 3
WORKING CAPITAL
CHAPTER 3
WORKING CAPITAL
A. MEANING OF WORKING CAPITAL Every company needs the funds for two purposes, long term funds are require for acquiring fixed assets by means of which company is able to built The required infrastructure and plant capacity for achieving desire goal. Short-term fund are required for day to day running of business i.e. for payment to supplier of raw material, wages and salaries and payment of services taken by company. The fund required for these proposes is called as working capital of company if this capital is not available the working of company may be disturbed which may affect business performance. Working capital has following dimension. 1. 2. 3. 4 5. When we talk of total current asset held by company it is called a gross working capital. The different between current asset and current liability is called as Net working capital. This is very important concept and working capital of a company is always referred to by this amount When current assets more than current liabilities it is called a +ve working capital. When current liabilities are more than current assets, it is called a - Ve working capital and this is a bad position of working capital of company. Certain amount of CA are always held by company irrespective of level of business this is called as permanent or core working capital Generally FA & core working capital is financed out of long term funds. Working capital required above permanent level of W.C. is called as variable or temporary W.C. This varies with seasonal requirement of business. If F.A. financed from short-term fund then it is negative W.C.
6. 7.
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Chapter : 3 Working Capital / 45
SARASWATI CLASSES FOR CA, CS & ICWA Thus for all practical purpose working capital =
CURRENT ASSETS - CURRENT LIABILITIES = WORKING CAPITAL Sundry Debtors Bills receivable Closing stock (R.material, WIP, Finished goods) Cash in hand Cash at bank Pre paid expenses Short term advances Accrued income LESS Sundry Creditors Bills payable Outstanding expenses Short-term loan Bank over draft Advances taken Provision for tax proposed dividend
B. SIGNIFICANCE OF WORKING CAPITAL No activity in business can be carried out without sufficient funds. Working capital is the nerve center of business and in absence of adequate working capital business in paralyzed. Following aspect of business are affected due to inadequate working capital 1. Solvency of business i.e. various amounts owed by business. If working capital is insufficient company cannot full fill its promises to various parties. This lowers the image and prestige of company. 2. When working capital is sufficient company can make various payments on the promised date this required for maintaining goodwill and image of company. 3. Banks always gives the loan to those company who are having good are standing and with sufficiency of working capital this is taken care of. 4. When working capital is sufficient purchase can be done on cash basis and discount can be taken from suppliers. 5. If Payment is given on time then suppliers provides regular supply of raw material, which is very essential for smooth running of business. 6. If salaries & wages are paid in time labour trouble can be avoided and production comes out smoothly. 7. Various payments can be done by company as per the commitments 8. Favorable market condition can be exploited by increasing supply to the market. 9. Company develops on ability to face critical situations. 10. By optimizing the investment in current assets and by reducing the level of current liabilities, the company can reduce the locking up of funds in working capital thereby, it can improve the return on capital employed in the business.
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C. FACTORS ON WHICH WORKING CAPITAL OF COMPANY DEPENDS 1) Nature of business For e.g. working capital requirement of mfg business will differ from the requirements of trading business. Trader need small amount of working capital as he carries most of the business on cash basis. But mfg needs to maintain sufficient inventory in such case amount of working capital required is higher. The service organisation needs lesser working capital than trading and financial organisations. Therefore, the requirement of working capital depends upon the nature of business carried by the organisation. 2) Size of business Bigger the size of business higher would be requirement of working capital and small business organisation needs lesser working capital. It also depends upon movement of inventory, faster the movement lesser the investment & vice versa. 3) Production process In case of labour intensive industries high working capital is needed. But in case of capital intensive industries the production process is faster & it requires lesser amount of working capital. 4) Credit Policy It depends upon credit allowed to debtors and terms received from supplier. For e.g. a firm might be purchasing goods and services on credit terms but selling goods only for cash. The working capital requirement of this firm will be lower than that of a firm, which is purchasing on cash basis but has to sell on credit basis. 5) Manufacturing cycle Working capital depends upon production cycle time. Longer this cycle higher will the requirements of working capital by company. The industries involved in quick conversion of raw material into finished goods requires lesser amount of working capital. 6) Distribution time Distribution time involved in supplying goods to customer. 7) After sale service After sale service facilities provided by company. 8) New Business If business is at the stage of growth & expansion their working capital requirement will increase
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SARASWATI CLASSES FOR CA, CS & ICWA 9) Market competition
Competition plays an important role in the working capital determination. Sometimes firm have to give extra credit to attract customer. In such case more working capital is needed. 10) Profit Margin The working capital requirement will depend on profit margin of company higher the margins, more cash will be available and there would be less pressure on working capital requirement 11) Divided policy Divided policy of company influence working capital requirement. If policy is liberal then more dividend is paid & working capital requirement will increase in reverse case working capital requirement would be less as dividend one paid less. 12) Seasonal Operations If firm is operating in goods and services having seasonal fluctuation then working capital requirement will be higher during season. Inventory policy The traditional production systems generate more stocks of finished goods and level of raw material and WIP stocks. Whereas the adoption of JIT, supply chain management will drastically reduce the level of stocks. Business standing In case of newly established concern the materials are required to be purchased in cash and sales are to be made on credit basis. Such new concerns require high levels of working capital. Whereas established companies can negotiate for credit terms with supplier and sell the product at lesser credit period to customers. Therefore it requires less working capital as compared to new organisation. Business cycle Economic boom or recession have their influence on the transactions and consequently on the quantum of working capital required. More working capital is needed during peak or boom conditions. But in case of economic recession, the company requires low or moderate working capital. D. OPERATING CYCLE It is a period required by business to convert cash again into cash. The operating cycle is the length of time between the company's outlay on raw materials, wages and other expenses and inflow of cash from sale of goods. Operating cycle is an important concept in management of cash and management of working capital. Quicker the operating cycle less amount of investment in working capital is needed and it improves the profitability. The duration of operating cycle depends on the nature of industry and the efficiency in the working capital management. - operating cycle of a mfg. business has following steps
13)
14)
15)
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SARASWATI CLASSES FOR CA, CS & ICWA a) b) c) d) e) f)
Purchasing raw material from supplier Maintaining stocks of raw material before it is used for production. Semi finished goods or WIP stage. Storing of finish good before they are sold. Sale of finish goods to customer on credit which creates sundry debtors. Receiving payment from S. debtors & thus getting back cash in business. The operating cycle of mfg. business can be shown as in following chart CASH RAW MATERIAL WORK IN PROGRESS
SUNDARY DEBTORS
FINISHED GOODS
Reasons for prolonged operating cycle Purchase of material in excess/short of requirement Defective inventory policy Lack of production planning, coordination and control Use of outdated machinery, technology Poor maintenance and upkeep of plant, equipments Buying inferior, defective materials Failure to get discount How to improve operating cycle Following remedies may be used to reduce the length of operating cycle Purchase management Production management Marketing management Credit collection policies External environment E. 1. TECHNIQUE FOR ASSESSMENT OF WORKING CAPITAL REQUIREMENTS Estimation of components of working capital method As WC = CA - CL, under this method items and their amount which constitute working capital i.e. CA & CL need to be find out. Difference between CA & CL indicates working capital requirement.
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SARASWATI CLASSES FOR CA, CS & ICWA 2.
3.
Per cent of Sales Approach Under this method ratio between sales and working capital is found out. According to sales forecast amount needed, as working capital can be determined. The basic criticism of this technique is that it assumes linear relationship between sales and working capital, which is not true all the times. Operating cycle approach According to this approach working capital depend upon operating cycle time of the business. The duration of the working capital for the purpose of estimating working capital requirements is equivalent to the sum of the duration of each of these stages less the credit period allowed by the supplier of the firm. Symbolically, the duration of working capital cycle can be put as follows: O = R+W+F+D-C Where O = Duration of operating cycle R = Raw material and stores storage period W = Work in process period F = Finished goods storage period D = Debtors collection period C = Creditors collection period Each of above component of the operating cycle can be calculated as follows: R = Avg. Stock of raw material and stores Avg. raw material and stores consumption per day W = Avg. Stock work in process inventory Avg. cost of production per day F = Avg. Finish stock Avg. cost of good sold per day D = Avg. Debtors Avg. credit sale per day C = Avg. Creditors Avg. credit purchase per day After computing the period of one operating cycle, the total number of operating cycles that can be completed during the year can be computed by dividing 365 days with the number of operating days in a cycle. The total operating expenditure in a year gives the average amount of the working capital requirements.
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SARASWATI CLASSES FOR CA, CS & ICWA 4. Regression analysis method
It is a statistical technique applied for forecasting working capital requirements. It establishes relationship between sales and working capital and its various components in the past years.
F.
OPERATING CYCLE DEPENDS ON Type of business Credit period allowed by Suppliers Efficiency of inventory management Peculiarities of production process Demand for product Distribution system sufficiency of company Credit period allowed to debtors
G.
TYPES OF WORKING CAPITAL
1.
Permanent / Fixed working capital It indicate minimum amount of investment in all current assets which is required all times to carry out minimum level of business activities It represents current assets required on continuous basis. It depends upon the size of business, greater the size of business, greater the amount of such working capital. It is the irreducible minimum amount necessary for maintaining the circulation of current assets. The minimum level of investment in current assets is permanently locked up in business and it is also referred to as regular working capital. It represents the assets required on continuing basis over the entire year. Tandon committee has referred to this type of working capital as core current assets. Temporary / Fluctuating working capital It represents that amount of working capital, which keeps on fluctuating from time to time on the basis of business activities. It represents additional current assets required at different times during the year. It depends upon the changes in production and sales, over and above the permanent working capital. It is the extra working capital needed to support the changing business activities.
2.
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H. DIAGRAM SHOWING DIFFERENCE BETWEEN PERMANENT AND TEMPORARY WORKING CAPITAL Fluctuating WC Fluctuating WC
Avg. Wc
Permanent WC Permanent WC
Figure a
Figure b
In Fig. a, permanent working capital is fixed over a period of time and temporary working capital is fluctuating. In fig. b, the permanent working capital is increasing over a period of time with the increase in the level of business activities. Hence the permanent working capital line is not the horizontal line with the base line as in fig. a. I. WORKING CAPITAL FINANCING This should be financed form long-term sources such as shares, debentures, and long-term loan. In addition to finance temporary working capital short-term loan is required. 1. Trade Creditors Business can purchase raw material on credit for one or two or three months. This source is very convenient as no paper work is involved; however supplier is likely to charge more money. 2. Public Deposit Company may invite fixed deposit from public at large for a period of 1 to 3 year. This is also called as medium term loan. However while accepting deposit requirements of company's act and norm set down by RBI must be followed by the company. 3. Short Term Loan Business can take short-term loan for a period less thon 1 year from banks for which security of stock has to be given. 4. Cash credit and overdraft Under this arrangement company is allowed to draw amount from its a/c up to a certain limit, even if there is no balance in the account. The difference between cash credit and overdraft is as under. Cash credit is permanent facility. Bank overdraft is temporary facility. Cash credit is provided on the basis certain documents and hypothecation of stock where as bank overdraft is provied on the basis of relationship with bank.
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SARASWATI CLASSES FOR CA, CS & ICWA 5.
Purchasing or discounting of bill By discounting bills with bank company can arrange funds required for short period. The Tandon committee has suggested three method of working out the maximum amount that a unit may expect from the bank, which is termed as maximum permissible bank finance (MPBF). MPBF under three alternative are ascertained as follows First Method MPBF = 75% of (Current asset - Current Liabilities other than banks borrowings) The borrowing firm should provide the remaining 25% from long term sources. The minimum CR required under this method works out to 1:1. Second Method The borrowing firm should raise finance to the extent of 25% of current assets from long term sources. The minimum CR required under this method works out to 1.33:1. Third Method MPBF = [75% of (Current asset - Core current assets)] - Current Liabilities other than banks borrowings) The borrowing firm should contribute 100% core current assets and 25% of balance current assets from long term sources. The minimum CR required under this method works out to 1.5:1. J. WORKING CAPITAL POLICIES
1.
Restricted policy It involves the rigid estimation of working capital to the requirement of the concern and then forcing it to adhere to the estimate. The estimates will not provide for any contingencies or for any unexpected events.
2. Relaxed policy In involves the allowing sufficient cushion for fluctuation in funds requirement for financing various items of working capital. The estimate is made after taking into account the provision for contingencies or for any unexpected events. 3. Moderate policy The working capital level is estimated in between the two extremes. K. HINTS FOR SOLVING PROBLEMS 1. 2. 3. If nothing is given regarding degree of completion then assume Material 100%, Labour & Overhead 50% complete. In nothing is given regarding Material/Labour/ Overhead payment then assume to be paid on cash basis. Profit & depreciation are to be excluded while calculation working capital.
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FORMAT OF STATEMENT SHOWING WORKING CAPITAL PARTICULARS A) CURRENT ASSETS Cash and bank balance Stock of raw material Work-in-progress Finished goods Debtors Temporary investments Prepaid investments = B) CURRENT LIABILITIES Creditors for materials Creditors for wages Creditors for overheads Taxes and dividend payable Other liabilities payable within one year = C) NET WORKING CAPITAL ADD : provision for contingencies TOTAL WORKING CAPITAL REQUIRED Notes : There are two methods of preparing w.c. statements a) Cash Cost Method : In this method ignore profit & dep for working capital estimation. b) Total Cost Method : In this method consider profit & dep for working capital estimation. TOTAL CURRENT LIABILITIES (A - B) TOTAL CURRENT ASSETS RS
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SARASWATI CLASSES FOR CA, CS & ICWA Liquidity vs. Profitability
The basic objective of working capital is to provide adequate support for the smooth functioning of the normal business operations of a company. The question then arises as to the determination of the quantum of investment in working capital of current assets that can be regarded as 'adequate'. Once we recognize the fact that a company has to operate in an environment permeated with uncertainty/risk, the term 'adequate working capital' becomes somewhat subjective depending upon the attitude of the management towards uncertainty/risk. In view of the uncertainty/risk, the quantum of investment in current assets has to be made in a manner that it not only meets the needs of the forecasted sales but also provides a built-in cushion in the form of safety stocks to meet unforeseen contingencies arising out of factors such as delays in arrival of raw materials, sudden spurts in sales demand etc. Consequently, the investment in current assets for a given level of forecasted sales will be higher if the management follows a conservative attitude than when it follows an aggressive attitude. Thus a company following a conservative approach is subjected to a lower degree of risk than the one following an aggressive approach. Further, in the former situation the high amount of investment in current assets imparts greater liquidity to the company than under the latter situation wherein the quantum of investment in current assets is less. This aspect considers exclusively the liquidity dimension of working capital. There is another dimension to the issue, viz., the 'profitability' and it is discussed below. Once we recognize the fact that the total amount of financial resources at the disposal of a company is limited and these resources can be put to alternative uses, the larger the amount of investment in current assets, the smaller will be the amount available for investment in other profitable avenues at hand with the company. A conservative attitude in respect of investment in current assets leaves less amount for other investments than an aggressive approach does. Further, since current assets will be more for a given level of sales forecast under the conservative approach, the turnover of current assets (calculated as the ratio of net sales to current assets) will be less than what they would be under the aggressive approach. This being so, even if we assume the same level of sales revenue, operating profit before interest and tax and net (operating) fixed assets, the company following a conservative policy will have a low percentage of operating profitability compared to its counterpart following an aggressive approach as can be seen from the numerical illustration 3.1.
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SARASWATI CLASSES FOR CA, CS & ICWA Illustration S.No. 1. 2. 3. 4. 5. 6. Particulars Net Sales Operating Profit Before Interest and Tax . Net (Operating) Fixed Assets Current Assets Total Operating Assets [=(3) + (4)] Net Operating Profit Margin Conservative Policy Rs.50 lakh Rs.5 lakh Rs.10 lakh Rs.8 lakh Rs.18 lakh
Aggressive Policy Rs.50 lakh Rs.5 lakh Rs.10 lakh Rs.5 lakh Rs.15 lakh
5 = 10% 50
7.
Turnover of Net Operating Fixed Assets

(1) = = 3 ( )
50 = 10% times 10
50 = 10% times 10
8.
Turnover of Current Assets

(1) = ( 4)
50 ( ) 82 5 5 = = =210%0 . 5 0.8 = 5 = 2.78 times 1 10 (1) 50 180
50 = 10 times 5
9.
Turnover of Total Operating

(1) Assets = 5 ( )
50 = 3.33 times 15
10.
Rate of Return on Total Operating Assets
27.8%
33.3%
11.
Ratio of Current Assets to Net Operating Fixed

( 4) Assets = 3 ( )
5 = 0.5 10
= 80%
= 50%
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From the illustration, it can be easily seen from item (10), that the alternative of following a conservative approach to investment in current assets results in a low profitability of 27.8 percent compared to the profitability of 33.3 percent obtained under the alternative - an aggressive approach. The reason for this can be directly traced to the low turnover of current assets leading to a lower turnover of total operating assets under the conservative approach compared to that under the aggressive approach. From item (11) it can be seen that current assets comprise 80 percent of net operating fixed assets resulting in higher proportion of current assets and hence greater liquidity compared to the corresponding figure of 50 percent indicating low liquidity under the aggressive approach.
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PROBLEMS ON WORKING CAPITAL
Illustration 1 The cost sheet of PQR Ltd. provides the following data: Cost Per Unit Raw material Direct Labour Overheads (including depreciation of Rs. 10) Total cost Profits Selling price Rs. 50 20 40 110 20 130
Average raw material in stock is for one month. Average material in work-in-progress is for half month. Credit allowed by suppliers: one month; credit allowed to debtors: one month. Average time lag in payment of wages: 10 days; average time lag in payment of overheads 30 days. 25% of the sales are on cash basis. Cash balance to be Rs. 1, 00,000. Finished goods lie in the warehouse for one month. You are required to prepare a statement of the working capital needed to finance a level of the activity of 54,000 units of output. Production is carried on evenly throughout the year and wages and overheads accrue similarly. State your assumptions, if any, clearly. Illustration 2 The following information has been extracted from the records of a Company: Product cost sheet Raw materials Direct Labour Overheads Total Profit Rs. 45 20 40 105 15
Selling price 120 Raw materials are in stock on an average for two months. The materials are in process on an average for one month. The degree of completion is 50% in respect of all elements of cost. Finished goods stock on an average is for one month. Time lag in payment of wages and overheads is 11/ 2 weeks. Time lag in receipt of proceeds from debtors is 2 months. Credit allowed by suppliers is one month. 20% of the output is sold against cash. The company expects to keep a Cash balance Rs. 1, 00,000.
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The Company is poised for a manufacture of 1, 44,000 units in the next year. You are required to prepare a statement showing the Working Capital requirements of The Company Illustration 3 Grow More Ltd. is presently operating at 60% level, producing 36,000 units Per annum. In view of favorable market conditions, it has been decided that from 1st January 2004, the Company would operate at 90% capacity. The following information is available: i) Existing cost-price structure per unit is given below: Raw material Rs. 4.00 Wages 2.00 Overheads (Variable) 2.00 Overheads (Fixed) 1.00 Profits 1.00 ii) It is expected that the cost of raw material, wages rate, expenses and sales per unit will remain unchanged in 2000. iii) Raw materials remain in stores for 2 months before these are issued to production. These units remain in production process for 1 month. iv) Finished goods remain in godown for 2 months. v) Credit allowed to debtors is 2 months. Credit allowed by creditors is 3 months. vi) Lag in wages and overhead payments is 1 month. It may be assumed that wages and overhead accrue evenly throughout the production cycle. You are required to: a) b) Prepare profit statement at 90% capacity level; and Calculate the working requirements on an estimated basis to sustain the increased production level. Assumptions made if any, should be clearly indicated. Illustration 4 Hi-tech Ltd. Plans to sell 30,000 units next year. The expected cost of goods Sold is as follows: Rs. (Per Unit) Raw material Manufacturing expenses Selling, administration and financial expenses Total Profit Selling price 100 30 20 150 50 200
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The duration at various stages of the operating cycle is expected to be as Follows: Raw material stage Work-in-progress stage Finished stage Debtors stage 2 months 1 month 1/2 month 1 month
Assuming the monthly sales level of 2,500 units, estimate the gross working Capital requirement if the desired cash balance is 5% of the gross working capital requirement, and work-in-progress is 25% complete with respect to manufacturing expenses. Illustration 5 Calculate the amount of working capital requirement for SRCC Ltd. from the following information: Rs. (Per Unit) Raw material direct labor Overheads Total cost Profit 160 60 120 340 60
Selling price 400 Raw materials are held in stock on an average for one month. Materials are in process on an average for half-a-month. Finished goods are in stock on an average for one month. Credit allowed by suppliers is one month and credit allowed to debtors is two months. Time lag in payment of wages is 1 1/2 weeks. Time lag in payment of overhead expenses is one month. One fourth of the sales are made on cash basis. Cash in hand and at the bank is expected to Rs. 50,000: and expected level of production amounts to 1, 04,000 units for a year of 52 weeks. You may assume that production is carried on evenly throughout the year and a time period of four weeks is equivalent to a month.
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On 1st January 2005, the Board of Directors of Dowell Co. Ltd. wishes to know the amount of working capital that will be required to meet the program of activity they have planned for the year. The following information is available: i) Issued and paid-up capital Rs. 2, 00,000. ii) 5% Debentures (secured on assets) Rs. 50,000. iii) Fixed assets valued at Rs. 1, 25,000 on 31.12.2000. iv) Production during the previous year w 60,000 units. It is planned that the level of activity should be maintained during the present year. v) The ratios of cost to selling price are-raw materials 60%, direct wages 10% and overheads 20%. vi) Raw materials are expected to remain in stores for an average of two months before these are issued for production. vii) Each unit of production is expected to be in process for one month. viii) Finished goods will stay in warehouse for approximately three months. ix) Creditors allow credit for 2 months from the date of delivery of raw materials. x) Credit allowed to debtors is 3 months from the date of dispatch. xi) Selling price per unit is Rs. 5. xii) There is a regular production and sales cycle. Also prepare an estimated Profit and Loss Account and Balance Sheet at the end of the year. Illustration 7 Raju brother's pvt ltd sells goods on a GP of 25%. Depreciation is considered in the cost of production. The following are the annual figures given to you Sales (2 month credit) 18, 00,000 Material consumed (1 month credit) 4, 50,000 Wages paid (1 month lag in payment) 3, 60,000 Administrative expenses (1 month lag in payment) 1, 20,000 Sales promotion expenses (paid quarterly in advance) 60,000 Income tax payable in 4 equal installments of which one falls in the next year 1, 50,000 Cash mfg. expenses (1 month lag in payment) 4, 80,000 The co. 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.
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A company newly commencing business in 2005 has the under mentioned projected profit & loss. Sales 42, 00,000 Less: Cost of goods sold 30, 60,000 = Gross profit 11, 40,000 Less: Administrative exp 2.80.000 Less: Selling expenses 2, 60,000 = Profit before tax 6, 00,000 Less: Provision for taxation 2, 00,000 Profit after tax 4, 00,000 The cost of goods sold has been arrived as under Material used 16, 80,000 Wages & mfg. exp 12, 50,000 Depreciation 4, 70,000 34, 00,000 Less: stock of Finished goods 3, 40,000 30, 60,000 The figures given above relates only to finished goods & not to WIP. Goods equal to15% of the year's production will be in process on the avg. requiring full materials but only 40% of the other expenses. The company believes in keeping material equal to two months consumption in stock. All expenses will be paid one month in arrear. Suppliers of material will extend 1.5 months credit & credit given to Drs 2 months. Cash sales 20%. 90% of income tax will be paid in advance in quarterly installments. Required cash balance Rs 1, 00,000. Prepare statement showing working capital.
1. 2.
3. 4. 5. 6. 7.
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Estimate the working capital requirement form the data of Delhi LTD. Cost price per unit Raw material Rs 40 Labour Rs 10 Overheads Rs 30 Projected sales 75000 units @ Rs 100 per unit Debtors credit period 10 weeks Credit allowed by supplier 4 weeks Raw material in stock 6 weeks Finished stock 8 weeks Processing time 4 weeks Wages are paid once in a 4 weeks Contingency 10% of working capital Cash balance required Rs 1, 87,500. Illustration 10 Calculate working capital from the following information. Annual expenses Wages Stores & material Office salaries Rent Other expenses Average amount of stock to be maintained Raw material Finished goods Annual sales Home market Foreign market Lag in payment of Wages Materials Office salaries Rent Other expenses 1.5weeks 1.5months 0.5months 6 months 1.5months Rs 62,400 Rs 15,600 (credit allowed 6 weeks) (credit allowed 1.5 weeks) Rs 1,600 Rs 1,000 Rs 52,000 Rs 9,600 Rs 12,480 Rs 2,000 Rs 9,600
Expenses paid quarterly in advance Rs 1600 p.a.
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The following information has been extracted from the records of a Company: Product cost sheet Raw materials Direct Labour Overheads Total Profit Selling price Rs. 20 5 15 40 10 50
Raw materials are in stock on an average for two months. The materials are in process on an average for one month. The degree of completion is 50% in respect of all elements of cost. Finished goods stock on an average is for one month. Time lag in payment of wages is 1 month and overheads is 1.5 weeks. Time lag in receipt of proceeds from debtors is 2 months. Credit allowed by suppliers is one month. Overheads includes depreciation of Rs 5. 25% of the output is sold against cash. The company expects to keep a Cash balance Rs. 20,000. The Company is poised for a manufacture of 1, 80,000 units in the next year. You are required to prepare a statement showing the Working Capital requirements of the Company & determine MPBF available under the first two methods suggested by Tondon committee.
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CHAPTER 4
MANAGEMENT OF RECEIVABLES
Chapter : 4
MANAGEMENT OF RECEIVABLES
1. INTRODUCTION Business firms generally sell goods on credit, to facilitate sales especially from those customers who cannot borrow from other sources, or find it very expensive or difficult to do so. Finished goods sold on credit get converted (from the point of view of the selling firm) into receivables (book debts) which when realized generate cash. The average balance in the receivables account would approximately be: average daily credit sales multiplied by average collection period. For Illustration, if the average daily credit sales of a firm are Rs.300000 and the average collection period is 40 days, the average balance in the receivables account would be Rs. 12000000. Since receivables often account for a significant proportion of the total assets, management of receivables take up a lot of the Finance Manager's time. 2. PURPOSE OF RECEIVABLES The purpose of receivables can be understood if we can grasp the basic objective of receivables management. The objective of receivables management is to promote sales and profits until that point is reached where the returns that the company gets from funding of receivables is less than the cost that the company has to incur in order to fund these receivables. Hence, the purpose of receivables is directly connected with the company's objectives of making credit sales, which are: To increase total sales; because when a company sells goods on credit, it will be in a position to sell more goods than if it insists on immediate cash payment. To increase profits; because this results in an increase in sales not only in volume, but also because companies charge a higher margin of profit on credit sales as compared to cash sales. To meet increasing competition; and for this the company may have to grant better credit facilities than those offered by its competitors.
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Chapter : 4 Management Receivables / 66
SARASWATI CLASSES FOR CA, CS & ICWA 3. COST OF MAINTAINING RECEIVABLES Additional fund requirement for the company
When a firm maintains receivables, some of the firm's resources remain blocked in them because there is a time lag between the credit sale to customer and receipt of cash from them as payment. To the extent that the firm's resources are blocked in its receivables, it has to arrange additional finance to meet its own obligations towards its creditors and employees, like payments for purchases, salaries and other production and administrative expenses. Whether this additional finance is met from its own resources or from outside, it involves a cost to the firm in terms of interest (if financed from outside) or opportunity costs (if internal resources, they could have been put to some other use.) Administrative costs When a company maintains receivables, it has to incur additional administrative expenses in the form of salaries to clerks who maintain records of debtors, expenses on investigating the credit worthiness of debtors, etc. Collection costs These are costs which the firm has to incur for collection of the amounts at the appropriate time from the customers. Defaulting costs When customers make default in payments, not only is the collection effort to be increased but the firm may also have to incur losses from bad debts. The size of receivables or investment in receivables is determined by the firm's credit policy and the level of its sales. The following aspects of receivables management are discussed in this chapter: Formulation of credit policy. Credit evaluation. Credit granting decision. Monitoring receivables. Credit Policy The credit policy of a company can be regarded as a kind of trade-off between increased credit sales leading to increase in profit and the cost of having larger amount of cash locked up in the form of receivables and the loss due to the incidence of bad debts. In a competitive market, the credit policy adopted by a company is considerably influenced by the practices followed by the industry. A change in the credit policy of a company, say, by extending credit period to 30 days, when the other companies are following a credit period of 15 days can result in such a high demand for the company's product that it cannot cope with. Further, other companies also may have to fall in line in the long
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run. It is assumed generally that such factors have already been taken into consideration before making changes in the credit policy of a company. The term credit policy encompasses the policy of a company in respect of the credit standards adopted, the period over which credit is extended to customers, any incentive in the form of cash discount offered, as also the period over which the discount can be utilized by the customers and the collection effort made by the company. Thus, the various variables associated with credit policy are: Credit standards Credit period Cash discount Collection program. All these variables underlying a company's credit policy influence sales, the amount locked up in the form of receivables and some of the receivables turning spur and eventually becoming bad debts. While the variables of credit policy are related to each other, for the purpose of clarity in understanding, we shall follow what is technically known as comparative static analysis by considering each variable independently, holding some or all others constant, to study the impact of a change in that variable on the company's profit. It is also assumed that the company is making profits and has adequate unutilized capacity to meet the increased sales caused by a change in some variables without incurring additional fixed costs like wages and salaries, rent, etc. Credit Standards When a company is confronted with the question of the standards to be applied to customers before deciding whether to extend credit or not, application of very stiff standards for the purpose is likely to result in a low level of sales, less amount of money locked up in the form of receivables, virtually no bad debt losses and less amount to be spent for collection. On the other hand, indiscriminate extension of credit without bothering much about the credit standards expected of the customers is likely to increase sales. But in its wake, the company is more likely to be saddled with a large quantum of money locked up in the form of accounts receivable, higher incidence of bad debt losses and increased expenses on the collection front. In the United States, there are excellent professional credit rating agencies such as Dun and Brad-street whose services can be utilized for a consideration. In the Indian situation, no such reputed agencies exist except for credit rating of public issues. Let us assume for the time being (because we shall consider these aspects in the section on credit evaluation) that the company has rated the customers into four categories ranging from 'high', 'good', 'fair' and 'limited' in the descending order of credit rating. Let us also assume that the company has been currently extending credit to only those customers rated as high and good. This way, the company has been foregoing sales from 'fair' and 'limited' categories. The company has' been contemplating to increase its sales from its existing level by liberalizing or relaxing its credit standards to some extent. What course of action should it take - liberalize or not? The answer to the above question lies in making a comparison of the incremental benefits associated with a liberalized policy and the associated incremental costs. The decision to liberalize will be justified only when the net incremental benefits are positive. Before going into the analysis we have to reckon with the factor that the existing and top-rated customers may take a lenient view in their
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paying habit once they come to know that the lowly rated customers of the company are taking a longer period for payment than what they themselves have been taking to pay. With a view to facilitating the exposition, it is assumed that the existing customers will not alter their paying habit even after liberalization of credit by the company (lest they be relegated to the lower rated groups) and the company can meet the increase in sales demand without incurring additional fixed costs as stated earlier on. 4. FACTORING Factoring is the method of financing whereby a firm sells its trade debts at a discount to financial institutions. He is a agent who collects bill on behalf on his client for certain fee. He is into business of buying up trade debts or lending money on the security of trade debts. Services provided by factor Maintenance of accounts Collection of receivables Protections against credit risk Generation of various reports Follow up with the customers Credit investigation Benefits of factoring Factor can do sales administrative function which helps org. to reduce administrative costs. Factor provides finance to the company which reduces working capital requirement. It improves liquidity position which helps the org. to honour its obligation without any dealy. The improved credit standing helps the org. to get the benefits of lower purchase price, longer credit period from supplier, trade discount on bulk purchases etc. By shifting the functions associated with credit management, the firms save time and they can focus on more important managerial work. Disadvantages of factoring The risk of non-payment by customer is not born by the factor but it is to be borne by selling firm. While making credit evaluation, he may follow conservative approach with the purpose of minimizing the risk of dealy and default, it may restrict the sales growth of the company. It indicates that company is not able to manage its receivables.
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CHAPTER 5
CAPITAL BUDGETING DECISION
CHAPTER 5
CAPITAL BUDGETING DECISION
1. MEANING Capital budgeting denotes situation where funds are invested immediately and returns are expected after a year. In growing orgnisation capital budgeting is more or less continuous process and it is carried out by top management. The role of any Finance Manager is to critically evaluate proposal, evaluation of alternative proposal and select best one. The following are the some of the cases where heavy capital investment may be necessary. A) Replacement of fixed assets : To replace old Assets. To buy Asset with latest technology. B) Expansion : It means increase in production capacity to meet additional demand. C) Research and Development : It is required for those industry where technology in changing rapidly. D) Diversification : To set up factories, to fulfill need of various markets. To reduce dependency on one market E) Miscellaneous : To meet legal norms, such as investment in pollution control equipment. 2. FEATURES AND SIGNIFICANCE OF CAPITAL BUDGETING Capital budgeting includes investment for long firm funds for long term and their utilisation. Capital budgeting decision affects profitability of firm. Therefore these decisions are very important. A wrong decision taken by finance manager may affect firm's profitability. The relevance and significance of capital budgeting may be stated as follows.
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Chapter : 5 Capital Budgeting Decision / 71
A) Involvement of heavy funds : Capital budgeting decision requires large amount of capital. Therefore it is absolutely necessary to evaluate investment proposal carefully, to arrange funds in time and to see that they are put to most profitable ways. B) Long term effect : Capital decisions are having long-term impact on the risk, rate of return and growth of organisation. This decision affects future position of business. C) Irreversible Decisions: Most of the capital budgeting decisions are irreversible decisions. A firm cannot cancel decision unless it is ready to absorb heavy losses due to wrong decision. D) Most difficult to make : Capital budgeting decisions are related to future that is uncertain. It is very difficult to estimate future. It also involves large commitment of funds for a longer period of time. E) It may affect competence to compete : If wrong capital budgeting decision is taken if may affect capacity and strength of a firm to face the competition. 3. PROBLEMS AND DIFFICULTIES IN CAPITAL BUDGETING A) Uncertainty about future : All capital budgeting decision involves long period, which is uncertain, even if proper care is taken exact future forecast is not possible. The Finance Manager should try to evaluate and judge proposal properly. The uncertainty may be related to expected profit, cost, competition, demand and legal provision. B) Time Element Capital budgeting decision involves long period between initial investment and expected return. As a result cost and benefit of capital budgeting decision are generally not comparable unless adjusted for time value of money. C) It involves high degree of risk. 4) CAPITAL EXPENDITURE BUDGET Capital expenditure budget / Capital budget is a type of functional budget. This budget is prepared to find out amount of capital needed to finance proposal. The budget is prepared after considering available production capacity, and other resources. This type of budget is required to control expenditure. 5) TYPES OF CAPITAL BUDGETING DECISION A. New firm may be required to take different decision such as selection of plant to be installed. Capacity utilization etc. B. Existing firm may require to take various decision to meet the challenges of competition to meet demand to reduce cost of production. C. Other decision
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Expansion Diversification Replacement Modernisation D. Mutually exclusive decision : Decision said to be mutually exclusive when acceptance of one decision results in automatic rejection of other proposals. For e.g. selection of one location out of different locations. E. Accept reject decision : An accept reject decision occurs when a proposal is independently accepted or rejected without regard to any other alternative proposal. Such decision is possible only when, this decision does not affect other proposals. F. Contingent Decision : These are the decision where acceptance depends upon acceptance of one or more other proposal. For e.g. computerization of a bank branch may require not only air conditioning but also transfer of some staff member to other branches. 6. CAPITAL INVESTMENT PROCESS To take capital budgeting decision following assumption are required. Certainly with Respect to cost and benefit It is assume that cost and benefit are known. It is assume that accurate for cast of cost and benefit of a proposal available for the entire economic life of proposal. Profit motive It is assumed that capital investment decisions are taken to fulfill primary objective of earning profit. Following procedure is followed in capital investment budget. Search for investment opportunities It is the first step. Company will consider no. Of proposal which are compatible with the firms objectives. Screening of alternative In this step all proposals are checked in details to find out whether proposal is giving expected return, availability of resources etc. Evaluation of proposal The next step is evaluate every proposal in terms of profitability, risk and economic life. Authorisation Once evaluation of project is done then next step is to get approval of top management. Implementation Once top management approves project, it will be implemented. Normally responsibilities are fixed to carry out proposal and monitor its performance. Control This is last step in capital budgeting process. Here actual performance is compared with budgeted performance. Evaluation is done in terms of funds allocated, resources utilized and benefit accrued.
A.
B.
i.
ii.
iii. iv. v.
vi.
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SARASWATI CLASSES FOR CA, CS & ICWA 6. TECHNIQUE OF EVALUATION
Investment in any proposal depends upon following investment. A] The amount of investment B] The expected return C] Economic life of project A proper analysis is required before investing in any proposal. There are different techniques available for evaluation, which are explained as under. Capital Budgeting Decision Time adjusted or Discounted Cash Flow
Traditional or Non-discounting Pay back Period (1) Net Present Value (3)
Accounting Rate of Return (2)
Profitability Index (4)
Internal Rate of Return (5)
Traditional method dose not consider present value of future cash inflow. 1) Payback period It is period required to recover initial investment in project. While calculating cash inflow, depreciating is added back to the profit after tax since the depreciation is not a real cash flow. Cash inflow = Profit after tax + depreciation The payback period calculated is compared with targeted payback period. If payback period is less than targeted recovery period then the proposal should be accepted and if it is more than targeted period then proposal should be rejected. Advantages A) B) C) D) It is easy to understand and simple to calculate. It can be adopted by any firm as it dose not required special skills to calculate. Risk can be measured, and project having less pay back period can be selected. It gives an indication of liquidity, on the basis of cash inflow. Disadvantages A) This method ignores cash inflow, which may occur after payback period. In some cases cash inflow may higher then it was before payback period. B) This concept ignores time value of money. C) This method gives more importance to recovery rather than profitability. To recover capital is not enough but to earn profit is more important.
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SARASWATI CLASSES FOR CA, CS & ICWA 2)
Accounting rate of return or Average rate of return This method is also known as return on investment or return on capital employed method. This method takes into account profit rather than cash inflow as a criterion for accepting or rejecting proposal. How to calculate A.R.R. A) Calculate profit after tax and depreciation. B) Formula ARR = Average profit after Tax & deprecation x 100 Avg. Investment Where, Average profit = Total profit after Tax & deprecation No. Of years Avg. Investment = Initial Investment 2 ARR calculated by using above formula is compared with pre specified rate of return. If ARR is more than pre specified rate then proposal is likely to be expected and vice versa. Advantages A) B) C) It is easy to calculate and simple to understand. It considers profitability as a base for taking decision rather than cash in flow. Profit after payback is considered under this method. Disadvantages A) B) C) D) E) F) It ignores time value of money. It ignores fluctuation in profits. Profit may be affected by different accounting policies followed. It dose not consider economic life of project. This technique also ignores salvage value of the proposal. If ignores amount of funds requires for the project. If may happen that two project are having different initial cost but may have some ARR.
3) Discounted cash flows or time-adjusted technique This technique considers time value of money. Money received today is worth more than received latter. Difference in value of money received today and latter is due to inflation and interest rate increase. This technique-overcome disadvantage of traditional method. A) Net present value method The NPV of an investment proposal may be defined as the sum of the present values of all the cash inflow less the sum of present value of all cash outflow associated with a proposal.
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To calculate present value of all cash inflows discounting rate is used. The discounting rate may be equal to rate of return, the investor expected to get from similar investment. How to calculate NPV NPV = PV of cash inflow - PV of cash outflow If discounting rate is not given then it can be calculated by using following formula 1 PI = n (1 + r) Where r = discounting rate n = year If NPV is positive then accept proposal. If NPV is negative then reject proposal. Advantages This technique considers time value of money. NPV of different project can be added to calculate NPV for a business. This feature is not available for other technique. The NPV uses the discounted cash flows in terms of current rupees. Disadvantages If involves difficult calculations. The NPV requires the predetermination of the expected rate of return (K), which is very difficult. Projects return cannot be assessed. B) Profitability Index (PI) This technique is also known as benefit cost ratio. Under this technique profitability of different proposal is assessed and project giving highest return can be selected. How to Calculate PI: Total present value of cash inflow Total present value of cash outflow If PI is more than 1 then accept proposal. If PI is less than 1 then reject proposal. NPV and PI technique will give some result because PI will be more than 1 only for that project which has a positive NPV. The NPV and PI may give different result if benefits and the initial cost are different.
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SARASWATI CLASSES FOR CA, CS & ICWA C) Internal rate of return (IRR)
IRR is that rate at which discounted cash inflows are equal to the discounted cash outflows. The indication given by IRR that this is the maximum rate at which the company will be able to pay towards the interest on amount for borrowed in the projects without loosing anything. This is also called as break even rate. How to calculate IRR. IRR Where A C O D B = A + C-O C-D x (B - A)
= = = = =
Lower rate of discounting Present value of cash flows at lower rate. Original investment Present value of cash flow at higher rate Higher rate of discounting
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PROBLEMS ON CAPITAL BUDGETING

Illustration 1 A company is considering investing in a project that is expected to cost Rs 10, 00,000. The expected cash inflows are given below. YEAR 1 2 3 4 5 CASHINFLOWS 2,50,000 2,50,000 2,50,000 2,50,000 2,50,000
Calculate: 1) Pay back period 2) ARR 3) NPV at 10% Illustration 2 A company is considering investing in a project that is expected to cost Rs 10, 00,000. The expected cash inflows are given below. YEAR 1 2 3 4 5 CASHINFLOWS 1,50,000 2,50,000 3,50,000 3,10,000 2,50,000
Calculate: 1) Pay back period 2) ARR 3) NPV at 10% Illustration 3 From the following information find out which of the two machines will be more profitable? Initial investment Rs 50,000 each Discounting rate 10% Project period 5 yrs YEAR 1 2 3 4 5 Machine A (Cash inflow) 8,000 10,000 12,000 18,000 15,000 Machine B (Cash inflow) 12,000 16,000 19,000 17,000 10,000
Calculate: 1) Pay back period 2) ARR 3) NPV 4) Profitability Index

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A company is planning to buy a machine. Two machines are available A & B. Suggest the management which one is better with the help of following information. The company is following straight line method of depreciation. YEAR Cost of machine Working life Tax rate 1 2 3 4 5 6 Illustration 5 A company is considering investing in a project that is expected to cost Rs 12, 00,000. The expected cash inflows are given below. YEAR 1 2 3 4 5 CASHINFLOWS 2,50,000 2,80,000 3,50,000 2,90,000 2,50,000 Machine A (Earning before tax) 50,000 4 yrs 50% 10,000 15,000 20,000 15,000 Machine B (Earning before tax) 80,000 6 yrs 50% 8,000 14,000 25,000 30,000 18,000 13,000
Calculate: 1) Pay back period 2) ARR 3) NPV at 10% 4) PI at 15% 5) IRR
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National Ltd has under consideration two projects X and Y each costing Rs 120 lakhs. The projects are mutually exclusive and company is considering the question of selecting one of the two. Estimated life of X is 8yrs & Y 6yrs. Salvage value is expected to be zero at end of their operational life. Tax rate applicable to company is 50 % & the cost of capital of company is 15%. EBIT of both machines is given below. (Rs in lakh) Year 1 2 3 4 5 6 7 8 Project X 25 35 45 65 65 55 35 15 Project Y 40 60 80 50 30 20 PV @ 15% 0.870 0.756 0.685 0.572 0.497 0.432 0.376 0.327
The company follows straight line method of depreciation assets. Advise the company regarding the selection of the project. Illustration 7 XYZ ltd is considering purchase of machine in replacement of an old one. Two models M & Z are offered at price of Rs 22.50 lakhs & Rs 30 lakhs respectively. Further details are given below Particulars Economic life(yrs) Scrap value at the end(in lakhs) Annual cash inflow (in lakhs) Year 1 2 3 4 5 6 Evaluate proposals under 1) PBP 2) NPV @ 12%. Which model would you recommend & why ? 5 7.50 10 9 8.5 6 8 10 12 10.5 9.5 M 5 2 Z 6 2.5
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ITC ltd has decided to increase capacity to meet the growing demand. There are 3 machines under consideration of the management. The relevant data is given to you Particulars Initial investment required Estimated annual sales Cost of production (estimated) Direct materials Direct labour Factory overheads Administrative overheads Selling overheads Economic life (yrs) Scrap value 40,000 50,000 60,000 20,000 10,000 1 40,000 50,000 30,000 50,000 10,000 10,000 3 25,000 48,000 36,000 58,000 15,000 10,000 3 30,000 M1 3,00,000 5,00000 M2 3,00,000 400000 M3 3,00,000 450000
Find out most profitable machine using pay back period. Illustration 9 Z ltd is thinking of investing in a project costing Rs 20 lakhs. The life of the project is five yrs & the estimated salvage value of the project is zero. Straight line method of charging depreciation is followed. The tax rate is 50%. The expected cash flows before tax are as follows. Year Cash flow before dep & tax ( Rs lakhs) 1 4 2 6 3 8 4 8 5 10
You are required to determine the PBP, ARR, NPV @ 10% & benefit cost ratio. Illustration 10 Y ltd is considering to purchase a machine in order to produce a new product. It is expected that the new product will generate an annual profit of Rs 15, 00,000 per year for first 5 yrs. The material cost required for this production is expected to be Rs 4, 50,000 per year, labour of Rs 5, 50,000 and other expenditure Rs 1, 50,000 p.a. The cost of machine is Rs 5, 85,000, installation expenses Rs 15,000 & scrap value of Rs 1, 00,000. The expected life of machine is expected 5 yrs. The machine will also require an investment of working capital of Rs 75,000 which will be recovered at the end of 5th year. Advise the company by using NPV method.
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CHAPTER 6
CAPITALISATION
CHAPTER 6
CAPITALISATION
1) INTRODUCTION In simple terms, the capitalization means the net amount raised by the firm or company through the long-term sources of the capital (shares, debentures & long term loans). The firm requires financial help from the internal as well as the external sources. However, the internal sources may not be sufficient to solve the financial needs & wants of the firm on regular basis. So the firm has to depend upon the external sources. These external sources are the shares, debentures & long-term loans. From these sources the firm can generate the required amounts of funds as its capital. The need of studying capitalization concept mainly arises due to the tendency of the firms regarding the fund raising. The capitalization suggests that the firm should have to raise exactly the equal amount from the external sources which is actually required to fulfill its financial needs & wants. It means, no firm can raise the excess or less amount than its actual financial requirement. But as we know that the financial requirements are not steady or constant for the longer period. These show the fluctuations on regular basis. The firm must have to make proper financial plan for collecting the funds from the external sources. Before raising the funds, it is essential to determine the capital structure of the firm. 2) CAPITAL STRUCTURE Capital Structure: The capital structure shows the overall picture of the capital, which is raised by the firm through the external sources. It is the classification of the capital as Owned Capital & Borrowed Capital. The firm-wise financial requirement is different & the capital structure is also different for firm to firm. The capital structure for two firms which are engaged in similar kind of business activity & required the same amount of capital, is also entirely different. See the given example.
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Chapter : 6 Capitalisation / 83
SARASWATI CLASSES FOR CA, CS & ICWA Example of Capital Structure Sources of Capital Equity Share Capital Debenture Capital Long Term Loans Internal Finance (Reserves & Surplus) Total Capital 1000000 A. Ltd (amount in Rs.) 500000 200000 250000 50000
B. Ltd. (amount in Rs.) 350000 400000 175000 75000
1000000
From the given example, it is clear that the net capital requirement of both the companies is exactly the same (Rs. 10 lakhs). But there is a difference in the capital structure. The Equity Share Capital of A. Ltd is Rs. 5 lakhs, whereas of B Ltd. is Rs.3.5 lakhs. So A. Ltd has more Owned Capital than B.Ltd. In case of B.Ltd the total borrowed capital (Debenture & Loans) is more. But the Debenture Capital of B. Ltd is more & the Loan Capital is less than that of A. Ltd. The Owned Capital also includes the internal funds used (Reserves & Surplus). Both the companies use the Reserves but B. Ltd. has more amount of Reserve (Rs. 75 thousand), which can be used as the capital. The capital structure of both the companies can be explained in terms of percentage. It is as under, Capital Structure (Finance Pattern) Sources of Capital A Ltd. (% of total Capital) Owned Capital (Equity Capital + Reserves) Borrowed Capital (Debentures + loans) Total Capital 100% 100% 55% 45% 42.5% 57.5% B. Ltd (% of total Capital)
Here the conclusion can be drawn that, any investment in B.Ltd is risky at this stage because it has more proportion of the Borrowed Capital. Naturally the liabilities of B. Ltd are more than that of A. Ltd. 3) OVER CAPITALISATION Over capitalization means existence of excess capital as compared to the level of activity and requirement. The term 'over capitalization' should not be taken to mean excess funds. There can be a situation of over capitalization, still the company may not be having sufficient funds.
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SARASWATI CLASSES FOR CA, CS & ICWA Causes of over capitalization
i. ii. iii.
iv. v.
The situation of over capitalization may arise due to various reasons as stated below: The assets might have purchased during the inflationary situations. As such the value of assets is less than the book value of assets. 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 assets. The company might have spent huge amount during its formation stage or might have spent huge amount for the purchase of intangible assets like goodwill, patents, and trade marks. As a result the earning capacity of the company may be adversely affected. The requirement of funds might not have been properly planned by the company The company might have followed the relaxed dividend policy without bothering much about the building up the reverses. As a result the retained profits of the company may be adversely affected. Advantages of over capitalization
i. ii. iii. iv. v.
The management is assured of adequate capital for present operations. Ample capital has a beneficial effect on an organization's morale. Ample capital gives added flexibility and latitude to the corporations operations. The profit rates tend to discourage possible competitors. For public utility companies when the price of service is based upon a fair 'Return to capital' High capitalization may be advantageous. Disadvantages
i.
Over capitalization may induce failure and the failure of the company may bring an unhealthy economic situation. ii. The ethical atmosphere of a business is not improved by over capitalization. iii. Due to over capitalization, there may be an inability to pay interest on bonds. iv. Injury to credit worthiness. v. Decline in the value of securities. Effects of over capitalization Adverse effects of over capitalization can be classified into the following categories: i. on the company: a. The market price of the equity shares fall which reduces the credit standing of the company. b. Due to poor profitability it cannot internally finance the projects. c. The company fails to maintain the dividend rate. d. Due to the reduced credit standing the marketability of future issues of capital is jeopardized. ii. On the shareholders: a. They do not get fair return on their investment. b. The market price of the shares of an over capitalized concern falls.
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SARASWATI CLASSES FOR CA, CS & ICWA iii.
On society: a. If such units enjoy monopoly, they exploit consumers and employers. b. The productivity of such unit is less. Thus scarce resources are poorly employed. c. For survival, they trouble the government for assistance and concessions. This increases the quantum of public expenditure. 4) UNDER CAPITALISATION Meaning
Under capitalization is the reverse of over capitalization. It should not be confused with a condition implying a lack of funds. The situation of under capitalisation indicates the excess of real net 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 symptom of under capitalization. As such, under capitalization is an indication of effective and proper utilisation of funds employed in the business. It also indicates sound financial position and good management of company. Under capitalization comes as a result of: i. Under estimation of future earnings at the time of promotion and / or, ii. An unforeseen in earnings resulting from later developments, iii. Under capitalization exists when a company a sufficient income to meet its fixed interest and fixed dividend charges and is able to pay a considerably better rate on its equity shares than the prevailing rates of similar shares in similar business. Causes of under capitalization i. Under estimation of earnings: It is possible that earnings may be under estimated, as a result of which the actual earning may be much higher than those expected. ii. Efficiency: A corporation may have optimally utilized its assets and enhanced its efficiency by exploiting every possibility of modernization and by taking the maximum advantage of market opportunities. iii. Under estimation of funds: It may have take place when the total funds required have been under estimated. iv. Retained earnings: Because of its conservative dividend policy, a corporation may retain the earnings which might have accumulated into mass savings. This is bound to improve the financial health of the corporation. Effects of under capitalization Adverse effects of over capitalization can be classified into the following categories:
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SARASWATI CLASSES FOR CA, CS & ICWA i. a. b. c. d. On the company:
High EPS indicates that the line of business is very lucrative which may increase competition. High profit increases tax liability of the company. Higher prices of shares may restrict the market and shares may be traded at prices below those justified by the usually high earnings. Labour unrest: Employees are of ten organized and become conscious of the fact that the corporation is making enormous profits. They feel that they have a legitimate right to share in these profits. This generates a feeling of unfriendliness on the part of the employees and leads to labour unrest.
ii.
On the shareholders : a. b. c. d. They can earn high rate of dividend. Higher the market value of share. Shareholder can loan on these securities due high credit standing of company. Market for share limited due to high market value.
iii.
On society and consumers a. Consumer dissatisfaction: Consumers feel that the unusual earnings of the corporation could have been utilized by effecting a price reduction or by improving the product quality. It may encourage new entrepreneurs to start new ventures. It may increase industrial production & employment level too.
b.
5)
COST OF CAPITAL
The sources through which the firm generates the funds to meet its financial requirements are Equity & Preference Share Capital, Debentures, and Loans & Reserves & Surplus. Each of the above sources of capital has its own cost & the firm has to incur it. E.g. if a firm raises capital of Rs. 500000 by acquiring the bank loan @ 8% interest. Here Rs. 40000 (8% on Rs. 500000) are treated as the amount of Interest, which the firm has to pay to the bank. So Interest is the cost of bank loan. Accordingly, the firm has to pay Dividend for the equity & preference share capital & Interest for the debenture capital. So Interest & Dividend are the costs of capital. Definition : "Cost of capital may be defined as the cost incurred on the funds raised from different sources of capital". More accurate definition can be given as, "Cost of Capital may be defined as the rate of return that a firm must earn on its investments so that the expectations of the investors are satisfied". The cost of capital is highly affected due to the risk factor, which is involved in the capital investments & funds raising. The firm raises funds from certain short-term sources of finance such as Short-term bank loans. Bills Discounting, Bank overdraft etc. The minimum risk is involved in such
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types of funds raising. So the cost of capital is also minimum. On the contrary, when the firm raises funds by issuing preference shares or debentures, it is obligatory to pay off the dividend & interest to the investors. Here more risk is involved & so the cost of capital is also more. Naturally, when the firm generates the capital funds from the sources like debentures, long term loan & preference shares, it expects very high rate of return from these investments. It should be noted that, the equity share capital involves relatively less risk as the obligation of paying dividend can be avoided in case of such type of share capital. Estimation Methods of Cost of Capital : Each separate source of capital (shares, debentures, loans & reserves) has separate method of calculating the cost of capital. The cost of capital has to be calculated by using various formulae, which are given for each separate source of capital. These are explained as under A) Cost of Equity Share Capital : As mentioned earlier, the minimum risk is involved (from the point of view of the firm) in the borrowings of funds by issuing the equity shares. But the equity share capital is not a cost-free source. An estimation of the cost on equity share capital is little difficult, as the exact returns from such a source cannot be ascertained easily. The cost of equity share capital can be estimated by adopting several sub-methods. These are as follows, Dividend Price Method : The market price per equity share becomes equal to the present value (amount) of the dividend, which are expected by the shareholders. The formula is, Ke = D / P
D (ke - Cost of Capital, D - Dividend per share, P - Market price per share) +g P Example
R ltd is expected to disburse a dividend of Rs 30 on each equity share of Rs 10. The current market value is Rs 80 per share. Calculate the cost of equity share. Dividend Price & Growth Rate Method : When the equity shareholders expect certain increase (growth) in the dividend rate per share, the cost of capital also expected to be increase. Ke = (g - Growth rate) Example The equity share of N ltd presently traded in the mkt at Rs 90 each. The is expected current year dividend is Rs 18 per share. The expected growth rate is 6%. Calculate the cost of equity share.
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Earnings Price Method : Instead of considering the dividend rate & the growth in it, the earnings per share are taken into account while calculating the cost of capital by the earnings price method. The earnings per share (EPS) are increasing when the firm gets high Net Profits (after paying all the taxes & interests). The formula is Ke = EPS / P Example Pranab ltd has 50,000 equity shares of Rs 10 each with current mv is Rs 45 each. The profit after tax is Rs 9, 60,000. Calculate the cost of equity share. B) Cost of Preference Share Capital : In the case of preference shares, the dividend rate can be taken as the cost since it is the amount which the company intends paying against preference shares. As in the case of debt, the issue expenses or the discount / premium on issue/ redemption has also to be taken into account. Suppose a company issues 13% preference share (face value Rs. 100) at Rs. 102 each. Suppose further that the brokerage and under-writing commission on 1000 shares sold comes to Rs. 3000. Thus the company realizes Rs. 99,000 in cash by this issue. Against this, its cost is Rs. 13,000 per annum. The formula applied is, Kp = PD + (F - P) / n -------------------F+P/2 (Kp = Cost of pref. Capital, PD - Preference Dividend, F - Repayable value, P - Net amount realized, n= Redemption period of pref. Capital.) C) Cost of Debt Capital (Debentures) : The explicit cost of debt is the interest rate as per the contract adjusted for tax and the cost of raising the debt. Suppose a company issues 1000, 15% debentures of the face value of Rs. 100 each at a discount of Rs. 5. Suppose further, that the underwriting and other costs are Rs. 5000/- for the total issue. Thus Rs. 90,000 is actually realized, i.e., Rs. 1, 00,000 minus Rs. 5000 as discount and Rs. 5000 as under-writing expenses. The interest per annum Rs. 15,000 is therefore the cost of 90,000, actually received by the company. This is because interest is a charge on profit and every year the company will save Rs. 7500 as tax, assuming that the income tax rate is 50%. Hence the after tax cost of Rs. 90,000 is Rs. 7500 which comes to 8.33%. However, debt has an implicit cost also. This arises due to the fact that if the debt content rises above the optimal level, investors will start considering the company to be too risky and therefore, their expectations from equity shares will rise. This rise in the cost of equity shares is actually the implicit cost of debt. The formula is calculating the cost of loan is, Kd = I (1 - t) (Kd - Cost of debenture) t : tax rate I : Intest rate
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E) Cost of Reserve & Surplus : These are the internal sources of finance. The firm generates funds to meet its capital requirement from the net profits earned after paying all the taxes & interests. The reserves & surpluses are those portions of the Net Profits of the firm, which are not distributed to the shareholders in form of dividend. So these are treated as the undistributed profits or retained earnings of the firm. The cost of reserve & surplus can be calculated by considering the cost of equity share capital & the amount of returns, which the firm is expecting to acquire from the reserve & surplus 6) TYPES OF COST CAPITAL 1) Component cost of capital It means cost of each element which is part of capital structure. For e.g. cost of equity, cost of debentures etc. 2 ) Composite cost of capital / Weighted cost of capital It is the overall cost of capital i.e. cost of all components included in capital structure. The CIMA defines the weighted average cost of capital "as the average cost of the company's capital weighted according to the proportion each element bears to the total pool of capital, weighting is usually based on market valuation currents yield and costs after costs". Formula to calculate WACC Total weighted costs X 100 Total weights OR (Cost of equity X % of equity ) + (Cost of debt X % of debt) Illustration A Ltd has share capital of 60L & debenture of 40L. Their respective costs are 10% & 12%. Calculate WACC before tax & after tax based on book values. What will be WACC if market value of equity is 90L & debt is 50L? 7) WHICH ARE THE DIFFERENT CAPITAL STRUCTURE THEORIES Following are the four theories/ Approaches of capital structure: i. Net Income Approach (NI) : This approach is given by Durant David. According to this approach, the capital structure decision is relevant to the valuation of the firm. This approach states that, with an increase in leverage, the overall cost of capital declines and the value of the firm increases so that the optimum capital structure would be reached at 99.9% level of debt in the capitalization. In short cost of equity and cost of debt remain constant when debt equity ratio changes. There are three basic assumptions of this approach: a. Corporate taxes do not exist. b. Debt content does not change the risk perception of the investors.
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SARASWATI CLASSES FOR CA, CS & ICWA c. Cost of debt is less than the cost of equity.
ii. Net Operating Income Approach (NOI) : As per this approach value of the firm is independent on its capital structure. It believes that the leverage has no effect at all on the overall cost of capital and the value of the firm. Hence, every capital structure is optimal. According to this approach, the overall capitalization rate and the cost of debt remain constant for all degrees of leverage. In short overall capitalization rate and cost of debt remain constant for all degrees of financial leverage. Assumptions of this approach : a. b. c. d. The investors see the firm as a whole and thus capitalise the total earning of the firm to find the value of the firm as a whole. The overall cost of capital 'Ko' of the firm is constant and depends upon the business risk which is assumed to be unchanged. The cost of debt 'Kd' is also constant. There is no tax.
iii. Modigliani-miller Approach : This approach is that of Modigliani and Miller. They a r g u e that the total cost of capital of a particular corporation is independent of its methods and level of financing. They argue that the average cost of capital of a firm is completely independent of its capital structure. Assumptions of this approach : a. b. c. d. e. f. iv. Perfect capital market exists where individuals and companies can borrow unlimited amounts at the same rate of interest. There are no taxes or transaction cost. The firm's investment schedule and cash flows are assumed constant and perpetual. Firms exist with the same business or systematic risk at different levels of gearing. The stock markets are perfectly competitive. Investors are rational and expect other investors to behave rationally.
Traditional Approach : The traditional theorist argue that a firm can change its overall cost of capital by increasing or decreasing the debt equity mix i.e. by increasing the amount of loan content in the total capital or by decreasing the same. This implies that each source of funds involves cost. They contend that as the ratio of debt to equity increases, the overall weighted cost of capital decreases, since debt is a cheaper mode of finance.
8) FACTORS THAT DETERMINE CAPITAL STRUCTURE OF THE COMPANY Following are the factors responsible for determining the capital structure : i. Trading on equity: In case of Rate of Return (ROI) on the total capital employed i.e. shareholder's funds plus long term borrowings, is more than the rate of interest on borrowed funds or rate of dividend on preference shares, it is said that the company is trading on equity.
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SARASWATI CLASSES FOR CA, CS & ICWA Example on trading on equity The capital structure of X Ltd & Y ltd is given to you. Particulars Equity Share capital of Rs 10 each 10% Loan X Ltd 2,000 18,000
Y Ltd 18,000 2,000
Prepare profitability statement of both companies when sales are Rs 40,000 & Rs 36,000. Variable costs are 50% of sales & fixed costs are Rs 10,000. Particulars Sales Less : Variable costs = Contribution Less : fixed costs = EBIT Less : Interest on loan = EBT Less : Income tax = EAT EPS ii. Tax consideration: Under the Income tax laws, dividend on shares is not deductible while interest paid on borrowed capital is allowed as deduction. Owing to these provisions corporate taxation plays an important role in determining the choice between different sources of financing. iii. Government policy: Government policies play an important role in determining capital structure. Monetary and fiscal policies of the government also affect the capital structure decisions. iv. Legal requirements: The finance manager has to keep in view the legal requirements while deciding about the capital structure of the company. v. Marketability: To obtain a balanced capital structure it is necessary to consider the ability of the company to market corporate securities. vi. Flexibility: Flexibility refers to the capacity of the business and its management for expected and unexpected change in circumstances. Vii Timing: Proper timing of a security issue often brings substantial savings because of the dynamic nature of the capital market. Viii. Size of the company: Smaller companies heavily rely on owners funds while large companies are generally considered to be less risky by the investors and therefore, they can issue different types of securities. ix. Purpose of financing: The purpose of financing also to some extent affects the capital structure 40,000 36,000 40,000 36,000 X Ltd Y Ltd
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of the company. x. Period of financing: To raise funds either by borrowing or by issue of shares is depend on period of financing. xi. Cash flow ability of the company and nature of enterprise. xii. Requirement of investors: Different types of securities are issued to different classes of investors. xii. Provision of future: While planning capital structure the provision for future also to be made. 9. LEVERAGE AND TYPES OF LEVERAGES The term leverage represents the impact of one financial variable over some other related financial variable. Leverage refers to the ability of a firm in employing long term funds having fixed cost to enhance return given to the owners. Management accountants defined leverage "as the ability of a firm to use fixed cost assets or funds to magnify the returns to its owners". Leverage and risk Since leverage is intended to magnify the returns to its owners, obviously, it is intimately connected with risks. Here risk indicates the degree of uncertainty involved in getting the expected from the use of fixed cost assets or funds. Leverage may be favourable or unfavourable. A favourable leverage exists when earnings are more than the fixed cost of funds. However, if the rate of return remains to be lower, then it may be a case of unfavourable leverage. Classification of leverage a) Operating leverage and b) financial leverage. c) Combined leaverage
a. Operating leverage : Operating leverage refers to the extent to which the firm has fixed operating costs. A firm with high operating leverage will have relatively high fixed costs in comparison with a firm having low operating leverage. Degree of Operating Leverage (DOL) measures the sensitivity of operating income (EBIT) to change in revenues (or quantity sold). It is calculated with the help of following formula: Contribution __________________________ Operating leverage = Earning before interest and taxes Here, Contribution = Sales - Variable cost Earnings before interest and taxes = EBIT = Contribution - Fixed cost Conclusion If operating leverage is 2 it means for every 1% increase in contribution will increase the EBIT by 2% & vice versa. b. Financial leverage : Financial leverage refers to the extent to which the firms have fixed
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financing costs arising from the use of debt capital. A firm with high financial leverage will have relatively high fixed costs compared to a firm with low financial leverage. Prof. Kohler defines financial leverage as the tendency of residual net income to vary disproportionately with net income. It is calculated with the help of the following formula : Earning before Interest and Taxes (EBIT) _____________________________________ Financial leverage = Earnings before Taxes (EBT) Financial leverage is also termed as Trading on equity. This means that major contribution in capital structure of the company is of share capital and residual is from outside debt. So that Earning per Share (EPS) is very much important in this situation. If the effect on EPS is positive (i.e. arising out of increase in EBIT), the leverage is said to be favorable. On the other hand, if the effect on EPS (arising out of decrease in EBIT) is negative, the leverage is said to be unfavorable. Conclusion If financial leverage is 1.5 then it means for every 1% increase in EBIT will increase EPS by 1.5% & vice versa. Combined leverage It is also termed as total leverage and reflects the degree to which a firm has fixed operating cost and fixed financing cost. The combined effect of operating leverage and financing leverage measures 'the total risk involved' in a firm. Conclusion If combine leverage is 2, it means for every 1% increase in contribution will increase EPS by 2%. DCL = DOL x DFL
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The various combinations of the leverages and their effects combined are given below : No. Operating Financial Leverage i. ii. High High High Low Combined effect leverage Combination is risky and should be avoided Partly good as some advantageous for debt financing to maximize return of equity can be taken. iii. Low High Ideal situation for profit maximisation with minimum risk. iv. Low Low Cautious approach but it may be losing good Investment opportunities. Applications of leverages : i. ii. iii. Operating leverage: It helps us to understand as to how EBIT would change with respect to change in quantity produced and sold. It also helps in measuring business risk. Financial leverage: It helps us to understand as to how EPS would change with respect to change in EBIT. It also helps us in assessing and measuring the financial risk. Combined/ Total leverage: It helps us in measuring total risk involved in a firm.
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PROBLEMS ON CAPITAL STRUCTURE AND LEVERAGES Illustration 1 ACC ltd has the following capital structure. PARTICULARS Equity share capital Preference share capital Debentures MARKET VALUE 80L 30L 40L BOOK VALUE 120L 20L 40L COST % 18 15 14
Calculate WACC based on book values & market values. Illustration 2 In considering most desirable capital mix, the following estimates of the cost of debt and equity capital after tax is given to you. Debt as % of total capital employed 0 10 20 30 40 50 60 Cost of debt % 7.0 7.0 7.0 7.5 8.0 8.5 9.5 Cost of equity % 15.0 15.0 15.5 16.0 15.0 19.0 20.0
You are required to determined the optimal debt equity mix for the company by calculating composite cost of capital.
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SARASWATI CLASSES FOR CA, CS & ICWA IIIustration 3
In considering most desirable capital mix, the following estimates of the cost of debt and equity capital after tax is given to you. Debt as % of total capital employed 0 20 40 60 Cost of debt % (before tax) 12 12 16 20 Cost of equity % 16 16 20 24
You are required to determined the optimal debt equity mix for the company by calculating composite cost of capital .Assume tax rate 50%. IIIustration 4 From the following information calculate WACC before & after tax. PARTICULARS Equity share capital Preference share capital Retained earnings 10% debenture 12% Term loan TOTAL CAPITAL EMPLOYED A) Returns expected by equity shareholders 15% B) Dividend payable to preference shareholders at 12% C) Tax rate 50% IIIustration 5 H ltd has earned EBIT of Rs 6,00,000 for the year ended 31st March 2010. A company is planning to raise 30L for expansion. It has got two options a) Raise entire amount by issuing shares of Rs 10 each. b) Raise 20L by issuing shares of Rs 10 each & balance by issuing 14% debentures of Rs 100 each.. Advise the management which option is better & why ? IIIustration 6 A company is considering raising of funds of about Rs 100 lakhs by one of the two options given below. a) 14% Term loan b) 13% debentures RS IN LAKHS 300 200 50 100 75 725
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Debenture issued at discount of 2.5% and would involve cost of issue of Rs 1 lakh. Suggest which option is better. IIIustration 7 The existing capital structure of ABC Ltd is as under Equity share capital of Rs 100 each Retained earnings 9% Preference capital 7% Debentures Rs 40L Rs 10L Rs 25L Rs 25L
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 25L to finance its expansion plan for which 3 options are given below a) b) c) Issue of 20,000 equity share at a premium of 25 per share Issue of 10% preference capital Issue of 8% debentures
It is estimated that P/E ratios in case of equity, preference and debenture financing would be 20,17 & 16 respectively. Suggest which option is better ? IIIustration 8 A ltd has following capital structure Equity capital of Rs 10 each 10% Preference capital of Rs 100 each 13% Debentures of 100 each 14% Term loan Rs 10L Rs 1L Rs 5L Rs 8L
Expected dividend per share is Rs1.50 with the expected growth rate of 7%. Market value per share is Rs 20. Preference shares and Debentures are selling at Rs 75 & Rs 80 respectively. Calculate WACC based on Book values & market values. IIIustration 9 Calculate Financial, Operating and combined leverage from the following information. Sales Variable costs Fixed costs Interest Tax rate Rs 20 L 50% of sales Rs 5L Rs 1L 50%
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SARASWATI CLASSES FOR CA, CS & ICWA IIIustration 10
Operative leverage and combined leverage of a company is 2 & 3 respectively at the present level lf sales of 10,000 units. The SP per unit is Rs 12 while its variable cost is Rs 6. Tax rate applicable is 50%. The rate of interest is 16% p.a. What is the amount of debt in the capital structure of the company ? IIIustration 11 The balance sheet of X ltd is given to you. Liabilities Equity capital at 10 each 10% Long term loan Retained earnings Current liabilities Rs 60,000 80,000 20,000 40,000 2,00,0000 The total assets turnover ratio is 3 & fixed costs are Rs 1,00,000. Variable costs are 40% of sales & tax rates 40%. Calculate Leverages for the company. Determine EBIT required is desired EPS is Rs 3. IIIustration 12 The selected financial data for A,B, & C ltd are given below. Particulars Variable expenses as % of sales Interest expenses DOL DFL Income tax rates Prepare Income statements. A 66 Rs. 200 5 3 50% B 75 Rs. 300 6 4 50% C 50 Rs. 1000 2 2 50% 2,00,000 Assets Fixed assets Current Assets Rs 1,50,000 50,000
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CHAPTER 7
DIVIDEND DISTRIBUTION THEORIES
CHAPTER 7
DIVIDEND DISTRIBUTION THEORIES
1. DIVIDEND Dividend is return given to shareholders for investing money into business. The main objective of every business is to maximise shareholders wealth & this is possible by two ways, first by paying dividend and second increasing the market value of share. Dividend payment is treated as cash outflow therefore it is treated as finance decision. It reduces liquidity of the firm and hence it is a very important decision. The dividend payable to equity shareholders is depends upon profit of the company but whereas rate of dividend to preference shareholder is fixed. 2. DETERMINANTS OF DIVIDEND POLICY Dividend policy is most important decision to be taken by finance manager. It is a distribution of profits into two parts, retained earnings and distributed profit. Retained earnings are treated as internal source of finance to achieve desired level of growth, whereas dividend decision constitute outflow of cash and hence understanding of following factors are necessary A. Transaction costs Whenever funds are required by the org. the borrowing cost is associated with such type of decision. The costs required to raise new capital are called as floatation costs which can be reduced by paying less or no dividend. B. Personal Taxation High taxation educes the earnings of the company and affects the rate of dividend. Dividend payment is also subject to personal taxation so shareholder is liable to pay tax on dividend income.
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Chapter : 7 Dividend Distribution Theories / 101
SARASWATI CLASSES FOR CA, CS & ICWA C. Income of Investors
If income of investor is on higher side then he expects lower dividend and more capital appreciation whereas lower income investors expect high rate of dividend. D. Dividend payout ratio DPR indicate percentage of dividend declared and paid out of the earnings per share. A high DPR indicate liberal dividend policy whereas low DPR indicates conservative dividend policy, which helps organization to accumulate funds required for expansion. E. Liquidity Dividend decision represents outflow of cash. Therefore before paying dividend every company must evaluate its financial commitments. It is not necessary that company earning high profit will have large amount of cash for disposal. F. Expansion Plan Rate of expansion is needs to be taken into consideration. If company plans for expansion then the needs more funds to finance its expansion. In such case company will pay less amount of dividend and keep maximum amount as a reserve. G. Rate of return Profits earn by the oganisation affects dividend / retention policy. If rate or return on assets employed decide the dividend to be paid and amount to be transfer to the reserve account. H. Stability of earnings A firm with relatively stable profits tends to pay higher dividend. This is possible because they can predict future profits and accordingly decides dividend policies. On the other hand firm with unstable profits find it difficult its future profitability. Such firms try to keep maximum amount of reserve than paying dividend. I. Legal restrictions The company has to fulfill following provisions before paying dividend. Company act 1956: As per provision company should earn sufficient profit to distribute profit as dividend. But before paying dividend company must transfer certain % of profits to reserve and then if profit is sufficient to pay dividend then only company can pay dividend. Income Tax act: Dividend is subject to dividend distribution tax which is to be deductible before paying dividend to shareholders. Company should fulfill requirements of SEBI before declaring Bonus shares. J. Cost of financing Cost of external borrowing may affects dividend payout. If company spends more amount towards interest then it will affects profitability and ultimately it will affect dividend.
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SARASWATI CLASSES FOR CA, CS & ICWA K. Economic stability
If political and economic situation is unstable then company may prefer to pay less amount of dividend. On the other handPoit is favorable then company may follow liberal dividend policy. if = 3. DIVIDEND POLICIES Constant dividend policy Under this method dividend is paid as fixed percentage of profits of the company. The amount of dividend varies from year to year as it depends upon profits. This method is also known as constant payout ratio method. Constant dividend rate policy Under this policy dividend is paid at a constant rate even though earnings very from year to year. For this company has to create dividend equalisation reserve. Gordon growth valuation model This model assumes constant level of growth in dividends. The value of share reflects the value of future dividend accruing to that share. Hence dividend payment and its growth are very important to value share of the company. This model holds that value of share is equal to the value of future dividend accruing to that share. Assumptions : All financing is done through equity only. The company has perpetual life and earnings are perpetual. Corporate tax dose not exist. Annual growth rate of dividend is assumed to be remain constant. The firms cost of capital remains constant and same is taken as the appropriate discount rate. Formula The value of share under this model is to be calculated as under Do ( 1 + g ) Po = Ke - g Where Po = Do = Ke = g =
Market price of share Current year dividend Cost of equity capital Expected future growth rate of dividend
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SARASWATI CLASSES FOR CA, CS & ICWA OR E1 ( 1 - b ) Po Where Po E1 b (1 - b) Ke r OR rA ( 1 - b ) Po = K e - br Where r Po b (1 - b) Ke br A = = = = = = = rate of earning Market price of share retention ratio dividend payout ratio cost of capital g = growth rate of earnings and dividends Investment per share = = = = = = Market price of share expected earnings per share retention ratio dividend payout ratio cost of capital rate of earning = Ke - br
The Gordon growth model used to show that the value of the company ultimately depends on its dividend paying capacity. Criticism It is not possible to maintain constant dividend growth and constant earnings growth. The model ignores personal and corporate taxation. As per this model if dividend for current year is zero then value of share is nil. Capital gains are ignored by this model.
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SARASWATI CLASSES FOR CA, CS & ICWA Walter's valuation model (Prof. James E. Walter)
According to this model share value reflects present value of expected dividends. Formula Ra Rc Rc (E -D)
P=D+
Where P E D (E-D) Ra Rc
= = = = = =
Current market value of share Earnings per share Dividend per share Retained earnings per share Rate of return on firms investments Cost of capital
Assumptions Retained earnings represent the only source of funds. Firms IRR and its cost of capital are constant. The return on investment remains constant. The firm has an infinite life and is a going concern. No change in EPS and DPS. The optimum dividend policy can be determined by the relationship of R and R . If Ra > Rc if the firm can earn higher IRR than the cost of capital, the firm can retain the earnings. Such firms are called as growth firms and optimal dividend payout ratio for such firm is nil. When the rate of return on investment exceed the cost of capital the price per share increases as the dividend payout ratio decreases. If Ra < Rc if the cost of capital is more than IRR or when the firm dose not have profitable investment opportunities, the optimum dividend policy would be to distribute the entire earnings as dividend. Such firms are called as declining firms'. The optimum payout ratio for such firms is 100%. If Ra = Rc i.e. If IRR of the firm is equal to its cost capital, it dose not matter whether the firms retains or distribute its earnings, such firm are called as normal firms. For such companies share price dose not very with the changes in dividend payout ratio. Modigliani and Miller's dividend irrelevancy theory MM has argued that a firm's dividend policy has no effect on its value of assets. For example, if the rate of dividend declared by a company is less, its retained earnings will increase and so also the net worth and vice versa. Their argument is that value of he firm is unaffected by dividend policy. MM asserts that a firm's value is determined by the investment decisions.
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SARASWATI CLASSES FOR CA, CS & ICWA Formula P1 + D1 P0 = 1 + Ke Where Po P1 D1 Ke = = = =
Prevailing market value of a share Market value of share at the end of period one Dividend to be received at the end of period one Cost of equity capital
Assumption There are no personal or corporate taxes There are no stock flotation costs All investors can lend or borrow at the same rate of interest Dividend policy has no effect on the firms cost of equity Investment opportunities and future net income of all companies are known with certainty to all market participants. 4. TYPES OF DIVIDEND 1. Interim dividend Interim dividend is a dividend which is declared between two annual general meetings. While paying such dividend cash availability and future profit should betaken into consideration. Interim dividend helps company to raise additional capital. Final Dividend This dividend is paid after financial year is over. The amount of dividend is depends upon profit earned by the company for that year. Final dividend is declared in the annual general meeting. Preference dividend Preference shareholders get fix ate of dividend & they get dividend before equity shareholders. AOA of the company empower the directors to declare and pay dividend. 5. IMPORTANT DATES IN CONNECTION WITH PAYMENT OF DIVIDEND Dividend declaration date It is the date on which dividend is declared Record Date Dividend is paid to the shareholders whose names appear in the register of members on a particulars date, which is called as record date. Payment date The date on which dividend is actually paid. 6. LEGAL PROVISIONS AS TO PAYMENTS OF DIVIDEND (SECTION 205) Dividend is to be paid from the profit earned for any financial year after providing for depreciation of that year. If any dividend is declared or paid out of the past profits of the company, the undistributed
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2.
3.
profits available after providing deprecation shall be eligible for payment of dividend. The company can also pay dividends out of money provided by the central govt or state govt for payment of dividend in pursuance of a guarantee given by that government. The central govt. may, in the public interest allows any company to pay dividend for any financial year even without providing for depreciation. The amount of interim dividend and the amount of dividend shall be deposited in a separate bank account within 5 days from the date of declaration of such dividend. Dividend shall be declared or paid for any financial year only after the transfer of profits of that yea to reserves not exceeding 10% as may be prescribed by central government. Dividend shall be payable in cash Dividend can also be paid by cheque or warrant. COMPANIES (TRANSFER OF PROFITS TO RESERVES) RULES 1975 Before declaration of dividends a company must transfer a prescribed % of profits to reserve. The provision of the companies act rules 1975 are as under A company must transfer certain % of profits of current year to reserve, before declaring a dividend. A company may transfer higher amount to reserve than prescribed. The transfer is required only in respect of profits of current year after providing for depreciation. Transfer in respect of profits of previous years is not required. The prescribed % of profits to be transferred to general reserve areas follows as per the said rules If dividend proposed is upto 10% If dividend proposed is 10.01% to 12.50% If dividend proposed is 12.51% to 15.00% If dividend proposed is 15.01% to 20.00% If dividend proposed is over 20% Nil 2.5% of current profits 5% of current profits 7.5% of current profits 10% of current profits
COMPANIES (DECLARATION OF DIVIDEND OUT OF RESERVES) RULES 1975 Sometimes current profits are not sufficient to declare dividend. In such cases, a company can declare dividend out of accumulated reserve subject to the provision of the companies Rules 1975. The summary of provisions are given below If, in a particular year, profits are not adequate to declare a dividend, dividend can be declared out of reserve subject to the conditions prescribed in the said rules. Such dividend cannot be more than average of rates at which dividend we announced in previous 5 yrs of 10% whichever is less. Total amount drawn from reserve shall not exceed an amount equal to one-tenth of the sum of its paid up capital and free reserve. The amount drawn from reserve shall be first utilized to losses incurred in the current financial year and then, surplus if any can be utilized towards declaration of dividend on equity and
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preference shares. Balance in reserve account shall not fall below 15% of paid up capital of the company. Bonus shares Bonus shares are those shares which are issued to existing shareholders free of cost. If company is profit making, its accumulated profits and reserves go on increasing. Thus actual capital employed is much higher than the amount of share capital. To avoid this abnormality in the capital structure, part of free reserves can be distributed among the existing shareholders by issue of bonus shares. Advantages It preserves the company's liquidity as no cash leaves the company. Company can easily increase their share capital. It reduces market value of shares, making is more marketable. It indicates financial soundness of company. Disadvantages The future rate of dividend will decline. The future market value of share will decline.
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QUESTION BANK
QUESTION BANK
CHAPTER 1 1) 2) 3) 4) Describe the importance of the finance function in the management of a corporation. Explain the traditional and modern concept of finance function. State the functions to be performed by finance manager. Describe the various forms of business organization. CHAPTER 2 1) 2) a) b) c) 3) What is ratio analysis ? Explain its advantages & limitations ? Write short notes Liquidity ratios Profitability ratios Solvency ratios Write a detail note on Fund flow statement. CHAPTER 3 & 4 1) 2) 3) 4) 5) a) b) c) What is working capital? Explain factors affecting working capital. Discuss the importance of working capital. What is operating cycle? Explain factors affecting operating cycle. What are the sources of working capital financing ? Write shot notes Liquidity Vs Profitability Types of working capital Tondon committee
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SARASWATI CLASSES FOR CA, CS & ICWA d) 6) 7) Need for working capital
Write detail note on Receivable management & costs associated with it. Write a note on factoring. CHAPTER 5
1) 2)
What is capital budgeting? Explain risk associated with capital budgeting decisions. Discuss capital budgeting techniques. CHAPTER 6
1) 2) 3) 4) 5) 6) 7)
What is capital structure? Explain the factors on which capital structure depends. Which factors are to be considered while deciding debt-equity mix. What is Over capitalization? Explain its causes & effects on company, shareholders & society. What is Under capitalization? Explain its causes & effects on company, shareholders & society. Explain theories of capital structure. What is trading on equity? Explain its merits & demerits. Explain the term Leverage & its types. CHAPTER 7
1) 2) 3)
Which factors affect divided policy decisions of a company ? Discuss various legal and procedural formalities to be compiled with by a company while paying dividend. Write a note on bonus shares & SEBI guidelines for the issue of bonus shares.
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Financial Management

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FINANCIAL MANAGEMENT

CA, CS & CWA

INTRODUCTION TO FINANCIAL MANAGEMENT

SARASWATI CLASSES FOR CA, CS & ICWA

INTRODUCTION TO FINANCIAL MANAGEMENT

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Chapter : 1 Introduction to Financial Management / 4

SARASWATI CLASSES FOR CA, CS & ICWA

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Chapter : 1 Introduction to Financial Management / 5

SARASWATI CLASSES FOR CA, CS & ICWA

Vipul Shah / 9881 236 536

Chapter : 1 Introduction to Financial Management / 6

SARASWATI CLASSES FOR CA, CS & ICWA

Vipul Shah / 9881 236 536

SARASWATI CLASSES FOR CA, CS & ICWA ii)

SARASWATI CLASSES FOR CA, CS & ICWA

SARASWATI CLASSES FOR CA, CS & ICWA Functions

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Chapter : 1 Introduction to Financial Management / 11

SARASWATI CLASSES FOR CA, CS & ICWA Limitations

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Chapter : 1 Introduction to Financial Management / 12

ANALYSIS OF FINANCIAL STATEMENTS

SARASWATI CLASSES FOR CA, CS & ICWA

ANALYSIS OF FINANCIAL STATEMENTS

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SARASWATI CLASSES FOR CA, CS & ICWA

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Chapter : 2 Analysis of Finacial Statements / 15

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Chapter : 2 Analysis of Finacial Statements / 16

Absolute Liquid Ratio

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Chapter : 2 Analysis of Finacial Statements / 17

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Chapter : 2 Analysis of Finacial Statements / 18

This ratio compares sales generated with available assets.

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Chapter : 2 Analysis of Finacial Statements / 19

PURPOSE Indicate efficiency of production department.

This ratio shows overall efficiency of business

PAT X 100 Total Assets

PBIT Capital Employed

Operating profit X 100 Net Sales

Operating Profit = Gross profit operating expenses

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Chapter : 2 Analysis of Finacial Statements / 20

SARASWATI CLASSES FOR CA, CS & ICWA

Proprietary Ratio Shareholders Fund Total Assets

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Chapter : 2 Analysis of Finacial Statements / 21

Dividend Payout Ratio Dividend Per Share Earning Per Share

Dividend yield ratio Dividend per share X 100 Market price

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Chapter : 2 Analysis of Finacial Statements / 22

SARASWATI CLASSES FOR CA, CS & ICWA

*** *** ***

Add : Less : = Less :

........ ........ ........ ****

*** *** ***

= Add: Less : = Less: = Less = Less = Less =

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* * ***

* * ***

. . . . . . . . . ** . . . . . .

**

Rs. 2,13,421 30,000 _ _

___ _ _____