Financial Management
Financial management refers to the efficient and effective
management of organization. It is strategically planning how
a business should money (funds) in such a manner as to
accomplish the objectives of the earn and spend money.
This includes decisions about raising capital, borrowing
money and budgeting. Financial management also involves
setting financial goals and analyzing data.
The general meaning of finance refers to providing
funds, as and when needed. However, as management
function, the term ‘Financial Management’ has a distinct
meaning.
Financial management deals with the study of
procuring funds and its effective and judicious utilization,
in terms of the overall objectives of the firm, and
expectations of the providers of funds.
The basic objective is to maximize the value of the firm.
The purpose is to achieve maximization of share value
to the owners i.e. equity shareholders.
.
DEFINITIONS
The term financial management has been defined,
differently, by various authors. Some of the authoritative
definitions are given below:
 “Financial Management is concerned with the efficient
use of an important economic resource, namely,
Capital Funds” —Solomon
 “Financial Management is concerned with the
managerial decisions that result in the acquisition and
financing of short-term and long-term credits for the
firm” —Phillioppatus
 “Business finance is that business activity which is
concerned with the conservation and acquisition of
capital funds in meeting financial needs and overall
objectives of a business enterprise” —Wheeler
 “Financial management is concerned with raising
financial resources and their effective utilisation
towards achieving the organisational goals” --Dr. S. N.
Maheshwari
 “Financial management is the process of putting the
available funds to the best advantage from the long
term point of view of business objectives” Richard A.
Brealey
Scope of Financial Management
Financial management has a wide scope. According to Dr. S.
C. Saxena, the scope of financial management includes the
following five ‘A’s.
1. Anticipation:
Financial management estimates the
financial needs of the company. That is, it finds out how
much finance is required by the company.
2. Acquisition:
It collects finance for the company from
different sources.
3. Allocation:
It uses this collected finance to purchase
fixed and current assets for the company.
4. Appropriation:
It divides the company’s profits among
the shareholders, debenture holders, etc. It keeps a part
of the profits as reserves.
5. Assessment: It also controls all the financial activities of
the company. Financial management is the most
important functional area of management. All other
functional areas such as production management,
marketing management, personnel management, etc.
depend on financial management.
Efficient financial management is required for survival,
growth and success of the company or firm.
Aim of finance functions
The following are the aims of finance function:
1. Acquiring Sufficient and Suitable Funds:
The primary aim
of finance function is to assess the needs of the enterprise,
properly, and procure funds, in time. Time is also an
important element in meeting the needs of the
organisation. If the funds are not available as and when
required, the firm may become sick or, at least, the
profitability of the firm would be, definitely, affected. It is
necessary that the funds should be, reasonably, adequate to
the demands of the firm. The funds should be raised from
different sources, commensurate to the nature of business 6
Financial Management and risk profile of the organisation.
When the nature of business is such that the production
does not commence, immediately, and requires long
gestation period, it is necessary to have the long-term
sources like share capital, debentures and long term loan
etc. A concern with longer gestation period does not have
profits for some years. So, the firm should rely more on the
permanent capital like share capital to avoid interest burden
on the borrowing component.
2. Proper Utilisation of Funds:
Raising funds is important,
more than that is its proper utilisation. If proper utilisation
of funds were not made, there would be no revenue
generation. Benefits should always exceed cost of funds so
that the organisation can be profitable. Beneficial projects
only are to be undertaken. So, it is all the more necessary
that careful planning and cost-benefit analysis should be
made before the actual commencement of projects.
3. Increasing Profitability:
Profitability is necessary for
every organisation. The planning and control functions of
finance aim at increasing profitability of the firm. To achieve
profitability, the cost of funds should be low. Idle funds do
not yield any return, but incur cost. So, the organisation
should avoid idle funds. Finance function also requires
matching of cost and returns of funds. If funds are used
efficiently, profitability gets a boost.
4. Maximising Firm’s Value:
The ultimate aim of finance
function is maximising the value of the firm, which is
reflected in wealth maximisation of shareholders. The
market value of the equity shares is an indicator of the
wealth maximisation.
Functions of finance
Finance function is the most important function of a
business. Finance is, closely, connected with production,
marketing and other activities. In the absence of finance, all
these activities come to a halt. In fact, only with finance, a
business activity can be commenced, continued and
expanded. Finance exists everywhere, be it production,
marketing, human resource development or undertaking
research activity. Understanding the universality and
importance of finance, finance manager is associated, in
modern business, in all activities as no activity can exist
without funds.
Financial Decisions or Finance Functions are closely interconnected.
All decisions mostly involve finance. When a
decision involves finance, it is a financial decision in a
business firm. In all the following financial areas of decisionmaking, the role of finance manager is vital. We can classify
the finance functions or financial decisions into four major
groups:
(A) Investment Decision or Long-term Asset mix decision
(B) Finance Decision or Capital mix decision
(C) Liquidity Decision or Short-term asset mix decision
(D) Dividend Decision or Profit allocation decision
(A) Investment Decision
Investment decisions relate to selection of assets in which
funds are to be invested by the firm. Investment
alternatives are numerous. Resources are scarce and
limited. They have to be rationed and discretely used.
Investment decisions allocate and ration the resources
among the competing investment alternatives or
opportunities. The effort is to find out the projects, which
are acceptable. Investment decisions relate to the total
amount of assets to be held and their composition in the
form of fixed and current assets.
Both the factors influence
the risk the organisation is exposed to. The more important
aspect is how the investors perceive the risk.
The investment decisions result in purchase of assets.
Assets can be classified, under two broad categories:
(i) Long-term investment decisions – Long-term assets
(ii) Short-term investment decisions – Short-term assets
Long-term Investment Decisions:
The long-term capital
decisions are referred to as capital budgeting decisions,
which relate to fixed assets. The fixed assets are long term,
in nature. Basically, fixed assets create earnings to the firm.
They give benefit in future. It is difficult to measure the
benefits as future is uncertain.
The investment decision is important not only for
setting up new units but also for expansion of existing units.
Decisions related to them are, generally, irreversible. Often,
reversal of decisions results in substantial loss. When a
brand new car is sold, even after a day of its purchase, still,
buyer treats the vehicle as a second-hand car. The
transaction, invariably, results in heavy loss for a short
period of owning. So, the finance manager has to evaluate
profitability of every investment proposal, carefully, before
funds are committed to them.
Short-term Investment Decisions:
The short-term
investment decisions are, generally, referred as working
capital management. The finance manger has to allocate
among cash and cash equivalents, receivables and
inventories. Though these current assets do not, directly,
contribute to the earnings, their existence is necessary for
proper, efficient and optimum utilisation of fixed assets.
(B) Finance Decision
Once investment decision is made, the next step is how to
raise finance for the concerned investment. Finance
decision is concerned with the mix or composition of the
sources of raising the funds required by the firm. In other
words, it is related to the pattern of financing.
In finance
decision, the finance manager is required to determine the
proportion of equity and debt, which is known as capital
structure. There are two main sources of funds,
shareholders’ funds (variable in the form of dividend) and
borrowed funds (fixed interest-bearing). These sources have
their own peculiar characteristics. The key distinction lies in
the fixed commitment. Borrowed funds are to be paid
interest, irrespective of the profitability of the firm. Interest
has to be paid, even if the firm incurs loss and this
permanent obligation is not there with the funds raised
from the shareholders. The borrowed funds are relatively
cheaper compared to shareholders’ funds, however they
carry risk.
This risk is known as financial risk i.e. Risk of
insolvency due to non-payment of interest or nonrepayment of borrowed capital.
On the other hand, the shareholders’ funds are
permanent source to the firm. The shareholders’ funds
could be from equity shareholders or preference
shareholders. Equity share capital is not repayable and does
not have fixed commitment in the form of dividend.
However, preference share capital has a fixed commitment,
in the form of dividend and is redeemable, if they are
redeemable preference shares.
Barring a few exceptions, every firm tries to employ
both borrowed funds and shareholders’ funds to finance its
activities. The employment of these funds, in combination,
is known as financial leverage. Financial leverage provides
profitability, but carries risk. Without risk, there is no return.
This is the case in every walk of life!
When the return on capital employed (equity and
borrowed funds) is greater than the rate of interest paid on
the debt, shareholders’ return get magnified or increased. In
period of inflation, this would be advantageous while it is a
disadvantage or curse in times of recession.
Example:
Total investment:
Rs. 1, 00,000
Return
15%.
Composition of investment:
Equity
Debt @ 7% interest
Return on investment
Rs. 60,000
Rs. 40,000
@ 15%
Rs. 15,000
Interest on Debt
Rs. 2,800
7% on Rs.40, 000
Earnings available to
Equity shareholders
Rs. 12,200
Return on equity (ignoring tax) is 20%, which is at the
expense of debt as they get 7% interest only.
In the normal course, equity would get a return of 15%.
But they are enjoying 20% due to financing by a
combination of debt and equity.
This area would be discussed in detail while dealing
with Leverages, in the later chapter.
The finance manager follows that combination of
raising funds which is optimal mix of debt and equity. The
optimal mix minimises the risk and maximises the wealth of
shareholders.
(C) Liquidity Decision
Liquidity decision is concerned with the management of
current assets. Basically, this is Working Capital
Management. Working Capital Management is concerned
with the management of current assets. It is concerned with
short-term survival. Short term-survival is a prerequisite for
long-term survival.
When more funds are tied up in current assets, the firm
would enjoy greater liquidity. In consequence, the firm
would not experience any difficulty in making payment of
debts, as and when they fall due. With excess liquidity,
there would be no default in payments. So, there would be
no threat of insolvency for failure of payments. However,
funds have economic cost. Idle current assets do not earn
anything. Higher liquidity is at the cost of profitability.
Profitability would suffer with more idle funds. Investment
in current assets affects the profitability, liquidity and risk. A
proper balance must be maintained between liquidity and
profitability of the firm. This is the key area where finance
manager has to play significant role. The strategy is in
ensuring a trade-off between liquidity and profitability.
This
is, indeed, a balancing act and continuous process. It is a
continuous process as the conditions and requirements of
business change, time to time. In accordance with the
requirements of the firm, the liquidity has to vary and in
consequence, the profitability changes. This is the major
dimension of liquidity decision working capital
management. Working capital management is day to day
problem to the finance manager. His skills of financial
management are put to test, daily.
(D) Dividend Decision
Dividend decision is concerned with the amount of profits to
be distributed and retained in the firm.
Dividend:
The term ‘dividend’ relates to the portion of
profit, which is distributed to shareholders of the company.
It is a reward or compensation to them for their investment
made in the firm. The dividend can be declared from the
current profits or accumulated profits.
Which course should be followed – dividend or
retention? Normally, companies distribute certain amount
in the form of dividend, in a stable manner, to meet the
expectations of shareholders and balance is retained within
the organisation for expansion. If dividend is not distributed,
there would be great dissatisfaction to the shareholders.
Non-declaration of dividend affects the market price of
equity shares, severely. One significant element in the
dividend decision is, therefore, the dividend payout ratio i.e.
what proportion of dividend is to be paid to the
shareholders. The dividend decision depends on the
preference of the equity shareholders and investment
opportunities, available within the firm. A higher rate of
dividend, beyond the market expectations, increases the
market price of shares. However, it leaves a small amount in
the form of retained earnings for expansion. The business
that reinvests less will tend to grow slower. The other
alternative is to raise funds in the market for expansion. It is
not a desirable decision to retain all the profits for
expansion, without distributing any amount in the form of
dividend.
There is no ready-made answer, how much is to be
distributed and what portion is to be retained. Retention of
profit is related to
• Reinvestment opportunities available to the firm.
• Alternative rate of return available to equity
shareholders, if they invest themselves.
Objective of finance function
1. Profit maximisation : The main objective of financial
management is profit maximisation within the private
sector. The finance manager is responsible to assist in
earning maximum profits for the company, in the shortterm and for the long-term. However they cannot
guarantee profits in the long term because of the
uncertainty of business. However, a company can earn
maximum profits if:A. Management and the finance manager take proper
financial decisions and plan well.
B. The organisation uses the finances of the company
carefully and strategically.
Other factors
Profit
Maximization
2. Wealth maximisation: Wealth maximisation
(shareholders’ value maximisation) is also a main
objective of financial management. Wealth
maximisation means to earn maximum wealth for the
shareholders. So, the finance manager will attempt to
achieve maximum dividends to shareholders, and they
will also try to increase the market value of the shares.
The market value of the shares should be directly
related to the performance of the company. The better
the performance, the higher is the market value of
shares and vice-versa. So, the finance manager must try
to maximise shareholder’s value.
Risk Associated
Future expected cash
flow
Wealth
maximization
Pay back Period
Time Value of Money
 Wealth maximization uses the concept of future
expected cash flows rather then the ambiguous term
Profits.
 It considers time value of money.
 It considers Risk associated with investment
 Also the Pay Back Period of specific projects.
3. Adequate forecasting of the total financial cash
requirement : Proper estimation of the total financial
requirements is a very important objective of financial
management. The finance manager must forecast the total
financial requirements of the organisation.
They must find out how much finance cash will be required
to start and run the organisation. They must find out the
fixed capital and working capital requirements of the
company. Their forecasting must be as accurate as possible.
If not, there could be a shortage or surplus of finance
available. Forecasting the financial requirements is a very
difficult job. The finance manager must consider many
factors, such as the type of technology used by company,
number of employees employed, scale of operations, legal
requirements, competition, external environment, economy
etc.
4. Proper resourcing : Collection of finance is an important
objective of financial management. After forecasting the
financial requirements, the finance manager must decide
where the finance cash will be sourced.They can collect
finance from many sources such as shares, debentures,
bank loans, etc. There must be a proper balance between
owned finance and borrowed finance. The company must
borrow money at as low a rate of interest as achieveable.
5. Proper utilisation of finance cash : Proper utilisation of
finance is an important objective of financial management.
The finance manager must plan the optimum use of finance.
They must use the finance profitably delivering best value
for money. They must not waste the money of the
organisation. They must assist and advise not to invest the
company’s financial resources into unprofitable projects.
They must forecast adequately the cash flow to enable
smooth stock control. They must have a good supply of
short credit.
6. Maintaining proper cash flow : Maintaining proper cash
flow is a short-term objective of financial management. The
company must have a proper cash flow to pay the day-today expenses such as purchasing of raw materials, the
payment of wages and salaries, rent, electricity bills, etc. If
the company has good cash flow, it can take advantage of
many opportunities such as taking cash discounts on
purchases, large-scale purchasing, giving credit to
customers, etc. A healthy cash flow improves the chances of
survival and success of the company. Also gives strength
against competition and the ability to make acquisitions.
7. Survival of company : Survival is the most important
objective of sound financial management. The company
must survive in this competitive business world. The finance
manager must be very careful while making financial
decisions.
8. Creating reserves : One of the objectives of financial
management is to create reserves. The company should not
distribute the full profits as a dividend to the shareholders.
It should keep a part of its profit in reserves. Reserves can
be used for future growth and expansion. It can also be used
to face contingencies in the future if any emergencies
should arise, or give strength for a possible merger or
acquisition.
9. Proper co-ordination : Financial management assist and
try to have proper planning and coordination between the
finance department and other departments of the
company.
10. Creating goodwill : Financial management must try to
create goodwill for the company. It must improve the image
and reputation of the company. Goodwill helps the
company to survive in the short-term and succeed in the
long-term. It also helps the company during bad times. It
also adds value to company’s net worth in an event of a
takeover or buy out.
11. Increase efficiency : Financial management should
facilitate increasing the efficiency of all the departments of
the company. Proper distribution of finance to all the
departments will increase the efficiency of the entire
company.
12. Financial discipline : Financial management should
create a financial discipline within the organisation.
Financial discipline means:
•To invest finance only in productive areas. This will bring
higher returns (profits) to the company.
•To avoid wastage and misuse of finance.
13. Reducing the cost of capital : Financial management try
to reduce the cost of capital. That is, it will attempt to
borrow money at a low rate of interest. The finance
manager must plan the capital structure in such a way that
the cost of capital it minimised, either through debt, gearing
or equity finance.
14. Reducing operating risks : Financial management also
tries to reduce the operating risks. There are many risks and
uncertainties in a business. The finance manager must take
steps to reduce these risks. They must avoid high-risk
projects unless it is the policy of the company. They must
also take proper adequate insurance.
15. Constructing the best capital structure : Financial
management help prepare the capital structure of the
organisation. It assists in the ratio between owned finance
and borrowed finance. It brings a proper balance between
the different sources of capital. This balance is necessary for
liquidity, economy, flexibility and stability. This is connected
to gearing.
Time value of money
The time value of money (TVM) is the idea that money
available at the present time is worth more than the same
amount in the future due to its potential earning capacity.
The principle of the time value of money explains
why interest is paid or earned: Interest, whether it is on
a bank deposit or debt, compensates the depositor or
lender for the time value of money. This core principle
of finance holds that, provided money can earn interest, any
amount of money is worth more the sooner it is received.
TVM is also sometimes referred to as present discounted
value.
DEFINITIONS
1) Price put on the time an investor or lender has to wait
until the investment or loan is fully recouped. TVM is
based on the concept that money received earlier is
worth more than the same amount of money received
later, because it can be 'employed' to earn interest over
time. Computed as compound interest.
2) The time value of money theory states that a dollar that
you have in the bank today is worth more than a
reliable promise or expectation of receiving a dollar at
some future date. You can invest the dollar today and
earn a return on that investment, such as interest or
dividend payments.
The time value of money draws from the idea that rational
investors prefer to receive money today rather than the
same amount of money in the future because of money's
potential to grow in value over a given period of time. For
example, money deposited into a savings account earns a
certain interest rate, and is therefore said to be
compounding in value.
Further illustrating the rational investor's preference;
assume you have the option to choose between receiving
$10,000 now versus $10,000 in two years. It's reasonable to
assume most people would choose the first option. Despite
the equal value at time of disbursement, receiving the
$10,000 today has more value and utility to the beneficiary
than receiving it in the future due to the opportunity
costs associated with the wait. Such opportunity costs could
include the potential gain on interest were that money
received today and held in a savings account for two years.
There are two techniques to determine time value of money
i.e., compounding and discounting
Compounding
Compounding is essentially about the money moving
forwards in time. It’s the process, which determines the
future value of your money, such as an investment. In this
technique, the interest is compounded and becomes a part
of initial principal at the end of compounding period.
The idea of compound growth tells you that if you have
$500 today and it earns an annual interest of 2%, then your
initial money will grow into something bigger in the future.
Furthermore, compounding shows the future value in
instances where the interest continues to add as the value
goes up. What does this mean? Well if you originally invest
$500 and your investment earns 2% every year, with your
investment lasting five years. On the first year, you gain
interest on the original $500, but after that you gain interest
on the $500 + the interest from previous years. This would
mean:
Starting investment: $500
Year One: $500 + 2% interest = $510
Year Two: ($500 + 2% interest) + 2% interest = $520.20
And so on. The initial amount is compounding because it
gains interest on the initial amount, but also because it
earns interest on the interest payments.
Compounding can be used to solve three major themes of
issues in regards to understanding a future value of money.
These are:

The future value of a single sum. If I get $500, what will
it be worth in 5 years with a determined annual interest?

The future value of a series of payments. If I get $500
every year, what will it be worth in 5 years with a
determined annual interest?

The payments needed to make in order to achieve a
future value. If I want to have $10,000 in five years and I
know the determined interest, how much do I need to have
at the moment or invest annually to achieve this?
In this technique, time value of money is calculated by
following formula:
A = P (1+r)n
Where A = Amount at the end of the period
P = Principal Amount
r = rate of interest
n = Number of years
Illustration:
If Mr. X invests Rs. 10,000 in fixed deposit carrying
interest rate@10% p.a. compounding annually for four
years. Calculate the amount he will receive at the end of
four years.
Sol- A = P / (1+r)n
A = 10,000( 1 +0.10)4
A = 14,641
Discounting
Discounting is the opposite of compounding. In discounting,
money is moving backwards in time. The process
determines what the present value of a known value in the
future is. In discounting, the current value is determined by
applying the opportunity cost to the value expected to be
received in the future. So, if you were told to receive $500 in
five years, you could determine the present value of this
money with the technique of discounting. Discounting is
essentially the inverse of growing.
Discounting can be useful to solve three specific issues of
TVM. These are:

The present value of a single sum. If I’m told to have
$500 in five years, with the interest standing at 2% annually
what is the value today?

The present value of a series of payments. If I have an
annuity that pays $1,000 every month for next ten years,
how much shall I pay for it, in order to gain 2% each year?

The amount needed to amortize a present value. How
much do I need to pay on a 10-year loan of $20,000 if the
annual compound rate is 3.5%?
In this technique, time value of money is calculated by
following formula:
P = A / (1+r)n
Where P = Present value
A = Sum received in future
I = Rate of interest
n = Number of Years
Illustration:
If Mr. X is given an opportunity to receive Rs. 10,000 after
two years, where he can earn interest at 10% p.a. on his
investment, what should be the amount he should invest
today so that he may be able to get Rs.10,000 after two
years?
Sol- P = A / (1+r)n
P = 10,000 / (1 +0.10)2
P = 8,264
Valuation of bonds & shares
The valuation of any asset, real finance is equivalent to the
current value of cash flows estimated from it.
Bonds
A bond is a debt instrument that provides a periodic stream
of interest payments to investors while repaying the
principal sum on a specified maturity date. A bond’s terms
and conditions are contained in a legal contract between
the buyer and the seller, known as the indenture.
A bond is defined as a long-term debt tool that pays the
bondholder a specified amount of periodic interest over a
specified period of time. In financial area, a bond is an
instrument of obligation of the bond issuer to the holders. It
is a debt security, under which the issuer owes the holders a
debt and, depending on the terms of the bond, is obliged to
pay them interest and/or to recompense the principal at a
later date, called the maturity date. Interest is generally
payable at fixed intervals such as semi-annual, annual, and
monthly. Sometimes, the bond is negotiable, i.e. the
ownership of the instrument can be relocated in the
secondary market. This means that once the transfer agents
at the bank medallion stamp the bond, it is highly liquid on
the second market.
It can be established that Bonds signify loans extended by
investors to companies and/or the government. Bonds are
issued by the debtor, and acquired by the lender. The legal
contract underlying the loan is called a bond indenture.
Normally, bonds are issued by public establishments, credit
institutions, companies and supranational institutions in the
major markets. Simple process for issuing bonds is through
countersigning. When a bond issue is underwritten, one or
more securities firms or banks, forming a syndicate, buy the
whole issue of bonds from the issuer and re-sell them to
investors. The security firm takes the risk of being unable to
sell on the issue to end investors. Primary issuance is
organised by book runners who arrange the bond issue,
have direct contact with depositors and act as consultants
to the bond issuer in terms of timing and price of the bond
issue. The book runner is listed first among all underwriters
participating in the issuance in the tombstone ads
commonly used to announce bonds to the public. The bookrunners' willingness to underwrite must be discussed prior
to any decision on the terms of the bond issue as there may
be limited demand for the bonds.
On the contrary, government bonds are generally issued in
an auction. In some cases both members of the public and
banks may bid for bonds. In other cases, only market
makers may bid for bonds. The overall rate of return on the
bond depends on both the terms of the bond and the price
paid. The terms of the bond, such as the coupon, are fixed in
advance and the price is determined by the market.
 Key features of Bonds
Each bond can be characterized by several factors. These
include:







Face Value
Coupon Rate
Coupon
Maturity
Call Provisions
Put Provisions
Sinking Fund Provisions
a) Face Value - The face value (also known as the par value)
of a bond is the price at which the bond is sold to investors
when first issued; it is also the price at which the bond is
redeemed at maturity. In the U.S., the face value is usually
$1,000 or a multiple of $1,000.
b) Coupon Rate - The periodic interest payments promised
to bond holders are computed as a fixed percentage of the
bond’s face value; this percentage is known as the coupon
rate.
c) Coupon - A bond’s coupon is the dollar value of the
periodic interest payment promised to bondholders; this
equals the coupon rate times the face value of the bond. For
example, if a bond issuer promises to pay an annual coupon
rate of 5% to bond holders and the face value of the bond is
$1,000, the bond holders are being promised a coupon
payment of (0.05)($1,000) = $50 per year.
d) Maturity - A bond’s maturity is the length of time until
the principal is scheduled to be repaid. In the U.S., a bond’s
maturity usually does not exceed 30 years. Occasionally a
bond is issued with a much longer maturity; for example,
the Walt Disney Company issued a 100-year bond in 1993.
There have also been a few instances of bonds with an
infinite maturity; these bonds are known as consols. With a
consol, interest is paid forever, but the principal is never
repaid.
e) Call Provisions - Many bonds contain a provision that
enables the issuer to buy the bond back from the
bondholder at a pre-specified price prior to maturity. This
price is known as the call price. A bond containing a call
provision is said to be callable. This provision enables issuers
to reduce their interest costs if rates fall after a bond is
issued, since existing bonds can then be replaced with lower
yielding bonds. Since a call provision is disadvantageous to
the bond holder, the bond will offer a higher yield than an
otherwise identical bond with no call provision. A call
provision is known as an embedded option, since it can’t be
bought or sold separately from the bond.
f) Put Provisions - Some bonds contain a provision that
enables the buyer to sell the bond back to the issuer at a
pre-specified price prior to maturity. This price is known as
the put price. A bond containing such a provision is said to
be putable. This provision enables bond holders to benefit
from rising interest rates since the bond can be sold and the
proceeds reinvested at a higher yield than the original
bond. Since a put provision is advantageous to the bond
holder, the bond will offer a lower yield than an otherwise
identical bond with no put provision.
g) Sinking Fund Provisions - Some bonds are issued with a
provision that requires the issuer to repurchase a fixed
percentage of the outstanding bonds each year, regardless
of the level of interest rates. A sinking fund reduces the
possibility of default; default occurs when a bond issuer is
unable to make promised payments in a timely manner.
Since a sinking fund reduces credit risk to bond holders,
these bonds can be offered with a lower yield than an
otherwise identical bond with no sinking fund.
 Bond Valuation
Valuation of a bond needs an estimate of predictable cash
flows and a required rate of return specified by the investor
for whom the bond is being valued. If it is being valued for
the market, the markets expected rate of return is to be
determined or estimated. The bond’s fair value is the
present value of the promised future coupon and principal
payments. At the time of issue, the coupon rate is set such
that the fair value of the bonds is very close to its par value.
Afterwards, as market conditions change, the fair value may
differ from the par value.
At the time of issue of the bond, the interest rate and
other conditions of the bond would have been impacted by
numerous factors, such as current market interest rates, the
length of the term and the creditworthiness of the issuer.
These factors are likely to change with time, so the market
price of a bond will diverge after it is issued. The market
price is expressed as a percentage of nominal value. Bonds
are not necessarily issued at par (100% of face value,
corresponding to a price of 100), but bond prices will move
towards par as they approach maturity (if the market
expects the maturity payment to be made in full and on
time) as this is the price the issuer will pay to redeem the
bond. This is termed as "Pull to Par". At other times, prices
can be above par (bond is priced at greater than 100), which
is called trading at a premium, or below par (bond is priced
at less than 100), which is called trading at a discount.
The market price of a bond is the present value of all
expected future interest and principal payments of the bond
discounted at the bond's yield to maturity, or rate of return.
That relationship is the definition of the redemption yield on
the bond, which is expected to be close to the current
market interest rate for other bonds with similar
characteristics. The yield and price of a bond are inversely
related so that when market interest rates rise, bond prices
fall and vice versa. The market price of a bond may be cited
including the accumulated interest since the last coupon
date. The price including accrued interest is known as the
"full" or "dirty price". The price excluding accrued interest is
known as the "flat" or "clean price".
The interest rate divided by the current price of the bond is
termed as current yield. This is the nominal yield multiplied
by the par value and divided by the price. There are other
yield measures that exist such as the yield to first call, yield
to worst, yield to first par call, yield to put, cash flow yield
and yield to maturity.
The link between yield and term to maturity for otherwise
identical bonds is called a yield curve. The yield curve is a
graph plotting this relationship. Bond markets, dissimilar to
stock or share markets, sometimes do not have a
centralized exchange or trading system. Reasonably, in
developed bond markets such as the U.S., Japan and
Western Europe, bonds trade in decentralized, dealer-based
over-the-counter markets. In such a market, market liquidity
is offered by dealers and other market contributors
committing risk capital to trading activity. In the bond
market, when an investor buys or sells a bond, the
counterparty to the trade is almost always a bank or
securities firm which act as a dealer. In some cases, when a
dealer buys a bond from an investor, the dealer carries the
bond "in inventory", i.e. holds it for his own account. The
dealer is then subject to risks of price fluctuation. In other
cases, the dealer instantly resells the bond to another
investor.
Bond markets can also diverge from stock markets in
respect that in some markets, investors sometimes do not
pay brokerage commissions to dealers with whom they buy
or sell bonds. Rather, the dealers earn income through the
spread, or difference, between the prices at which the
dealer buys a bond from one investor the "bid" price and
the price at which he or she sells the same bond to another
investor the "ask" or "offer" price. The bid/offer spread
signifies the total transaction cost associated with
transferring a bond from one investor to another.
Basically, the value of a bond is the present value of all
the future interest payments and the maturity value,
discounted at the required return on bond commensurate
with
the
prevailing
interest
rate
and
risk.
Where:
Interest 1 to n = Interests in periods 1 to n.
Unless otherwise mentioned, the maturity value of the
bond is the face value.
1. When the required rate of return is equal to the
coupon rate, the bond value equals the par value.
2. When the required rate of return is more than the
coupon rate, the bond value would be less than its par
value. The bond in this case would sell at a discount.
3. When the required rate of return is less than the
coupon rate, the bond value would be more than its
par value. The bond in this case would sell at a
premium.
Illustration:
Let us assume the face value of the bond is $1,000
(maturity value $1,000). The bond has a 10% coupon rate
payable semi-annually and the yield to maturity (return) is
9%. The bond matures in 5 years period from now. What is
the
value
of
the
bond?
Interest 1 till 10 = $50 per semi-annual period. ($100
annually)
n=10 because 5 years x 2 payments per period.
Yield to maturity = 9%, therefore, semi-annual YTM (return )
=9/2 = 4.5% or 0.045
Solving
for
the
above
Bond price = $1,040 (rounded)
equation,
we
get
Shares
In financial markets, a share is described as a unit of account
for different investments. It is also explained as the stock of
a company, but is also used for collective investments such
as mutual funds, limited partnerships, and real estate
investment trusts. The phrase 'share' is delineated by
section 2(46) of the Companies Act 1956 as "share means a
share in the share capital of a company includes stock
except where a distinction between stock and share is
expressed or implied".
Companies issue shares which are accessible for sale to
increase share capital. The owner of shares in the company
is a shareholder (or stockholder) of the corporation. A share
is an indivisible unit of capital, expressing the ownership
affiliation between the company and the shareholder. The
denominated value of a share is its face value, and the total
of the face value of issued shares represent the capital of a
company, which may not reflect the market value of those
shares. The revenue generated from the ownership of
shares is a dividend. The process of purchasing and selling
shares often involves going through a stockbroker as a
middle man.
 Share valuation:
Shares valuation is done according to numerous principles in
different markets, but a basic standard is that a share is
worth price at which a transaction would be expected to
occur to sell the shares. The liquidity of markets is a major
consideration as to whether a share is able to be sold at any
given time. An actual sale transaction of shares between
buyer and seller is usually considered to provide the best
prima facie market indicator as to the "true value" of shares
at that specific time.
Shares are often promised as security for raising loans.
When one company acquires majority of the shares of
another company, it is required to value such shares. The
survivors of deceased person who get some shares of
company made by will. When shares are held by the
associates mutually in a company and dissolution takes
place, it is important to value the shares for proper
distribution of partnership property among the partners.
Shares of private companies are not listed on the stock
exchange. If such shares are appraisable by the shareholders
or if such shares are to be sold, the value of such shares will
have to be determined. When shares are received as a gift,
to determine the Gift Tax & Wealth Tax, the value of such
shares will have to be ascertained.
 Values of shares:
1. Face Value: A Company may divide its capital into
shares of @10 or @50 or @100 etc. Company’s share
capital is presented as per Face Value of Shares. Face
Value of Share = Share Capital / Total No of Share. This
Face Value is printed on the share certificate. Share
may be issued at less (or discount) or more (or
premium) of face value.
2. Book Value: Book value is the value of an asset
according to its balance sheet account balance. For
assets, the value is based on the original cost of the
asset less any devaluation, amortization or impairment
costs made against the asset.
3. Cost Value: Cost value is represented as price on which
the shares are purchased with purchase expenses such
as brokerage, commission.
4. Market Value: This values is signified as price on which
the shares are purchased or sold. This value may be
more or less or equal than face value.
5. Capitalised Value:
Capitalised Value of profit
Capitalised Value of= ------------------------------------share
Total no. of shares
1. Fair Value: This value is the price of a share which
agreed in an open and unrestricted market between
well-informed and willing parties dealing at arm’s
length who are fully informed and are not under any
compulsion to transact.
2. Yield Value: This value of a share is also called
Capitalised value of Earning Capacity. Normal rate of
return in the industry and actual or expected rate of
return of the firm are taken into consideration to find
out yield value of a share.
 Need for Valuation:
1. When two or more companies merge
2. When absorption of a company takes place.
3. When some shareholders do not give their approval for
reconstruction of the company, there shares are valued
for the purpose of acquisition.
4. When shares are held by the associates jointly in a
company and dissolution takes place, it becomes
essential to value the shares for proper distribution of
partnership property among the partners.
5. When a loan is advanced on the security of shares.
6. When shares of one type are converted in to shares of
another type.
7. When some company is taken over by the government,
compensation is paid to the shareholders of such
company and in such circumstances, valuation of
shares is made.
8. When a portion of shares is to be given by a member of
proprietary company to another member, fair price of
these shares has to be made by an auditor or
accountant.
 Methods of valuation:
1. Net Assets Value (NAV) Method: This method is called
intrinsic value method or breakup value method (Naseem
Ahmed, 2007). It aims to find out the possible value of share
in at the time of liquidation of the company. It starts with
calculation of market value of the company. Then amount
pay off to debenture holders, preference shareholders,
creditors and other liabilities are deducted from the realized
amount of assets. The remaining amount is available for
equity shareholders. Under this method, the net value of
assets of the company are divided by the number of shares
to arrive at the value of each share. For the determination
of net value of assets, it is necessary to estimate the worth
of the assets and liabilities. The goodwill as well as nontrading assets should also be included in total assets. The
following points should be considered while valuing of
shares according to this method:
o
o
o
o
o
o
o
Goodwill must be properly valued
The fictitious assets such as preliminary expenses,
discount on issue of shares and debentures,
accumulated losses etc. should be eliminated.
The fixed assets should be taken at their realizable
value.
Provision for bad debts, depreciation etc. must be
considered.
All unrecorded assets and liabilities (if any) should be
considered.
Floating assets should be taken at market value.
The external liabilities such as sundry creditors, bills
payable, loan, debentures etc. should be deducted
from the value of assets for the determination of net
value.
The net value of assets, determined so has to be divided by
number of equity shares for finding out the value of share.
Thus the value per share can be determined by using the
following formula:
Value Per Share= (Net Assets-Preference
Capital)/Number Of Equity Shares
Share
Net asset method is useful in case of amalgamation, merger,
acquisition, or any other form of liquidation of a company.
This method determines the rights of various types of
shares in an efficient manner. Since all the assets and
liabilities are values properly including ambiguous and
intangibles, this method creates no problem for valuation of
preference or equity share. However it is difficult to make
proper valuation of good will and estimate net realisation
value of various other assets of the company. Such
estimates are likely to be influenced by personal factors of
valuers. This method is suitable in case of companies likely
to be liquidated in near future or future maintainable profits
cannot be estimated properly or where valuation of shares
by this method is required statutorily (Naseem Ahmed,
2007).
2. Yield-Basis Method: Yield is the effective rate of return on
investments which is invested by the investors. It is always
expressed in terms of percentage. Since the valuation of
shares is made on the basis of Yield, it is termed as YieldBasis Method.
Yield may be calculated as under:
Normal profit
Yield
= -------------------------------------X 100
Capital Employed
Under Yield-Basis method, valuation of shares is made on;
I. Profit Basis: Under this method, profit should be
determined on the basis of past average profit;
subsequently, capitalized value of profit is to be determined
on the basis of normal rate of return, and, the same
(capitalized value of profit) is divided by the number of
shares in order to find out the value of each share.
Following procedure is adopted:
Profit
Capitalised value of= ---------------------------X 100
profit
Normal
return
rate
of
Capitalised value of profit
Value of each equity=
share
------------------------------------Number of shares
Profit
Or, Value of
equity share
each= -------------------------------------X 100
Normal rate of return X
Number of equity shares
II. Dividend Basis: In this type of valuation, shares are valued
on the basis of expected dividend and normal rate of return.
The value per share is calculated through following formula:
Expected rate of dividend = (profit available
dividend/paid up equity share capital) X 100
for
Value per share = (Expected rate of dividend/normal rate of
return) X 100
Valuation of shares may be made either (a) on the basis of
total amount of dividend, or (b) on the basis of percentage
or rate of dividend
3. Earning Capacity (Capitalisation) Method: In this valuation
procedure, the value per share is calculated on the basis of
disposable profit of the company. The disposable profit is
found out by deducting reserves and taxes from net profit
(Naseem Ahmed, 2007). The following steps are applied for
the determination of value per share under earning
capacity:
Step 1: To find out the profit available for dividend
Step 2: To find out the capitalized value
Capitalized Value = (Profit available for equity
dividend/Normal
rate
of
return)
X
100
Step 3: To find out value per share
Value per share = Capitalized Value/Number of Shares
In this method, profit available for equity shareholders, as
calculated under capitalization method, are capitalized on
the basis of normal rate of return. Then the value of equity
share is ascertained by dividing the capitalized profit by
number of equity share as shown under (Naseem Ahmed,
2007):
Appraisal of Earning Capacity: This method is suited only
when maintainable profit and normal rate of return (NRR)
can be ascertained clearly. It is possible when market
information is easily available. However, while calculating
NRR, risk factors must be taken into consideration (Naseem
Ahmed, 2007).
4. Average (Fair Value) Method: In order to overcome the
inadequacy of any single method of valuation of shares, Fair
Value Method of shares is considered as the most
appropriate process. It is simply an average of intrinsic value
and yield value or earning capacity method. For valuing
shares of investment companies for wealth tax purposes,
Fair Value Method of shares is recognized by government. It
is well suited to manufacturing and other companies. The
fair value can be calculated by following formula (Naseem
Ahmed, 2007):
To summarize, bonds and their alternatives such as loan
notes, debentures and loan stock, are IOUs issued by
governments and companies in order to increase finance.
They are often called fixed income or fixed interest
securities, to differentiate them from equities, in that they
often make known returns for the investors (the bond
holders) at regular intervals. These interest payments, paid
as bond coupons, are fixed, unlike dividends paid on
equities, which can be variable. Most corporate bonds are
redeemable after a specified period of time. Valuation of
share involves the use of financial and accounting data. It
depends on valuer’s judgement experience and knowledge.
Cash Flow Statement
Cash Flow Statement also known as Statement of Cash
Flows is a statement which shows theChanges in the Cash
Position of an organisation between 2 periods. Along with
showing the changes in the Cash Position of an organisation,
it also depicts the reasons for such change during the
period.
The main reason for the preparation of the Cash Flow
Statement is that the Income Statement of an enterprise is
always prepared on an Accrual Basis and it may show profits
in the Income Statement but the Cash received out of these
profits may be low to run the business or vice-versa.
 Preparation of cash flow statement
Cash Flows Statement is required to be prepared
using International Accounting Standard 7 (or using
the Accounting Standard 3 in India). While preparing the
Cash Flow Statement, the cash flows during the period are
classified into 3 major categories:
1) Cash Flow from Operating Activities (Direct Method/
Indirect Method)
2) Cash Flow from Investing Activities
3) Cash Flow from Financing Activities
Classification by activities provides information that allows
users to assess the impact of those activities on the financial
position of the enterprise. This information also helps in
evaluating the inter-relationships between these activities.
Cash Flows from Operating Activities
Cash Flows from operating Activities are primarily derived
from the Principal Revenue-producing activities of the
enterprise.
1. Direct Method
2. Indirect Method
1. Direct Method
While preparing the Cash Flow Statement as per Direct
Method, Actual Cash Receipts from Operating Revenues and
Actual Cash Payments for Operating Activities are arranged
and presented in the Cash Flow Statement. The difference
between Cash Receipts and Cash Payments is the Net Cash
Flow from Operating Activities under the Direct Method. In
other words, it is a Income Statement (Profit & Loss A/c)
prepared on Cash Basis under the Direct Method.
While preparing the Cash Flow Statement as per Direct
Method, items like Depreciation, Amortisation of Intangible
Assets, Preliminary Expenses, Debenture Discount etc are
ignored fromCash Flow Statement since the Direct
Method includes only Cash Transactions and Non-Cash
Transactions are omitted.
Likewise, no adjustment is made for Loss/Gain on the Sale
of Fixed Assets and Investments while preparing the Cash
Flow Statement as per the Direct Method.
Format for Computation of Cash Flows from Operating
Activities as per Direct Method
Particulars
Amount
Cash Receipts from Customers
xxx
Cash Paid to suppliers and
(xxx)
employees
Cash generated from Operations
xxx
Income Tax Paid
(xxx)
Cash Flow before Extra-ordinary
xxx
Items
Extra-ordinary items
xxx
Net Cash from Operating Activities
xxx
(Direct Method)
2. Indirect Method
While preparing the Cash Flow Statement as per the
Indirect Method, the Net Profit/Loss for the period is used
as the base and then adjustments are made for items that
affected the Income Statement but did not affect the Cash
While preparing the Cash Flow Statement as per the Indirect
Method, Non Cash and Non Operating charges in
the Income Statement are added back to the Net Profits
while Non-Cash & Non-Operating Credits are deducted to
calculate
the
Operating
Profit
before Working
CapitalChanges. The Indirect Method of preparing of Cash
Flow Statement is a partial conversion of accrual basis profit
to Cash basis profit. Further, necessary adjustments are
made for Increase/Decrease in Current Assets and Current
Liabilities to obtain Net Cash Flows from Operating Activities
as per the Indirect Method.
Format of Cash Flows from Operating Activities – Indirect
Method
Particulars
Net Profit before Tax and Extraordinary items
Adjustments for
- Depreciation
- Foreign Exchange
- Investments
- Gain or Loss on Sale of Fixed
Assets
- Interest Dividend
Operating Profit before Working
Capital Changes
Adjustments for
- Trade and Other Receivables
- Inventories
- Trade Payable
Cash generated from Operations
- Interest Paid
- Direct Taxes
Cash before Extra-Ordinary Items
Deferred Revenue
Amount
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
(xxx)
(xxx)
xxx
xxx
Net Cash Flow from Operating
Activities (Indirect Method)
xxx
Cash Flow from Investing Activities
The activities of Acquisition and Disposal of Long Term
Assets and other Investments not included in cash
equivalents are Investing activities. Separate disclosure of
Cash Flows arising from Investing Activities is important
because the Cash Flows represent the extent to which
expenditures have been made for resources intended to
generate future income and cash flows.
Format of Cash Flow from Investing Activities:Particulars
Amount
Purchase of Fixed Assets
(xxx)
(Add) Proceeds from Sale of
xxx
Fixed Assets
(Add) Interest received
xxx
(Add) Dividend received
xxx
Net Cash Flow from Investing
xxx
Activities
Cash Flows from Financing Activities
Financing Activities are those activities which result in a
change in the size and composition of owner’s capital and
borrowing of the organisation. The separate disclosure of
cash flows arising from financing activities is important
because it is useful in predicting the claims on future cash
flows by the providers of funds.
Format of Cash Flow from Financing Activities:Particulars
Amount
Proceeds from Issue of Share
xxx
Capital
Proceeds from Long Term
xxx
Borrowings
Repayment of Long Term
(xxx)
Borrowings
Interest Paid
(xxx)
Dividend Paid
(xxx)
Net Cash Flows from Financing
xxx
Activities
The Comprehensive Format of the complete Cash Flow
Statement is as follows:Particulars
Cash flow from Operating Activities (Direct Method/
Indirect Method)
(Add) Cash Flow from Investing Activities
(Add) Cash Flow from Financing Activities
(=)Net Increase/Decrease in Cash
Amount
Xxx
Xxx
Xxx
Xxx
(Add) Opening Balance of Cash & Cash Equivalents
(=) Closing Balance of Cash & Cash Equivalents
Xxx
Xxx
Financial Statement Analysis
The analysis of the data available from Profit and loss A/c,
B/s and by making the group of related data is known as
Financial Statement Analysis.
Financial statement analysis is the process of reviewing
and evaluating a company's financial statements (such as
the balance sheet or profit and loss statement), thereby
gaining an understanding of the financial health of the
company and enabling more effective decision making.
Financial statements record financial data; however, this
information must be evaluated through financial
statement analysis to become more useful to investors,
shareholders, managers and other interested parties.
 Financial Statements
Financial statement analysis allows analysts to identify
trends by comparing ratios across multiple time periods and
statement types. These statements allow analysts to
measure liquidity, profitability, company-wide efficiency and
cash flow. There are three main types of financial
statements: the balance sheet, income statement and cash
flow statement. The balance sheet is a snapshot in time of
the company's assets, liabilities and shareholders' equity.
Analysts use the balance sheet to analyze trends in assets
and debts. The income statement begins with sales and
ends with net income. It also provides analysts with gross
profit, operating profit and net profit. Each of these is
divided by sales to determine gross profit margin, operating
profit margin and net profit margin. The cash flow
statement provides an overview of the company's cash
flows from operating activities, investing activities and
financing activities.
 Financial Statement Analysis
Each financial statement provides multiple years of data.
Used together analysts can track performance measures
across financial statements using several different methods
for financial statement analysis, including vertical and
horizontal analysis. An example of vertical analysis is when
each line item on the financial statement is listed as a
percentage of another. Horizontal analysis compares line
items in each financial statement against previous time
periods. In ratio analysis, line items from one financial
statement are compared with line items from another. For
example, many analysts like to know how many times a
company can pay off debt with current earnings. Analysts
can do this by dividing debt, which comes from the balance
sheet, by net income, which comes from the income
statement. Likewise, return on assets (ROA) and the return
on equity (ROE) compare company net income found on the
income statement with assets and stockholders' equity as
found on the balance sheet.
 Objectives
1. Assessment of past performance
Past performance is a good indicator of future
performance. Investors or creditors are interested in
the trend of past sales, cost of good sold, operating
expenses, net income, cash flows and return on
investment. These trends offer a means for judging
management's past performance and are possible
indicators of future performance.
2. Assessment of current position
Financial statement analysis shows the current position of
the firm in terms of the types of assets owned by a business
firm and the different liabilities due against the enterprise.
3. Prediction of profitability and growth prospects
Financial statement analysis helps in assessing and
predicting the earning prospects and growth rates in
earning which are used by investors while comparing
investment alternatives and other users in judging earning
potential of business enterprise.
4. Prediction of bankruptcy and failure
Financial statement analysis is an important tool in assessing
and predicting bankruptcy and probability of business
failure.
5. Assessment of the operational efficiency
Financial statement analysis helps to assess the operational
efficiency of the management of a company. The actual
performance of the firm which are revealed in the financial
statements can be compared with some standards set
earlier and the deviation of any between standards and
actual performance can be used as the indicator of
efficiency of the management.
 Types of financial statement analysis
Financial statement analysis are classified according to
their objectives, Materials used and Modus
operandi. Financial statement analysis, according to
objectives are further subdivided into Short term
and long term.
Short term analysis include
i. Working capital position analysis,
ii. Liquidity analysis,
iii. Return analysis,
iv. Profitability analysis,
v. Activity analysis.
Long term analysis include
i. Profitability analysis,
ii. Capital structure analysis,
iii. Financial position,
iv. Future prospects.
Financial statement analysis according to materials
used include Internal and External analysis. Financial
statement analysis according to modus operandi
include Horizontal and vertical analysis. They are
briefly explained below.
1. Internal Analysis
Internal analysis is made by the top
management executives with the help of
Management Accountant. The finance and
accounting department of the business
concern have direct approach to all the
relevant financial records. Such analysis
emphasis on the overall performance of the
business concern and assessing the
profitability of various activities and
operations.
2. External Analysis
Shareholders as investors, banks, financial institutions,
material suppliers, government department and tax
authorities and the like are doing the external analysis. They
are fully depending upon the published financial
statements. The objective of analysis is varying from one
party to another.
3. Short Term Analysis
The short term analysis of financial statement is primarily
concerned with the working capital analysis so that a
forecast may be made of the prospects for future earnings,
ability to pay interest, debt maturities – both current and
long term and probability of a sound dividend policy.
A business concern has enough funds in hand to meet its
current needs and sufficient borrowing capacity to meet its
contingencies. In this aspect, the liquidity position of the
business concern is determined through analyzing current
assets and current liabilities. Hence, ratio analysis is highly
useful for short term analysis.
4. Long Term Analysis
There must be a minimum rate of return on investment. It is
necessary for the growth and development of the company
and to meet the cost of capital. Financial planning is also
necessary for the continued success of a company. The fixed
assets structure, leverage analysis, ownership pattern of
securities and the like are made in the long term analysis.
5. Horizontal Analysis
It is otherwise called as dynamic analysis. When financial
statements for a number of years are viewed and analyzed,
the analysis is called horizontal analysis. The preparation of
comparative statements is an example of this type of
analysis.
6. Vertical Analysis
It is otherwise called as static analysis. Under this type of
analysis, the ratios are calculated from the balance sheet of
one year and/or from the profit and loss account of one
year. It is used for short term analysis only.
 Tools and techniques of FSA
Important tools or techniques of financial statement
analysis are as follows.
1. Comparative Statement or Comparative Financial and
Operating Statements.
2. Common Size Statements.
3. Trend Ratios or Trend Analysis.
4. Average Analysis.
5. Statement of Changes in Working Capital.
6. Fund Flow Analysis.
7. Cash Flow Analysis.
8. Ratio Analysis.
9. Cost Volume Profit Analysis
1. Comparative Statement Analysis (Horizontal Analysis)
As the name suggests, comparative analysis provides a yearon-year review of the various financial statements. For
example, in the Income Statement, the Sales figure may be
compared over a period of consecutive years to understand
how the sales figures have grown (or declined) over the
year. It should be noted that horizontal analysis compares
the internal performance of the company.
Below is an example of a Comparative Income Statement.
Comparative Income Statement (All figures are in INR ‘000)
2. Common Size Statement Analysis (Vertical Analysis)
Vertical analysis is applicable for internal performance
review as well as for comparison to peers and benchmarking. In vertical analysis all the items in a particular
statement are represented as a percentage of a particular
item. For example, Operating Expenses, Depreciation,
Amortization, Profit before tax, Tax, Profit after tax, etc.
may be represented as a percentage of Sales in the Income
Statement. Common standard base can easily reveal the
internal make-up of financial statements and any
proportionate increase and decrease of the same.
Vertical analysis is also put to use for comparison across
companies as financial statements are converted to
common-size format, which can then be used to compare
with competitor or industry averages, highlighting key
differences which can then be analyzed.
Below is an example of a Common Size Income Statement.
Values are expressed as %age of Revenue.
3. Trend Analysis
The ratios of different items for various periods are find out and then
compared under this analysis. The analysis of the ratios over a period
of years gives an idea of whether the business concern is trending
upward or downward. This analysis is otherwise called as Pyramid
Method.
Whenever, the trend ratios are calculated for a business concern,
such ratios are compared with industry average. These both trends
can be presented on the graph paper also in the shape of curves. This
presentation of facts in the shape of pictures makes the analysis and
comparison more comprehensive and impressive.
4. Ratio Analysis
Ratio analysis is an attempt of developing meaningful relationship
between individual items (or group of items) in the balance sheet or
profit and loss account. Ratio analysis is not only useful to internal
parties of business concern but also useful to external parties. Ratio
analysis highlights the liquidity, solvency, profitability and capital
gearing.
There are several general categories of ratios, each designed to
examine a different aspect of a company's performance. The
general groups of ratios are:
o
o
o
o
o
o
i) Liquidity ratios - This is the most fundamentally important set of
ratios, because they measure the ability of a company to remain
in business. Click the following links for a thorough review of
each ratio.
Cash coverage ratio. Shows the amount of cash available to pay
interest.
Current ratio. Measures the amount of liquidity available to pay for
current liabilities.
Quick ratio. The same as the current ratio, but does not include
inventory.
Liquidity index. Measures the amount of time required to convert
assets into cash.
ii) Activity ratios - These ratios are a strong indicator of the quality
of management, since they reveal how well management is
utilizing company resources. Click the following links for a
thorough review of each ratio.
Accounts payable turnover ratio. Measures the speed with which a
company pays its suppliers.
Accounts receivable turnover ratio. Measures a company's ability
to collect accounts receivable.
Fixed asset turnover ratio. Measures a company's ability to
generate sales from a certain base of fixed assets.
o Inventory turnover ratio. Measures the amount of inventory
needed to support a given level of sales.
o Sales to working capital ratio. Shows the amount of working capital
required to support a given amount of sales.
o Working capital turnover ratio. Measures a company's ability to
generate sales from a certain base of working capital.
iii) Leverage ratios. These ratios reveal the extent to which a
company is relying upon debt to fund its operations, and its ability
to pay back the debt. Click the following links for a thorough
review of each ratio.
o Debt to equity ratio. Shows the extent to which management is
willing to fund operations with debt, rather than equity.
o Debt service coverage ratio. Reveals the ability of a company to
pay its debt obligations.
o Fixed charge coverage. Shows the ability of a company to pay for
its fixed costs.
iv) Profitability ratios. These ratios measure how well a company
performs in generating a profit. Click the following links for a
thorough review of each ratio.
o Breakeven point. Reveals the sales level at which a company
breaks even.
o Contribution margin ratio. Shows the profits left after variable
costs are subtracted from sales.
o Gross profit ratio. Shows revenues minus the cost of goods sold, as
a proportion of sales.
o Margin of safety. Calculates the amount by which sales must drop
before a company reaches its break even point.
o Net profit ratio. Calculates the amount of profit after taxes and all
expenses have been deducted from net sales.
o Return on equity. Shows company profit as a percentage of equity.
o
o
o
Return on net assets. Shows company profits as a percentage of
fixed assets and working capital.
Return on operating assets. Shows company profit as percentage
of assets utilized.
4. Fund Flow Analysis
Fund flow analysis deals with detailed sources and application of
funds of the business concern for a specific period. It indicates where
funds come from and how they are used during the period under
review. It highlights the changes in the financial structure of the
company.
7. Cash Flow Analysis
Cash flow analysis is based on the movement of cash and bank
balances. In other words, the movement of cash instead of
movement of working capital would be considered in the cash flow
analysis. There are two types of cash flows. They are actual cash
flows and notional cash flows.
9. Cost Volume Profit Analysis
This analysis discloses the prevailing relationship among sales, cost
and profit. The cost is divided into two. They are fixed cost and
variable cost. There is a constant relationship between sales and
variable cost. Cost analysis enables the management for better profit
planning.
Cost Volume Profit Analysis
Definition: The cost volume profit analysis, commonly referred to as
CVP, is a planning process that management uses to predict the
future volume of activity, costs incurred, sales made, and profits
received. In other words, it’s a mathematical equation that computes
how changes in costs and sales will affect income in future periods.
The CVP analysis classifies all costs as either fixed or variable. Fixed
costs are expenses that don’t fluctuate directly with the volume of
units produced. These costs effectively remain constant. An example
of a fixed cost is rent. It doesn’t matter how many units the assembly
line produces. The rent expense will always be the same.
For example, a bike factory would classify bicycle tire costs as a
variable cost. Every bike that is produced must have two tires. The
more units produced, the more tire costs increase.
The CVP analysis uses these two costs to plot out production levels
and the income associated with each level. As production levels
increase, the fixed costs become a smaller percentage of total
income while variable costs remain a constant percentage. Cost
accountants and management analyze these trends in an effort to
predict what costs, sales, and profits the company will have in the
future.
They also use cost volume profit analysis to calculate the break-even
point in production processes and sales. The break-even point is
drawn on the CVP graph where the sales, fixed costs, and variable
costs’ lines all intersect. This is a key concept because it shows
management that the revenue from a project will be able to cover all
the costs associated with it. Using a variation of the CVP,
management can calculate the break-even point in profits, units, and
even dollars.
Cost-volume-profit (CVP) analysis is
used to determine how changes in
costs and volume affect a company's operating income and net
income. In performing this analysis, there are several assumptions
made, including:
Sales price per unit is constant.
Variable costs per unit are constant.
Total fixed costs are constant.
Everything produced is sold.
Costs are only affected because activity changes.
If a company sells more than one product, they are sold in the same
mix.
CVP analysis requires that all the company's costs, including
manufacturing, selling, and administrative costs, be identified as
variable or fixed.
Contribution margin and contribution margin ratio
Key calculations when using CVP analysis are the contribution
margin and the contribution margin ratio. The contribution margin
represents the amount of income or profit the company made before
deducting its fixed costs. Said another way, it is the amount of sales
dollars available to cover (or contribute to) fixed costs. When
calculated as a ratio, it is the percent of sales dollars available to
cover fixed costs. Once fixed costs are covered, the next dollar of
sales results in the company having income.
The contribution margin is sales revenue minus all variable costs. It
may be calculated using dollars or on a per unit basis. If The Three
M's, Inc., has sales of $750,000 and total variable costs of $450,000,
its contribution margin is $300,000. Assuming the company sold
250,000 units during the year, the per unit sales price is $3 and the
total variable cost per unit is $1.80. The contribution margin per unit
is $1.20. The contribution margin ratio is 40%. It can be calculated
using either the contribution margin in dollars or the contribution
margin per unit. To calculate the contribution margin ratio, the
contribution margin is divided by the sales or revenues amount.
Break-even point
The break‐even point represents the level of sales where net income
equals zero. In other words, the point where sales revenue equals
total variable costs plus total fixed costs, and contribution margin
equals fixed costs. Using the previous information and given that the
company has fixed costs of $300,000, the break‐even income
statement shows zero net income.
This income statement format is known as the contribution margin
income statement and is used for internal reporting only.
The $1.80 per unit or $450,000 of variable costs represent all variable
costs including costs classified as manufacturing costs, selling
expenses, and administrative expenses. Similarly, the fixed costs
represent total manufacturing, selling, and administrative fixed costs.
Break‐even point in dollars. The break‐even point in sales dollars of
$750,000 is calculated by dividing total fixed costs of $300,000 by the
contribution margin ratio of 40%.
Another way to calculate break‐even sales dollars is to use the
mathematical equation.
In this equation, the variable costs are stated as a percent of sales. If
a unit has a $3.00 selling price and variable costs of $1.80, variable
costs as a percent of sales is 60% ($1.80 ÷ $3.00). Using fixed costs of
$300,000, the break‐even equation is shown below.
The last calculation using the mathematical equation is the same as
the break‐even sales formula using the fixed costs and the
contribution margin ratio previously discussed in this chapter.
Break‐even point in units. The break‐even point in units of 250,000 is
calculated by dividing fixed costs of $300,000 by contribution margin
per unit of $1.20.
The break‐even point in units may also be calculated using the
mathematical equation where “X” equals break‐even units.
Again it should be noted that the last portion of the calculation using
the mathematical equation is the same as the first calculation of
break‐even units that used the contribution margin per unit. Once
the break‐even point in units has been calculated, the break‐even
point in sales dollars may be calculated by multiplying the number of
break‐even units by the selling price per unit. This also works in
reverse. If the break‐even point in sales dollars is known, it can be
divided by the selling price per unit to determine the break‐even
point in units.
Targeted income
CVP analysis is also used when a company is trying to determine what
level of sales is necessary to reach a specific level of income, also
called targeted income. To calculate the required sales level, the
targeted income is added to fixed costs, and the total is divided by
the contribution margin ratio to determine required sales dollars, or
the total is divided by contribution margin per unit to determine the
required sales level in units.
Using the data from the previous example, what level of sales would
be required if the company wanted $60,000 of income? The $60,000
of income required is called the targeted income. The required sales
level is $900,000 and the required number of units is 300,000. Why is
the answer $900,000 instead of $810,000 ($750,000 [break‐even
sales] plus $60,000)? Remember that there are additional variable
costs incurred every time an additional unit is sold, and these costs
reduce the extra revenues when calculating income.
This calculation of targeted income assumes it is being calculated for
a division as it ignores income taxes. If a targeted net income (income
after taxes) is being calculated, then income taxes would also be
added to fixed costs along with targeted net income.
Assuming the company has a 40% income tax rate, its break‐even
point in sales is $1,000,000 and break‐even point in units is 333,333.
The amount of income taxes used in the calculation is $40,000
([$60,000 net income ÷ (1 – .40 tax rate)] – $60,000).
A summarized contribution margin income statement can be used to
prove these calculations.
Capital Budgeting
Capital budgeting is the process of analyzing the effectiveness of
projects on hand based on capital required for investment and
forecasting the future earnings from the projects.
It is a process used by companies for evaluating and ranking potential
expenditures or investments that are significant in amount. The large
expenditures could include the purchase of new equipment,
rebuilding existing equipment, purchasing delivery vehicles,
constructing additions to buildings, etc. The large amounts spent for
these types of projects are known as capital expenditures.
Capital budgeting usually involves the calculation of each project's
future accounting profit by period, the cash flow by period, the
present value of the cash flows after considering the time value of
money, the number of years it takes for a project's cash flow to pay
back the initial cash investment, an assessment of risk, and other
factors. Capital budgeting is a tool for maximizing a company's future
profits since most companies are able to manage only a limited
number of large projects at any one time.
 Process of capital budgeting
There are five steps of capital budgeting process.
A) Project identification and generation:
The first step towards capital budgeting is to generate a proposal for
investments. There could be various reasons for taking up
investments in a business. It could be addition of a new product line
or expanding the existing one. It could be a proposal to either
increase the production or reduce the costs of outputs.
B) Project Screening and Evaluation:
This step mainly involves selecting all correct criteria’s to judge the
desirability of a proposal. This has to match the objective of the firm
to maximize its market value. The tool of time value of money comes
handy in this step.
Also the estimation of the benefits and the costs needs to be done.
The total cash inflow and outflow along with the uncertainties and
risks associated with the proposal has to be analyzed thoroughly and
appropriate provisioning has to be done for the same.
C) Project Selection:
There is no such defined method for the selection of a proposal for
investments as different businesses have different requirements.
That is why, the approval of an investment proposal is done based on
the selection criteria and screening process which is defined for every
firm keeping in mind the objectives of the investment being
undertaken.
Once the proposal has been finalized, the different alternatives for
raising or acquiring funds have to be explored by the finance team.
This is called preparing the capital budget. The average cost of funds
has to be reduced. A detailed procedure for periodical reports and
tracking the project for the lifetime needs to be streamlined in the
initial phase itself. The final approvals are based on profitability,
Economic constituents, viability and market conditions.
D) Implementation:
Money is spent and thus proposal is implemented. The different
responsibilities like implementing the proposals, completion of the
project within the requisite time period and reduction of cost are
allotted. The management then takes up the task of monitoring and
containing the implementation of the proposals.
E) Performance review:
The final stage of capital budgeting involves comparison of actual
results with the standard ones. The unfavorable results are identified
and removing the various difficulties of the projects helps for future
selection and execution of the proposals.
 Techniques of capital budgeting
Traditional
Modern
(Considering Time
Value Of Money
Capital budgeting consists of various techniques used by managers
such as:
1.
2.
3.
4.
5.
6.
Payback Period
Discounted Payback Period
Net Present Value
Accounting Rate of Return
Internal Rate of Return
Profitability Index
All of the above techniques are based on the comparison of cash
inflows and outflow of a project however they are substantially
different in their approach.
A brief introduction to the above methods is given below:





Payback Period measures the time in which the initial cash flow is
returned by the project. Cash flows are not discounted. Lower
payback period is preferred.
Net Present Value (NPV) is equal to initial cash outflow less sum of
discounted cash inflows. Higher NPV is preferred and an investment
is only viable if its NPV is positive.
Accounting Rate of Return (ARR) is the profitability of the project
calculated as projected total net income divided by initial or average
investment. Net income is not discounted.
Internal Rate of Return (IRR) is the discount rate at which net
present value of the project becomes zero. Higher IRR should be
preferred.
Profitability Index (PI) is the ratio of present value of future cash
flows of a project to initial investment required for the project.
The above techniques are explained in detail one by one as follows:
1. Pay Back Period
Payback period is the time in which the initial cash outflow of an
investment is expected to be recovered from the cash inflows
generated by the investment. It is one of the simplest investment
appraisal techniques.
Formula:
The formula to calculate payback period of a project depends on
whether the cash flow per period from the project is even or uneven.
In case they are even, the formula to calculate payback period is:
Initial Investment
Payback Period = ---------------------------------Cash Inflow per Period
When cash inflows are uneven, we need to calculate the cumulative
net cash flow for each period and then use the following formula for
payback period:
Payback Period = A +B/C
In the above formula,
A is the last period with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the
period A;
C is the total cash flow during the period after A
Both of the above situations are applied in the following examples.
Decision Rule Accept the project only if its payback period is LESS than the target
payback period.
Examples -
Example 1: Even Cash Flows
Company C is planning to undertake a project requiring initial
investment of $105 million. The project is expected to generate $25
million per year for 7 years. Calculate the payback period of the
project.
Solution
Payback Period = Initial Investment ÷ Annual Cash Flow = $105M ÷
$25M = 4.2 years
Example 2: Uneven Cash Flows
Company C is planning to undertake another project requiring initial
investment of $50 million and is expected to generate $10 million in
Year 1, $13 million in Year 2, $16 million in year 3, $19 million in Year
4 and $22 million in Year 5. Calculate the payback value of the
project.
Solution
(cash flows in millions)Cumulative
Year
Cash Flow Cash Flow
0
(50)
(50)
1
10
(40)
2
13
(27)
3
16
(11)
4
19
8
5
22
30
Payback Period
= 3 + (|-$11M| ÷ $19M)
= 3 + ($11M ÷ $19M)
≈ 3 + 0.58
≈ 3.58 years
Advantages and Disadvantages
Advantages of payback period are:
o Payback period is very simple to calculate.
o It can be a measure of risk inherent in a project. Since cash
flows that occur later in a project's life are considered more
uncertain, payback period provides an indication of how certain
the project cash inflows are.
o For companies facing liquidity problems, it provides a good
ranking of projects that would return money early.
Disadvantages of payback period are:
o Payback period does not take into account the time value of
money which is a serious drawback since it can lead to wrong
decisions. A variation of payback method that attempts to
remove this drawback is called discounted payback
period method.
o It does not take into account, the cash flows that occur after the
payback period.
2. Discounted Pay Back Period
One of the major disadvantages of simple payback period is that it
ignores the time value of money. To counter this limitation, an
alternative procedure called discounted payback period may be
followed, which accounts for time value of money by discounting the
cash inflows of the project.
Formulas and Calculation Procedure
In discounted payback period we have to calculate the present value
of each cash inflow taking the start of the first period as zero point.
For this purpose the management has to set a suitable discount rate.
The discounted cash inflow for each period is to be calculated using
the formula:
Discounted Cash Inflow =
Actual Cash Inflow
(1 + i)n
Where,
i is the discount rate;
n is the period to which the cash inflow relates.
Usually the above formula is split into two components which are
actual cash inflow and present value factor ( i.e. 1 / ( 1 + i )^n ). Thus
discounted cash flow is the product of actual cash flow and present
value factor.
The rest of the procedure is similar to the calculation of simple
payback period except that we have to use the discounted cash flows
as calculated above instead of actual cash flows. The cumulative cash
flow will be replaced by cumulative discounted cash flow.
Discounted PayBack period = A + B / C
Where,
A = Last period with a negative discounted cumulative cash flow;
B = Absolute value of discounted cumulative cash flow at the end of
the period A;
C = Discounted cash flow during the period after A.
Note: In the calculation of simple payback period, we could use an
alternative formula for situations where all the cash inflows were
even. That formula won't be applicable here since it is extremely
unlikely that discounted cash inflows will be even.
The calculation method is illustrated in the example below.
Decision Rule
If the discounted payback period is less that the target period, accept
the project. Otherwise reject.
Example
An initial investment of $2,324,000 is expected to generate $600,000
per year for 6 years. Calculate the discounted payback period of the
investment if the discount rate is 11%.
Solution
Step 1: Prepare a table to calculate discounted cash flow of each
period by multiplying the actual cash flows by present value factor.
Create a cumulative discounted cash flow column.
Year
n
Cash Flow
CF
0
$
−2,324,000
600,000
600,000
600,000
600,000
600,000
600,000
1
2
3
4
5
6
Present Value
Factor
PV$1=1/(1+i)n
1.0000
0.9009
0.8116
0.7312
0.6587
0.5935
0.5346
Discounted
Cash Flow
CF×PV$1
$ −2,324,000
Cumulative
Discounted
Cash Flow
$ −2,324,000
540,541
486,973
438,715
395,239
356,071
320,785
− 1,783,459
− 1,296,486
− 857,771
− 462,533
− 106,462
214,323
Step 2: Discounted Payback Period = 5 + |-106,462| / 320,785 ≈ 5.32
years
Advantages and Disadvantages
Advantage: Discounted payback period is more reliable than simple
payback period since it accounts for time value of money. It is
interesting to note that if a project has negative net present value it
won't pay back the initial investment.
Disadvantage: It ignores the cash inflows from project after the
payback period.
3. Net Present Value
Net present value (NPV) of a project is the potential change in an
investor's wealth caused by that project while time value of money is
being accounted for. It equals the present value of net cash inflows
generated by a project less the initial investment on the project. It is
one of the most reliable measures used in capital budgeting because
it accounts for time value of money by using discounted cash flows in
the calculation.
Net present value calculations take the following two inputs:


Projected net cash flows in successive periods from the project.
A target rate of return i.e. the hurdle rate.
Where,
Net cash flow equals total cash inflow during a period, including
salvage value if any, less cash outflows from the project during the
period.
Hurdle rate is the rate used to discount the net cash
inflows. Weighted average cost of capital (WACC)is the most
commonly used hurdle rate.
Calculation Methods and Formulas
The first step involved in the calculation of NPV is the estimation of
net cash flows from the project over its life. The second step is to
discount those cash flows at the hurdle rate.
The net cash flows may be even (i.e. equal cash flows in different
periods) or uneven (i.e. different cash flows in different periods).
When they are even, present value can be easily calculated by using
the formula for present value of annuity. However, if they are
uneven, we need to calculate the present value of each individual net
cash inflow separately.
Once we have the total present value of all project cash flows, we
subtract the initial investment on the project from the total present
value of inflows to arrive at net present value.
Thus we have the following two formulas for the calculation of NPV:
When cash inflows are even:
1 − (1 + i)-n
NPV = R ×
− Initial Investment
i
In the above formula,
R is the net cash inflow expected to be received in each period;
i is the required rate of return per period;
n are the number of periods during which the project is expected to
operate and generate cash inflows.
When cash inflows are uneven:
R1
R2
R3
NPV =
+
+
+ ... − Initial Investment
(1 + i)1 (1 + i)2 (1 + i)3
Where,
i is the target rate of return per period;
R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second period;
R3 is the net cash inflow during the third period, and so on ...
Decision Rule
In case of standalone projects, accept a project only if its NPV is
positive, reject it if its NPV is negative and stay indifferent between
accepting or rejecting if NPV is zero.
In case of mutually exclusive projects (i.e. competing projects),
accept the project with higher NPV.
Examples
Example 1: Even Cash Inflows: Calculate the net present value of a
project which requires an initial investment of $243,000 and it is
expected to generate a cash inflow of $50,000 each month for 12
months. Assume that the salvage value of the project is zero. The
target rate of return is 12% per annum.
Solution
We have,
Initial Investment = $243,000
Net Cash Inflow per Period = $50,000
Number of Periods = 12
Discount Rate per Period = 12% ÷ 12 = 1%
Net Present Value
= $50,000 × (1 − (1 + 1%)^-12) ÷ 1% − $243,000
= $50,000 × (1 − 1.01^-12) ÷ 0.01 − $243,000
≈ $50,000 × (1 − 0.887449) ÷ 0.01 − $243,000
≈ $50,000 × 0.112551 ÷ 0.01 − $243,000
≈ $50,000 × 11.2551 − $243,000
≈ $562,754 − $243,000
≈ $319,754
Example 2: Uneven Cash Inflows: An initial investment of $8,320
thousand on plant and machinery is expected to generate cash
inflows of $3,411 thousand, $4,070 thousand, $5,824 thousand and
$2,065 thousand at the end of first, second, third and fourth year
respectively. At the end of the fourth year, the machinery will be sold
for $900 thousand. Calculate the net present value of the investment
if the discount rate is 18%. Round your answer to nearest thousand
dollars.
Solution
PV Factors:
Year 1 = 1 ÷ (1 + 18%)^1 ≈ 0.8475
Year 2 = 1 ÷ (1 + 18%)^2 ≈ 0.7182
Year 3 = 1 ÷ (1 + 18%)^3 ≈ 0.6086
Year 4 = 1 ÷ (1 + 18%)^4 ≈ 0.5158
The rest of the calculation is summarized below:
Year
Net Cash Inflow
Salvage Value
Total Cash Inflow
× Present Value Factor
Present Value of Cash
Flows
Total PV of Cash Inflows
− Initial Investment
Net Present Value
1
$3,411
2
$4,070
3
$5,824
4
$2,065
900
$3,411
$4,070
$5,824
$2,965
0.8475
0.7182
0.6086
0.5158
$2,890.68 $2,923.01 $3,544.67 $1,529.31
$10,888
− 8,320
$2,568 thousand
Strengths and Weaknesses of NPV
Strengths
Net present value accounts for time value of money which makes it a
sounder approach than other investment appraisal techniques which
do not discount future cash flows such payback period and
accounting rate of return.
Net present value is even better than some other discounted cash
flows techniques such as IRR. In situations where IRR and NPV give
conflicting decisions, NPV decision should be preferred.
Weaknesses
NPV is after all an estimation. It is sensitive to changes in estimates
for future cash flows, salvage value and the cost of capital.
Net present value does not take into account the size of the project.
For example, say Project A requires initial investment of $4 million to
generate NPV of $1 million while a competing Project B requires $2
million investment to generate an NPV of $0.8 million. If we base our
decision on NPV alone, we will prefer Project A because it has higher
NPV, but Project B has generated more shareholders’ wealth per
dollar of initial investment ($0.8 million/$2 million vs $1 million/$4
million).
4. Accounting Rate of Return (ARR)
Accounting rate of return (also known as simple rate of return) is the
ratio of estimated accounting profit of a project to the average
investment made in the project. ARR is used in investment appraisal.
Formula
Accounting Rate of Return is calculated using the following formula:
ARR =
Average Accounting Profit
Average Investment
Average accounting profit is the arithmetic mean of accounting
income expected to be earned during each year of the project's life
time. Average investment may be calculated as the sum of the
beginning and ending book value of the project divided by 2. Another
variation of ARR formula uses initial investment instead of average
investment.
Decision Rule
Accept the project only if its ARR is equal to or greater than the
required accounting rate of return. In case of mutually exclusive
projects, accept the one with highest ARR.
Examples
Example 1: An initial investment of $130,000 is expected to generate
annual cash inflow of $32,000 for 6 years. Depreciation is allowed on
the straight line basis. It is estimated that the project will generate
scrap value of $10,500 at end of the 6th year. Calculate its accounting
rate of return assuming that there are no other expenses on the
project.
Solution
Annual Depreciation = (Initial Investment − Scrap Value) ÷ Useful Life
in Years
Annual Depreciation = ($130,000 − $10,500) ÷ 6 ≈ $19,917
Average Accounting Income = $32,000 − $19,917 = $12,083
Accounting Rate of Return = $12,083 ÷ $130,000 ≈ 9.3%
Example 2: Compare the following two mutually exclusive projects on
the basis of ARR. Cash flows and salvage values are in thousands of
dollars. Use the straight line depreciation method.
Project A:
Year
Cash Outflow
0
1
2
3
91
130
105
-220
Cash Inflow
Salvage Value
10
Project B:
Year
Cash Outflow
Cash Inflow
Salvage Value
Solution
0
1
2
3
87
110
84
-198
18
Project A:
Step 1: Annual Depreciation = ( 220 − 10 ) / 3 = 70
Step 2: Year
Cash Inflow
1
2
3
91
130
105
Salvage Value
Depreciation*
10
-70
-70
-70
Accounting Income 21
60
45
Step 3: Average Accounting Income = ( 21 + 60 + 45 ) / 3
= 42
Step 4: Accounting Rate of Return = 42 / 220 = 19.1%
Project B:
Step 1: Annual Depreciation = ( 198 − 18 ) / 3 = 60
Step 2: Year
Cash Inflow
1
2
3
87
110
84
Salvage Value
Depreciation*
18
-60
-60
-60
Accounting Income 27
50
42
Step 3: Average Accounting Income = ( 27 + 50 + 42 ) / 3
= 39.666
Step 4: Accounting Rate of Return = 39.666 / 198 ≈ 20.0%
Since the ARR of the project B is higher, it is more favorable than the project A.
Advantages and Disadvantages
Advantages
o Like payback period, this method of investment appraisal is easy
to calculate.
o It recognizes the profitability factor of investment.
Disadvantages
o It ignores time value of money. Suppose, if we use ARR to
compare two projects having equal initial investments. The
project which has higher annual income in the latter years of its
useful life may rank higher than the one having higher annual
income in the beginning years, even if the present value of the
income generated by the latter project is higher.
o It can be calculated in different ways. Thus there is problem of
consistency.
o It uses accounting income rather than cash flow information. Thus
it is not suitable for projects which having high maintenance costs
because their viability also depends upon timely cash inflows.
5. Internal Rate of Return
Internal rate of return (IRR) is the discount rate at which the net
present value of an investment becomes zero. In other words, IRR is
the discount rate which equates the present value of the future cash
flows of an investment with the initial investment. It is one of the
several measures used for investment appraisal.
Decision Rule
A project should only be accepted if its IRR is NOT less than the target
internal rate of return. When comparing two or more mutually
exclusive projects, the project having highest value of IRR should be
accepted.
IRR Calculation
The calculation of IRR is a bit complex than other capital
budgeting techniques. We know that at IRR, Net Present Value (NPV)
is zero, thus:
NPV = 0; or
PV of future cash flows − Initial Investment = 0; or
CF1
CF2
1
(1+r)
+
CF3
2
(1+r)
+
3
+ ... − Initial Investment = 0
(1+r)
Where,
r is the internal rate of return;
CF1 is the period one net cash inflow;
CF2 is the period two net cash inflow,
CF3 is the period three net cash inflow, and so on ...
But the problem is, we cannot isolate the variable r (=internal rate of
return) on one side of the above equation. However, there are
alternative procedures which can be followed to find IRR. The
simplest of them is described below:
o Guess the value of r and calculate the NPV of the project at that
value.
o If NPV is close to zero then IRR is equal to r.
o If NPV is greater than 0 then increase r and jump to step 5.
o If NPV is smaller than 0 then decrease r and jump to step 5.
o Recalculate NPV using the new value of r and go back to step 2.
Example
Find the IRR of an investment having initial cash outflow of $213,000.
The cash inflows during the first, second, third and fourth years are
expected to be $65,200, $96,000, $73,100 and $55,400 respectively.
Solution
Assume that r is 10%.
NPV at 10% discount rate = $18,372
Since NPV is greater than zero we have to increase discount rate, thus
NPV at 13% discount rate = $4,521
But it is still greater than zero we have to further increase the
discount rate, thus
NPV at 14% discount rate = $204
NPV at 15% discount rate = ($3,975)
Since NPV is fairly close to zero at 14% value of r, therefore
IRR ≈ 14%
6. Profitability Index
Profitability index is an investment appraisal technique calculated by
dividing the present value of future cash flows of a project by the
initial investment required for the project.
Formula:
Profitability Index
Present Value of Future Cash Flows
=
Initial Investment Required
=1+
Net Present Value
Initial Investment Required
Explanation:
Profitability index is actually a modification of the net present value
method. While present value is an absolute measure (i.e. it gives as
the total dollar figure for a project), the profibality index is a relative
measure (i.e. it gives as the figure as a ratio).
Decision Rule
Accept a project if the profitability index is greater than 1, stay
indifferent if the profitability index is 1 and don't accept a project if
the profitability index is below 1.
Profitability index is sometimes called benefit-cost ratio too and is
useful in capital rationing since it helps in ranking projects based on
their per dollar return.
Example
Company C is undertaking a project at a cost of $50 million which is
expected to generate future net cash flows with a present value of
$65 million. Calculate the profitability index.
Solution
Profitability Index = PV of Future Net Cash Flows / Initial Investment
Required
Profitability Index = $65M / $50M = 1.3
Net Present Value = PV of Net Future Cash Flows − Initial Investment
Required
Net Present Value = $65M-$50M = $15M.
The information about NPV and initial investment can be used to
calculate profitability index as follows:
Profitability Index = 1 + (Net Present Value / Initial Investment
Required)
Profitability Index = 1 + $15M/$50M = 1.3
Cost of capital
A. Cost of Capital
The cost of capital is the cost of a firm's debt and equity funds, or the
required rate of return on a portfolio of the company's existing
securities. It is used to evaluate and decide new projects, as well as
the minimum return investors expect from the invested capital.
The cost of capital is determined by computing the costs of various
financing sources and weighing them proportionately, in balance, to
their designated use in the capital structure. It is important to
maximize the firm's value, while minimizing the cost of capital. Each
capital structure component's cost is closely related to the valuation
of that source.
The cost of capital may be computed using debt, equity, and
weighted average formulas and is useful in making capital budgeting
decisions. A proposal is not accepted if its rate of return is less than
the cost of capital. Financial performance and investment
acceptability may be determined from analyzing the discounted cash
flows.
Debt and preferred stock carry inherent risk. The cost is directly
related to the current yield, and debt is adjusted lower to reflect the
tax-deductible interest. The cost of retained earnings of common
stock is the current dividend yield plus anticipated future growth
rate. Adjustments are typically made to the calculation to determine
the cost of new common stock.
Capital structure elements are weighted to obtain a minimum overall
cost. Debt (borrowing) may appear to be the least costly solution.
Caution is advised, however, as excessive debt creates more risk,
which in turn drives up costs of all financing sources. The debt
component that results in the lowest overall cost of capital is
preferred. Then, the weighted average cost of capital may be used as
the discount rate to estimate the present value of future flows. It also
helps ensure the firm is earning at least the cost of financing.
The firm's present rate of earnings is less when the cost of capital is
high, which indicates there is more risk and that the capital structure
is not balanced. Investors can expect higher rates of returns in such
instances.
The marginal cost of capital is the capital raised within a given period.
The marginal cost of capital increases as the amount of capital
increases.
The marginal cost of capital is considered and calculated as the "last
dollar of capital raised." That is, as the last of the retained earnings
(equity) is depleted, the cost of financing goes up. Higher-cost, new
common stock is substituted for retained earnings, using the
appropriate debt-to-equity ratio, to maintain the most favorable
capital structure.
B. Cost of Debt versus Cost of Equity
Firms typically use debt or equity resources to expand the firm.
Debt is money borrowed that must be repaid with interest.
Equity is money that has been raised through stock options or other
interests in the company.
The cost of capital sources varies and depends on the firm's particular
operating history, profitability, credit riskiness, and so forth. New
companies with limited operating histories will experience higher
costs of capital, since investors will demand a higher risk premium.
COST OF DEBT
The cost of debt is interest paid on the amount borrowed. It is the
interest rate on a risk-free bond whose duration is the same as the
term structure of the firm's debt plus the default premium -- and
default premium and risk increase as the debt increases.
ADVANTAGES
Raising debt capital is less complicated than raising (equity) capital
from shareholders. There is no requirement to comply with state or
federal securities laws and regulations. Nor does the firm need to
have shareholder consensus before acting, or is it required
periodically to update investors and shareholders on the status of the
debt. Additional advantages of debt financing include the following:
More tax efficient than equity financing,
o Cost of debt is an after-tax cost (equal to the cost of equity).
o Interest (debt) expense is deductible.
o Dividends on common shares must be paid with after-tax dollars.
Lenders have no claim to equity in the company.
Lenders are only entitled to repayment of agreed principal, plus
interest.
Ownership interest is not diminished by the debt.
A larger end gain is realized than if equity was sold to finance the
growth, and
Principal and interest re-payments are structured (except for variable
rates), and may be planned for and forecast.
DISADVANTAGES
An excess of debt results in high leverage, which in turn leads to
higher lender interest rates necessary to offset the higher default
risk.
DISCOUNTED TAX RATE
For profitable firms, debt is discounted by the tax rate. Since interest
expense is tax deductible, the after-tax cost of debt is calculated as:
Yield to maturity = Debt x (1 - T)
Where:
T = The company's marginal tax rate
Debt x = Risk free rate
COST OF EQUITY
The cost of equity is money raised from shareholders by:
1. Issuing more shares to shareholders, or
2. Issuing shares to new shareholders, and the dividend (interest)
paid is the cost of equity.
The rate of return that equity investors require is not as neatly
defined as the return on debt is by lenders. The cost of equity is
approximated by comparing the particular investment to other
investments having similar risk profiles. A future dividend stream is
estimated based on the firm's dividend history and an assumed
growth rate. The calculated market capitalization rate is equivalent to
the current market price. Firms' estimated "dividend paying
capacity," that do not distribute dividend profits, is from average
cash flow and net income, which are compared to dividends that
another, similar firm distributes.
The cost of equity is approximated, using the Capital Asset Pricing
Model (CAPM). Typically using common stock returns over time,
CAPM associates the risk-return trade offs of individual assets to
market returns, and operates only in a market of equilibrium. Stock
prices and market indexes are readily available and efficiently priced.
The CAPM represents, "a linear relationship between individual stock
return and stock market return over time." Using the Least Squares
Regression formula:
Kj = α + βKm + e
Where:
Kj = Common stock return
α = "Alpha," the intercept on the y-axis (expected risk-free rate of
return)
β = "Beta," the co-efficient (sensitivity to market movement)
Km = Stock market return (typically S&P 500 Index)
e = Error term
Perhaps a simpler version of the CAPM may also be expressed as:
Es = Rf + βs (Rm – Rf)
Where:
Es = Expected return on a security
Rf = Expected risk-free rate of return in the relevant market
βs = Sensitivity to market risk for the particular security
Rm = Historic return of the equity market
(Rm – Rf) = Risk premium of market assets over risk-free assets.
COST OF PREFERENCE SHARE
The cost of preference share capital is apparently the dividend which
is committed and paid by the company. This cost is not relevant for
project evaluation because this is not the cost at which further capital
can be obtained. To find out the cost of acquiring the marginal cost,
we will be finding the yield on the preference share based on the
current market value of the preference share.
The preference share is issued at a stated rate of dividend on the face
value of the share. Although the dividend is not mandatory and it
does not create legal obligation like debt, it has the preference of
payment over equity for dividend payment and distribution of assets
at the time of liquidation. Therefore, without paying the dividend to
preference shares, they cannot pay anything to equity shares. In that
scenario, management normally tries to pay a regular dividend to the
preference shareholders.
Broadly, preference shares can be of two types – Redeemable and
Irredeemable.
COST OF REDEEMABLE PREFERENCE SHARE
These shares are issued for a particular period and at the expiry of
that period, they are redeemed and principal is paid back to the
preference shareholders. The characteristics are very similar to debt
and therefore the calculations will be similar too. For finding cost of
redeemable preference shares, following formula can be used.
Here, preference share is traded at say P0 with dividend payments ‘D’
and principal repayment ‘P’. The cost of debt is designated by Kp.
Kp can be determined by solving above equation.
EXPLANATION TO COST OF REDEEMABLE PREFERENCE CAPITAL WITH
EXAMPLE
For example, a firm had on the balance sheet, a 9% preference stock
which matures after 3 years. The face value is 1000. Putting the
formula when current market price of the debenture is 950, we get,
Solving the above equation, we will get 11.05%. This is the cost of
preference share capital. In the case of debt, it would have required
further adjustment with respect to tax because debt enjoys tax
shield. Preference dividend is paid out of profits and not treated as
an expense for the company. Rather it is called profit distribution.
COST OF IRREDEEMABLE PREFERENCE SHARE
These shares are issued for the life of the company and are not
redeemed. Cost of irredeemable preference shares can be calculated
as follows:
Here, preference share is traded at say P0 with dividend payments
‘D’. The cost of debt is designated by Kp. Kp can be determined by
solving above equation.
EXPLANATION TO COST OF IRREDEEMABLE PREFERENCE CAPITAL
WITH EXAMPLE
For example, a firm issued a 10% preference stock of $1000 which
has a current market price of $900. Cost can be calculated as below:
Kp = 100/900
Solving the above equation, we will get 11.11%. This is the cost of
redeemable preference share capital.
METHODS FOR MEASURING COST OF CAPITAL
Cost of capital can be defined both from organization’s and investor’s
point of view.
From an organization’s point of view, cost of capital is a rate at which
an organization raises capital to invest in various projects.
The basic motive of an organization to raise any kind of capital is to
invest in its various projects for earning profit. Further, out of that
profit, the organization pays interest and dividend to the sources of
capital. The amount paid as interest and dividend is considered as
cost of capital.
From the investors’ point of view, cost of capital is the rate of return,
which investors expect from the capital invested by them in the
organization. The calculation of cost of capital is very significant for
the management of an organization.
The significance of cost of capital is as follows:
(a) Capital Budgeting Decision:
Refers to the decision, which helps in calculating profitability of
various investment proposals.
(b) Capital Requirement:
Refers to the extent to which fund is required by an organization at
different stages, such as incorporation stage, growth stage, and
maturity stage. When an organization is in its incorporation stage or
growth stage, it raises more of equity capital as compared to debt
capital. The evaluation of cost of capital increases the profitability
and solvency of an organization as it helps in analyzing cost efficient
financing mix.
(c) Optimum Capital Structure:
Refers to an appropriate capital structure in which total cost of
capital would be least. Optimal capital structure suggests the limit of
debt capital raised to reduce the cost of capital and enhance the
Value of an organization.
(d) Resource Mobilization:
Enables an organization to mobilize its fund from non-profitable to
profitable areas. Resource mobilization helps in reducing risk factor
as an organization can shut down its unproductive projects and move
the resources to productive projects to earn profit.
(e) Determination of duration of Project:
Refers to evaluating whether the project, for which the capital is
raised, is long term or short term. If the project is long term in nature
then the organization decides to raise equity capital. However, if the
project is short term in nature then the organization determines to
raise debt capital.
Cost of capital can be measured by using various methods, as
shown in Figure-2:
The explanation of methods measuring cost of capital (as shown in
Figure-2) is as follows.
Cost of Debt Capital:
Generally, cost of debt capital refers to the total cost or the rate of
interest paid by an organization in raising debt capital. However, in a
real situation, total interest paid for raising debt capital is not
considered as cost of debt because the total interest is treated as an
expense and deducted from tax.
This reduces the tax liability of an organization. Therefore, to
calculate the cost of debt, the organization needs to make some
adjustments. Let us understand the calculation of cost of debt with
the help of an example.
Suppose an organization raised debt capital of Rs. 10000 and paid
10% interest on it. The organization is paying corporation tax at the
rate of 50%. In this ca.se, the total 10% of interest rate would not be
deducted from tax and the deduction would be 50% of 10%.
Therefore, the cost of debt would be only 5%. While calculating cost
of debt capital, discount allowed, underwriting commission, and cost
of advertisement are also considered. These expenses are added to
the amount of interest paid, which is considered as total cost of debt
capital.
For example, when an organization increases its proportion of debt
capital more than the optimum level, then it increases its risk factor.
Therefore, the investors feel insecure and their expectations of EPS
start increasing, which is the hidden cost related to debt capital.
Formulae to calculate cost of debt are as follows:
1. When the debt is issued at par
KD = [(1-T)*R]*100
Where,
KD = Cost of debt
T = Tax rate
R = Rate of interest on debt capital
KD = Cost of debt capital
2. Debt issued at premium or discount when debt is irredeemable:
KD = [1/NP*(1-T)* 100]
Where,
NP = Net proceeds of debt
3. Cost of redeemable debt:
KD = [{I (1-T) -H (P-NP/N) * (1- T)}/ (P -H NP/2)] * 100
Where,
N = Numbers of years of maturity
P = Redeemable value of debt
For example, an organization issued 10% debentures of the face
value of Rs. 100 redeemable at par after 20 years.
Assuming 50% tax rate and 5% floatation cost, calculate cost of debt
in the following conditions:
1. When debentures are issued at par
2. When debentures are issued at 10% discount
3. When debentures are issued at 10% premium
Solution:
The solution is given as follows:
Cost of redeemable debt = [{I (1-T) + (P- NP/N) (1- T)}/ (P + NP/2)] *
100
1. When debentures are issued at par
KD = [{10(1 – 0.50) + (100 – 95/20) (1 – 0.50)}/ (100 + 95/2)] *100
= 5.25%
2. When debentures are issued at 10% discount
KD = [{10(1 – 0.50) + (100 – 85/20) (1 – 0.50)}/ (100 + 85/2)] *100
= 5.81%
3. When debenture is issued at 10% premium
KD = [{10(1 – 0.50) + (100 – 110/20) (1 – 0.50)}/ (100 + 110/2)] *100
= 4.52%
Cost of Preference Capital:
Cost of preference capital is the sum of amount of dividend paid and
expenses incurred for raising preference shares. The dividend paid on
preference shares is not deducted from tax, as dividend is an
appropriation of profit and not considered as an expense.
Cost of preference share can be calculated by using the following
formulae:
1. Cost of redeemable preference shares:
KP = [{D + F/N (1 – T) + RP/N}/ {P + NP/2}] * 100
Where,
KP = Cost of preference share
D = Annual preference dividend
F = Expenses including underwriting commission, brokerage, and
discount
N = Number of years to maturity
RP = Redemption premium
P = Redeemable value of preference share
NP = Net proceeds of preference shares
2. Cost of irredeemable preference shares:
KP = (D/NP) * 100
For example, an organization issues 10% preference shares of Rs. 100
each, redeemable at par after 20 years.
Assuming 4% floatation cost and 50% corporate tax; calculate cost
of preference share in the following conditions:
1. When preference shares are issued at par
2. When preference shares are issued at 10% discount
3. When preference shares are issued at 10% premium
Solution:
The solution is given as follows:
Cost of redeemable preference shares = [{(D + F)/N (1 – T) + RP/N}/
{(P + NP)/2}] * 100
1. When preference shares are issued at par:
KP = [{(10 + 4)/20 (1 – 0.50) + 0/20}/ {(100 + 96)/2}] * 100
= 10.30%
2. When preference shares are issued at 10% discount:
KP = [{(10 + 4)/20 (1 – 0.50) + 0/20}/ {(100 + 86)/2}] * 100
= 10.86%
3. When preference shares are issued at 10% premium:
KP = [{(10 + 4)/20 (1 – 0.50) + 0/20}/ {(100 + 106)/2}] * 100
= 9.80%
Cost of Equity Capital:
Calculating the cost of equity capital is a little difficult as compared to
debt capital and preference capital. The main reason is that the
equity shareholders do not receive fixed interest or dividend. The
dividend on equity shares varies depending upon the profit earned by
an organization. Risk factor also plays an important role in deciding
rate of dividend to be paid on equity capital.
Therefore, there are various approaches to calculate cost of equity
capital, as shown in Figure-3:
The explanation of these approaches (as shown in Figure-3) is as
follows:
Dividend Price Approach:
The dividend price approach describes the investors’ view before
investing in equity shares. According to this approach, investors have
certain minimum expectations of receiving dividend even before
purchasing equity shares. An investor calculates present market price
of the equity shares and their rate of dividend.
The dividend price approach can be mathematically calculated by
using the following formula:
KE = (Dividend per share/Market price per share) * 100
KE = Cost of equity capital
However, the dividend price approach is criticized on certain
grounds, which are as follows:
a. Does not take into consideration the appreciation in the value of
capital. The dividend price approach is based on the assumption that
investors expect some dividend on their shares. It completely ignores
the fact that some investors also consider the chances of capital
appreciation, which increases the value of their shares.
b. Ignores the impact of retained earnings, which affect both the
market price of shares and the amount of dividend paid. For
example, suppose if an organization keeps major portion of its profit
as retained earnings then it would pay low dividend, which may
decrease the market price of its shares.
Earnings Price Ratio Approach:
The earnings price ratio approach suggests that cost of equity capital
depends upon amount of fixed earnings of an organization. According
to the earnings price ratio approach, an investor expects that a
certain amount of profit must be generated by an organization.
Investors do not always expect that the organization distribute
dividend on a regular basis. Sometimes, they prefer that the
organization invests the amount of dividend in further projects to
earn profit. In this way, the organization’s profit would increase,
which in turn increases the value of its shares in the market.
The formula to calculate cost of capital through the earnings price
ratio approach is as follows:
KE = E/MP
Where,
E = Earnings per share
MP = Market price
However, this approach is criticized on the following grounds:
a. Assumes that EPS would remain constant
b. Assumes that market price per share would remain constant
c. Ignores the fact that all the earnings of an organization are not
distributed in the form of dividend. However, some part of earnings
may be kept in form of retained earnings.
Dividend Price plus Growth Approach:
The dividend price plus growth approach refers to an approach in
which the rate of dividend grows with the passage of time. In the
dividend price plus growth approach, investors not only expect
dividend but regular growth in the rate of dividend. The growth rate
of dividend is assumed to be equal to the growth rate in EPS and
market price per share.
In the dividend price plus growth approach, cost of capital can be
calculated mathematically by using the following formula:
KE = [(D/MP) + GJ * 100
Where,
D = Expected dividend per share, at the end of period
G = Growth rate in expected dividends
This approach is considered as the best approach to evaluate the
expectations of investors and calculate the cost of equity capital. For
example, your company’s share is quoted in the market at Rs. 20
currently. The company pays as dividend of Re. 1 per share and the
investor’s market expects a growth rate of 5% year.
a. Compute the company’s equity cost of capital.
b. If the anticipated growth rate is 6% p.a., calculate the indicated
market price per share.
c. If the company’s cost of capital is 8% and the anticipated growth
rate is 5% p.a., calculate the indicated market price if the dividend of
Re. 1 per share is to be maintained.
Solution:
The equity cost of capital is as follows:
a. KE = [{D/MP) + G] * 100
= [(1/20) + 0.05] * 100= 10%
b. MP = [{D + (G * MP)}/KE] * 100 = [{1 + (0.06 * MP)}/0.10] * 100 =
Rs. 16.94
c. MP = [{D + (G * MP)}/KE] * 100 = [{1 + (0.05 * MP)}/0.08] * 100 =
Rs. 20.32
Realized Yield Approach:
In the realized yield approach, an investor expects to earn the same
amount of dividend, which the organization has paid in past few
years. In this approach, the growth in dividend is not considered as
major factors for deciding the cost of capital.
This approach is based on the following assumptions:
a. Risk factor remains constant in an organization. Returns in the
given risk remain the same as per the expectations of shareholders.
b. Realized yield is equivalent to the reinvestment opportunity rate
for shareholders.
According to the realized yield approach, cost of capital can be
calculated mathematically by using the following formula:
KE = [{(D-P)/p} – 1] * 100
Where,
P = Price at the end of the period,
p = Price per share to day
Capital Asset Price Model (CAPM):
CAPM helps in calculating the expected rate of return from a share of
equivalent risk in the capital market. The cost of shares that carry risk
would be equal to cost of lost opportunity. For example, an investor
has two investment options- to buy the shares of either X Ltd. or Y
Ltd. If the investor decides to buy the shares of X Ltd. then the cost of
shares of Y Ltd. would be the cost of lost opportunity.
CAPM is based on the following assumptions:
a. A rationale investor would always avoid risk
b. A rationale investor would always wish to maximize the expected
yield
c. All investors would have similar expectations
d. All investors can lend freely on the riskless rates of return
e. Capital market is in good condition and there is no existence of tax
f. Capital market is competitive in nature
g. Securities are completely divisible and there is no transaction cost
The computation of cost of capital using CAPM is based on the
condition that the required rate of return on any share should be
equal to the sum of risk less rate of interest and premium for the risk.
According to CAPM, cost of capital can be calculated
mathematically by using the following formulae:
E = R1 +β {E (R2) – R1}
Where,
E = Expected rate of return on asset
β = Beta coefficient of assets
R1 = Risk free rate of return
E (R2) = Expected return from market portfolio
This value can be calculated by analyzing data of usually five years.
Formula used to calculate beta value is as follow:
β = PIM (SD1) (SDM)/SD2M
Where,
β = Beta of stock
PIM = Correlation coefficient between the returns on stock, I and the
returns on market portfolio, M.
SD1 = Standard deviation of returns on assets
SDM = Standard deviation of returns on the market portfolio
SD2M = Variance of market returns
Bond Yield plus Risk Premium Approach:
The bond yield plus risk premium approach states that the cost on
equity capital should be equal to the sum of returns on long-term
bonds of an organization and risk premium given on equity shares.
The risk premium is paid on equity shares because they carry high
risk.
Mathematically, the cost of capital is calculated as:
Cost of equity capital= Returns on long-term bonds + Risk premium
The bond yield plus risk premium approach is based on the fact that a
risky organization would have high financial leverage. As a result of
this, it would be earning higher profit. Therefore, the equity
shareholders due to higher risks on their investments expect higher
returns in the form of risk premium.
Gordon Model:
The Gordon model was proposed by Myron Gordon to calculate cost
of equity capital. As per this model, an investor always prefers less
risky investment as compared to more risky investment.
Therefore, an organization should pay risk premium only on risky
investment. The Gordon model also suggests that an investor would
always prefer more of those investments, which would provide them
current income.
The Gordon model is based on the following assumptions:
a. The rate of return on the investments of an organization is
constant
b. The cost of equity capital is more than the growth rate
c. The corporation tax does not exist in the economy
d. The organization has perpetual existence
e. The growth rate of the organization is a part of retention ratio and
its rate of return
According to the Gordon model, cost of capital can be calculated
mathematically by using the following formula:
P = E (1 -b)/K – br
Where,
P = Price per share at the beginning of the year
E = Earnings per share at the end of the year
b = Fraction of retained earnings
K = Rate of return required by shareholders
r = Rate of return earned on investments made by the organization
For example, assume that the organization pays the corporation tax
at the rate of 50%.
Compute after tax cost of capital in the following cases:
a. 10% preference shares sold at par.
b. Irredeemable debentures sold at par at the interest rate of 10%.
c. Redeemable debentures of Rs. 100 each, sold at Rs. 95 carrying 8%
interest rate. The maturity period of debentures is after 10 years.
d. Equity shares sold at market price of Rs. 100 and paying a current
dividend of Rs. 10 per share. The expected growth in the dividend of
the share is 8%.
Solution:
The solution is given as follows:
a. The cost of preference shares after tax is 10%
b. Cost of debt for irredeemable debenture when issued at par = [(1 –
T) * R] * 100
KD = [(1 – 0.50) * 10%)] * 100
= 5%
c. Cost of redeemable debenture = [{I (1-T) + (P – NP/N) (1- T)}/ (P +
NP/2)] * 100
KD = [{8(1 – 0.50) + (100 – 95/10) (1 – 0.50)}/ (100 + 95/2)] * 100
= 4.61%
d. Cost of equity share when growth rate of dividend is given =
[(D/MP) + G] * 100
KE = [(10/100) + 8%J * 100
= 18%
Cost of Retained Earnings:
Retained earnings are organizations’ own profit reserves, which are
not distributed as dividend. These are kept to finance long-term as
well as short-term projects of the organization. It is argued that the
retained earnings do not cost anything to the organization. It is
debated that there is no obligation either formal or implied, to earn
any profit by investing retained earnings.
However, it is not correct because the investors expect that if the
organization is not distributing dividend and keeping a part of profit
as reserves then it should invest the retained earnings in profitable
projects. Further, the investors expect that the organization should
distribute the profit earned by investing retained earnings in the form
of dividend.
Cost of retained earnings can be calculated with the help of various
approaches, which are as follows:
(a) KE = KR Approach:
Assumes that if the profit earned by an organization is not retained
but is distributed as dividend, then the shareholders would invest this
dividend in other projects to earn further profit. If an organization
retains the dividend then it prohibits the shareholders from earning
more profit.
Therefore, for retaining the dividend, the organization should earn
the profit, which the shareholders would have earned by investing
the dividend in other projects. Therefore, the amount of profit
expected from the organization on retained earnings is the cost of
retained earnings.
(b) Soloman Erza Approach:
Includes the two options that an organization has that is either to
retain the earnings to meet future uncertainties or invest in its or
other organization’s projects.
Weighted Average Cost of Capital:
Weighted average cost of capital is determined by multiplying the
cost of each source of capital with its respective proportion in the
total capital. Let us understand the concept of weighted average cost
of capital with the help of an example. Suppose an organization
raises capital by issuing debentures and equity shares.
It pays interest on debt capital and dividend on equity capital. When
the organization adds the total interest paid on debt capital to the
total dividend paid on equity capital, it obtains weighted average cost
of capital. An organization requires to generate the profit on its
various investments equal to the weighted average cost of capital.
Weighted average cost of capital can be calculated mathematically
by using the following formula:
Weighted Average Cost of Capital = (KE * E) + (KP * P) + (KD * D) + (KR*
R)
Where,
E = Proportion of equity capital in capital structure
P = Proportion of preference capital in capital structure
D = Proportion of debt capital in capital structure
KR = Cost of proportion of retained earnings in capital structure
R = Proportion of retained earnings in capital structure
Let us understand the weighted average cost of capital with the help
of some examples.
Example-1:
ABC Ltd. has the following capital structure on 31st March 2008:
Equity shares (10000 shares issued) = Rs. 1000000
10% preference shares = Rs. 200000
10% debentures = Rs. 600000
The shares of the organization are currently sold at Rs. 100. It is
expected that the organization would provide dividend of Rs. 10 per
share, which would grow at the rate of 10% forever. Assuming 50%
corporate tax rate, calculate weighted average cost of capital on
existing capital structure.
Solution:
The solution is given as follows:
Cost of debt after tax = [(1 – T) * R] * 100
KD = [(1-0.50)* 10%] * 100
= 5%
Cost of equity capital when growth rate is given = [(D/MP) + G] * 100
KE = [(10/100) + 10%]* 100
= 10%
Calculation of weighted average cost of capital is shown as follows:
Therefore, weighted average cost of capital = 0.0825
Example-2:
A fan manufacturing organization wishes to determine the weighted
average cost of capital to evaluate capital budgeting projects.
You have been given the following information:
Additional Information:
a. 10 years 10% debentures of? 1000 face value, redeemable at 10%
premium can be sold at par, 5% floatation costs.
b. 10% preference shares of selling price Rs. 1000 per share and 5%
floatation costs
c. Equity shares of selling price Rs. 100 per share with Rs. 10
floatation cost per share
The corporate tax is 50% and expected growth in equity dividend is
20% per year. The expected dividend at the current financial year is
Rs. 10 per share. You are required to calculate the weighted average
cost of capital.
Solution:
The solution is given as follows:
Cost of debt capital = [{I (1-T) + (P – NP/N) (1-T)}/ (P + NP/2)] * 100
KD =[ 1(100 (1 – 0.50) + (1100 – 950/10) (1 – 0.50))/ (1100 + 950/2)1
]* 100
= 5.6%
Cost of preference share = (D/NP) * 100
KP = {10/ (1000 – 50)} * 100
= 1.05%
Cost of equity capital = [(D/MP) + G] * 100
KE = 1(10/100) + 0.20) * 100
= 30%
Therefore, weighted average cost of capital is = 15.024%
Example-3:
The following is the capital structure of Saras Ltd. As on 31-12-2005:
The market price of the company’s share is Rs. 110 and it is expected
that a dividend of Rs. 10 per share would be declared after one year.
The dividend growth rate is 6%.
a. If the company is in the 50% tax bracket, compute weighted
average cost of capital.
b. Assuming that in order to finance an expansion plan, the company
intends to borrow a fund of Rs. 20 lakhs bearing 14% rate of interest,
what will be the company’s revised weighted average cost of capital?
This financing decision is expected to increase dividend from Rs. 10 to
Rs. 12 per share. However, the market price of equity share is
expected to decline from Rs. 110 to 105 per share.
Solution:
The solution to the given problem is as follows:
a. KE = [(D/MP) + G]* 100
= [(10/110) + 0.06] *100 = 15.09
KD = [(1 – T) * R] *100
= [(1-0.50)* 0.12]* 100 = 6%
KP = 10%
a. KE = [(D/MP) + G]*100
= [(12/105) + 0.20J * 100 = 31.42
KD = [(1-T)*R]*100
= [(1-0.50) * 0.14] * 100 = 7%
KP = 10%
Marginal Cost of Capital:
Marginal cost of capital can be defined as the cost of additional
capital required by an organization to finance the investment
proposals. It is calculated by first estimating the cost of each source
of capital, which is based on the market value of the capital.
After that, it is identified that which source of capital would be more
appropriate for financing a project. The marginal cost of capital is
ascertained by taking into consideration the effect of additional cost
of capital on the overall profit. In simpler terms, the marginal cost of
capital is calculated in the same manner as the weighted average cost
of capital is calculated by just adding additional capital to the total
cost of capital.
Marginal cost of capital can be calculated mathematically by using
the following formula:
Marginal Cost of Capital = KE {E/ (E + D + P + R)} + KD {D/ (E + D + P +
R)} + KP (P/ (E + D + P R)} + KR {R/ (E + D + P + R)}
For example a company has equity shares of Rs. 100 each, 10%
preference shares, and 12% debentures in the proportion of 3:2:5.
The company needs further capital that is available from a financial
institution @ 14% interest. The new proportion would be 3:2:5:5 for
equity capital, preference capital, debentures, and loans from
financial institutions, respectively.
The company pays 40% tax on income. The market price of equity
shares is Rs. 120 per share. Expected dividend at the end of the year
is Rs. 6 per share. Dividends are expected to grow every year @ 5%.
How will the cost of capital change on borrowing funds from financial
institutions?
Solution:
The calculations of equity and debt capital are as follows:
KE = [(D/MP) + G] *100
= [(6/120) + 0.0.05] * 100 = 10%
KD = [(1-T) *R] * 100
= [(1 – 0.40)* 0.121 * 100
= 7.2%
Cost of loan raised from bank, KD = [(1 – T) * R] * 100
= [(1-0.40) * 0.12] * 100 = 8.4
Therefore it can be analyzed from the calculation that the cost of
capital decreases on borrowing funds from the financial institution.
Before borrowing loan from the financial institution, cost of capital
was 0.086, which reduced to 0.083 after borrowing.
Risk Analysis
Risk analysis is the process of assessing the likelihood of an adverse
event occurring within the corporate, government, or environmental
sector. Risk analysis is the study of the underlying uncertainty of a
given course of action and refers to the uncertainty of forecasted
cash flow streams, variance of portfolio/stock returns, the probability
of a project's success or failure, and possible future economic states.
Risk analysts often work in tandem with forecasting professionals to
minimize future negative unforeseen effects.
A risk analyst starts by identifying what could go wrong. The negative
events that could occur are then weighed against a probability metric
to measure the likelihood of the event occurring. Finally, risk analysis
attempts to estimate the extent of the impact that will be made if the
event happens.
QUANTITATIVE RISK ANALYSIS
Risk analysis can be quantitative or qualitative. Under quantitative
risk analysis, a risk model is built using simulation or deterministic
statistics to assign numerical values to risk. Inputs which are mostly
assumptions and random variables are fed into a risk model. For any
given range of input, the model generates a range of output or
outcome. The model is analyzed using graphs, scenario analysis,
and/or sensitivity analysis by risk managers to make decisions to
mitigate and deal with the risks.
A Monte Carlo simulation can be used to generate a range of possible
outcomes of a decision made or action taken. The simulation is a
quantitative technique that calculates results for the random input
variables repeatedly, using a different set of input values each time.
The resulting outcome from each input is recorded, and the final
result of the model is a probability distribution of all possible
outcomes. The outcomes can be summarized on a distribution graph
showing some measures of central tendency such as
the mean and median, and assessing variability of the data
through standard deviation and variance.
The outcomes can also be assessed using risk management tools such
as scenario analysis and sensitivity tables. A scenario analysis shows
the best, middle, and worst outcome of any event. Separating the
different outcomes from best to worst provides a reasonable spread
of insight for a risk manager. For example, an American Company
that operates on a global scale might want to know how its bottom
line would fare if the exchange rate of select countries strengthens. A
sensitivity table shows how outcomes vary when one or more
random variables or assumptions are changed. A portfolio manager
might use a sensitivity table to assess how changes to the different
values of each security in a portfolio will impact the variance of the
portfolio. Other types of risk management tools include decision
trees and break-even analysis.
QUALITATIVE RISK ANALYSIS
Qualitative risk analysis is an analytical method that does not identify
and evaluate risks with numerical and quantitative ratings.
Qualitative analysis involves a written definition of the uncertainties,
an evaluation of the extent of impact if the risk ensues, and
countermeasure plans in the case of a negative event occurring.
Examples of qualitative risk tools include SWOT Analysis, Cause and
Effect diagrams, Decision Matrix, Game Theory, etc. A firm that wants
to measure the impact of a security breach on its servers may use a
qualitative risk technique to help prepare it for any lost income that
may occur from a data breach.
Almost all sorts of large businesses require a minimum sort of risk
analysis. For example, commercial banks need to properly hedge
foreign exchange exposure of oversees loans while large department
stores must factor in the possibility of reduced revenues due to a
global recession. It is important to know that risk analysis allows
professionals to identify and mitigate risks, but not avoid them
completely.
RISK ANALYSIS TECHNIQUES
It is important to keep in mind that when a company analyzes a
potential project, it is forecasting potential not actual cash flows for a
project. As we all know, forecasts are based on assumptions that may
be incorrect. It is therefore important for a company to perform a
sensitivity analysis on its assumptions to get a better sense of the
overall risk of the project the company is about to take.
There are three risk-analysis techniques that should be known for the
exam:
1. Sensitivity Analysis
Sensitivity analysis is simply the method for determining how
sensitive our NPV analysis is to changes in our variable assumptions.
To begin a sensitivity analysis, we must first come up with a basecase scenario. This is typically the NPV using assumptions we believe
are most accurate. From there, we can change various assumptions
we had initially made based on other potential assumptions. NPV is
then recalculated, and the sensitivity of the NPV based on the change
in assumptions is determined. Depending on our confidence in our
assumptions, we can determine how potentially risky a project can
be.
2. Scenario Analysis
Scenario analysis takes sensitivity analysis a step further. Rather than
just looking at the sensitivity of our NPV analysis to changes in our
variable assumptions, scenario analysis also looks at the probability
distribution of the variables. Like sensitivity analysis, scenario analysis
starts with the construction of a base case scenario. From there,
other scenarios are considered, known as the "best-case scenario"
and the "worst-case scenario". Probabilities are assigned to the
scenarios and computed to arrive at an expected value. Given its
simplicity, scenario analysis is one the most frequently used riskanalysis techniques.
3. Monte Carlo Simulation
Monte Carlo simulation is considered to be the "best" method of
sensitivity analysis. It comes up with infinite calculations (expected
values) given a number of constraints. Constraints are added and the
system generates random variables of inputs. From there, NPV is
calculated. Rather than generating just a few iterations, the
simulation repeats the process numerous times. From the numerous
results, the expected value is then calculated.
Working capital management
Working capital management is the way a company manages the
relationship between assets and liabilities in the short term. Simply
put, working capital management is how a company manages its
money for day to day operations as well as any immediate debt
obligations. When managing working capital, the company has to
manage accounts receivable, accounts payable, inventory and cash.
The goal of working capital management is to have adequate cash
flow for continued operations and have the most productive usage of
resources.
Working capital management refers to a company's managerial
accounting strategy designed to monitor and utilize the two
components of working capital, current assets and current liabilities,
to ensure the most financially efficient operation of the company.
The primary purpose of working capital management is to make sure
the company always maintains sufficient cash flow to meet its shortterm operating costs and short-term debt obligations.
There are a few calculations in working capital management. To
calculate working capital, a company would take current assets and
subtract current liabilities.
Working capital management commonly involves monitoring cash
flow, assets and liabilities through ratio analysis of key elements of
operating expenses, including the working capital ratio, collection
ratio and the inventory turnover ratio. Efficient working capital
management helps with a company's smooth financial operation, and
can also help to improve the company's earnings and profitability.
Management of working capital includes inventory management and
management of accounts receivables and accounts payables.
 Elements of Working Capital Management
The working capital ratio, calculated as current assets divided by
current liabilities, is considered a key indicator of a company's
fundamental financial health since it indicates the company's ability
to successfully meet all of its short-term financial obligations.
Although numbers vary by industry, a working capital ratio below 1.0
is generally indicative of a company having trouble meeting shortterm obligations, usually due to insufficient cash flow. Working
capital ratios of 1.2 to 2.0 are considered desirable, but a ratio higher
than 2.0 may indicate a company is not making the most effective use
of its assets to increase revenues.
The collection ratio, also known as the average collection period
ratio, is a principal measure of how efficiently a company manages its
accounts receivables. The collection ratio is calculated as the number
of days in an accounting period, such as one month, multiplied by the
average amount of outstanding accounts receivables, with that total
then divided by the total amount of net credit sales during the
accounting period. The collection ratio calculation provides the
average number of days it takes a company to receive payment, in
other words, to convert sales into cash. The lower a company's
collection ratio, the more efficient its cash flow.
The final element of working capital management is inventory
management. To operate with maximum efficiency and maintain a
comfortably high level of working capital, a company has to carefully
balance sufficient inventory on hand to meet customers' needs while
avoiding unnecessary inventory that ties up working capital for a long
period of time before it is converted into cash. Companies typically
measure how efficiently that balance is maintained by monitoring the
inventory turnover ratio. The inventory turnover ratio, calculated as
revenues divided by inventory cost, reveals how rapidly a company's
inventory is being sold and replenished. A relatively low ratio
compared to industry peers indicates inventory levels are excessively
high, while a relatively high ratio indicates the efficiency of inventory
ordering can be improved.
 Concept of Working Capital
There are two concepts of working capital:
(i)
Gross working capital
(ii)
Net working capital.
Gross working capital is the capital invested in total current assets
of the enterprise. Examples of current assets are : cash in hand and
bank balances, Bills Receivable, Short term loans and advances,
prepaid expenses, Accrued Incomes etc. The gross working capital is
financial or going concern concept. Net working capital is excess of
Current Assets over Current liabilities.
Net Working Capital = Current Assets – Current Liabilities
When current assets exceed the current liabilities the working capital
is positive and negative working capital results when current
liabilities are more than current assets. Examples of current liabilities
are Bills Payable, Sunday debtors, accrued expenses, Bank Overdraft,
Provision for taxation etc. Net working capital is an accounting
concept of working capital.
 Classification or Kinds of Working Capital
Working capital may be classified in two ways:
(a) On the basis of concept
(b) On the basis of time
On the basis of concept working capital is classified as gross working
capital and net working capital. On the basis of time working capital
may be classifies as Permanent or fixed working capital and
Temporary or variable working capital.
Permanent or Fixed or long term working capital
It is the minimum amount which is required to ensure effective
utilisation of fixed facilities and for maintaining the circulation of
current assets. There is always a minimum level of current assets
which its continuously required by enterprise to carry out its normal
business operations. As the business grows, the requirements of
permanent working capital also increase due to increase in current
assets. The permanent working capital can further be classified as
regular working capital and reserve working capital required to
ensure circulation of current assets from cash to inventories, from
inventories to receivables and from receivables to cash and so on.
Reserve working capital is the excess mount over the requirement for
regular working capital which may be provided for contingencies that
may arise at unstated periods such as strikes, rise in prices,
depression etc.
Temporary or Variable or short term working capital
It is the amount of working capital which is required to meet the
seasonal demands and some special exigencies. Variable working
capital is further classified as seasonal working capital and special
working capital. The capital required to meet seasonal needs of the
enterprise is called seasonal working capital. Special working capital
is that part of working capital which is required to meet special
exigencies such as launching of extensive marketing campaigns for
conducting research etc.
Importance or Advantages of Adequate Working Capital
: Working capital is the life blood and nerve centre of a business.
Hence, it is very essential to maintain smooth running of a business.
No business can run successfully without an adequate amount of
working capital. The main advantages of maintaining adequate
amount of working capital are as follows:
1.
Solvency of the Business: Adequate working capital helps in
maintaining solvency of business by providing uninterrupted flow
of production.
2.
Goodwill: Sufficient working capital enables a business
concern to make prompt payments and hence helps in creating
and maintaining goodwill.
3.
Easy Loans: A concern having adequate working capital, high
solvency and good credit standing can arrange loans from banks
and others on easy and favourable terms.
4.
Cash Discounts: Adequate working capital also enables a
concern to avail cash discounts on purchases and hence it
reduces cost.
5.
Regular Supply of Raw Material: Sufficient working capital
ensure regular supply of raw materials and continuous
production.
6.
Regular payment of salaries, wages and other day to
day commitments: A company which has ample working capital
can make regular payment of salaries, wages and other day to
day commitments which raises morale of its employees,
increases their efficiency, reduces costs and wastages.
7.
Ability to face crisis: Adequate working capital enables a
concern to face business crisis in emergencies such as
depression.
8.
Quick and regular return on investments: Every investor
wants a quick and regular return on his investments. Sufficiency
of working capital enables a concern to pay quick and regular
dividends to is investor as there may not be much pressure to
plough back profits which gains the confidence of investors and
creates a favourable market to raise additional funds in future.
9.
Exploitation of Favourable market conditions: Only
concerns with adequate working capital can exploit favourable
market conditions such as purchasing its requirements in bulk
when the prices are lower and by holding its inventories for
higher prices.
10.
High Morale: Adequacy of working capital creates an
environment of security, confidence, high morale and creates
overall efficiency in a business.
Excess or Inadequate Working Capital
Every business concern should have adequate working capital to
run its business operations. It should have neither excess working
capital nor inadequate working capital. Both excess as well as short
working capital positions are bad for any business.
Disadvantages of Excessive Working Capital
1. Excessive working capital means idle funds which earn no profits
for business and hence business cannot earn a proper rate of
return.
2. When there is a redundant working capital it may lead to
unnecessary purchasing and accumulation of inventories causing
more chances of theft, waste and losses.
3. It may result into overall inefficiency in organization.
4. Due to low rate of return on investments, the value of shares may
also fall.
5. The redundant working capital gives rise to speculative
transaction.
6. When there is excessive working capital, relations with banks and
other financial institutions may not be maintained.
Disadvantages of Inadequate working capital
1. A concern which has inadequate working capital cannot pay its
short-term liabilities in time. Thus, it will lose its reputation and
shall not be able to get good credit facilities.
2. It cannot buy its requirements in bulk and cannot avail of
discounts.
3. It becomes difficult for firm to exploit favourable market
conditions and undertake profitable projects due to lack of
working capital.
4. The rate of return on investments also falls with shortage of
working capital.
5. The firm cannot pay day-to-day expenses of its operations and it
created inefficiencies, increases costs and reduces the profits of
business.
The Need or Objects or Working Capital
The need for working capital arises due to time gap between
production and realisation of cash from sales. There is an operating
cycle involved in sales and realisation of cash. There are time gaps in
purchase of raw materials and production, production and sales, and
sales and realisation of cash. Thus, working capital is needed for
following purposes.
1. For purchase of raw materials, components and spares.
2. To pay wages and salaries.
3. To incur day-to-day expenses and overhead costs such as fuel,
power etc.
4. To meet selling costs as packing, advertisement
5. To provide credit facilities to customers.
6. To maintain inventories of raw materials, work in progress, stores
and spares and finished stock.
Greater size of business unit large will be requirements of working
capital. The amount of working capital needed goes on increasing
with growth and expansion of business till it attains maturity. At
maturity the amount of working capital needed is called normal
working capital.
 Factors Determining the Working Capital Requirements
The following are important factors which influence working capital
requirements:
1. Nature or Character of Business: The working capital
requirements of firm depend upon nature of its business.
Public utility undertakings like electricity, water supply need
very limited working capital because they offer cash sales only
and supply services, not products, and such no funds are tied
up in inventories and receivables whereas trading and
financial firms require less investment in fixed assets but have
to invest large amounts in current assets and as such they
need large amount of working capital. Manufacturing
undertaking require sizeable working capital between these
two.
2. Size of Business/Scale of Operations: Greater the size of a
business unit, larger will be requirement of working capital
and vice-versa.
3. Production Policy: The requirements of working capital depend
upon production policy. If the policy is to keep production
steady by accumulating inventories it will require higher
working capital. The production could be kept either steady
by accumulating inventories during slack periods with view to
meet high demand during peak season or production could be
curtailed during slack season and increased during peak
season.
4. Manufacturing process / Length of Production cycle: Longer the
process period of manufacture, larger is the amount of
working capital required. The longer the manufacturing time,
the raw materials and other supplies have to be carried for
longer period in the process with progressive increment of
labour and service costs before finished product is finally
obtained. Therefore, if there are alternative processes of
production, the process with the shortest production period
should be chosen.
5. Credit Policy: A concern that purchases its requirements on
credit and sell its products/services on cash requires lesser
amount of working capital. On other hand a concern buying
its requirements for cash and allowing credit to its customers,
shall need larger amount of working capital as very huge
amount of funds are bound to be tied up in debtors or bills
receivables.
6. Business Cycles: In period of boom i.e. when business is
prosperous, there is need for larger amount of working capital
due to increase in sales, rise in prices etc. On contrary in times
of depression the business contracts, sales decline, difficulties
are faced in collections from debtors and firms may have
large amount of working capital lying idle.
7. Rate of Growth of Business: The working capital requirements
of a concern increase with growth and expansion of its
business activities. In fast growing concerns large amount of
working capital is required whereas in normal rate of
expansion in the volume of business the firm may have
retained profits to provide for more working capital.
8. Earning Capacity and Dividend Policy. The firms with high
earning capacity generate cash profits from operations and
contribute to working capital. The dividend policy of concern
also influences the requirements of its working capital. A firm
that maintains a steady high rate of cash dividend irrespective
of its generation of profits need more working capital than
firm that retains larger part of its profits and does not pay so
high rate of cash dividend.
9. Price Level Changes: Changes in price level affect the working
capital requirements. Generally, the rising prices will require
the firm to maintain large amount of working capital as more
funds will be required to maintain the same current assets.
The effect of rising prices may be different for different firms.
10. Working Capital Cycle: In a manufacturing concern, the
working capital cycle starts with the purchase of raw material
and ends with realisation of cash from the sale of finished
products. This cycle involves purchase of raw materials and
stores, its conversion into stocks of finished goods through
work in progress with progressive increment of labour and
service costs, conversion of finished stock into sales, debtors
and receivables and ultimately realisation of cash and this
cycle again from cash to purchase of raw material and so on.
The speed with which the working capital completes one cycle
determines the requirements of working capital longer the
period of cycle larger is requirement of working capital.
 Managemant of Working Capital
Working capital refers to excess of current assets over current
liabilities. Management of working capital therefore is concerned
with the problems that arise in attempting to manage current assets,
current liabilities and inter relationship that exists between them.
The basic goal of working capital management is to manage the
current assets and current of a firm in such a way that satisfactory
level of working capital is maintained i.e. it is neither inadequate nor
excessive. This is so because both inadequate as well as excessive
working capital positions are bad for any business. Inadequacy of
working capital may lead the firm to insolvency and excessive
working capital implies idle funds which earns no profits for the
business. Working capital Management policies of a firm have a
great effect on its profitability, liquidity and structural health of
organization. In this context, evolving capital management is three
dimensional in nature.
1. Dimension I is concerned with formulation of policies with regard
to profitability, risk and liquidity.
2. Dimension II is concerned with decisions about composition and
level of current assets.
3. Dimension III is concerned with decisions about composition and
level of current liabilities.
 Principles of Working Capital Management
Principles of Working Capital Management
Principle of Risk
Principle of
Variation
Maturity of
Principle of
Cost of Capital
Principle of
Equity position
Payment
1. Principle of Risk Variation: Risk refers to inability of firm to
meet its obligation as and when they become due for payment.
Larger investment in current assets with less dependence on shortterm borrowings increases liquidity, reduces risk and thereby
decreases opportunity for gain or loss. On other hand less investment
in current assets with greater dependence on short-term borrowings
increases risk, reduces liquidity and increases profitability.
There is definite direct relationship between degree of risk and
profitability. A conservative management prefers to minimize risk by
maintaining higher level of current assets while liberal management
assumes greater risk by reducing working capital. However, the goal
of management should be to establish suitable trade off between
profitability and risk. The various working capital policies indicating
relationship between current assets and sales are depicted below:2. Principle of Cost of Capital: The various sources of raising
working capital finance have different cost of capital and degree of
risk involved. Generally, higher the risk lower is cost and lower the
risk higher is the cost. A sound working capital management should
always try to achieve proper balance between these two.
3. Principle of Equity Position: This principle is concerned with
planning the total investment in current assets. According to this
principle, the amount of working capital invested in each component
should be adequately justified by firm’s equity position. Every rupee
invested in current assets should contribute to the net worth of firm.
The level of current assets may be measured with help of two ratios.
(i) Current assets as a percentage of total assets and
(ii) Current assets as a percentage of total sales.
4. Principle of Maturity of Payment: This principle is concerned
with planning the sources of finance for working capital. According to
this principle, a firm should make every effort to relate maturities of
payment to its flow of internally generated funds. Generally, shorter
the maturity schedule of current liabilities in relation to expected
cash inflows, the greater inability to meet its obligations in time.
(1) The Hedging or Matching Approach: The term ‘hedging’ refers
to two off-selling transactions of a simultaneous but opposite nature
which counterbalance effect of each other. With reference to
financing mix, the term hedging refers to ‘process of matching of
maturities of debt with maturities of financial needs’. According to
this approach the maturity of sources of funds should match the
nature of assets to be financed. This approach is also known as
‘matching approach’ which classifies the requirements of total
working capital into permanent and temporary working capital.
The hedging approach suggests that permanent working capital
requirements should be financed with funds from long-term sources
while temporary working capital requirements should be financed
with short-term funds.
(2) The Conservative Approach: This approach suggests that the
entire estimated investments in current assets should be financed
from long-term sources and short-term sources should be used only
for emergency requirements. The distinct features of this approach
are:
(i) Liquidity is greater
(ii) Risk is minimised
(iii)The cost of financing is relatively more as interest has to
be paid even on seasonal requirements for entire
period.
Trade off Between the Hedging and Conservative Approaches
The hedging approach implies low cost, high profit and high risk while
the conservative approach leads to high cost, low profits and low risk.
Both the approaches are the two extremes and neither of them
serves the purpose of efficient working capital management. A trade
off between the two will then be an acceptable approach. The level
of trade off may differ from case to case depending upon the
perception of risk by the persons involved in financial decision
making. However, one way of determining the trade off is by finding
the average of maximum and the minimum requirements of current
assets. The average requirements so calculated may be financed out
of long-term funds and excess over the average from short-term
funds.
(3). Aggressive Approach: The aggressive approach suggests that
entire estimated requirements of current asset should be financed
from short-term sources even a part of fixed assets investments be
financed from short-term sources. This approach makes the finance –
mix more risky, less costly and more profitable.
Hedging Vs Conservative Approach
Hedging Approach
Conservative Approach
1. The cost of financing is 1. The cost of financing is
reduced.
higher
2. The investment in net 2. Large Investment is
blocked in temporary
working capital is nil.
working capital.
3. Frequent efforts are 3. The firm does not face
required to arrange
frequent
financing
funds.
problems.
4. The risk is increased as 4. It is less risky and firm is
firm is vulnerable to
able to absorb shocks.
sudden shocks.
Cash Management
Cash management is the corporate process of collecting and
managing cash, as well as using it for (short-term) investing. It is a key
component of ensuring a company's financial stability and solvency.
Corporate treasurers or business managers are frequently
responsible for overall cash management and the related
responsibilities to remain solvent.
Successful cash management involves not only avoiding insolvency, but
also reducing the length of account receivables (AR), increasing
collection rates, selecting appropriate short-term investment vehicles, and
increasing cash on hand to improve a company's cash position and
profitability.
Successfully managing cash is an essential skill for small business
developers, because they typically have less access to affordable
credit and have a significant amount of upfront costs to manage
while waiting for receivables. Wisely managing cash enables a
company to meet unexpected expenses, and to handle regularly
occurring events such as payroll distribution.
Cash management is a broad term that refers to the collection,
concentration, and disbursement of cash. The goal is to manage the
cash balances of an enterprise in such a way as to maximize the
availability of cash not invested in fixed assets or inventories and to
do so in such a way as to avoid the risk of insolvency. Factors
monitored as a part of cash management include a company's level
of liquidity, its management of cash balances, and its short-term
investment strategies.
In some ways, managing cash flow is the most important job of
business managers. If at any time a company fails to pay an
obligation when it is due because of the lack of cash, the company is
insolvent. Insolvency is the primary reason firms go bankrupt.
Obviously, the prospect of such a dire consequence should compel
companies to manage their cash with care. Moreover, efficient cash
management means more than just preventing bankruptcy. It
improves the profitability and reduces the risk to which the firm is
exposed.
Cash management is particularly important for new and growing
businesses. Cash flow can be a problem even when a small business
has numerous clients, offers a product superior to that offered by its
competitors, and enjoys a sterling reputation in its industry.
Companies suffering from cash flow problems have no margin of
safety in case of unanticipated expenses. They also may experience
trouble in finding the funds for innovation or expansion. It is,
somewhat ironically, easier to borrow money when you have money.
Finally, poor cash flow makes it difficult to hire and retain good
employees.
It is only natural that major business expenses are incurred in the
production of goods or the provision of services. In most cases, a
business incurs such expenses before the corresponding payment is
received from customers. In addition, employee salaries and other
expenses drain considerable funds from most businesses. These
factors make effective cash management an essential part of any
business's financial planning. Cash is the lifeblood of a business.
Managing it efficiently is essential for success.
When cash is received in exchange for products or services rendered,
many small business owners, intent on growing their company and
tamping down debt, spend most or all of these funds. But while such
priorities are laudable, they should leave room for businesses to
absorb lean financial times down the line. The key to successful cash
management, therefore, lies in tabulating realistic projections,
monitoring collections and disbursements, establishing effective
billing and collection measures, and adhering to budgetary
restrictions.
Functions of Cash Management
Cash management is the treasury function of a business, responsible
for achieving optimal efficiency in two key areas: receivables, which is
cash coming in, and payables, which is cash going out.
Receivables Management
When a business issues an invoice it is reported as a receivable,
which is cash earned but yet to be received. Depending on the terms
of the invoice, the business may have to wait 30, 60 or 90 days for
the cash to be received. It is common for a business to report
increasing sales, yet still run into a cash crunch because of slow or
poorly managed receivables. There are a number of things a business
can do to accelerate its receivables and reduce payment float,
including clarifying billing terms with customers, using an automated
billing service to bill customers immediately, using electronic
payment processing through a bank to collect payments, and staying
on top of collections with an aging receivables report.
Payables Management
When a business controls its payables, it can better control its cash
flow. By improving the overall efficiency of the payables process, a
business can reduce costs and keep more cash working in the
business. Payables management solutions, such as electronic
payment processing, direct payroll deposit, and controlled
disbursement can streamline and automate the payable functions.
Most of the receivables and payables management functions can be
automated using business banking solutions. The digital age has
opened up opportunities for smaller businesses to access the same
large-scale cash management technologies used by bigger
companies. The cost savings generated from more efficient cash
management techniques easily offsets the costs. More importantly,
management will be able to reallocate precious resources to growing
the business.
 Motives For Holding Cash
Cash is known as most liquid and less productive assets of a firm. If
cash remains idle, earns nothing but involves cost in terms of interest
payable to finance it. Although cash is least productive current assets,
firm should hold certain amount of cash for marketable securities.
Mainly, there are three motives for holding cash.
1. Transaction Motive Of Holding Cash
Transaction motive refers to the need to hold cash to satisfy normal
disbursement collection activities associated with a firm's ongoing
operation. Transaction means the act of giving and taking of cash or
kinds in the ordinary course of business. A firm frequently involves in
purchase and sales of goods or services. A firm should make payment
in terms of cash for the purchase of goods, payment of salary, wages,
rent, interest, tax, insurance, dividend and so on. A firm also receives
cash in terms of sales revenue, interest on loan, return on
investments made outside the firm and so on. If these receipts and
payments were perfectly synchronized, a firm would not have to hold
cash for transaction motive. But in real, cash inflows and outflows
cannot be matched exactly. Some times receipts of cash exceeds the
disbursement whereas at other time disbursement exceeds the
receipt. Because of this reason, if disbursement exceeds the receipt,
a firm should hold certain level of cash to meet current payment of
cash in excess of its receipt during the period.
2. Precautionary Motive Of Holding Cash
Precautionary motive refers to hold cash as a safety margin to act as
a financial reserve. A firm should hold some cash for the payment of
unpredictable or unanticipated events. A firm may have to face
emergencies such as strikes and lock-up from employees, increase in
cost of raw materials, funds and labor, fall in market demand and so
on. These emergencies also bound a firm to hold certain level of cash.
But how much cash is held against these emergencies depends on
the degree of predictability associated with future cash flows. If there
is high degree of predictability, less cash balance is sufficient. Some
firms may have strong borrowing capacity at a very short notice, so
that they can borrow at the time when emergencies occur. Such a
firm may hold very minimum amount of cash for this motive.
3. Speculative Motive Of Holding Cash
The speculative motive refers to the need to hold cash in order to be
able to take advantage of bargain purchases that might arise,
attractive interest rates and favorable exchange rate fluctuations.
Some firms hold cash in excess than transaction and precautionary
needs to involve in speculation. Speculative needs for holding cash
require that a firm possibly may have some profitable opportunities
to exploit, which are out of the normal course of business. These
opportunities arise in conditions, when price of raw material is
expected to fall, when interest rate on borrowed funds are expected
to decline and purchase of inventory occurs at reduced price on
immediate cash payment.
 Principles of cash management
1. Accelerated Cash Collection.
This is another arrangement made by the company to
accelerate cash collection. Under this arrangement the
company hires a post office box at important collection
centers. The customers are directed to make the payment
directly to the lock box. The local bankers collect cheques
from the lock box and deposit in the bank account. Bank
informs the company about the details after crediting the
cheques to the company’s account. This system reduces
the postal float as well as bank float but at the same time
it involves cost.
2. Delay cash payment
3. Invest excess cash available
4. Maintain minimum cash balance
Receivables Management
A sound managerial control requires proper management of
liquid assets and inventory. These assets are a part of working capital
of the business. An efficient use of financial resources is necessary to
avoid financial distress. Receivables result from credit sales. A
concern is required to allow credit sales in order to expand its sales
volume. It is not always possible to sell goods on cash basis only.
Sometimes, other concerns in that line might have established a
practice of selling goods on credit basis. Under these circumstances,
it is not possible to avoid credit sales without adversely affecting
sales. The increase in sales is also essential to increase profitability.
After a certain level of sales the increase in sales will not
proportionately increase production costs. The increase in sales will
bring in more profits.
Thus, receivables constitute a significant portion of current
assets of a firm. But, for investment in receivables, a firm has to incur
certain costs. Further, there is a risk of bad debts also. It is, therefore,
very necessary to have a proper control and management of
receivables.
Meaning of Receivables
Receivables represent amounts owed to the firm as a result of
sale of goods or services in the ordinary course of business. These are
claims of the firm against its customers and form part of its current
assets. Receivables are also known as accounts receivables, trade
receivables, customer receivables or book debts. The receivables are
carried for the customers. The period of credit and extent of
receivables depends upon the credit policy followed by the firm. The
purpose of maintaining or investing in receivables is to meet
competition, and to increase the sales and profits.
Costs of Maintaining Receivables
The allowing of credit to customers means giving funds for the
customer’s use. The concern incurs the following cost on maintaining
receivables:
(1) Cost of Financing Receivables: When goods and services
are provided on credit then concern’s capital is allowed to be used by
the customers. The receivables are financed from the funds supplied
by shareholders for long term financing and through retained
earnings. The concern incurs some cost for colleting funds which
finance receivables.
(2) Cost of Collection: A proper collection of receivables is
essential for receivables management. The customers who do not
pay the money during a stipulated credit period are sent reminders
for early payments. Some persons may have to be sent for collection
these amounts. All these costs are known as collection costs which a
concern is generally required to incur.
(3) Bad Debts : Some customers may fail to pay the amounts
due towards them. The amounts which the customers fail to pay are
known as bad debts. Though a concern may be able to reduced bad
debts through efficient collection machinery but one cannot
altogether rule out this cost.
Factors Influencing the Size of Receivables
Besides sales, a number of other factors also influence the size
of receivables. The following factors directly and indirectly affect the
size of receivables.
(1) Size of Credit Sales: The volume of credit sales is the first
factor which increases or decreases the size of receivables. If a
concern sells only on cash basis as in the case of Bata Shoe Company,
then there will be no receivables. The higher the part of credit sales
out of total sales, figures of receivables will also be more or vice
versa.
(2) Credit Policies: A firm with conservative credit policy will
have a low size of receivables while a firm with liberal credit policy
will be increasing this figure. If collections are prompt then even if
credit is liberally extended the size of receivables will remain under
control. In case receivables remain outstanding for a longer period,
there is always a possibility of bad debts.
(3) Terms of Trade: The size of receivables also depends upon
the terms of trade. The period of credit allowed and rates of discount
given are linked with receivables. If credit period allowed is more
then receivables will also be more. Sometimes trade policies of
competitors have to be followed otherwise it becomes difficult to
expand the sales.
(4) Expansion Plans: When a concern wants to expand its
activities, it will have to enter new markets. To attract customers, it
will give incentives in the form of credit facilities. The period of credit
can be reduced when the firm is able to get permanent customers. In
the early stages of expansion more credit becomes essential and size
of receivables will be more.
(5) Relation with Profits: The credit policy is followed with a
view to increase sales. When sales increase beyond a certain level the
additional costs incurred are less than the increase in revenues. It will
be beneficial to increase sales beyond the point because it will bring
more profits. The increase in profits will be followed by an increase in
the size of receivables or vice-versa.
(6) Credit Collection Efforts: The collection of credit should be
streamlined. The customers should be sent periodical reminders if
they fail to pay in time. On the other hand, if adequate attention is
not paid towards credit collection then the concern can land itself in
a serious financial problem. An efficient credit collection machinery
will reduce the size of receivables.
(7) Habits of Customers: The paying habits of customers also
have bearing on the size of receivables. The customers may be in the
habit of delaying payments even though they are financially sound.
The concern should remain in touch with such customers and should
make them realise the urgency of their needs.
Meaning and Objectives of Receivables Management
Receivables management is the process of making decisions
relating to investment in trade debtors. We have already stated that
certain investment in receivables is necessary to increase the sales
and the profits of a firm. But at the same time investment in this
asset involves cost considerations also. Further, there is always a risk
of bad debts too. Thus, the objective of receivables management is to
take a sound decision as regards investment in debtors. In the words
of Bolton, S.E., the objectives of receivables management is “to
promote sales and profits until that point is reached where the return
on investment in further funding of receivables is less than the cost
of funds raised to finance that additional credit.”
Dimensions of Receivables Management
Receivables management involves the careful consideration of the
following aspects:
1. Forming of credit policy.
2. Executing the credit policy.
3. Formulating and executing collection policy.
1. Forming of Credit Policy
For efficient management of receivables, a concern must adopt
a credit policy. A credit policy is related to decisions such as credit
standards, length of credit period, cash discount and discount period,
etc.
(a) Quality of Trade Accounts of Credit Standards: The volume
of sales will be influenced by the credit policy of a concern. By
liberalising credit policy the volume of sales can be increased
resulting into increased profits. The increased volume of sales is
associated with certain risks too. It will result in enhanced costs and
risks of bad debts and delayed receipts. The increase in number of
customers will increase the clerical wok of maintaining the additional
accounts and collecting of information about the credit worthiness of
customers. There may be more bad debt losses due to extension of
credit to less worthy customers. These customers may also take more
time than normally allowed in making the payments resulting into
tying up of additional capital in receivables. On the other hand,
extending credit to only credit worthy customers will save costs like
bad debt losses, collection costs, investigation costs, etc. The
restriction of credit to such customers only will certainly reduce sales
volume, thus resulting in reduced profits.
A finance manager has to match the increased revenue with
additional costs. The credit should be liberalised only to the level
where incremental revenue matches the additional costs. The quality
of trade accounts should be decided so that credit facilities are
extended only upto that level. The optimum level of investment in
receivables should be where there is a trade off between the costs
and profitability. On the other hand, a tight credit policy increases
the liquidity of the firm. On the other hand, a tight credit policy
increases the liquidity of the firm. Thus, optimum level of investment
in receivables is achieved at a point where there is a trade off
between cost, profitability and liquidity as depicted below:
(b) Length of Credit Period: Credit terms or length of credit
period means the period allowed to the customers for making the
payment. The customers paying well in time may also be allowed
certain cash discount. A concern fixes its own terms of credit
depending upon its customers and the volume of sales. The
competitive pressure from other firms compels to follow similar
credit terms, otherwise customers may feel inclined to purchase from
a firm which allows more days for paying credit purchases.
Sometimes more credit time is allowed to increase sales to existing
customers and also to attract new customers. The length of credit
period and quantum of discount allowed determine the magnitude of
investment in receivables.
(c) Cash Discount: Cash discount is allowed to expedite the
collection of receivables. The concern will be able to use the
additional funds received from expedited collections due to cash
discount. The discount allowed involves cost. The discount should be
allowed only if its cost is less than the earnings from additional funds.
If the funds cannot be profitably employed then discount should not
be allowed.
(d) Discount Period: The collection of receivables is influenced
by the period allowed for availing the discount. The additional period
allowed for this facility may prompt some more customers to avail
discount and make payments. This will mean additional funds
released from receivables which may be alternatively used. At the
same time the extending of discount period will result in late
collection of funds because those who were getting discount and
making payments as per earlier schedule will also delay their
payments.
2. Executing Credit Policy
After formulating the credit policy, its proper execution is very
important. The evaluation of credit applications and finding out the
credit worthiness of customers should be undertaken.
(a) Collecting Credit information: The first step in implementing
credit policy will be to gather credit information about the
customers. This information should be adequate enough so that
proper analysis about the financial position of the customers is
possible. This type of investigation can be undertaken only upto a
certain limit because it will involve cost.
The sources from which credit information will be available
should be ascertained. The information may be available from
financial statements, credit rating agencies, reports from banks,
firm’s records etc. Financial reports of the customer for a number of
years will be helpful in determining the financial position and
profitability position. The balance sheet will help in finding out the
short term and long term position of the concern. The income
statements will show the profitability position of concern. The
liquidity position and current assets movement will help in finding
out the current financial position. A proper analysis of financial
statements will be helpful in determining the credit worthiness of
customers. There are credit rating agencies which can supply
information about various concerns. These agencies regularly collect
information about business units from various sources and keep this
information upto date. The information is kept in confidence and may
be used when required.
Credit information may be available with banks too. The banks
have their credit departments to analyse the financial position of a
customer.
In case of old customers, business own records may help to
know their credit worthiness. The frequency of payments, cash
discounts availed, interest paid on over due payments etc. may help
to form an opinion about the quality of credit.
(b) Credit Analysis: After gathering the required information,
the finance manager should analyse it to find out the credit
worthiness of potential customers and also to see whether they
satisfy the standards of the concern or not. The credit analysis will
determine the degree of risk associated with the account, the
capacity of the customer borrow and his ability and willingness to
pay.
(c) Credit Decision: After analysing the credit worthiness of the
customer, the finance manager has to take a decision whether the
credit is to be extended and if yes then upto what level. He will
match the creditworthiness of the customer with the credit standards
of the company. If customer’s creditworthiness is above the credit
standards then there is no problem in taking a decision. It is only in
the marginal case that such decisions are difficult to be made. In such
cases the benefit of extending the credit should be compared to the
likely bad debt losses and then decision should be taken. In case the
customers are below the company credit standards then they should
not be outrightly refused. Rather they should be offered some
alternative facilities. A customer may be offered to pay on delivery of
goods, invoices may be sent through bank. Such a course help in
retaining the customers at present and their dealings may help in
reviewing their requests at a later date.
(d)
Financing
Investments
in
Receivables
and
Factoring: Accounts receivables block a part of working capital.
Efforts should be made that funds are not tied up in receivables for
longer periods. The finance manager should make efforts to get
receivables financed so that working capital needs are met in time.
The quality of receivables will determine the amount of loan. The
banks will accept receivable of dependable parties only. Another
method of getting funds against receivables is their outright sale to
the bank. The bank will credit the amount to the party after
deducting discount and will collect the money from the customers
later. Here too, the bank will insist on quality receivables only.
Besides banks, there may be other agencies which can buy
receivables and pay cash for them. This facility is known
asfactoring. The factoring may be with or without recourse. It is
without recourse then any bad debt loss is taken up by the factor but
if it is with recourse then bad debts losses will be recovered from the
seller.
Factoring is collection and finance service designed to improve he
cash flow position of the sellers by converting sales invoices into
ready cash. The procedure of factoring can be explained as follows:
1. Under an agreement between the selling firm and factor firm, the
latter makes an appraisal of the credit worthiness of potential
customers and may also set the credit limit and term of credit for
different customers.
2. The sales documents will contain the instructions to make
payment directly to factor who is responsible for collection.
3. When the payment is received by the factor on the due date the
factor shall deduct its fees, charges etc and credit the balance to
the firm’s accounts.
4. In some cases, if agreed the factor firm may also provide advance
finance to selling firm for which it may charge from selling firm. In
a way this tantamount to bill discounting by the factor firm.
However factoring is something more than mere bill discounting,
as the former includes analysis of the credit worthiness of the
customer also. The factor may pay whole or a substantial portion
of sales vale to the selling firm immediately on sales being
effected. The balance if any, may be paid on normal due date.
Benefits and Cost of Factoring
A firm availing factoring services may have the following benefits:
§ Better Cash Flows
§ Better Assets Management
§ Better Working Capital Management
§ Better Administration
§ Better Evaluation
§ Better Risk Management
However, the factoring involves some monetary and non-monetary
costs as follows:
Monetary Costs
a)
The factor firm charges substantial fees and commission
for collection of receivables. These charges sometimes may
be too much in view of amount involved.
b)
The advance fiancé provided by factor firm would be
available at a higher interest costs than usual rate of interest.
Non-Monetary Costs
a)
The factor firm doing the evaluation of credit worthiness of
the customer will be primarily concerned with the minimization
of risk of delays and defaults. In the process it may over look
sales growth aspect.
b)
A factor is in fact a third party to the customer who may not
feel comfortable while dealing with it.
c)
The factoring of receivables may be considered as a symptom
of financial weakness.
Factoring in India is of recent origin. In order to study the
feasibility of factoring services in India, the Reserve Bank of India
constituted a study group for examining the introduction of factoring
services, which submitted its report in 1988.On the basis of the
recommendations of this study group the RBI has come out with
specific guidelines permitting a banks to start factoring in India
through their subsidiaries. For this country has been divided into four
zones. In India the factoring is still not very common. The first factor
i.e. The SBI Factor and Commercial Services Limited started working
in April 1991. The guidelines for regulation of a factoring are as
follows:
(1) A factor firm requires an approval from Reserve Bank of
India.
(2) A factor firm may undertake factoring business or other
incidental activities.
(3) A factor firm shall not engage in financing of other firms
or firms engaged in factoring.
3. Formulating and Executing Collection Policy
The collection o f amounts due to the customers is very
important. The collection policy the termed as strict and lenient. A
strict policy of collection will involve more efforts on collection. Such
a policy has both positive and negative effects. This policy will enable
early collection of dues and will reduce bad debt losses. The money
collected will be used for other purposes and the profits of the
concern will go up. On the other hand a rigorous collection policy will
involve increased collection costs. It may also reduce the volume of
sales. A lenient policy may increase the debt collection period and
more bad debt losses. A customer not clearing the dues for long may
not repeat his order because he will have to pay earlier dues first,
thus causing.
The objective is to collect the dues and not to annoy the
customer. The steps should be like (i) sending a reminder for
payments (ii) Personal request through telephone etc. (iii) Personal
visits to the customers (iv) Taking help of collecting agencies and
lastly (v) Taking legal action. The last step should be taken only after
exhausting all other means because it will have a bad impact on
relations with customers.
Illustration 1: A company has prepared the following projections for
a year
Sales
21000 units
Selling Price per unit
Rs.40
Variable Costs per unit
Rs.25
Total Costs per unit
Rs.35
Credit period allowed
One month
The company proposes to increase the credit period allowed to its
customers from one month to two months .It is envisaged that the
change in policy as above will increase the sales by 8%. The company
desires a return of 25% on its investment. You are required to
examine and advise whether the proposed credit policy should be
implemented or not?
Solution:
Particulars
Present
Proposed
Incremental
Sales (units)
21000
22680
1680
Contribution per unit
Rs.15
Rs.15
Rs.15
Total Contribution
Rs.3,15,000 Rs.3,40,000
Rs.25,200
Variable cost @ Rs.25 5,25,000
2,10,000
Fixed Cost
7,35,000
5,67,000
42,000
2,10,000
------
7,77,000
42,000
1 month
2 month
-----
Rs.61250
Rs.1,29,500
Rs.68,250
Total Cost
Credit period
Average debtors at
cost
Incremental Return = Increased Contribution/Extra Funds
Blockage *100
= Rs.25,200/Rs.68,250*100
=36.92%
Illustration 2: ABC & Company is making sales of Rs.16,00,000 and it
extends a credit of 90 days to its customers. However, in order to
overcome the financial difficulties, it is considering to change the
credit policy. The proposed terms of credit and expected sales are
given hereunder:
Policy
Terms
Sales
I
75 days
Rs.15,00,000
II
60 days
Rs. 14,50,000
III
45 days
Rs 14,25,000
IV
30 days
Rs 13,50,000
V
Rs.13,00,000
15
days
The firm has variable cost of 80% and fixed cost of Rs.1,00,000. The
cost of capital is 15%. Evaluate different policies and which policy
should be adopted?
Solution:
figures in Rs.
Particula Present I
rs
II
III
IV
V
Sales
16,00,0
00
15,00,0
00
14,50,0
00
14,25,0
00
13,50,0
00
13,00,0
00
-Variable
cost
12,80,0
00
12,00,0
00
11,60,0
00
11,40,0
00
10,80,0
00
10,40,0
00
1,00,00
0
1,00,00
0
1,00,00
0
1,00,00
0
1,00,00
0
1,00,00
0
2,20,00
0
2,00,00
0
1,90,00
0
1,85,00
0
1,70,00
0
1,60,00
0
13,80,0
00
13,00,0
00
12,60,0
00
12,40,0
00
11,80,0
00
11,40,0
00
3,45,00
0
2,70,83
3
2,10,00
0
1,55,00
0
98,333
47,500
14,750
7,125
1,55,25
0
1,52,87
5
-- Fixed
Cost
Profit (A)
Total
Cost
Average
Receivab
le (at
cost)
(Cost¸36
0x credit
period
Cost of
debtors
@ 15%
(B)
Net
profit (A
– B)
51,750
1,68,25
0
40,625
1,59,35
0
31,500
1,58,50
0
23,250
1,61,75
0
Illustration3: A trader whose current sales are Rs.15 lakhs per annum
and average collection period is 30 days wants to pursue a more
liberal credit policy to improve sales. A study made by consultant firm
reveals the following information.
Credit Policy
Increase in sales
increase in collection period
A
Rs.60,000
15
B
90,000
days
30 days
C
1,50,000
45
days
D
1,80,000
60
days
E
90
days
2,00,000
The selling price per unit is Rs.5. Average Cost per unit is Rs.4 and
variable cost per unit I Rs.2.75 paise per unit. The required rate of
return on additional investments is 20 percent Assume 360 days a
year and also assume that there are no bad debts. Which of the
above policies would you recommend for adoption.
Solution:
Particulars
Present
A
B
C
D
E
Credit
period
No. of
units @
Rs.5
30 days 45 days 60 days 75 days 90 days
120
days
3,12,00 3,18,00 3,30,00 3,36,00
0
0
0
0 3,40,00
3,00,00
0
0
Sales
Variable
cost@
2.75
15,60,0 15,90,0 16,50,0 16,80,0
00
00
00
00 17,00,0
00
Fixed Cost
Total Cost
15,00,0
00
8,58,00 8,74,50 9,07,50 9,24,00
0
0
0
0 9,35,00
0
Profit (A)
Average
debtors(at
cost)
3,75,00 3,75,00 3,75,00 3,75,00
0
0
0
0 3,75,00
0
12,33,0 12,49,5 12,82,5 12,99,0
8,25,00
00
00
00
00 13,10,0
0
00
cost¸360x
credit
period
Cost of
3,27,00 3,40,50 3,67,50 3,81,00
0
0
0
0 3,90,00
0
3,75,00
investmen
t@ 20%
(B)
Net Profit
(A-B)
0
1,54,12 2,08,25 2,67,18 3,24,75
5
0
8
0
12,00,0
00
3,00,00
0
30,825
41,650
53,437
4,36,66
7
64,950
87,333
1,00,00
2,96,17 2,98,85 3,14,06 3,16,05
0
5
0
3
0
3,02,66
7
20,000
2,80,00
0

The receivables emerge when goods are sold on credit and the
payments are deferred by the customers. So, every firm should
have a well-defined credit policy.




The receivables management refers to managing the receivables
in the light of costs and benefit associated with a particular credit
policy.
Receivables management involves the careful consideration of the
following aspects: Forming of credit policy, Executing the credit
policy, Formulating and executing collection policy.
The credit policy deals with the setting of credit standards and
credit terms relating to discount and credit period.
The credit evaluation includes the steps required for collection
and analysis of information regarding the credit worthiness of the
customer.