Professional Documents
Culture Documents
Executive
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WALTER MODEL
GORDON MODEL
MM APPROACH
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INSTRUCTIONS
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SYLLABUS
UNIT I:
Financial Accounting: Meaning of double entry
accounting, Meaning, nature and importance
Accounting cycle, accounting equation. Journal, Ledger
and Trial Balance .Accounting concepts and
conventions, Financial statements- Profit & Loss
account & Balance sheet. Financial statement AnalysisComparative Analysis, Common size & Trend Analysis
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UNIT II
Financial Statement Analysis - Ratio analysis
Classification of ratios, Advantages & Disadvantages Fund flow statements advantages and disadvantagesMarginal costing Cost Volume Profit analysis Break
Even analysis BEP, P/V ratio, MS
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UNIT III:
Introduction to Financial Management Nature of
Financial management Objectives of financial
management -Financial Decisions- Organization of
Finance function Agency Problem
Working capital Concepts Types Determinants
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UNIT IV
Sources of capital -Cost of Capital Meaning and
Significance Components Cost of Equity, Cost of
Debt, Cost of Preferred capital, Cost of retained
earnings and weighted average cost of capital. Capital
budgeting meaning Different methods Payback, Net
Present Value, Internal rate of return, Profitability
index and average rate of return
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UNIT V
Financial ,Operating and Combined Leverages Meaning
of Capital Structure -Determinants of capital
structure .Dividend decision Dividend policy - Dividend
theories Walter and Gordon modelof dividend
Stability of dividend Share split Buyback of shares.
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REFERENCES
1. I.M.Pandey, Financial Management, Vikas publishing
house Ltd., 9th edition, 2007.
2. Prasanna Chandra, Financial Management Theory and
Practice, Tata McGraw Hill, 7th Edition, 2008.
3. Financial and Management accounting by Reddy and
Moorthy
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UNIT 1
ACCOUNTING:
Accounting is the process of collecting, recording,
classifying summarizing and interpreting financial data
for the needs of management.
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COST ACCOUNTING
COST SHEET
STANDARD COSTING
VARIANCE ANALYSIS
MANAGEMENT ACCOUNTING
- FINANCIAL STATEMENT ANALYSIS COMPARATIVE, COMMON SIZE, TREND ANALYSIS
CAPITAL BUDGETING
RATIO ANALYSIS
FUND FLOW STATEMENT
MARGINAL COSTING
BREAK EVEN ANALYSIS
P/V RATIO
MARGIN OF SAFETY
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Financial accounting
The main purpose is to ascertain the profit or loss and
to indicate the financial position of the company.
The two important statements prepared in financial
accounting are Profit & loss accounts and Balance
sheet.
Profit & loss accounts to know the profitability of the
company
Balance sheet to know the financial position of the
company on a particular date.
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Functions/advantages/need/importance/purpose/objective
s/uses of financial accounting
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Cost accounting
The process of accounting for cost from the point at
which expenditure is incurred or committed to the
company of its ultimate relationship with cost centres
and cost units.
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Functions/Advantages/need/importance/purpose/objectiv
es/uses of cost accounting
Ascertaining cost
Fixation of selling price
Cost control
Cost reduction
Evaluation of performance
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Management accounting
Management accounting is the presentation of
accounting information in such a way as to assist
management in the creation of policy and in the day to
day operations of the company.
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Functions/Advantages/need/importance/purpose/objectiv
es/uses of Management accounting
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ACCOUNTING CYCLE
JOURNAL
LEDGER
-RECORDING
-CLASSIFYING
TRIAL BALANCE
-SUMMARISING
FINAL ACCOUNTS
- INTERPRETING
TRADING ACCOUNT
PROFIT & LOSS ACCOUNT
BALANCE SHEET
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FINANCIAL
STATEMENTS
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ACCOUNTING CYCLE
JOURNAL:
Journal is a daily record of business transactions.
It is also called as day book
The process of recording transactions in the journal called
Journalizing
The entries made in journal called journal entries
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ACCOUNTING CYCLE
FORMAT OF JOURNAL
S.No
(Rs.)
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Date
Particulars
L.F
Debit(Rs.)
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Credit
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ACCOUNTING CYCLE
ADVANTAGES OF JOURNAL:
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ACCOUNTING CYCLE
DISADVANTAGES OR LIMITATIONS OF JOURNAL:
It will be too long if all the transactions are recorded
Difficult to ascertain the balance of each account
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ACCOUNTING CYCLE
LEDGER:
Ledger provides a summary of similar transactions at one
place.
It is a summary statement of complete transactions relating to
an account.
Ledger is considered as main book of accounts
It is considered to be the principal book of accounts which
helps us in attaining the main objective of accounting.
It provides vital information like
Total sales value periodically
Total purchases periodically
Amount due from individual customers
Amount due to individual suppliers
Amount spent on specific items of expenditure etc
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ACCOUNTING CYCLE...
DIFFERENCE BETWEEN JOURNAL AND LEDGER
JOURNAL
LEDGER
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ACCOUNTING CYCLE...
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Journal is the book of prime (first) entry, while Ledger is the book of final entry.
In other words, ledger contains analytical records, while journal contains chronological records.
Narration is required in a journal that is not the case in the ledger.
Transactions are recorded in the sequence of occurrence in the journal, whereas transactions are
classified and recorded in relevant accounts in the ledger.
Data can be classified based on transaction in the ledger, while the basis of classification of data are
accounts in the ledger.
A transaction is firstly recorded in the journal soon after the occurrence of it; it is only then transferred
to the ledger.
Final accounts cannot directly be prepared from journal, but ledgers form the basis for easy
preparation of final accounts.
Accuracy of journal cannot be tested, but accuracy of ledger can be tested to a certain extent using
trial balance.
Journal has two columns for debit and credit, whereas a ledger has two sides of an account one for
debit and the other for credit.
Journals are not balanced at the end of a period, but accounts in the ledger are balanced at the end of
a specific period.
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ACCOUNTING CYCLE..
TRIAL BALANCE:
A statement containing the balances of all ledger accounts, as
at any given date, arranged in the form of debit and credit
columns placed side by side and prepared with the object of
checking the arithmetical accuracy of ledger postings.
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ACCOUNTING CYCLE..
IMPORTANCE OR SIGNIFICANCE OF TRIAL BALNCE:
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ACCOUNTING CYCLE..
LIMITATIONS OF TRIAL BALANCE:
Trial Balance only confirms that the total of all debit balances
match the total of all credit balances.
Trial balance totals may agree in spite of errors. An example
would be an incorrect debit entry being offset by an equal
credit entry.
Likewise, a trial balance gives no proof that certain
transactions have not been recorded at all because in such
case, both debit and credit sides of a transaction would be
omitted causing the trial balance totals to still agree.
Types of accounting errors and their effect on trial balance are
more fully discussed in the section on Suspense Accounts.
If avoucheris completed omitted to be entered in a day book
then it will not affect the total of the trial balance.
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Accounting conventions
Convention of full disclosure
All information should be revealed
Convention of consistency
Rules, practices and concepts should be used
Convention of materiality
Only required and important items in financial items.
Unimportant should ne left out or merged.
Convention of conservatism
Playing safe. To have accounting alternative for transactions.
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(Dr)
Credit: (Cr)
Benefit giving aspect
In Ledger, Trial balance and Profit & Loss account, the left
hand side is known as debit side and right side know as credit
side.
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NATURE OF ACCOUNT
PERSONAL ACCOUNT
EG: RAMU A/C, GANESH A/C, BANK A/C, RS & CO A/C ETC
REAL ACCOUNT
TANGIBLE ASSETS
EG: MACHINE, LAND, STOCK ETC
INTANGIBLE ASSETS
EG: GOODWILL, PATENTS ETC
NOMINAL ACCOUNT
EXPENSES
EG: SALARY A/C, RENT A/C
INCOME
EG: INTEREST RECEIVED
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NATURE OF
ACCOUNT
DEBIT (DR)
CREDIT (CR)
PERSONAL
A/C
THE
RECEIVER
THE GIVER
REAL A/C
WHAT
COMES IN
WHAT GOES
OUT
NOMINAL
A/C
EXPENSES
INCOME AND
AND LOSSES GAINS
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FINANCIAL STATEMENTS
PROFIT AND LOSS ACCOUNT
BALANCE SHEET
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Profit & loss account is prepared to ascertain the net profit or net loss of the company in an
accounting period
It is an account into which all gains and losses are collected in order to ascertain the excess of
gains over the losses or vice versa
The left side of the profit and loss account is the debit side (dr) where all the operating and
non operating expenses are mentioned.
The right side of the statement is called as credit side (Cr) where all the operating and non
operating income are mentioned
If income is more than the expenses, then company gets Net profit
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Sales
Interest, dividend received
Rent received
Commission, discount received etc
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Purchases
Wages
Salary, rent
Discount
Tax
Interest
Power
Electricity
Carriage inwards
Carriage outwards
Clearing charges
Packing charges
Dock dues
Coal, gas
Factory light
INCOME
Sales
Commission received
Rent received
Interest received
Dividend received
Discount received
Other income
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Dividend paid
Trade charges
Manufacturing expenses
Stationary
Insurance
Repair
Office expenses
Sundry expenses
Establishment expenses
Commission paid
Advertise expenses
Selling and distribution expenses
Audit expenses
Depreciation
Bad debts
Travelling expenses
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BALANCE SHEET
The balance sheet comprises of list of assets and
liabilities of the company on a given date
It presents the financial position of a concern.
It is called as statement of equality.
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LIABILITIES
CURRENT LIABILITIES
Creditors
Bills payable
Outstanding expenses
Tax payable
Dividend payable
Bank overdraft
LONG TERM LIABILITIES
EQUITY
Equity share capital
Preference share capital
Reserves & Surplus (Retained Earnings)
DEBT
Debentures
Bank loan
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ASSETS
CURRENT ASSETS
Cash in hand
Cash at bank
Debtors
Bills receivable
Stock
Prepaid expenses
Short term investments
FIXED ASSETS
Land & building
Plant & machinery
Furniture
Loose tools
Motor car
Long term investment
Goodwill
Patents & copyrights
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FIXED ASSETS
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FINANCIAL STATEMENT
Financial statements refer to formal and original
statements prepared by a business concern to disclose
its financial information
The two major financial statements are
Profit & loss account
Balance sheet
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Prospective investors use financial statements to perform financial analysis, which is a key component in making investment decisions.
A lending institution will examine the financial health of a person or organization and use the financial statement to decide whether or not to lend
funds.
Philanthropies may use financial statements of a non-profit as a component in determining where to donate funds.
Government entities (tax authorities) need financial statements to ascertain the propriety and accuracy of taxes and other duties declared and paid
by a company.
Vendors who extendcreditmay use financial statements to assess the creditworthiness of the business.
Managersrequire Financial Statements to manage the affairs of the company by assessing its financial performance and position and taking
important business decisions.
Shareholdersuse Financial Statements to assess the risk and return of their investment in the company and take investment decisions based on their
analysis.
Customersuse Financial Statements to assess whether a supplier has the resources to ensure the steady supply of goods in the future. This is
especially vital where a customer is dependant on a supplier for a specialized component.
Competitorscompare their performance with rival companies to learn and develop strategies to improve their competitiveness.
General Publicmay be interested in the effects of a company on the economy, environment and the local community.
Governmentsrequire Financial Statements to determine the correctness of tax declared in the tax returns. Government also keeps track of
economic progress through analysis of Financial Statements of businesses from different sectors of the economy.
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Simplicity:Financial statements should be simple so that concerned individuals can easily understand and interpret them properly. For this, the
statements must be simple and clear.
Right time:These must be prepared at the right time. Any delay in their presentation may decrease their usefulness.
Compliance with legal requirements:Financial statements must be prepared in the form and style as required by the Act. They must have subjectmatter as prescribed and must be presented as stated in the Act.
Adherence of accounting principles:The financial statements must be based on the Generally Accepted Accounting Principles (GAAP) so that they
may have universal acceptance.
Disclosure:The financial statements should disclose all the relevant and material facts. It should be transparent so that the users of accounting
information can draw neat conclusions.
Authentic:The information contained in the financial statements should be authentic supported by evidence.
Relevant to the purpose:Financial statements must be relevant to their purposes. Irrelevant and unnecessary informations should not be included
in these statements.
Complete and accurate informations:Financial statements should include the complete and accurate information about the progress of a business
and its future prospects. Informations should be based on facts. False and incomplete information results in wrong interpretation.
Comparability:Financial statements should be comparable. The comparison can be made between present and past as well as between one business
and the other. It increases the utility of the statements. This can be done when similar accounting principles are adopted for their presentation.
Facilitating the analysis:Decisions can be taken only by proper analysis of the financial statements. Thus, financial statements should be prepared
in such a way that it may facilitate the analysis. For this, the various items should be classified and grouped in a proper manner, so that data can be
obtained easily for analysis.
Systematic arrangement:The information contained in the financial statements should be arranged systematically so that they may be comparable.
Audited:The financial statements should have been presented to the uses after being audited by the competent chartered accountants.
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Based on traditions and conventions:Financial statements are prepared and based upon traditions and conventions which allow the usage of personal judgments.
Based on historical data:Financial statements are based on historical data while parties are more interested in knowing the present position and future prospects of
the business enterprise.
Scope of manipulations:Financial statements are sometimes prepared according to the needs of the situation or whims of the management. Management can
manipulate financial statements by under-valuation or over-valuation of inventory, under or over charging of depreciation etc.
Sometimes window dressing is resorted to in order to show better financial position of a concern than its real position. So financial statements are not free from bias.
Influenced by personal judgements:Financial statements are influenced by personal judgements of the account. On many issues more than one methods are
permitted. For example, method of depreciation, valuation of stock, valuation of goodwill etc. all depend upon the personal judgements of the policy-maker of the
enterprise.
Ignore qualitative aspects:Financial statements show only those facts which can be expressed in money terms. Qualitative aspects of the business units are omitted
from the books, because they cannot be expressed in money terms. Thus, cordial employer-employee relations, efficiency of management, firm?s ability to develop
new products, customer satisfaction, etc. have a vital role in the profitability of the firm, but here ignored and omitted because these are qualitative in nature.
Ignore inflationary effects:Changes in price level make data meaningless. Financial statements record transactions at historical costs. No account is taken of the
present value.
Ignore the interest of other parties:Financial statements are prepared with a view to take care of the interest of proprietors only and ignore the interests of all
other interested parties like creditors, investors, workers, stock exchanges, taxation authorities, economists, researchers, politicians, etc.
Financial statements are only interim reports:Financial statements are essentially interim reports. They cannot be final. The actual profit or loss of a business can
be determined only when the business is ultimately closed. The existence of contingent assets and liabilities, deferred revenue expenses make the statement less
accurate and more subjective.
Artificial view:Financial statements do not reveal a real and correct picture of the worth of assets and their loss of value. The reason is that they are shown on
historical cost. Thus, these statements provide artificial view. Market or replacement value and the effect of the changes in the price level are completely ignored.
Incapable:Financial statements are incapable of showing profitability, operational efficiency, financial soundness, etc. of the business.
These limitations of financial statements can be removed by efficient analysis and interpretation of the financial statements.
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TREND ANALYSIS
Trend analysis is the analysis of the trend of the financialratiosof the company over the
years. It is an important tool of horizontal analysis. Under this analysis, ratios of different
items of the financial statements for various periods are calculated and the comparison is
made accordingly. The analysis over the prior years indicates the trend or direction. Trend
analysis is a useful tool to know whether the financial health of a business entity is
improving in the course of time or it is deteriorating.
RATIO ANALYSIS
Ratio analysis is the analysis of the interrelationship between two financial figures. The
most popular way to analyze the financial statements is computing ratios. It is an
important and widely used tool of analysis of financial statements. While developing a
meaningful relationship between the individual items or group of items of balance sheets
and income statements, it highlights the key performance indicators, such as,liquidity,
solvency and profitabilityof a business entity. The tool of ratio analysis performs in a way
that it makes the process of comprehension of financial statements simpler, at the same
time, it reveals a lot about the changes in the financial condition of a business entity.
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UNIT 2
RATIO ANALYSIS
A ratio is a mathematical relationship between two items expressed in a
quantitative form.
An accounting ratio can be defined as quantitative relationship between two or
more items of the financial statements connected with each other.
It is a comparison of the numerator with the denominator.
Examples: Liquidity ratios, Profitability ratios, Turnover ratios, solvency ratios.
Analysis and interpretation of financial statements with the help of ratios is
termed as ratio analysis.
It involves the process of computing, determining and presenting the
relationship of items or groups of items of financial statements.
It is an age old technique of financial analysis.
There are three steps in ratio analysis (a) Selection of relevant information (b)
Comparison of calculated ratios (c ) Interpretation and reporting.
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CLASSIFICATION OF RATIOS
These ratios are used for the purpose of assessing profitability, activity or operating efficiency and financial position of a concern.
These ratios are classified as profitability ratios, Turnover ratios, Financial or solvency ratios
Profitability ratios include Return on investment, Net profit ratio, Gross profit ratio, Operating profit ratio etc
Turnover ratios include Stock turnover, Debtor turnover, Creditors turnover, Working capital turnover etc
Financial or solvency ratios include current ratio, liquid ratio, Proprietary ratio, Debt equity ratio etc.
Classification of ratios by importance
This classification is being adopted by the British Institute of Management. These ratios are classified as
Primary ratios Also known as Explanatory ratios which include Return on capital employed, Assets turnover, Profit ratios
Secondary performance ratios Working capital turnover, Stock to turnover, Current assets to fixed assets, Fixed assets to total assets etc
Secondary credit ratios include Creditor turnover, Debtor turnover, Liquid ratio, Current ratio etc
Growth ratios include growth rate in sales, growth rate in net assets.
Classification of ratios by users
Ratios are classified on the basis of parties who use the ratios.
The following are the ratios for management viz Operating ratios, Stock turnover ratio, Debtor turnover ratio, Fixed assets turnover ratios,
Creditor turnover ratio, Net profit ratio, Gross profit ratio etc
Ratios for Creditors are Fixed charges cover, Debt service cover, Liquid ratio, Current ratio, Debt equity ratio, Capital gearing ratio, Solvency
ratio etc
Ratios for shareholders are Return on shareholders fund, Payout ratio, Dividend yield ratio, Capital gearing ratio etc.
Classification of ratios by statements
Accounting information is obtained mostly from profit & loss account and balance sheet.
Balance sheet ratios Liquidity ratio, Current ratio, Absolute liquidity ratio, Proprietary ratio, fixed assets ratio, Debt equity ratio etc.
Profit & loss account ratios Gross profit ratio, Net profit ratio, Operating profit ratio, Expense ratio etc
Mixed or composite ratios Return on investment, Return on Net worth, Stock turnover, Debtor turnover, Creditor turnover etc.
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Important ratios
1.Debt-to-Equity Ratio
The debt-to-equity ratio, is a quantification of a firms financial leverage estimated by dividing the total liabilities by stockholders
equity. This ratio indicates the proportion of equity and debt used by the company to finance its assets.
The formula used to compute this ratio is
Total Liabilities / Shareholders Equity
2.Current Ratio
The current ratio is a liquidity ratio which estimates the ability of a company to pay back short-term obligations. This ratio is also
known as cash asset ratio, cash ratio, and liquidity ratio. A higher current ratio indicates the higher capability of a company to pay
back its debts. The formula used for computing current ratio is:
Current Assets / Current Liabilities
3.Quick Ratio
The quick ratio, also referred as the acid test ratio or the quick assets ratio, this ratio is a gauge of the short term liquidity of a
firm. The quick ratio is helpful in measuring a companys short term debts with its most liquid assets.
The formula used for computing quick ratio is:
(Current Assets Inventories)/ Current Liabilities
A higher quick ratio indicates the better position of a company.
4.Return on Equity (ROE)
The return on equity is the amount of net income returned as a percentage of shareholders equity. Moreover, the return on equity
estimates the profitability of a corporation by revealing the amount of profit generated by a company with the money invested by the
shareholders. Also, the return on equity ratio is expressed as a percentage and is computed as:
Net Income/Shareholder's Equity
The return on equity ratio is also referred as return on net worth (RONW).
5.Net Profit Margin
The net profit margin is a number which indicates the efficiency of a company at its cost control. A higher net profit margin shows
more efficiency of the company at converting its revenue into actual profit. This ratio is a good way of making comparisons between
companies in the same industry, for such companies are often subject to similar business conditions.
The formula for computing the Net Profit Margin is:
Net Profit / Net Sales
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Important ratios...
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CURRENT RATIO
Theratioofcurrentassetstocurrentliabilitiesiscalledascurrentratio.
Itisusedtomeasuretheshorttermliquidityorsolvencyofacompany.
Itindicatestheabilityofaconcerntomeetitscurrentobligationasandwhentheyaredueforpayment.
Currentratio=Currentasset/Currentliabilities
CurrentassetsincludeDebtors,Billsreceivable,Stock,Cashinhandandatbanketc
CurrentliabilitiesincludesCreditors,Bankoverdraft,billspayable,Outstandingexpensesetc
Thestandardcurrentratiois2:1
Limitation of current ratio:
Differentratioindifferentpartoftheyear
Changeininventoryvaluationmethod
Currentratioisthetestofquantityandnotquality
Possibilityofmanipulation
Significance and interpretation
Currentratioisausefultestoftheshort-term-debtpayingabilityofanybusiness.Aratioof2:1orhigherisconsidered
satisfactoryformostofthecompaniesbutanalystshouldbeverycarefulwhileinterpretingit.Simplycomputingthe
ratiodoesnotdisclosethetrueliquidityofthebusinessbecauseahighcurrentratiomaynotalwaysbeagreensignal.It
requiresadeepanalysisofthenatureofindividualcurrentassetsandcurrentliabilities.Acompanywithhighcurrent
ratio may not always be able to pay its current liabilities as they become due if a large portion of its current assets
consistsofslowmovingorobsoleteinventories.Ontheotherhand,acompanywithlowcurrentratiomaybeableto
payitscurrentobligationsastheybecomedueifalargeportionofitscurrentassetsconsistsofhighlyliquidassetsi.e.,
cash,bankbalance,marketablesecuritiesandfastmovinginventories.Considerthefollowingexampletounderstand
howthecompositionandnatureofindividualcurrentassetscandifferentiatetheliquiditypositionoftwocompanies
havingsamecurrentratiofigure.
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QUICK RATIO
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This ratio is called as Stock velocity ratio (or) Stock turnover ratio.
It is calculated to ascertain the efficiency of inventory management
It shows the relationship between cost of goods sold and average inventory
It helps to evaluate and review inventory policy
Inventory turnover ratio = Cost of goods sold / Average inventory
Cost of goods sold = Sales Gross profit
Average inventory = (Opening stock + Closing stock) / 2.
Significance and Interpretation:
Inventory turnover ratio vary significantly among industries. A high ratio indicates fast moving inventories
and a low ratio, on the other hand, indicates slow moving or obsolete inventories in stock. A low ratio
may also be the result of maintaining excessive inventories needlessly. Maintaining excessive inventories
unnecessarily indicates poor inventory management because it involves tiding up funds that could be
used in other business operations.
Users must also observe various factors that can effect inventory turnover ratio (ITR) before interpreting
or making any decision. For example, companies using FIFO cost flow assumption may have a higher ITR
in the days of inflation because latest inventory purchased at higher prices remain in the stock under
FIFO. On the other hand, companies using LIFO cost flow assumption may have comparatively lower ITR
than others because oldest inventory purchased at comparatively lower prices remain in the stock under
LIFO.
Another factor that could influence this ratio is the use of just-in-time inventory method. Companies
using just in time system of inventory management usually have high inventory turnover ratio as
compared to others in the industry.
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Current assets
A current asset is an item on an entity's balance sheet that is either cash, a cash equivalent, or which can be converted into cash within one year.
Examples of current assets are:
Cash in hand and cash at bank - These assets are literally money in the bank: cold, hard cash
Short term Investments - These represent the next step above cash and equivalents. They normally come into play when a
company has so much cash on hand that it can afford to tie some of it up in bonds lasting less than one year. This money can't
immediately be liquefied without some effort, but it does earn a higher return than plain old cash. Cash and investments give
shares immediate value, and while they're not entirely easy to liquidate, in a pinch they can be distributed to shareholders with
minimal effort.
Prepaid expenses - The company has already paid these expenses to its suppliers. They can be a lump sum paid to an
advertising agency, or a credit for some bad merchandise issued by a supplier. Although these expenditures aren't technically
liquid, since the company does not actually have the money in question in the bank, having bills already paid is a definite plus.
It means that those bills won't have to be paid in the future, allowing more of the revenue for that particular quarter to flow to
the bottom line and become liquid assets.
Accounts receivableor Bills receivable - Normally abbreviated as A/R, these are funds that customers currently owe to a
company. They've received the company's products, but haven't yet paid for those goods or services. Companies routinely buy
goods and services from other companies on credit. Although A/R is almost always turned into cash within a short amount of
time, some customers aren't so diligent. In rare cases, companies have to write off bad accounts receivable if they've shipped
goods or provided services to a customer unwilling or unable to pay.
Inventory or Stock - These are the components and finished products that a company has currently stockpiled to sell to
customers. Not all companies have inventories, particularly if they are involved in advertising, consulting, services, or
information industries. For companies that do sell physical goods, however, inventories are extremely important.
Debtors
These items are typically presented in the balance sheet in their order of liquidity, which means that the most liquid items are shown first. The
preceding example shows current assets in their order of liquidity.
Creditors are interested in the proportion of current assets to current liabilities, since it indicates the short-term liquidity of an entity. In essence,
having substantially more current assets than liabilities indicates that a business should be able to meet its short-term obligations
The main problem with relying upon current assets as a measure of liquidity is that some of the accounts within this classification are not so liquid.
In particular, it may be difficult to readily convert inventory into cash. Similarly, there may be some extremely overdue invoices within the accounts
receivable number, though there should be an offsetting amount in the allowance for doubtful accounts to represent the amount that is not
expected to be collected. Thus, the contents of current assets should be closely examined to ascertain the true liquidity of a business.
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Current liabilities
Current liabilities are what a company currently owes to its suppliers and creditors. These are short-term debts, all due in less
than a year. Paying them off normally requires the company to convert some of its current assets into cash.
The important current liabilities are
Creditors - A creditor may be a bank, supplier or person that has provided credit to a company. In other words, a company
owes money to its creditors. The amounts owed to creditors are reported on the company'sbalance sheetasliabilities.
If a creditor required the company to sign a promissory note for the amount owed, the company will record and report
the amount as Notes Payable. If a creditor is a vendor or supplier that did not require the company to sign a promissory
note, the company will likely report the amounts owed asAccounts Payable. Other examples of creditors include
company's employees (who are owed wages and bonuses), governments (who are owed taxes), and customers (who made
deposits or other prepayments).
Some creditors are known as secured creditors because they have a lien or other legal claim to the company's(debtor's)
assets. Other creditors are often unsecured creditors since they do not have a lien or legal right to specific assets of the
company.
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Bills or Accounts payable - This is the money the company currently owes to its suppliers, partners, and employees -- the
basic costs of business that the company hasn't yet paid, for whatever reason. One company's accounts payable is another
company's accounts receivable, which is why both terms are similarly structured. A company has the power to push back
the due dates on some of its accounts payable. Paying those debts later than expected can often produce a short-term
increase in earnings and current assets.
Bank overdraft - n extension of credit from a lending institution when an account reaches zero. An overdraft allows the
individual to continue withdrawing money even if the account has no funds in it. Basically the bank allows people to
borrow a set amount of money.
Outstanding expenses - Outstanding expenses are those expenses which have been incurred andconsumed during an
accounting period and are due to be paid,but are not paid. Examples include outstanding salary, outstanding rent, etc.
Outstanding expenses are recorded in the books at the end of an accounting period to show true numbers of a business.
Provision for doubtful debts
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Balance sheet
It shows the position of assets and liabilities on a specific date.
It shows the real and personal accounts of a business, reflected in the assets and liabilities.
It aims at depicting the financial position of a business
It is the culmination of the accounting process of a period. It is meant for general purpose and
usage of various stakeholders.
It is based on the trial balance and additional information relating to a firm
It is prepared after the income statement is completed.
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(A funds flow statement cannot present a continuous change of financial activities including the
changes of working capital.
Since it is based on financial statement (i.e. Income Statement and Balance Sheet), it is not a
original statement.
A projected Funds Flow Statement does not always present very accurate estimates about the
financial position since it is a historic one.
It is not a substitute of financial statements, i.e. Income Statement and Balance Sheet. It
simply supplies information about the change of Working Capital position which, again, depends
on the data presented by the financial statements.
Cash Flow Statement, i.e. changes in cash position, is more important or more informative than
the changes in working capital which is presented by a Funds Flow Statement.
It is historical in nature. It shows what happened in the past. So, necessarily, its value is limited
from the point of view of future operations.
It is nothing but second data. The information in financial accounts is rearranged and
presented. So, its accuracy and reliability depend on the accounting department.
It is a summarised presentation of figures and cannot provide information about changes on a
continuous basis.
The effect of transactions between current assets and liabilities is not shown in the statement
It also ignores transactions between long term and liabilities.
It is not generally considered as a sophisticated technique of financial analysis.
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Fixed costs it is the total of all those costs termed as Period costs or
Time costs. They do not depend on the volume of production and sales.
Eg: Office rent, Managers salary etc
Variable costs these costs which increase or decrease in proportion to
the output and sales. It is also known as Product costs or Marginal costs.
They vary in direct proportion to the output. They include all direct costs.
Contribution it is the difference between sales and marginal costs. It is
the contribution towards fixed cost and profit. It is used to find the
profitability of products, processes, departments and divisions.
Profit Volume ratio (P/V ratio) this is the ratio of contribution to sales. It
is an important ratio analysing the relationship between sales and
contribution. High P/V ratio indicates high profitability and low value
means low profitability. It helps to compare profitability of various
products.
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P/V ratio
This is the ratio of contribution to sales. It is an important ratio analysing the relationship
between sales and contribution. High P/V ratio indicates high profitability and low value means
low profitability. It helps to compare profitability of various products.
Every organization should try to increase P/V ratio. It can be increased by
Decreasing the variable costs by effectively utilising materials, machines and men
Selecting most profitable product mix for production and sales
Increasing the selling price per unit
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CVP relationship can be analysed thoroughly which is useful for the management in decision making
Profitability of various levels of activity, products divisions and departments can be analysed through break even analysis
Total profits can be determined by aggregating the contribution of different products or divisions and reducing the fixed
cost from the total.
Limitations:
Clear classification of costs into fixed and variable costs not possible
Significance of opening and closing stock is ignored by valuing them at marginal costs
Different product and sales mixes cannot be studies since only one sales mix is analysed usually
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Formulae
1.
2.
3.
4.
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8. Contribution per unit = Selling price per unit Variable cost per unit
P/V Ratio
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Marginal costing
Definition:
The ascertainment of marginal costs and of the effect on profit of changes in volume or type of output by differentiating
between fixed costs and variable costs.
Advantages of Marginal costing
Automation investments:Marginal costing is useful to determine how much a firm stands to gain or lose by automating some
function. The key costs to take into consideration are the incremental labor cost of any employees who will be terminated versus the
new costs incurred from equipment purchase and subsequent maintenance.
Cost reporting:Marginal costing is very useful for controlling variable costs, because you can create a variance analysis report that
compares the actual variable cost to what the variable cost per unit should have been.
Customer profitability:Marginal costing can help determine which customers are worth keeping and which are worth eliminating.
Internal inventory reporting: Since a firm must include indirect costs in its inventory in external reports, and these can take a long
time to complete, marginal costing is useful for internal inventory reporting.
Profit-volume relationship:Marginal costing is useful for plotting changes in profit levels as sales volumes change. It is relatively
simple to create a marginal costing table that points out the volume levels at which additional marginal costs will be incurred, so that
management can estimate the amount of profit at different levels of corporate activity.
Outsourcing:Marginal costing is useful for deciding whether to manufacture an item in-house or maintain a capability in-house, or
whether to outsource it.
Cost control:Marginal costing makes it easier to determine and control costs of production. By avoiding the arbitrary allocation of
fixed overhead costs, management can concentrate on achieving and maintaining a uniform and consistent marginal cost.
Simplicity:Marginal costing is simple to understand and operate and it can be combined with other forms of costing (e.g. budgetary
costing and standard costing) without much difficulty.
Elimination of cost variance per unit:Since fixed overheads are not charged to the cost of production in marginal costing, units have
a standard cost.
Short-term profit planning:Marginal costing can help in short-term profit planning and is easily demonstrated with break-even charts
and profit graphs. Comparative profitability can be easily assessed and brought to the notice of the management for decision-making.
Accurate overhead recovery rate:This method of costing eliminates large balances left in overhead control accounts, which makes it
easier to ascertain an accurate overhead recovery rate.
Maximum return to the business:With marginal costing, the effects of alternative sales or production policies are more readily
appreciated and assessed, ensuring that the decisions taken will yield the maximum return to the business.
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Classifying costs:It is very difficult to separate all costs into fixed and variable costs clearly, since all
costs are variable in the long run. Hence such classification sometimes may give misleading results.
Furthermore, in a firm with many different kinds of products, marginal costing can prove less useful.
Accurately representing profits:Since the closing stock consists only of variable costs and ignores fixed
costs (which could be considerable), this gives a distorted picture of profits to shareholders.
Semi-variable costs:Semi-variable costs are either excluded or incorrectly analyzed, leading to
distortions.
Recovery of overheads:With marginal costing, there is often the problem of under or over-recovery of
overheads, since variable costs are apportioned on an estimated basis and not on actual value.
External reporting:Marginal costingcannotbe used in external reports, which must have a complete
view of all indirect and overhead costs.
Increasing costs:Since it is based on historical data, marginal costing can give an inaccurate picture in
the presence of increasing costs or increasing production.
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SOLE PROPRIETORSHIP
PARTNERSHIP COMPANY
PRIVATE LIMITED COMPANY
PUBLIC LIMITED COMPANY
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BALANCE SHEET
LIABILITIES
CURRENT LIABILITIES
Creditors
Bills payable
Outstanding expenses
Tax payable
Dividend payable
Bank overdraft
LONG TERM LIABILITIES
EQUITY
Equity share capital
Preference share capital
Reserves & Surplus (Retained Earnings)
DEBT
Debentures
Bank loan
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ASSETS
CURRENT ASSETS
Cash in hand
Cash at bank
Debtors
Bills receivable
Stock
Prepaid expenses
Short term investments
FIXED ASSETS
Land & building
Plant & machinery
Furniture
Loose tools
Motor car
Long term investment
Goodwill
Patents & copyrights
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FINANCE
Finance Definition:
Finance is the process of conversion of accumulated funds to productive
use
Finance may be defined as the administrative area or set of
administrative functions in an organization which relate with the
arrangement of cash and credit so that the organization may have the
means to carry out its objectives as satisfactorily as possible.
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FINANCIAL MANAGEMENT
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PROFIT MAXIMISATION
MAXIMISING PROFIT AFTER TAXES
MAXIMISING EPS
SHAREHOLDER WEALTH MAXIMISATION(SWM)
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FUND RAISING
FUND ALLOCATION
PROFIT PLANNING
UNDERSTANDING CAPITAL MARKETS
ROUTINE FUNCTIONS
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AGENCY PROBLEM
(OR)
Agency conflicts are direct outcome of the multiplicity of stake holders in a firm and their
resolutions lies in the convergence of the interests of varied stakeholders. Analyze.
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OR
HOW FINANCE DEPARTMENT IS ORGANISED
OR
ORGANISATION CHART OF FINANCE FUNCTION
FUNCTIONS OF TREASURER
FUNCTIONS OF CONTROLLER
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BOARD OF
DIRECTORS
MD
P - MANAGER
TREASURER
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HR MANAGER
F - MANAGER
CONTROLLER
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M -MANAGER
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TREASURER
Under him auditing, credit management,
retirement benefits, cost control etc
He takes care of the liability side of the balance
sheet
CONTROLLER
Under him planning & budgeting, inventory
management, performance evaluation,
accounting etc.
He takes care of the asset side of the balance
sheet.
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RELATIONSHIP BETWEEN RISK AND RETURN AND FINANCIAL DECISIONS
FINANCIAL DECISIONS
INVESTMENT
DECISIONS
FINANCING
DECISIONS
DIVIDEND
DECISIONS
LIQUIDITY
DECISIONS
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While taking all these financial decisions, the finance manager should
maintain a balance between risk and return and these decisions should
increase the shareholders wealth by maximizing the market value of
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FV(r,n) = PV
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(1+r)n 1
r
= PV X CVFA (r,n)
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PV(r,n) = FV(r,n)
(1 + r)n
= FV x PVF (r,n)
FOR ANNUITY
PV (r,n)
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= FV x PVFA (r,n)
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OWNERS OF RESIDUE
Equity shareholders or Ordinary shareholders are called
as owners of residue. Equity shareholders being the
owners of the company, bear the risk of ownership.
Equity shareholders will be given dividend only after
satisfying the claims of others. Even when the company
wound up, ordinary shareholders can claim on assets of
the firm at last only. So, they are called as owners of
residue.
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Equity share
Ordinary share is otherwise called as Equity share. A
person purchasing a equity share is called as equity
shareholder. Equity shareholders do not receive fixed
percentage of dividend, so equity share is called as
variable income security. Equity shareholders receive
only the residual income so they are called as Owners
of residue. Equity shareholders have voting rights.
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Preference share
Preference share: It is called as a hybrid security
because it has both the features of equity shares and
debentures. The dividend rate is fixed for preference
share. It has no voting rights. It can be redeemable or
irredeemable preference share.
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Debenture
Debenture is a long term promissory note for raising
loan capital. If the investors purchase debenture then
they are called as debenture holders and they receive
fixed percentage of interest from the company.
Debenture holders are the creditors of the company. It
may be Non convertible debenture (NCD), Partly
convertible debenture (PCD) and Fully convertible
debenture(FCD)
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Claim on income
Claim on assets
Right to control
Voting rights
Pre emptive rights
Limited liability
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Longterm,fixedincomefinancialsecurity.
Debentureholdersarethecreditorsofthefirm.
Theparvalueofadebentureisthefacevalueappearingonthedebenture
certificate
Interestrateisfixed
Debentureshavedefinitematuritydate
Redemption
Sinkingfund
Buybackprovision
Indentureordebenturetrustdeed
Security
Yield
Claimonassetsandincome
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WORKING CAPITAL
THE CAPITAL WHICH IS REQUIRED FOR DAY TO DAY
BUSINESS OPERATIONS
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CASH
CUSTOMERS (Debtors)
RAW MATERIALS
FINISHED GOODS
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NATURE OF BUSINESS
MARKET AND DEMAND CONDITIONS
TECHNOLOGY AND MANUFACTURING POLICY
CREDIT POLICY
AVAILABILITY OF CREDIT FROM SUPPLIERS
OPERATING EFFICIENCY
PRICE LEVEL CHANGES
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INVENTORY MANAGEMENT
INVENTORY (OR) STOCK
RAW MATERIAL
WORK IN PROCESS
FINISHED GOODS
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INVENTORY MANAGEMENT
OBJECTIVES OF INVENTORY MANAGEMENT
TO MAINTAIN A LARGE SIZE OF INVENTORIES OF RAW
MATERIALS AND WORK IN PROCESS FOR EFFICIENT
AND SMOOTH PRODUCTION OF FINISHED GOODS FOR
UNINTERRUPTED SALES OPERATIONS
TO MAINTAIN A MINIMUM INVESTMENT IN INVENTORIES
TO MAXIMISE PROFITABILITY
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Carrying cost
Costs incurred for maintaining a given level of inventory are called as
carrying costs.
It includes storage, insurance, taxes, detorioration, and obsolescence
costs.
The storage costs includes cost of storage space (warehousing cost),
stores handling costs, clerical and staff service costs incurred in
recording and providing special facilities such as fencing, lines, racks
etc.
Carrying cost vary with inventory size.
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REORDER POINT
Reorder time is the inventory level at which an order to
be placed to replenish the inventory.
To determine the Reorder point Lead time, average
usage and EOQ is needed.
Reorder point = Lead time X Average usage.
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SAFETY STOCK
Normally reorder point is computed under the assumption
of certainty.
It is difficult to predict the annual usage and lead time
accurately
The demand may vary as well as the lead time may also
vary.
If the demand increases and delivery delayed then the firm
face the problem of stock out which is costly for the firm.
In order to guard against stock out, the firm should
maintain safety stock.
Reorder point = Lead time X average usage + safety stock
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TRADE CREDIT
Trade credit happens when the firm sells its products or
services on credit and does not receive the cash
immediately.
Trade credit creates bills receivable and debtors
Debtor forms a substantial portion in current asset.
Advantages:
Easy availability
Flexibility
Informality
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COMMERCIAL PAPER
Commercial Paper (CP) is an important money market instrument.
It is issued in a form of unsecured promissory note to raise short term
funds by the firms.
The cost of commercial paper include discount, rating charges, stamp
charges and issuing and paying agent charges.
Merits
It is an alternate source of raising short term finance
It is the cheaper source of finance in comparison to bank credit
From an investors point of view, it provides an opportunity to make a safe, short
term investment of surplus funds
Demerits
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Trade credit
Open account
Notes payable
Trade acceptance
Accrued expenses
Deferred income
Bank finance
Overdraft
Cash credit
Bills discounting
Factoring
The sale of bills receivable to a company that is specialized in buying
receivables to acquire short term financing is called as factoring. The types of
factoring are (a) Full service non-recourse (b) Full service recourse factoring
(c) Bulk / agency factoring (d) Non-notification factoring.
Vels University
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Vels University
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CASH MANGEMENT
Cash is an important current asset for the operations of
the business.
Facets of cash management
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Cash planning
Managing the cash flows
Optimum cash levels
Investing surplus cash
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CASH MANAGEMENT
MOTIVES OF HOLDING CASH
The transaction motive
The precautionary motive
The speculative motive
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Decentralized collection
Lock box system
Concentration banking
Delaying payments
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CASH MANAGEMENT
MODELS IN CASH MANAGEMENT (OR) CASH MAANGEMENT
MODELS
BAUMOLS MODEL
THE MILLER ORR MODEL
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CASH MANAGEMENT
BAUMOLS MODEL
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CASH MANAGEMENT
BAUMOLS MODEL
Holding cost can be calculated using k(C/2)
Transaction cost can be calculated using c(T/C)
The total annual cost of the demand for cash will Total cost =
k(C/2) + c(T/C)
The optimum cash balance C* = 2cT/k
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CASH MANAGEMENT
THE MILLER ORR MODEL
The limitation of the Baumol model is that it does not allow
the cash flows to fluctuate.
Firms do not use their cash flows uniformly and not able to
predict daily cash inflows and outflows
The Miller Orr model overcomes this and allows for daily cash
flow variation
It assumes that net cash flows are normally distributed with
zero value of mean and a standard deviation.
The Miller Orr model provides two control limits.
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CASH MANAGEMENT
THE MILLER ORR MODEL
The upper control limit and the lower control limit as well as a
return point.
If the firms cash flows fluctuate randomly and hit the upper
limit, then it buys sufficient marketable securities to come
back to a normal level of cash balance (the return point).
If the firms cash balance hit the lower limit, then it sells the
sufficient marketable securities to bring the cash balance to
the normal level (the return point)
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CASH MANAGEMENT
THE MILLER ORR MODEL
The firm sets the lower control limit as per the requirement of
maintaining minimum cash balance.
The difference between upper control limit and lower control
limit depends on the following viz the transaction cost (c ),
the interest rate (i) and the standard deviation of net cash
flows (sigma)
The formula to calculate the distance between upper and
lower control limit (Z) is
Z = (3/4 X Transaction cost X Cash flow variance / Interest per
day)1/3
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CASH MANAGEMENT
THE MILLER ORR MODEL
The upper control limit is three times above the lower control
limit and the return point lies between the upper and lower
control limits.
Upper limit = Lower limit +3Z
Return point = Lower limit + Z
Average cash balance = Lower limit + 4/3Z
The Miller Orr model is realistic and allows variation in cash
balance with upper and lower limit.
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Factoring
Credit management is a specialized activity.
A company can assign its credit management and
collection to specialist organizations called factoring
organizations.
Factoring is a popular mechanism of managing,
financing and collecting receivables in developed
countries like USA and UK.
Factoring is a unique financial innovation.
It is defined as a contract between the suppliers of
goods and services and the factor.
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Factoring..
The factor provides the following three basic services
to clients
Sales ledger administration and credit management
Credit collection and protection against default bad debt losses
Financial accommodation against the assigned book debts.
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Factoring..
Costs of factoring
The factoring commission or service fee
Interest on advance granted by the factor to the firm
Benefits of factoring
Helps the firms management to concentrate on manufacturing
and marketing
Helps the firm to save cost of credit administration due to the
scale of economics and specialization.
Types of factoring
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COST OF DEBT
(a) Irredeemable debt (without maturity period)
Before tax
INT
Kd =
Bo
After tax
= Kd (1 T)
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COST OF DEBT
COST OF PREFERENCE SHARE (OR) PREFERRED CAPITAL
COST OF EQUITY SHARE (OR) EQUITY CAPITAL
COST OF RETAINED EARNINGS
WEIGHTED AVERAGE COST OF CAPITAL (WACC) (OR)
OVERALL COST OF CAPITAL (OR) COMPOSITE COST OF
CAPITAL
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COST OF DEBT
A company can raise debt by borrowing funds from
financial institutions or from public either in the form
of public deposits or debentures.
These are borrowed for specific period of time at a
certain rate of interest.
A debenture or bond may be issued at par or at discount
or at premium.
Interest should be calculated on the par value or face
value of bond or debenture.
Debt may be redeemable and irredeemable.
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COST OF DEBT
Redeemable debt (with maturity period)
Before tax
(Bn + Bo) / 2
After tax
= Kd (1 T)
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COST OF DEBT
Where,
INT = Annual interest
Bo = Issue price (or) Net value (or) Present value
(or) current value of bond or debenture
Kd = cost of debt
N = No. of years
Bn = Par value (or) maturity value (or) face value
T = tax rate
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Kp =
Vels University
Po
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Kp =
Vels University
(Pn + Po) / 2
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Where,
PDIV = Preference dividend
Po = Issue price (or) Net value (or) Present value
(or) current value of Preference share
Kp = cost of preference share
n = No. of years
Pn = Par value (or) maturity value (or) face value
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Div1
Ke =
+ g
Po
2. Ke =
Vels University
EPS1
Po
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g = ROE X b
DIV1 = EPS1 X Dividend ratio
Dividend ratio = 1 retention ratio
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Where,
Ke = cost of equity
Div1 = Dividend
Po = Present value or current value of equity
share
g = growth rate
EPS1 = Earnings per share
ROE = Return on equity
b = retention ratio
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BIM
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Vels University
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Vels University
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BIM
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Vels University
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Definition:
The firms decision to invest their current funds in long
term assets in anticipation of future benefits over a series
of years.
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Unrelated diversification
A firm may expand its activities in a new business apart from the
existing products. Eg. A packaging company starting a ball bearings
manufacturing company.
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Contingent investments
They are dependent projects.
The investment in one leads to investment in other investment.
Eg. If a company decides to build a factory in a remote, backward
area, then it may have to invest in houses, roads, hospitals, schools
etc for its employees.
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Acceptance rule:
The project with shortest payback can be selected
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Simplicity
cost effective
Short term effects
Risk shield
liquidity
Disadvantages
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Initial investment / 2
Acceptance rule:
In two projects, project with highest ARR is selected
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Disadvantages of ARR:
Cash flows ignored
Time value ignored
Arbitrary cut-off
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Disadvantages of NPV:
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PV of cash outflows
Acceptance rule:
If PI > 1 = accept the project
If PI = 1 = may or maynot accept the project
If PI < 1 = reject the project
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Disadvantages of PI
Difficult to estimate cash flow
Difficult to measure discount rate
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Disadvantages of IRR:
Multiple rates
Mutually exclusive projects
Value additivity
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CAPITAL RATIONING
It is the ability of the firm to accept more profitable
projects depending on the investment amount
available.
In this the firm chooses profitable investments by
ranking the projects using NPV and IRR.
Projects above the cutoff point will be funded while
projects below the cutoff points will be rejected.
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CAPITAL RATIONING
Cut off point is determined based on number of projects,
objectives of the firm, availability of finance etc.
Capital rationing may arise due to external factors or internal
constraints imposed by the management.
There are 2 types of capital rationing.
External capital rationing
It mainly occurs on account of the imperfections in the capital
markets.
Imperfections may be caused by deficiencies in market information.
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Cashflowisasimpleandobjectivelydefinedconcept.
Itissimplythedifferencebetweenrupeesreceivedandrupeespaidout
Cashflowisnotthesameasprofits.
Profit,asmeasuredbyanaccountant,isbasedonaccrualconcept.
CashflowCashinflowisrecognizedwhenitisearned,ratherthancashis
received.Cashoutflowisrecognizedwhenitisincurredratherthanwhencashis
paid.
Profitsincludescashrevenuesandreceivablesandexcludescashexpensesand
payables.
Profit=RevenuesExpensesDepreciation
Cashflow=RevenuesExpensesCapitalexpenditure.
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SCRAP VALUE:
scrap value is defined as the expected or estimated
value of the asset at the end of its useful life. Scrap
value is also referred to as an assets salvage value or
residual value
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Vels University
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Capital structure
Capital structure
The mix of debt and equity capital structure
Optimum capital structure
Optimum capital structure is the one in which
the weighted average cost of capital is
minimum that maximizes the market value of
ordinary share and value of the firm.
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Or
If financial leverage decreases, weighted average cost of
capital increases and total value of the firm & market value
of ordinary share decreases.
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Assumptions of NI approach:
There are no taxes
Cost of debt is less than cost of equity
The use of debt does not change the risk
perception of the investors
Operating profit (EBIT) is constant
If no debt, financial leverage is zero, so overall
cost of capital is equal to equity capitalisation
rate or cost of equity.
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NI approach
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NOI approach
To calculate total value of the firm and equity
capitalization rate:
Net operating income (EBIT)
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MM APPROACH
This is an irrelevant theory of capital structure
Assumptions of MM approach:
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MM approach
Criticism of MM approach
It is suitable only if the market is perfect
Firms are liable to pay taxes on their income
Bankruptcy cost can be quite high
Agency costs may arise because of the conflict managers and
shareholders and between shareholders and creditors.
Managers seem to have a preference for a certain sequence of
financing
Informational asymmetry exists because managers are better
than investors.
Personal leverage and corporate leverage are not perfect
substitutes.
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MM approach
Value of Unlevered firm:
PBT ( 1 t )
Vu =
Ke
Value of Levered firm:
VL = Vu + Dt
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MM approach
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Where,
Vu = Value of unlevered firm
PBT = Profit before tax
t = tax rate
Ke = Equity capitalisaztion rate or cost of equity
VL = Value of levered firm
D = value of debt
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MM APPROACH
Proposition I
The value of a firm is equal to its expected operating income
divided by the discount rate appropriate to its risk class. It is
independent of its capital structure
Proposition II
An increase in financial leverage increases the expected
earnings per share but not the share price.
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CAPITAL MIX
MATURITY AND PRIORITY
TERMS AND CONDITIONS
CURRENCY
FINANCIAL INNOVATIONS
FINANCIAL MARKET SEGMENTS
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Sales
(-) Variable cost
Contribution
(-) Fixed cost
EBIT (or) OP (Earnings before interest & tax or
Operating profit)
(-) Interest
PBT (Profit before tax)
(-) Tax
PAT (Profit after tax)
(-) Preference dividend
Net profit
EPS = PAT (or) Net profit / No. of equity shares
ROE = PAT (or) Net profit / Value of equity Shares
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Assets
Growth opportunities
Debt and non debt tax shields
Financial flexibility and operating strategy
Loan covenants
Financial slack
Sustainability and feasibility
Control
Marketability and timing
Issue costs
Capacity of raising funds
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LEVERAGE
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Leverage types
Operating leverage
Financial leverage
Combined leverage or composite leverage
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Operating leverage
Operating leverage =
Contribution
EBIT (or) Operating profit
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Operating leverage
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Financial leverage
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Financial leverage
The use of fixed charges sources of funds such as debt
and preference capital along with owners equity in the
capital structure is called as financial leverage
It is also called as Gearing or trading on equity
If only equity used unlevered firm
If debt and equity used levered firm
Financial leverage =
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Sales
(-) Variable cost
Contribution
(-) Fixed cost
EBIT (or) OP (Earnings before interest & tax or Operating profit)
(-) Interest
PBT (Profit before tax)
(-) Tax
PAT (Profit after tax)
(-) Preference dividend
Net profit
EPS = PAT (or) Net profit / No. of equity shares
ROE = PAT (or) Net profit / Value of equity Shares
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Indifference point
Otherwise called as EBIT EPS break even point
It is the point at which EPS is same regardless of the
level of financial leverage
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DIVIDEND DECISIONS
DIVIDEND
The return given to shareholders on purchase of share is called
as dividend
RETENTION RATIO
The percentage of earnings retained by the company is called
as retention ratio
CAPITAL GAIN
The gain the shareholders receive while selling the shares is
called as capital gain
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DIVIDEND DECISIONS:
It is the decision taken by the company to determine
the amount of earnings to be given as dividend and
the amount of earnings to be retained by the
company.
Optimum payout ratio:
It is the best payout ratio that the company can give to the
shareholders which should try to maximise the value of the
shareholders
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THEORIES OF DIVIDEND
1.RELEVANT THEORY
WALTER MODEL
GORDON MODEL
According to walter and gordon, the dividend
decision affects the market price of the share. So
the both the theories are called as relevant theory
2.IRRELEVANT THEORY
MM HYPOTHESIS
According to MM, the dividend decision does not
affect the market price, so it is called as irrelevant
theory
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BIM
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School of Management
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Vels University
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BIM
Executive
Placement 2003
School of Management
Studies Striving towards Excellence
Vels University
www.velsuniv.org
BIM
Executive
Placement 2003
School of Management
Studies Striving towards Excellence
Vels University
www.velsuniv.org
BIM
Executive
Placement 2003
School of Management
Studies Striving towards Excellence
Vels University
www.velsuniv.org
BIM
Executive
Placement 2003
School of Management
Studies Striving towards Excellence
Vels University
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BIM
Executive
Placement 2003
School of Management
Studies Striving towards Excellence
GORDON MODEL:
Formula
P0 = EPS ( 1 b)
k - br
Where,
P0 = Market price of share
EPS = Earnings per share
r = rate of return (or) internal rate of return (or)
productivity of retained earnings
K = cost of capital (or) discount rate (or)
capitalization rate (or) requires rate of return
b = retention ratio
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BIM
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GORDON MODEL:
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MM hypothesis
Formula to calculate market price of share
P1 = P0 ( 1 + Ke) Div1
Where
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MM hypothesis
According to MM hypothesis, a firm can pay dividend
and if they require any additional capital for
investments that can be get by retained earnings or by
issue of new shares to the shareholders.
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MM hypothesis
The number of new shares to be issued can be
found out
mP1 = I (X nDiv1)
Where
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Dividend policy
Dividend policy of the firm affects the firms investment
opportunities as well as wealth of the shareholders of that firm
If firm earns profit, that has to be divided into two parts: dividend
and retained earnings.
Retained earnings are used to finance long term investment
opportunities of the firm
Dividends are given to shareholders as cash
Both dividend and retained earnings result in cash outflow.
If more dividends are given , then retained earnings will be low.
For future investments the firm again has to issue new shares or
has to go for debt.
So, Dividend policy of the firm affects the firms investment
opportunities as well as wealth of the shareholders of that firm
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BIM
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Dividend policy
The following questions are related to the dividend
policy of the firm
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Legal restrictions
Liquidity
Financial conditions and borrowing capacity
Access to the capital market
Restrictions in loan agreements
Inflation
control
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Stability of dividend
Types:
Merits:
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Cash dividend
Stock dividend or bonus shares
Bond dividend
Scrip dividend
Property dividend
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Bonus share or stock dividend is nothing but giving a part as cash dividend
and balance dividend in the form of additional shares
Advantages:
To shareholders:
Tax benefits
Indication of higher future profits
Future dividends may increase
Psychological value
To company
Conservation of cash
Only means to pay dividend during financial difficulty
More attractive share price
Disadvantages:
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Reverse split
The reduction in the number of outstanding shares by
increasing the par value of the share is called as
reverse split
This is done if the companys share price falls.
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Buyback of shares
The buyback of shares is the repurchase of its own shares by a
company
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