Financial Management

Prof. G.S. POPLI

 Financial Management
• Maheshwari S.N. Financial Management – Principles
& Practice. Sultan Chand & Sons, New Delhi.
• Khan & Jain, Financial Management, Tata McGraw-
Hill Publishing Co. Ltd. New Delhi.
• V.K. Bhalla. Financial Management & Policy – Anmol
Publications Pvt. Ltd. New Delhi.
• John J. Hampton. Financial Decision Making –
Prentice Hall of India Pvt. Ltd. New Delhi.
 Financial Management
• Meaning of Business Finance : In
general, finance may be defined as the
provision of money at the time it is
wanted. However as a Management
Function, it has a special meaning.
• Guthman & Dougall : “Business finance
can broadly be defined as the activity
concerned with planning, raising,
controlling and administrating of the
funds used in the business.”
 Objectives of Financial
Management
1. Basic Objectives : Traditionally, basic objectives of FM are
(a). The maintenance of liquid assets, and
(b). Maximisation of the profitability of the firm.
2. Other Objectives :
(a). Ensuring a fair return to shareholders.
(b). Building up reserves for growth and expansion.
©. Ensuring maximum operational efficiency.
(d). Ensuring financial discipline in the organisation.
 Profit Maximisation
Concept-Criticism
1. It is a vague concept.
2. It ignores timings.
3. It overlooks quality aspects of future
activities.
4. Prof. Ezra Soloman has suggested
Wealth Maximisation concept.
5. WM Concept : Any financial action
which creates wealth or which has a net
present worth above zero is a desirable
one and should be undertaken.
 Nature of Finance
• Finance is a specialised functional field
under Business Administration.
• Is an applied field of B.A. Principles
developed by Financial Managers or
borrowed from accounting, economics
or other fields are applied to the
problems of managing money.
• Finance different from Accounting &
Economics.
 Scope of Financial
Management
• Traditional Approach : Corporation
Finance by Thomas Greene in 1897.
• Corporation Finance by Edward Meade
in 1910.
• Financial Policy of Corporations by
Arther Dewing in 1919.
• The traditional approach evolved during
1920 and continued to dominate
academic thinking upto early 50s.
 Scope of Financial
Management
• Traditional Approach :
(a). Arrangement of funds from
Financial Institutions.
(b). Arrangement of funds through
financial instruments viz. Shares,
bonds etc.
©. Looking after the legal and
accounting relationship between a
corporation and its sources of funds.
 Scope of Financial
Management
• Traditional Approach – Weaknesses
1.Outsider-looking – in approach.
2.Ignored routine problems.
3.Ignored non-corporate enterprises.
4.Ignored working capital financing.
5.No emphasis on allocation of funds.
 Scope of Financial
Management
• Modern Approach : Since Mid 50s.
(Also role of Finance Manager in the
changing scenario).
(a). Funds requirement decision
(b). Financing decision.
©. Investment decision.
(d). Dividend decision.
 Scope of Financial
Management
• Modern Approach : Analytical
Approach with the help of computers.
• What is the total volume of funds an
enterprise should commit?
• What specific assets should an
enterprise acquire?
• How should the funds required be
financed?
 Impact of Financial &
Economic Environment on
FM - Globalisation
• Boost in Trade & Commerce.
• Increase in Foreign Collaboration resulting
in transfer of latest technology.
• Optimum utilisation of finance material and
human resources which has led to
improvement in overall efficiency.
• Larger capital inflows – greater
industrialisation – increased foreign
exchange reserves.
• Development of infrastructural facilities
and new financial instruments.
 Methods of Financial
Management – Tools
Any logical method for the following purposes :
1. Measuring the effectiveness of firm’s actions &
decisions
2. Measuring the validity of the decisions regarding
accepting or rejecting future projects. Important
financial tools are :
• Cost of Capital
• Financial leverage or trading on equity
• Capital Budgeting Appraisal Methods.
• ABC Analysis, Cash Management Models, Aging
schedule of inventories, Debtor’s turnover Ratio etc.
• Ratio Analysis.
• Funds Flow and Cash Flow Analysis.
 Time Value of Money
• Time Value of a Money is a useful concept in
handling Capital Budgeting problems.
• Money has a time Value because of the
following reasons :
1.Individuals generally prefer current
consumption.
2.Investment for future greater value possible.
3.Inflation Factor – More Purchasing Power in
present than the future money.
 Valuation of Simple
Interest
M = P (I + i) x t Where,
M = Maturity Value
P = Initial Investment
I = Rupee value of interest earned
I = Interest rate
T = Time period for which funds are invested
• If Rs. 1000 is invested for 5 years at a
simple interest rate of 15%, what will be the
interest and maturity value?
 Valuation Concepts
• Compound Value Concept. Equation :
A = P (1 + i)n where,
A = Amount at the end of period ‘n’
P = Principal at the beginning of the period.
I = Interest rate
n = Number of years
• If Rs. 1000 is invested for 5 years at a compound
interest rate of 15%, what will be the interest and
maturity value? Ans : Rs. 2011.40
 Future Value of an
Annuity
Annuity : Investment made at regular intervals of time
in constant amount in recurring deposits or in LIC
Policy or Pension Fund. Future Value of Annuity :
F = A(I+i)t -I Where, F = Future Value
i A= Constant amount paid
I = Interest Rate
t = Number of years

• Calculate the compounded value of Rs. 1000 invested

every year for 10 years, at a 15% interest rate.
 Future Value of Annuity
F = 1000(1.15) 10 – 1)
0.15 = Rs.
20,300/-

• If every year Rs. 1000 is invested at

15% interest rate, it would become
Rs. 1,02,440/- in 20 years.
Sinking Fund Payment
• Sinking Fund is opposite to annuity. Companies
create a sinking fund every year so that on a
maturity date a large amount of payment can be
made. Formula :
• A = F( I )
(I+i)t-I
• If a Co. has to pay bonds worth Rs. 100
Crores at the end of 5 years and if it can earn
12% interest on investment, then the Co.
should create the Annual Sinking Fund of
What Amount?
 Sinking Fund
A = 100 ( 0.12 )
(I.12)5 –I = 15.74 Crores

• The Co. should keep aside Rs. 15.74

Crores every year for 5 years and
invest the same in 12% interest
securities. The Co. can use the maturity
value for the repayment of bonds.
 Present Value/Discounting
Concept
• Present Value after ‘n’ years.
__A____
Pv = (1 + i)n Where,
Pv = Principal amount the investor is willing
to forgo at present.
1 = Rupee value of interest earned.
i = interest rate, n = Number of year.
A = Amount at the end of the period n.
Note : This is reverse of the compounding
formula.
• Calculate Present Value of Rs. 1000 @
received in1 to 5 years
 Present Value/Discounting
Concept
Rs. 1000/- Received Working Present Value at
in 1,000/-

Year -1 1000/(1.15)1 869.60

2 1000/(1.15)2 756.10
3 1000/(1.15)3 657.50
4 1000/(1.15)4 571.80
5 1000/(1.15)5 497.20
 Present Value of
Perpetuity
• Some financial commitments like pension,
perpetual bonds etc. may involve a perpetual
annuity cash flow. The present value of
perpetuity can be calculated :

• PV of Perpetuity : Ax 1/I
• At a 20% discount rate, the maximum annuity
factor will be 5 (i.e. 1/0.2). If Rs. 1000 is
received every year upto the perpetuity, then
its present value will be 1000x5 = Rs. 5,000/-
 Capital Recovery
• Certain financial problems require reverse calculations
to those of the present value of annuity. For example a
Leasing Co. would like to calculate an annual rental
charge for the lease equipment or a bank would like to
recover a loan in equated annual installments.
• PV of Annuity : PV = A ( 1+i)t-1)
ix(1+i)t
• A Bank disbursed a loan of Rs. 1 Lac @18% recoverable
in 5 equated annual installments with interest.
Calculate the amount of installment?
 Capital Recovery
• Solution = 1,00,000x(0.18x(1.18)5
(1.18)5 – 1
=
1,00,000x(0.4118/1.2878)
= 1,00,000x0.3198
= Rs. 31,980/-
 Funds Flow Statement
• Funds : It refers to cash, cash equivalents or to working
Capital. Current Assets and Current Liabilities.
• Flow of Funds : The term ‘Flow’ means change and
therefore the term ‘Flow of Funds’ means change in Funds
or change in working capital. In other words any increase or
decrease in working capital means Flow of Funds.
• Funds Flow Statement : A summary of a firm’s changes
in financial position from one period to another. It is also
termed as a “Statement of Sources and Applications of
Funds” and “Where got and where gone funds”.
• Balance Sheet = Stock of funds
• Changes in Balance Sheet items = Net flow of funds
Sources & Uses of Funds
We prepare a basic, bare bones funds statement
by :
• Determining the amount and direction of net
Balance Sheet changes that occur between two
Balance Sheet dates.
• Classifying net Balance Sheet changes as either
sources or uses of funds, and
• Consolidating this information in a sources and
uses of funds statement format
 Uses/Importance of Funds
Flow Statement
1. It explains the financial
consequences of business
operations.
2. It answers intricate queries.
3. It acts as an instrument for
allocation of resources.
4. It is a test as to effective or
otherwise use of working capital.
 Techniques for preparing
Funds Flow Statement
1. Schedule of changes in Working Capital
It can be prepared by comparing the current
assets and current liabilities of two periods.
2. Funds Flow Statement
For preparing a Funds Flow Statement, it is
necessary to find out the sources and Application
of Funds. Here, attention is given to changes in
Fixed Assets and Fixed Liabilities and the changes
in current assets and current liabilities are ignored.
 Schedule of changes in
Working Capital - Rules
1. Increase in current assets results in
increase (+) in working capital.
2. Decrease in current assets results in
decrease (-) in working capital.
3. Increase in current liability, results
in decrease (-) in working capital.
4. Decrease in current liability, results
in increase (+) in working capital.
 Funds Flow Statement
1. Sources of Funds
• Issue of Shares
• Issue of Debentures
• Long term Borrowing
• Sale of fixed assets
• Operating profit
Total Sources
 Funds Flow Statement
2. Application of Funds
• Redemption of redeemable Preference Shares
• Redemption of Debentures.
• Payment of other long term loans.
• Purchase of Fixed Assets.
• Operating Loss
• Payment of dividend, Tax etc.
Total Uses
Net Increase/Decrease in Working Capital
(Total Sources – Total Uses.
 Funds Flow Statement
• Tip to remember : The following
device should help you to remember
what constitutes a source or use of
funds :

A L
S - +
U + -
 Funds Flow Statement
• The following is the Comparative Balance Sheet of
M/s. ABC Ltd. Prepare a Funds Flow Statement
Balance Sheet
• Liabilities 31.12.2008 31.12.2009
Share Capital 8,000 8,500
P&L Appropriation A/c. 1,450 2,450
Creditors 900 500
Mortgage Loan 500
----------------------------
10,350 11,950
 Funds Flow Statement
• Balance Sheet : Assets 31.12.08 31.12.09
Land 5,000 5,000
Plant 2,400 3,400
Debtors 1,650 1,950
Stock 900 700
Cash at Bank 400 900
------------------------
10,350 11,950
 Funds Flow Statement
Solution :
Schedule of Changes in Working Capital
Assets/Liability Increase(+) Decrease (-)
Stock 200
Debtors 300
Cash at Bank 500
Creditors 400
------ -----
1,200 200
Net Increase in Working Capital Rs. 1,000
 Funds Flow Statement
Funds Flow Statement
• Sources of Funds
Increase in Share Capital 500
Mortgage Loan 500
Funds from Operations 1,000
Total Sources 2,000
• Application of Funds
Plant purchased 1,000
Total Application 1,000
Net Increase in Working Capital 1,000
 Funds Flow Statement
Adjustments :
• Recognise Profits and Dividends.
Source : Net Profit
Less Use : Cash Dividends
Net source : Increase in Retained Earnings
• Recognise Depreciation and Gross change in
Fixed Assets :
Source Depreciation
Less Use : Additions to Fixed Assets
Net Source : Decrease in Fixed Assets
 Cash Flow Statement
What is Balance Sheet?
• A Balance Sheet is a statement showing
the financial position of the firm as at
the last day of the account period.
What is Profit & Loss Account?
• This is an income statement which
focuses on financial performance due to
the operating activities of a firm during
the period.
 Cash Flow Statement
• What is Funds Flow Statement :
A summary of a firm’s changes in
financial position from one period to
another. It is also termed as a
“Statement of Sources and
Applications of Funds” and “Where
got and where gone funds”.
 Cash Flow Statement
What is Cash Flow Statement?
• Cash Flow Statement is a statement which
indicates sources of cash inflows and
transactions of cash outflows of a firm during
an accounting period. The activities /
transactions which generate cash inflows are
known as sources of cash and activities which
cause cash outflows are known as uses of
cash. It is also termed as “Where got where
gone statement”.
 Cash Flow Statement
Sources of Cash Inflows
• Business Operations/Operating activities
• Non-business/operating activities (Interest,
Dividend received)
• Sale of Long term assets (Plant, building
and equipment)
• Issue of additional Long term securities
(Equity, Preference Shares and Debentures)
• Additional Long term borrowings ( Banks &
Financial Institutions)
• Other sources (specify them)
 Cash Flow Statement
Sources of Cash Outflows :
• Purchase of Long term assets (Plant &
Machinery, Land & Building, Office equipment
& Furniture)
• Redemption of Preference Shares &
Debentures
• Repurchase of Equity Shares
• Repayment of long term borrowings
• Cash dividends paid to shareholders
(Preference & Equity)
• Other items (Specify)
Net Increase/Decrease in Cash.
 Usefulness of Cash Flow
Statement
It helps in answering the following questions:
• How much cash has been generated from normal
business operating activities / operations of a
company.
• What have been the other premier financing
activities of the firm through which cash has been
raised? What has happened to cash so obtained?
• How much cash has been spent on investment
activities, say on purchase of new Plant &
Equipments?
 Usefulness of Cash Flow
Statement
• How was the redemption of Preference Shares and
Debentures accomplished?
• How long term sources of cash (internally
generated plus raised externally) adequate to
finance purchase of new long term/fixed assets.
• What has been the proportion of Debt and Equity
for cash raised from outside?
• Why are dividends not larger?
• Is the Co. borrowings to pay cash dividends?
• Has the liquidity position of the Co. improved
Preparation of Cash Flow
Statement-
Format
Balance as on 01.01.20 (Opening
Balances)
• Cash Balance
• Bank Balance
Add : Sources of Cash
Issue of Shares
Raising of long term loans
Sale of Fixed Assets
Short term borrowings
 Cash Flow Statement
Cash from Operations :
• Profit as per P & L Account
Add/Less : Adjustment for Non-Cash items
Add : Increase in Current liabilities
Decrease in Current Assets
Less : Increase in Current Assets
Decrease in Current Liabilities
Total Cash Available (1)
 Cash Flow Statement
Less : Application of Cash
Redemption of Preference Shares
“ Long term Loans
Purchase of Fixed Assets
Decrease in deferred payment liabilities
Cash outflow on account of operations
Tax Paid
Dividend paid
Decrease in unsecured loans, deposits etc.
Total Applications (2)
Closing Balances
Cash Balance
Bank Balance
 Utility of Cash Flow
Analysis
• Helps in efficient Cash Management.

• Helps in internal Financial Management.

• Discloses the movements of cash

• Discloses success or failure of cash

planning
 Limitations-Cash Flow
Statement
• Cannot be equated with Income Statement

• It may not disclose the true financial position

of the business. For example : Postponement
of purchases and other payments.

• It cannot replace Income Statement or Funds

Flow Statement.
 Difference between Funds
Flow & Cash Flow
Statement
(a). Statement of changes in cash position
• The Cash Flow Statement takes care of the
changes in the cash position between two
balance sheets irrespective of the fact whether
the inflow relates to transactions of previous
years or the current period or whether of revenue
nature or capital nature. On the other hand, the
Funds Flow Statement takes into account all
funds flowing in or out of the business and cash is
only one of those funds.
 Difference between Funds
Flow & Cash Flow
Statement
(b). A tool for Short-term Finances
• Cash Flow statement can let know the position
for short of meeting a liability which is going to
fall due within a short period say month or
quarter. For relatively longer period analysis,
the Funds Flow may be more suitable concept.
(c). Effect on Funds of the Company :
The Cash Flow Statement affect the working
capital as it is one of the components of the total
funds. On the other hand, the changes in funds,
do not necessarily affect the cash position, since
the funds which do not involve cash do not affect
the cash position at all.
 Difference between Funds
Flow & Cash Flow
Statement
(d). Cash is part of WC. Improvement in cash
position results in improvement of Funds
position but the reverse is not true.
(e). Technique of Preparation. An increase in CL
or decrease in CA results in decrease in WC
and vice versa. While an increase in CL or
decrease in CA (other than cash) will result in
increase in cash and vice versa.
 Cash from Operations
31.12.2008 31.12.2009
Debtors Rs.50,000 Rs.47,000
Bills Receivable 10,000 12,500
Creditors 20,000 25,000
Bills Payable 8,000 6,000
Outstanding Exps. 1,000 1,200
Prepaid Exps. 800 700
Accrued Income 600 750
Income recd. In advance 300 250
Profit made during the year ---- 1,30,000
Que : Calculate Cash From Operations
 Cash from Operations
Profit made during the year Rs. 1,30,000
Add : Decrease in Debtors 3,000
“ in Prepaid Exps. 100
Increase in Creditors 5,000
Increase in O/S Exps. 200 8,300

1,38,300
 Cash from Operations
B/F
1,38,300
Less : Increase in B.R 2,500
“ in Accrued Income 150
Decrease in B.P 2,000
“ in Ad. Income 50
4,700

Cash from Operations

1,33,600
 Balance Sheet
Liabilities : Owned Funds
• Proprietor’s Capital or Paid up Share Capital
• Reserves
• Share Premium Reserve
• Revaluation Reserve
• Investment Allowance Reserve
• Depreciation Reserve
• Share/debenture/bonds Redemption
Reserve
• Capital Subsidy Reserve
• Retained Profits
 Balance Sheet
Long Term or Deferred Liabilities
• Debentures or Public Fixed Deposits
• Term Loans raised from Banks and
Financial Institutions
• Deferred Payment Credits
• Loans from Friends & Relatives and
Associate Concerns
 Balance Sheet
Short Term or Current Liabilities
• Sundry Creditors
• Bills Payables
• Unsecured Loans of short term nature
• Public Deposits maturing within one year
• Expenses Payable
• Advance Payments from customers
• Provision for Bad & Doubtful Debts
• Instalments of Loans, debentures, bonds, redeemable
Preference Shares etc.
• Statutory Liabilities i.e. PF dues, Provision for Taxation,
Sales Tax, Excise Tax Etc.
• Misc. Current Liabilities i.e. Dividends, gratuity, other
exps.
 Balance Sheet
Contingent Liabilities : These are not shown in
B.S. but are recorded as a footnote.
• Pending Law Suits
• Claims against the organisation not acknowledged
as debt.
• Guarantees given by the organisation on behalf of
others.
• Guarantees issued by banks on behalf of the
organisation.
• Taxes and Duties under dispute with the Govt.
• Bills or Cheques discounted by banks. (If
accounted)
 Balance Sheet
Assets : Fixed
• Land
• Buildings and Structures
• Machinery, Tools and Equipment of all
types
• Vehicles
• Furniture and Fixture
• Capital work in progress or advance
against fixed assets
 Balance Sheet
Current Assets
• Cash and Cash at Bank
• Bills Receivables
• Closing Stocks (Raw Material, Stock in
Process, Finished Goods)
• Short Term Investments
• Advance Payment of Tax
• Pre-Paid Expenses
 Balance Sheet
Misc. Assets (Non-Current Assets)
• Investment in Non-Marketable Securities
• Investment in Long Term Loans to sister
or Allied or Associate Firms.
• Other Long term investments
• Non-consumable spare parts & stores.
• Loans and Advances of long term nature
• Prepaid Expenses of long term nature.
 Balance Sheet
Intangible Assets : Certain Assets, which do
not have any physical presence but just book
entries created with some specific objective :
• Goodwill
• Patents
• Copyrights
• Trademarks
• Formulae
• Preliminary and Formation Expenses
• Loss incurred by the organisation.
 Ratio Analysis
• Meaning : Ratios are relationships expressed
in mathematical terms between figures which
are connected with each other in some manner.
• Ratios can be expressed in two ways
(a). Times : When one value is divided with
another, the unit used to express the quotient
is termed as times.
(b). Percentage : If the quotient obtained is
multiplied by 100, the unit of expression is
termed as percentage.
 Classification of Ratios
1. Traditional Method

2. Functional Method
 Traditional Method
• The traditional classification has been on the
basis of the financial statement to which the
determinants of a ration belong.

(a). Profit & Loss Account Ratios : Gross

Profit Ratio, Stock Turnover Ratio.

(b). Balance Sheet Ratios : Current Ratio,

Debt Equity Ratio

©. Composite Ratios : Fixed Assets Turnover

Ratio, Overall Profitability Ratio.
 Functional Ratios
• Profitability Ratios.

• Coverage Ratios.

• Turnover Ratios.

• Financial Ratios :
 Profitability Ratios
(a). Gross Profit Ratio = Gross Profit X 100
Net Sales
(b). Net Profit Ratio = Net Profit X 100
Net Sales
©. Operating or = Operating Costs X
100
Expenses Ratio Net Sales
 Profitability Ratios
(d). Overall Profitability Ratio : It is also
called as “Return on Investment” or
“Return on Capital Employed”. It indicates
the % of return on the total capital
employed in the business. The formula is :

Operating Profit X 100

Capital Employed
 Capital Employed
(a). Sum total of Long Term funds employed in the
business :
Share Capital + Res & Surplus + Long Term Loans – (Non
Business Assets + Fictitious Assets)
Or
(b). Sum total of all Assets whether Fixed or Current.
• “Operating Profit” means Profit before Intt. and Tax. Interest
means ‘Interest on long term borrowings’. Interest on short
term borrowings will be deducted for computing operating
profit. Non trading incomes such as interest on Govt. securities
or non trading losses or expenses such as loss on account of
fire etc. will also be excluded.
 Return on Capital
Employed
• From the following figures of M/s. ABC & Co. Calculate
the return on total capital employed.
Fixed Assets 4,50,000 Reserves 1,00,000
Current Assets 1,50,000 Debentures 1,00,000
Investment in 1,00,000 Income from
(Govt. Securities) Investment 10,000
Sales 5,00,000 Prov. For Tax at 50% of
Cost of Goods 3,00,000 Net Profit
Sold Intt. On Debentures 10%
Share Capital : 10% Preference Rs. 1,00,000
: Equity Rs. 2,00,000
 Return on Capital
Employed
= Net Operating Profit before Intt. &
Tax X 100
Total Capital Employed
• Net Operating Profit = Net Profit +
Provision for Tax – Income from
Investment + Intt. On Debentures.
= 1,00,000 + 1,00,000 – 10,000 +
10,000 =
2,00,000
 Return on Capital
Employed
• Capital Employed : (a).Share Capital + Reserves +
Debentures + P&L Balance – Investment in Govt.
Securities
= (3,00,000 + 1,00,000 + 1,00,000 + 1,00,000 –
1,00,000 = Rs. 5,00,000)
• (b).Fixed Assets + Current Assets – Prov. for Tax
(4,50,000 + 1,50,000 – 1,00,000 = 5,00,000)
= 2,00,000 X 100 = 40%
5,00,000
 Profitability Ratios
• Net Profit to total Assets
= Net Profit after Tax + Interest X 100
Total Assets
• Return on Shareholder’s funds
= Profits available for Equity Shareholders X 100
Average Equity Shareholder’s Funds
• Earning per Equity Share
= Profits available for Equity Shareholders X 100
No. of Equity Shares
• Price Earning Ratio = Market Price per Equity Share
Earning per Share
Turnover or Efficiency Ratio
• Inventory Turnover (Stock) :
Cost of Goods Sold
Average Inventory
(Ave. Inventory = Opening Stock +
Closing Stock)
2
• Accounts Receivable Turnover
Net Sales on Credit
Average Receivable
 Financial Ratio
• Current Ratio : Current Assets
Current Liabilities

• Quick Ratio : Also known as Acid Test Ratio or Liquidity

Ratio. Prepaid Exps and Stock are not taken as Liquid
Assets & Bank Overdraft and C.C. facilities are excluded
from the C.L.
Quick Assets
Current Liabilities and

Quick Assets
Quick Liabilities
• Super Quick Ratio can also be calculated by dividing
Cash & Marketable securities with Current/Quick
Liabilities.
• Debt Equity Ratio : (a). External Equities
Internal Equities,
(b). Total Long Term Debt
Total Long Term Funds
• Debt Service Coverage Ratio :
Profit After Tax + Depreciation +
Interest on term debt + Lease Rentals, if any
Repayment of term + Interest on term debt + Lease
Rentals, if any
• Overall Profitability Ratio = Operating Profit X 100
Capital employed
 Computation of Ratios
• From the following information, prepare P & L A/C & B/S of
ABC & Co.
Opening Stock 1,50,000 Purchases 3,00,000
Sales 10,00,000 Wages 2,00,000
Closing Stock 2,50,000 Mfg Exps. 1,00,000
Salary 25,000 Loss on Sale 55,000
Insurance 25,000 Plant
Rent 30,000 Debtors 1,00,000
Reserves 1,00,000 Creditors 1,00,000
Comm. Paid 20,000 Bank Balance 50,000
 Computation of Ratios
Intt. On Debentures 10,000 Deb. 2,00,000
Pft on sale of shares 50,000 B.Payable 35,000
Share Capital : O/S Exps 15,000
Equity 1,00,000
Preference 1,00,000
Machinery 1,00,000
Furniture 1,00,000
Prepaid Exps 50,000
 Computation of Ratios
• Also calculate the following Ratios.
1. Gross Profit & Net Profit Ratio
2. Return on Investment Ratio
3. Current Ratio
4. Debt-Equity Ratio
5. Stock Turnover Ratio
6. Liquidity Ratio
7. Overall Profitability Ratio
 Sources of Finance -
Classification
1. According to Period :
(a). Long Term Sources : Shares,
Debentures, Long term Loans
(b). Short Term Sources : Advances from
Banks, Public Deposits, Advances from
customers & Trade Creditors etc.
2. According to Ownership :
(a). Own Capital viz. Share Capital,
Retained-Earnings and Surpluses etc.
(b). Borrowed Capital viz. Debentures,
Public Deposits and Loans etc.
 Sources of Finance -
Classification
3. According to Source of Generation :
(a). Internal Sources viz. Retained
Earnings and Depreciation Fund etc.

(b). External Sources viz. Securities

such as Shares & Debentures, Loans
etc.
 Capital Structure
• The Debt-Equity mix of a firm is
called Capital Structure.

• The Capital Structure decision is a

very significant financial decision
since it affects the shareholder’s
return and risk and consequently the
market value of the share
 Capital Structure
• How should the Investment Project be
financed?
• Does the way in which the investment
projects are financed matter?
• How does financing affect the shareholder’s
risk, return and value?
• Does there exist an optimum financing mix
in terms of the maximum value to the firm’
shareholders.
 Capital Structure
• Can the optimum financing mix be
determined in practice for a
Company?

• What factors in practice should a

Company consider in designing its
Financing Policy?
 Capital Structure-
Decision Process
• Capital Budgeting Decision
(a). Replacement
(b). Moderanisation
©. Expansion
(d). Diversification
• Need to raise funds
(a). Internal Funds
(b). Debt
©. External Equity
 Capital Structure-
Decision Process
• Capital Structure Decision
(a). Existing Capital Structure
(b). Desired Debt-Equity Mix
©. Payout Policy
• Desired Debt-Equity Mix : (a). Effect on
Return
(b). Effect on
Risk
• Effect on Cost of Capital – Optimum
Capital
Structure
• Value of the Firm
 Financial Leverage
• The use of the fixed-charges sources of funds such
as Debt and Preference Capital along with the
owner’s equity in the capital structure is described
as ‘Financial Leverage’ or ‘Gearing’ or
‘Trading on Equity’.
• The rate of interest on debt is fixed irrespective of
the Company’s rate of return on assets.
• The rate of preference dividend is also fixed but are
paid only when the Co. earns profits.