Financial Management PDF

FINANCIAL
MANAGEMENT
Vipul V. Shah
M.B.A., M.COM, AICWA, EXIM
Contact : 9881 236 536
saraswaticlasses.in
[email protected]
INDEX
SR. No. CHAPTER NAME PAGE NO
1 INTRODUCTION TO FINANCIAL MANAGEMENT 4
2 ANALYSIS OF FINANCIAL STATEMENT 14
3 WORKING CAPITAL 45
4 MANAGEMENT OF RECEIVABLES 66
5 CAPITAL BUDGETING DECISIONS 71
6 CAPITALISATION 83
7 DIVIDEND DISTRIBUTION THEORIES 101
QUESTION BANK 110
` Instruction
Notes are designed from syllabus point of view.
Strictly for private circulation
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CHAPTER 1
INTRODUCTION TO
FINANCIAL MANAGEMENT
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CHAPTER 1
INTRODUCTION TO
FINANCIAL MANAGEMENT
1. FINANCE
Finance is lifeblood of every business organization. It is a foundation of all economic activity.

Business needs finance to make more money. Only money can earn more money. Therefore efficient
management of business is closely linked with efficient management of finance.
2. BUSINESS FINANCE
This is a one of the most important Management function Business finance is defined as
procurement of fund & their effective utilization.
It is also defined as Activity concern with planning, raising controlling and administrating of the
funds used in business.
3. MEANING OF FINANCIAL MANAGEMENT
It concern with proper management of fund. The finance manager must see that the funds are
procured in a manner that the risk, cost and control consideration are properly balanced in a given
situation and there is optimum utilization of fund.
Financial Management can be defined as:
The management of the finances of a business / organisation in order to achieve financial

objectives
Taking a commercial business as the most common organisational structure, the key objectives
of financial management would be to:
Vipul Shah / 9881 236 536 Chapter : 1 Introduction to Financial Management / 4

Create wealth for the business
Generate cash, and
Provide an adequate return on investment bearing in mind the risks that the business is taking
and the resources invested
There are three key elements to the process of financial management:
(1) Financial Planning
Management need to ensure that enough funding is available at the right time to meet the needs
of the business. In the short term, funding may be needed to invest in equipment and stocks, pay
employees and fund sales made on credit.
In the medium and long term, funding may be required for significant additions to the productive
capacity of the business or to make acquisitions.
(2) Financial Control
Financial control is a critically important activity to help the business ensure that the business is
meeting its objectives. Financial control addresses questions such as:
Are assets being used efficiently?
Are the businesses assets secure?
Do management act in the best interest of shareholders and in accordance with business rules?
(3) Financial Decision-making
The key aspects of financial decision-making relate to investment, financing and dividends:
Investments must be financed in some way - however there are always financing alternatives
that can be considered. For example it is possible to raise finance from selling new shares,
borrowing from banks or taking credit from suppliers
A key financing decision is whether profits earned by the business should be retained rather
than distributed to shareholders via dividends. If dividends are too high, the business may be
starved of funding to reinvest in growing revenues and profits further.
4. BASIC OBJECTIVES/GOALS OF FINANCIAL MANAGEMENT
(1) Maintenance of liquid asset
Liquid assets are required to meet firms obligation at all times.

Liquid assets are those assets, which can be converted into cash with minimum loss.
Liquid assets have to be adequate. (Neither too low not too excessive) finance manager has to
maintain balance between profitability & liquidity as
Profitability increases liquidity decreases
Profitability decreases liquidity increases
(2) Goal of Profit maximization. Maximization of profits is generally regarded as the main
objective of a business enterprise. Each company collects its finance by way of issue of shares to the
public. Investors in shares purchase these shares in the hope of getting medium profits from the

company as dividend It is possible only when the company's goal is to earn maximum profits out of
its available resources. If company fails to distribute higher dividend, the people will not be keen to
invest their money in such firm and persons who have already invested will like to sell their stocks.
On the other hand, higher profits are the barometer of its efficiency on all fronts, i.e., production,
sales an management. A few replace the goal of 'maximization of profits' to 'fair profits'. 'Fair Profits'
means general rate of profit earned by similar organisation in a particular area. Concept of profit
maximisation has come under serve criticism in recent time due to following reason.
I) It is vague
It dose not clarify which profit dose it mean; whether short term or long term, PBT OR PAT
profit from shareholders point of view or from capital employed point of view.
Profit in the short term may be quite different from those in the long run. For e.g. if a firm
continues to run its business without having adequate maintenance of machinery, the firm profit
in the short run may increase because of saving in expenditure. However in the long run firm
may suffer heavy loss/expenditure since machine may have to be replaced or it may require
heavy expenditure.
ii) If ignores timing
The concept ignores the importance of the fact that the rupee recovered today is much more
valuable than a rupee recovered tomorrow for. e.g.
If company is having 2 project i.e. A & B
The expected rate of return is 14% & 13% respectively returns are expected for 4 & 6 years
respectively Now in order to decide which project should be accepted, It is not only enough to
see the rate of return, but the present value of cash flow available from both the project.
By comparing returns project A is acceptable, but it will stop giving returns after 4 years. It will
be more profitable than B if firm is having investment option after 4 years otherwise project B
is better as returns are available for 6 years.
iii) It ignore financial aspect & risk associated with particular decision
(3) Goal of Return Maximization. The second goal of financial management is to safeguard
the economic interest of the persons who are directly or indirectly connected with the company,
i.e.,shareholders, creditors and employees. The all such interested parties must get the maximum
return for their contributions. But this is possible only when the company earns higher profits or
sufficient profits to discharge its obligations to them. Therefore, the goal of maximization of returns
are inter-related.
(4) Goal of Wealth Maximization. Frequently, Maximization of profits is regarded a the proper
objective of the firm but it is not as inclusive a goal as that of maximising it value to its shareholders.
Value is represented by the market price of the ordinary share of the company over the long run
which is certainly a reflection of company's investment and financing decisions. The log run means a
considerably long period in order to work out a normalized market price. The management can

make decision to maximize the value of its shares on the basis of day-today fluctuations in the
market price in order t raise the market price of shares over the short run at the expense of the long
fun by temporarily diverting some of its funds to some other accounts or by cutting some of its
expenditure to the minimum at the cost of future profits. This does not reflect the true value of the
share because it will result in the fall of the share price in the market in the long run. It is, therefore,
the goal of the financial management to ensure its shareholders that the value of their shares will be
maximized in the long-run. In fact, the performances of the company can well be evaluated by the
value of its share.
Steps for wealth maximization
Avoid high level of risky projects

Pay dividend regularly by considering Market value of share & share holders expectation
Maintain growth in sales.
Maintain price of firms share
Social Responsibility
(5) Other objectives
Fair return to share holder

Building up reserves
Efficient & effective utilisation of available resources
5) SCOPE OF FINANCE FUNCTION
I) Traditional Approach
This approach limited the role of finance manager

He was expected to raise fund and administration of fund needed by organisation
This approach broadly covers 3 aspects
I) Procurement of fund from financial institution

ii) Procurement of funds from financial institution Such as Shares, bonds.
iii) Looking after legal and accounting relations between a corporation and its sources of funds
Role of finance manager
To keep accurate financial records.

Prepare reports on corporation status and performance.
Manage cash in order to pay bill on time.
The term corporate finance was used in place of present terms financial management.
Criticism against traditional approach
i) Outsider looking in approach

It has treated finance function from suppliers point of view i.e. investors & bankers. (As finance
function deals with raising and administration of fund)
It completely ignored the viewpoint of those who had to take decision.

ii) Ignored routine problems
It gives importance to event, which dose not happen frequently i.e. merger amalgamation. It
ignore routine & day to day finance problems
iii) Ignored working capital financing.
It gives more importance to long-term loan rather then short-term loan, which is required
finance working capital.
iv) No emphasis on allocation of funds
It gives more importance to raising of fund rather then allocation of funds.
II) Modern Approach
Traditional approach lost its utility due to changed business situation since 1950.
1950 : Technological development widened market operation,
Development of strong capital structure, healthy competition.
These changes require efficient use of available financial resources.
1960 : Computer helped manager to give more information to take decision.
1980 : Era of high inflation Interest rates rise dramatically Thus it was important for Manager to
raise loans on suitable basis which needs proper analysis
According to modern approach
Finance manager's Job is to acquire fund and allocation of fund by keeping in mind org. objective.
Under modern approach finance manager is expected to take following decision
i) Financing decision
The financing of capital investment proposals are done in two forms of finances in general i.e.
equity and debt. The finance decision should consider the cost of finances available in different forms
and risk associated with it. The reduction in the cost of capital will increase profit. Before selecting
any particular source of finance. It is necessary to understand advantages & risk associated with it.
The main task of finance manager is to minimize cost of capital & maximizing returns available to
the shareholders.
The finance manager involve in following finance decision
Determination of financing pattern of fund
Analyse different sources of finances
Arrangement of funds form financial institutions
Consideration of impact of interest on profitability & liquidity
Calculating component as well as composite cost of capital
Decide appropriate debt -equity mix.
Evaluation of alternative use of funds.
ii) Investment decision
Investment decision are those which determine how scare resources in terms of funds available
for projects. The investment decision should aim at investment in assets only when they are expected
to earn greater than minimum acceptable return. It is the function of finance manager to carefully

analyse different capital proposal & select the best proposal. Investment in current assets will demand
upon credit policy and inventory policy of firm. The investment decisions of a finance manager cover
the following areas
Funds allocation & its rationing.
Buy or lease decisions
Asset replacement decisions
Ascertainment of total volume of a funds, a firm can commit.
Measurement of risk and uncertainty in the investment proposals.
iii) Dividend decision.
Dividend decision involves the determination of the % of profit earned by enterprises, which is
to be paid to shareholders and frequency of such payments. The profit available to shareholders is
divided in two ways
Amt payable to shareholders as divided
Amt to be retained for internal finance
The finance manager will involve in taking the following dividend decisions
Determination of amount of divided & retention policies of firm.
How divided decision will affect market value of share ?
Considering the impact of legal and cash flow constraints on dividend decisions.
6) IMPORTANCE / SIGNIFICANCE OF FINANCIAL MANAGEMENT
i) Sound financial Management

It is necessary for efficient utilization of funds in fixed assets & in working capital.
ii) To borrow money
Finance manager estimate total requirement of fund both short term and long term & accordingly
loan is taken. He assesses various ratios such as return on capital debts equity ratio to determine
requirement.
iii) To minimize cost of borrowing
Finance manager evaluates various sources of borrowing & select best source, which will
minimize cost of borrowing.
iv) Helps in planning
Management helps in profit planning, investment analysis, controlling inventories, capital
spending & measuring cost.
v) Determination of future activity
Finance manager also helps is ascertaining how the company would perform in future. It helps
in indicating whether firm will generate enough funds to meets it various obligation like repayment
of installment due on loan, redemption of liabilities.
7) ROLE & KNOWLEDGE OF FINANCE MANAGER
Initially finance manager was called upon wherever company needs fund.
His role was limited to procurement of fund i.e. once funds were procured his function was over
but now days role of finance manager has changed.

Functions
Capital procurement
To provide adequate finance as when require.
Investor relations
To maintained proper relationship with bankers, lending institutions.
Short term financing
To meet short funds requirement of firm.
Reporting & interpretation
To provide necessary report to the management as and when required & to compare standard
performance with actual performance.
Allocation
To allocate funds available as per the requirement of each department.
Administrative function
To provide necessary reports to the government agencies.
To assess impact of economic, social & government policies on business environment.
8) FORMS OF BUSINESS ORGANISATION
I. PRPPRIETORY FIRMS/ SOLE TRADING CONCERN
Meaning
This form of organisation is called as One-man business.

One person invests capital.
Profit & loss shared by one person only.
Advantages
Flexibility
Quick decision
Less Government Intervention
Personal touch with customers
Easy to form
Direct relationship between efforts and rewards
Easy to adopt Market changes
Limitation
Limited Capital
Risk bear by one person
Useful for small business only
No legal status
Unlimited Liability
Existence of organization depends on existence of proprietor
Limited loan raising capacity

II. PARTNERSHIP FIRM
Meaning
Firm which is formed by minimum 2 or more person and maximum 20 members.

Registration under partnership act 1932 is required.
Advantages
Capital contribution by partners

Risk is shared by partners
Sharing of expertise and knowledge by partners
Better decision can be taken
Division of work according to specialization
Capacity to handle complex business problems
Less government intervention
Limitation
Difficult to fix up responsibility for common work

Conflict between partners
No legal status
Loan raising capacity is comparatively less but more than sole trading organizations.
Unlimited Liability
Transfer of ownership involves change in the constitution of business
No direct relation between efforts and rewards
Death of one partner affects existence of firm
III. JOINT STOCK COMPANY
Advantages
Large capital collection

Separate legal existence
Division of risk
Large scale operations
Skilled professional can be hired
Transferability of ownership
Capital appreciation
Dividend income
Repayment of capital at the time of Liquidation
Provides employment opportunities
Separation of ownership and management
Limited liability of shareholders

Limitations
Decision making takes time

Difficult to adopt changes
Lack of flexibility
Government intervention in the form of various rules and regulations
Types of Joint Stock company
Public Limited
A organization which has got Separate Legal existence independent of its members
Shareholders enjoy voting rights
Minimum 7 members required to from and no limit on maximum members
Capital contribution by issuing shares
Private Limited
Minimum 2 members required to form and maximum 50 members

Can not issue shares to public that means capital contribution by members only
Minimum paid up capital of Rs 1 crore is required
Can not invite or accept deposit from public
Restriction on transfer of ownership


CHAPTER 2
ANALYSIS OF FINANCIAL
STATEMENTS
CHAPTER 2
ANALYSIS OF FINANCIAL STATEMENTS
RATIO ANALYSIS
1. INTRODUCTION & MEANING: -
Profit & loss A/c & balance sheet are 2 basis parameters to judge the financial health of a company.
By looking to these statements one can know gross profit, net profit, current asset, current liabilities
etc. However making decision based on absolute figure without relating them to some other figure
becomes meaning less.
Meaning
Ratio analysis is a technique by which various figures in the profit & loss a/c & b/s are related to
each other to give a meaningful conclusion got interpreting & deciding the line of action for decision
making & control.
2. IMPORTANCE/ADVANTAGES OF RATIO ANALYSIS
It revels inter-relationship that may exist among different items in financial statement.
It is a powerful tool majoring, liquidity, Solvency, profitability & efficiency of business.
Ratio analysis is useful to management of company, investors, creditors, government, banks &
other outside parties.
Ratio analysis is useful to reduce expenditure & increased rate of profit.
It is useful for planning & formulating future policies.
It is useful for control purposes.
Standard ratios are compared with actual ratios & if there is difference correct actions are
taken.
Analysis reflects utilization of asset employed in business.
It is useful to locate trouble areas of business.
Vipul Shah / 9881 236 536 Chapter : 2 Analysis of Finacial Statements / 14

It is useful for compression between different units of same firm or between two firms.
3. LIMITATIONS OF RATIO ANALYSIS
It communicates only a relative picture. Every organization in one way or other is unique and
comparison may not be valid.
Ratios are only a tool. Their ultimate use depends upon management who use it. They only pass
guiding signals.
Sometimes attempts are made to window dress the accounts, i.e. efforts are made to manipulate
the accounts in a manner, that the picture being better than what actually it is.
Inflation distorts financial ratio analysis. Changes in the reported performance of a company
may be entirely due to inflation and not due to management.
Following Parties are interested in Ratio analysis.
Party Interested in which Ratio

I) Shareholder 1. Return on Capital employed.
2. Rate of dividend.
3. Long term solvency.
4. Earning per share.
II) Creditors 1. Current ratio.
2. Liquidity ratio.
3. Debts equity ratio.
III) Government 1. G.P. ratio.
2. N.P. ratio.
3. Capacity utilisation.
IV) Management 1. All turn over ratio.
4. TYPES OF RATIO
i) Liquidity Ratios
Means ability of company to make cash available as & when required. The liquidity ratios study
the firm's short term solvency and ability to pay off the liabilities. Consequently, these ratios focus on
current assets and current liabilities. Some of the common liquidity ratios are
1) Current Ratio
2) Quick Ratio/Acid Test Ratio
3) Absolute Quick ratio

ii) The Activity/ Turnover/ Performance Ratios
These ratios measure the effectiveness with which the firm uses its resources. It shows how
efficiently and effectively the assets of the firm being utilized. Some of the important activity ratios
are as follows
1) Working Capital Turnover Ratio
2) Inventory/Stock Turnover Ratio
3) Debtors Turnover Ratio
4) Creditors Turnover Ratio
5) Fixed Assets Turnover Ratio
6) Capital Turnover Ratio
7) Total asset turnover Ratio
iii) Leverage/Solvency Ratios
The term leverage in general refers to a relationship between two interrelated variables. In financial
analysis it represents the influence of one financial variable over some other related variable. It is an
ability of the firm to use fixed costs to magnify the returns to the shareholders.
1) Debt-Equity Ratio
2) Interest Coverage Ratio
3) Fixed Charge Coverage Ratio
4) Total debt ratio/ Debt-Asset Ratio
5) Fixed Assets Ratio
iv) Profitability Ratios
Profits are the ultimate test of the management. It can be measured by variety of ways. Profitability
ratios communicate the profitability of events that have already taken place. Important profitability
ratios are as follows
1) GP Ratio
2) NP Ratio
3) Operating Profit Ratio
4) Operating Ratio
5) Return on Asset
6) Return on Capital Employed
7) Return on Equity
8) Proprietary Ratio
v) Valuation Ratios/Miscellaneous Group
1) Earning Per Share

2) Dividend Payout Ratio
3) Price Earning Ratio
4) Capital gearing Ratio

LIQUIDITY RATIOS
SR RATIO DETAILS PURPOSE
1 Current Ratio Current assets = Debtors. + Cash The ratio tells us about the
Current Assets or Bank + Bills receivable + about the capabilities of a
Current Liabilities Prepaid Expenses + Closing Stock company to discharge its
+ Advances + Marketable security short term liabilities. Ideally
Current Liabilities = Creditors + the ratio should be 2:1 i.e.
Bills payable + Outstanding current asset should be
expenses + Bank Overdraft double that of current
liability. CR of 1.33:1
is considered by banks as the
minimum acceptable
level for providing
working capital finance.
2 Liquid /Acid Test / Liquid Assets = CA - Stock - This ratio indicates

Ratio Prepaid exp. immediate liquidity of
Quick /Liquid Assets Quick Liabilities = CL - Bank o/d company; ideally this ratio
Current Liabilities If bank overdraft is usually availed should be 1:1 that means
by the firm on more or less regular immediate & quick liabilities
Quick Ratio basis, and is not payable in real can be repaid by collecting
Quick /Liquid Assets sense, is therefore, deducted from money from sundry Drs. &
Quick liabilities the amount of total current cash available with company.
liabilities. If ratio goes below one it
indicate that liquidity
of company is disturbed.
3 Absolute Liquid Ratio This ratio is also called as Super This ratio indicates abilities
Quick / Cash/ cash reservoir of company to fulfill its
Cash + Mkt. Securities Ratio. immediate commitments on
Quick Liabilities Mkt. Investment means short time.
term investments. Ideal ratio 1:2.

TURNOVER RATIOS
SR. RATIO DETAILS PURPOSE

4 Inventory / Stock Cost of goods sold This ratio indicates the
Turnover Ratio = Sales - Gross Profit efficiency of inventory
Cost of Goods Sold Average Inventory = management when inventory
Average Inventory Opening Stock + Closing stock turnover ratio is goes down
OR 2 management has to review
Cost of Goods Sold its inventory policies &
Closing Inventory inventory stock levels.
5 Debtors Turnover Net Credit Sales This ratio indicates

Ratio = Credit Sale - Sales return efficiency of recovery
Net Credit Sales Accounts receivable department.
Avg. Accounts = Bills Receivable + Debtors
Receivable Avg. Accounts receivable =
Op. Receivable + Cl. Receivable / 2
Debt Collection Period This ratio indicate collection

12 months period in moths or days.
DTR
OR
365 days
DTR
6 Creditors Turnover Net Credit Purchase This ratio indicates credit

Ratio = Credit Purchase - Purchase return given by suppliers.
Net Credit Purchase Accounts payable = Bills Payable
Avg. Accounts Payable + Creditors
Avg. Accounts payable =
Op. payable+ Cl. payable / 2
Debt Payment Period This ratio indicate payment

12 months period in moths or days.
CTR
OR
365 days
CTR
7 Fixed Assets Turnover Net Sales = Sales - Sales returns This ratio indicate how
Ratio Fixed assets after depreciation efficiently fixed assets have
Net Sales been utilized in the business.
Fixed Assets Every company will try
OR to maximise this ratio.
COGS
Fixed Assets

8 Capital Turnover Ratio Capital Employed= share Capital + This ratio indicates the
Net Sales Reserve & Surplus + Long term Loans + efficiency of the organization
Capital Employed Debentures - Fictitious assets - with which capital employed
Accumulated losses is being utilized to generate
OR revenue.
Fixed Assets + Working Capital
9 Total Assets turnover Total assets = Fixed assets This ratio compares sales
ratio + Current assets generated with available
Net Sales assets.
Total Assets
10 Working Capital Net Sales = Sales - Ratio indicates efficiency

Turnover Ratio Sales returns Working Capital = of working capital
Net Sales Current Assets - Current Liabilities management of the company.
Working Capital Higher the ratio better
is the efficiency better is the
utilization of working capital.

PROFITABILITY RATIOS
SR. RATIO DETAILS PURPOSE
11 Gross Profit Ratio GP = Sales - cost of goods sold Indicate efficiency of

Sales = Cash and Credit Sales - production department.
GP X 100
Sales sales returns
12 Net Profit Ratio Sales = Cash and Credit Sales - This ratio shows overall
NP X 100 sales returns efficiency of business
Sales
13 Return on assets This ratio indicates how

firm has used assets to
PAT X 100
Total Assets maximise profit.
14 Return on Capital Capital Employed = share ROC Emeasures

Employed / Return on Capital + Reserve & Surplus profitability of the capital
+ Long term Loans + employed in the business
Investments
Deben tures - Fictitious assets-
PBIT accumulated losses
X 100
Capital Employed
15 Return Shareholder Shareholders funds = Equity This ratio indicates the

Funds capital +Pref. Capital + Reserves profitability of a firm in
& surplus - accumulated losses relation to the funds
PAT X 100 supplied by the
Total Shareholders' funds shareholders or owners.
OR
Return on Equity
PAT - Pref. dividend X 100
Total Shareholders' funds
- Pref. Share Capital
16 Operating Profit Ratio Operating Profit = Operating profit indicates

Gross profit - pure profit generated by the
Operating profit operation of the firm hence
X 100 operating expenses
Net Sales
it is calculated on the basis
of EBIT.

LEVERAGE/CAPITAL STRUCTURE RATIOS

17 Interest Coverage Ratio PBIT = Profit before depreciation, This ratio indicates funds
PBDIT interest and tax available to pay interest. An
Interest Charges Interest = Interest on long term interest cover of more than 7
loans only. times is regarded as safe &
more than 3 is desirable.
18 Debt- Equity Ratio Debts = Debentures + Long term Debt equity ration of 2:1 is the
Debt loans payable after year norms accepted by financial
Net Worth/ Shareholder's funds= institution for financing the
Shareholder Fund/ Equity & Preference capital + projects. It indicates the
Proprietors Fund Reserves & surplus- Fictitious cushion available to the
assets-Accumulated losses creditors on liquidation of the
organisation. High debt equity
ratio is maintained to maximize
returns given to shareholders.
19 Total Debt Ratio Total debts = Long Term Debts + The Total debt ratio depicts the
(Debt-Asset Ratio) Current Liabilities proportion of total assets
Total Assets = Fixed Asset + financed by the shareholders.
Total Debts
Current Assets
Total Assets
20 Capital gearing ratio Fixed income bearing Security = A high gearing ratio indicate
Preference share capital and that in the capital structure;
Fixed Income
Debentures fixed income bearing securities
Bearing Securities are more in comparison to the
Equity Capital = Equity Share
Equity Capital Capital + reserve & Surplus equity share capital and in that
case company is said to be
highly geared and vice versa.
21 Proprietary Ratio Shareholders Funds = Capital It expresses the relationship
Shareholders Fund employed - Long term Loans- between shareholders funds to
Total Assets Fictitious assets total assets.
Total Assets = Fixed assets +
Current assets - Fictitious assets
22 Debt service coverage This ratio is the key indicator

Ratio to the lender to assess the
extent of ability of the
PAT + Dep +Int
borrower to service the loan
Interest + Loan in regard to timely payment of
repayment in a year interest & loan. A ratio of 2
considered satisfactory by the
financial institutions.

VALUATION RATIO

23 Earning Per Share No of equity share = This ratio is used to measure
PAT - Preference Dividend Paid up capital profit available to shareholder.
No. of Equity Shares Face value per share Higher EPS indicate increasing
trend of profit.
24 Price Earning Ratio This ratio indicates the

Market Price Per Share expectations of the equity
Earning Per Share investors about the earnings of
the firm. The investor's
expectations are reflected in
the market price of the share.
The ratio indicates how much
an investor is prepared to pay
per rupee of earnings.
25 Dividend Payout Ratio This ratio explains relationship
Dividend Per Share between earnings belonging to
Earning Per Share shareholder and amount finally
paid to them in the form of
Dividend.
26 Dividend yield ratio The ratio reflects the % yield
Dividend per share that an investor receives on this
X 100 investment at the current
Market price
market price of the share

STEPS INVOLVED IN THE FINANCIAL STATEMENT ANALYSIS
The analysis of the financial statements requires:

(1) Methodical classification of the data given in the financial statements.
Methodical classification. In order to have a meaningful analysis it is necessary that figures
should be arranged properly. Usually instead of the two-column (T form statements as
ordinarily prepared, the statements are prepared in single (vertical) column form "which
should throw up significant figures by adding or subtracting." This also facilitates showing
the figures of a number of firms or number of years side by side for comparison purposes.
OPERATING (INCOME) STATEMENT

For the year ending
Rs. Rs.
Gross Sales ***
Less : Sales Returns ***
Sales Tax/Excise ***
Net Sales (or sales) for the year ........
Less : Cost of Goods sold :
Raw Materials consumed
(Op. stock of R.M + Purchase of R.M. + Expenses on
Purchases - Cl. Stock R.M) ***
Direct Wags ***
Manufacturing Expenses *** ........

Add : Opening Stock of Finished Goods ........
Less : Closing Stock of Finished Goods ........
= Gross Profit ****
Less : Operating Expenses :
Administration Expenses ***
Selling and Distribution Expenses ***
Depreciation *** …...

= Net Operating Profit (OPBIT) ****
Add: Non-trading Income ........
(Such as dividends, interest received, etc.) ........
Less : Non-trading Expenses (such as discount on issue of shares ........
written off)
= Income or Earning before Interest and Tax (EBIT) ****
Less: Interest on Loans and Debentures ........
= Income or Profit Before Tax (PBT) ****
Less Provision for Tax ........
= Profit after Tax ****
Less Preference Dividend ........
= Profit Available to Shareholders ****
Less Equity Dividend ........
= Retained Earnings ****

BALANCE SHEET AS ON
PARTICULARS RS RS
Preference Share Capital ……….
Equity Share Capital ……….
******
Total Share Capital (1)
Add Capital reserve ……….
General reserve ……….
Share Premium ……….
Capital Redemption Reserve ……….
Profit & Loss A/c ……….
Less Preliminary Expenses ……….
Accumulated Losses ………. ******

= Shareholders fund / Proprietors Funds / Net Worth (2) ******
Add Long Term Funds ……….
Debentures ………. ******

Capital Employed (3) ******
= Represented By
Fixed Assets ……….
Land & Building ……….
Plant & Machinery ……….
Furniture & Fixtures ……….
Gross Block ……….
Less Depreciation ……….
******
= Net Fixed Assets (4) ******
Current Assets (5)
Add Cash & Bank ……….
Debtors ……….
Bills Receivables ……….
Closing Stock ……….
Pre-paid Expenses etc ……….
……….
Less Current Liabilities (6)
Trade Creditors ……….
Bills Payable ……….
Bank Overdraft ……….
Outstanding Expenses ……….
Provision for Tax ……….
******
= Net Working Capital (7) = (5) - (6)
******
= Total Assets (4) + (7) ******

FUND FLOW STATEMENT
The profit & loss a/c and balance sheet statements are the common important accounting statement
of a business organization. These statement dose not provide information about movement of funds
which is equally important for shareholders. To provide this information Funds flow statement is
prepared. The statement is divided into two parts , sources and application.
The sources of funds shows
The funds generated from operation internally

The reasons for liquidity problems even though it is earning profits.
It helps the efficient working capital management
It indicate ability of firm in servicing its long term liabilities
The application of funds shows
How much amount is paid towards paying dividend & tax payment ?
How long term & short term funds utilized by the company?
What are the sources of funds available during the year ?
This statement shows difference between two balance sheet.
The term fund means working capital i.e., difference between current assets & current liabilities.
The flow means movement of funds which cause a change in working capital.
Benefits of fund flow statement
Fund flow statement helps in taking decisions regarding allocation of limited financial resources.
It helps in securing new laon.
It may allow company to declare dividend inspite of losses or low profits.
Drawbacks
The fund flow statement is historical in nature like any other financial statement.
It dose disclose the major policy decisions with regards to investment in current assets & fixed
assets.
Funds flow statement are depends upon correctness of financial statements.

How to prepare Fund Flow statement?
1) Prepare fund flow statement.

Source Rs Application Rs
1. Issue of shares 1. Redemption of shares
2. Issue of debentures 2. Redemption of debentures
3. Loan taken from bank 3. Payment of loan
4. Sale of assets 4. Purchase of assets
5. Decrease in working capital 5. Incerase in working capital
6. Operating profit 6. Operating loss
7. Dividend paid
8. Tax paid
TOTAL TOTAL
2) Prepare statement showing changes in Working Capital.
Particular Year 1 Year 2 Increase Decrease
A. Current Assets
1.Bank
2.Drs
3.Stock
4.Pre-paid expenses
5.Bills receivables
6.Short term investment
B. Current Liabilities
1.Credits
2.Bank overdrafts
3.Bills payable
4.Proposed Dividend*
5.Provision for Tax*
TOTAL ** **
Increase/Decrease in working capital
NET TOTAL ** **
* Proposed dividend & provision for Tax can be treated as current liability as well as non-current
liability (open separate ledger account).

Rules to decide increase or decrease in working capital
Increase or decrease in CA or CL Working Capital CA - CL = WC

100 - 50 = 50
Increase in Current Assets Increase in WC 120 - 50 = 70
Decrease in Current Assets Decrease in WC 80 - 50 = 30
Increase in Current Liabilities Decrease in WC 100 - 80 = 20
Decrease in Current Liabilities Increase in WC 100 - 30 = 70
3) Prepare necessary ledger account for adjustments and P&L account.
4) Record all adjustments with the help of journal entries & ledger posting.
I. Sale of Asset.
Cash or bank a/c Dr
To Asset a/c. Cr
II. Purchase of Asset.
Asset a/c Dr.
To bank a/c. Cr
III. Profit on sale of Asset.
Asset a/c Dr.
To P&L a/c. Cr
IV. Loss on sale of asset.
P&L a/c Dr.
To asset a/c. Cr
V. Depreciation on Assets.
P&L (depreciation) a/c Dr.
To Asset a/c. Cr
VI. Dividend paid.
P&L (Dividend) a/c Dr.
To cash a/c. Cr
VII. Dividend paid when proposed dividend is given (Treated as non-Current Liability).
Provision of dividend a/c Dr.
To Bank a/c Cr
VIII. Tax paid.
P&L (Tax) a/c Dr.
To bank a/c. Cr
IX. Tax paid when provision for tax account is given (Treated as non-Current Liability).
Provision for Tax a/c Dr.
To bank. Cr

X. Issue of share capital.
Cash a/c Dr.
To share capital. Cr
XI. Redemption of share capital.
Share capital a/c Dr.
To cash a/c. Cr
XII. Redemption of share capital/debenture at a premium
Share capital /Debenture a/c Dr
P&L (Premium on redemption) a/c Dr.
To bank a/c. Cr
XIII. Entry for creating provision.
P&L a/c Dr.
To respective provision. Cr
XIV. Assets purchased by issuing shares.
Assets a/c Dr.
To share. Capital a/c Cr
5) Balancing of ledger account except P&L account
Dr Asset a/c Cr
Particulars Rs Particulars Rs
To balance b/d By depreciation a/c

To Bank a/c By bank a/c (Sale of Assets)
By balance c/d
TOTAL TOTAL
Dr Loan / Share capital a/c Cr
To Bank a/c (Redemption/Repayment) By balance b/d

To balance c/d By bank a/c (Issue of share/ Loan Taken)
TOTAL TOTAL

Dr Provision/Reserve a/c Cr
To Bank a/c (Payment) By balance b/d

To balance c/d By P&L a/c (current year provision)
TOTAL TOTAL
6) Consider assets & liabilities (other than considered in working capital statement & adjustment).
7) Balance P&L account. Differences will be treated as operating profit or operating loss which is
to be transferred to fund flow statement.

PROBLEMS ON RATIO ANALYSIS
Illustration 1
Given below the balance sheet of X ltd.
Balance sheet of X Ltd
Liabilities Rs Assets Rs
Equity share capital 15,00,000 Fixed Assets 16,50,000
Retained earnings 6,00,000 Inventories 9,10,000
Long term debt 5,00,000 Debtors 12,40,000
Creditors 12,00,000 Cash 40,000
Bank overdraft 2,00,000 Short term investments 1,60,000
TOTAL 40,00,000 TOTAL 40,00,000
Annual sales Rs 74,40,000, GP Rs 7,44,000

Calculate
1) Debt-equity ratio
2) Current ratio
3) Quick ratio
4) Fixed asset turnover ratio
5) Debtors turnover ratio
6) Stock turnover ratio
7) Capital turnover ratio
8) Total asset turnover ratio
9) Gross profit ratio

Illustration 2
Certain items of the annual accounts of ABC Ltd. are missing as shown below:
TRADING AND PROFIT & LOSS ACCOUNT for the year ended 31st March, 2005
Particulars Amount Particulars Amount

To Opening stock Rs. 3,50,000 By Sales _______
To Purchase _______ By Closing Stock _______
To Direct Expenses 87,500
To Gross Profit c/d _______
To Office and other Expenses Rs. 2,13,421 By Gross Profit b/d _______
To Interest on Debentures 30,000 By Commission 50,000
To Provision for Taxation _______
To Net Profit for the year _______
To Proposed Dividends _______ By Balance b/d 70,000

To Transfer to General reserve _______ By Net Profit for the year
To Balance transferred to BS _______
BALANCE SHEET
As on 31st March, 2005
Liabilities Amount Assets Amount

Paid up Capital 5, 00,000 Fixed Assets:
General Reserve: Plan and Machinery Rs. 7, 00,000
Balance at the beginning _______ Other Fixed Assets: _______
Of the year
Proposed Addition _______ Current Assets:
Profit and Loss A/c _______ Stock-in-trade _______
10% Debenture _______ Sundry Debtors _______
Current Liabilities _______ Bank Balance 62,500
Total Total

You are required to supply the missing figures with the help of the following information:
i) Current ratio 2:1
ii) Closing Stock is 25% of sales.
iii) Proposed dividends are 40% of the Paid up capital.
iv) Gross Profit ratio is 60%
v) Ratio of Current liabilities to Debentures 2:1.
vi) Transfer to General reserve is equal to proposed dividends.
vii) Profit carried forward are 10% of the Proposed dividend.
viii) Provision for taxation is 50% of profit after tax.
ix) Balance to the credit of General reserve at the beginning of the year is twice the mount transferred
to that account from the current profits.
Illustration 3
As on 31st March, 2003, the paid up capital of Navroj Ltd. was Rs. 1, 00, 00,000. The ratios as
on that date were as under:
Current debt to Total debt 0.40
Total debt to Equity 0.60
Fixed assets to Equity 0.60
Total assets turnover (based on sales) 2 times
Inventory turnover (based on sales) 8 times
Draw the balance sheet of Navroj Ltd.
(C.S., Final, Dec. 2003)
Illustration 4
From the following details, prepare a Statement for Proprietary Funds with as many details
as possible.
a) Stock turnover 6
b) Capital turnover 2
c) Fixed assets turnover 4
d) Gross profit ratio 20%
e) Debtors turnover 2 Months
f) Creditors turnover 73 days
The Groff profit was Rs. 60,000; Reserves and Surplus amounted to Rs. 20,000;
Closing stock was Rs. 5,000 in excess of Opening stock.

Illustration 5
The following are the Ratios extracted from the Balance Sheet of a company as at 31st December,
2005. Draw up the Balance sheet of the firm.
Current liabilities 1.0
Current Assets 2.5
Working Capital Rs. 3, 00,000
Liquidity Ratio 1.5
Stock Turnover Ratio 6
Gross Profit Ratio 20%
Debt Collection period 2 months
Shareholders' Capital Rs. 5, 00,000
Reserve and Surplus Rs. 2, 50,000
Fixed Asset Turnover (on cost of sales) 2
Illustration 6
From the following information, prepare a summarized Balance Sheet s at 31st March, 2002 :
Working Capital Rs. 2, 40,000
Bank Overdraft Rs. 40,000
Fixed Assets to Proprietary ratio 0.75
Reserves and Surplus Rs. 1, 60,000
Current ratio 2.5
Liquid ratio 1.5
Illustration 7
ABC Ltd has made plan for the next year. It estimated that the company will employ total assets
of Rs 8, 00,000, 50% of the assets being financed by borrowed capital at an interest @ 16% p.a. The
direct costs for the year estimated at Rs 4, 80,000 and all other operating expenses are estimated at
Rs 80,000. The goods will be sold to customers at 150% of the direct costs. Income-tax is assumed
to be 50%. You are required to calculate
1. Income statement of ABC Ltd
2. Net Profit Margin
3. Assets Turnover
4. Return on Assets
5. return on owner's equity

Illustration 8
The following figures extracted from the book of XYX Ltd as on 30.09.2000
Particulars Rs
Net Sales 24, 00,000
(-)Operating Expenses 18, 00,000
Gross Profit 6, 00,000
(-)Non operating expenses 2, 40,000
Net profit 3, 60,000
Current Assets 7, 60,000

Inventories 8, 00,000
Fixed Assets 14, 40,000
Total Assets 30, 00,000
Net Worth 15, 00,000

Debts 9, 00,000
Current Liabilities 6, 00,000
Total Liabilities 30, 00,000
Working Capital 9, 60,000
Calculate
1. GP Ratio
2. NP Ratio
3. Return on Assets
4. Inventory Turnover
5. Working Capital Turnover
6. Net worth to Debts

Illustration 9
Using the following information prepare balance sheet.

Sales 36lacs
Sales/Total assets 3
Sales/Fixed assets 5
Sales/Current assets 7.5
Sales/Inventories 20
Sales/Debtors 15
Current ratio 2
Total asset/Net worth 2.5
Debt/Equity 1
Balance sheet
Net worth Fixed Assets
Long term debt Inventories
Current liabilities Debtors
Liquid assets
TOTAL TOTAL
Illustration 10
Using the following data prepare balance sheet.
Gross profit (20% of sales) Rs 60,000

Shareholders equity Rs 50,000
Credit sales to total sales 80%
Total assets turnover 3 times
Inventory turnover 8 times
ACP (360days a year) 18 days
Current ratio 2 times
Long term debt to equity 40%

Illustration 11
Using the following information prepare balance sheet.
Long term debt to net worth 0.5 to 1

Total assets turnover 2.5 times
Average collection period ½ month
Inventory turnover 9 times
GP ratio 10%
Acid test ratio 1:1
Balance sheet of XYZ Ltd
Equity share capital 100000 Fixed Assets ...........
Retained earnings 100000 Inventories ...........
Long term debt ........... Debtors ...........
Creditors 100000 Cash ...........
TOTAL TOTAL
Illustration 12
The following is the balance sheet of Amit Ltd.
Balance sheet of AMIT Ltd
Liabilities Rs. Assets Rs.
Equity share capital of Rs.10 each 5,00,000 Fixed Assets 30,00,000

Retained earnings 3,50,000 Less: Depreciation 4,50,000 25,50,000
Long term debt 17,50,000 Inventories 5,00,000
Creditors 2,50,000 Debtors 4,00,000
Profit & loss a/c 5,50,000 Cash 1,00,000
Other current liabilities 2,50,000
TOTAL 35,50,000 TOTAL 35,50,000
Additional information
1) Profit during the year Rs 4,00,000
2) The company has declared 25% dividend
3) Market price of share is Rs 500

Calculate
Debt equity ratio, Current ratio, Acid test ratio, EPS, P/E ratio, Divided payout ratio, Dividend
yield ratio
Illustration 13
The following is the balance sheet of Aditi Ltd.
Balance sheet of ADITI Ltd

Equity share capital of Rs 100 10,00,000 Plant & machinery 6,40,000

each Land 80,000
Retained earnings 3,68,000 Inventories 4,80,000
Creditors 1,04,000 Cash 1,60,000
Bills payable 2,00,000 Debtors 4,00,000
Less: RDD 40,000
3,60,000
Other current liabilities 20,000
Prepaid insurance 12,000
TOTAL 16,92,000 TOTAL 16,92,000
Income statement for the year ended 31st December
Sales 40, 00,000

Less: Cogs 30, 80,000
Gross profit 9, 20,000
Less: op. exp 6, 80,000
Net profit before tax 2, 40,000
Less; tax 50% 1, 20,000
PAT 1, 20,000
Sundry debtors & stock at the beginning of the year were Rs 3, 00,000 & Rs 4,00,000 respectively.
Calculate
CR, LR, STR, DTR, GP, NP, Operating profit ratio, EPS, ROCE, Market value if P/E ratio is 10 times.

Illustration 14
From the following information prepare balance sheet of Shri Mohan.
Current ratio 2
Working capital Rs 4, 00,000
Net worth + Deb to current assets 3:2
Fixed assets to turnover 1:3
Cash sales / Credit sales 1:2
Creditor's velocity 2 months
Stock velocity 2 months
Debtors' velocity 3 months
Net profit 10% of turnover
Reserves 2.5% of turnover
Debenture / Share capital 1:2
GP ratio 25%
Illustration 15
The actual ratios of a company compared to the industry standard are given below. Comment on
each ratio and indicate in one or two sentences the nature of action to be taken by the company.
RATIO INDUSTRY STANDARD ACTUAL FOR THE YEAR
Current ratio 2.2 2.7
Debtors turnover ratio 6 8
Stock turnover ratio 10 3
Net profit ratio 5% 2.4%
Total debt to total assets 7.5% 40%

PROBLEMS ON FUND FLOW STATEMENT
Problem 1 :
From the following balance sheets of X ltd prepare fund flow statement as on 31.03.2006.
Rs in thousand
LAIBILITIES 31.03.2005 31.03.2006 ASSETS 31.03.2005 31.03.2006
Share capital 500 500 Land & building 180 200

General reserve 200 220 Plant machinery 210 276
P & L a/c 40 32 Other fixed assets 30 45
Long term loan 100 Investments 50 50
Creditors 158 172 Stock 200 190
Provision for tax 45 30 Debtors 170 195
Cash at bank 103 98
TOTAL 943 1054 TOTAL 943 1054
Adjustments:
1) Dividend amounting to Rs 30,000 was paid during the year.

2) Provision for taxation made Rs 12,000.
3) Machinery worth Rs 15,000(book value) was sold at a loss of Rs 3,000.
4) Investment costing Rs 10,000 was sold for Rs 12,000.
5) Depreciate land & building by Rs 5,000 & machinery by Rs 20,000.
Problem 2:
From the following information, prepare a statement showing sources and application of the
funds for the year ended 31.12.84. Rs in lakhs
LAIBILITIES 31.121983 31.12.1984 ASSETS 31.12.1983 31.12.84
Share capital 4.50 4.50 Fixed assets 4.00 3.20
General reserve 3.00 3.10 Investments 0.50 0.60
P&L account 0.56 0.68 Inventories 2.40 2.10
Creditors 1.68 1.34 Debtors 2.10 4.55
Provision for tax 0.75 0.10 Bank 1.49 1.97
Mortgage loan - 2.70
TOTAL 10.49 12.42 TOTAL 10.49 12.42

Adjustments
1) Investment costing Rs 8,000 were sold during 1984 for Rs 8,500.

2) Provision for taxation was made during the year was Rs 9,000.
3) During the year, part of the fixed assets having the book value of Rs 10,000 was sold for Rs
12,000.
4) Dividend paid during the year amounted to Rs 40,000.
Problem 3:
Given below are the balance sheets of Liquid Ltd.

Equity capital 30,000 35,000 Fixed assets 51,000 62,000
9% pref.capital 20,000 10,000 Investment 3,000 8,000
Debentures 10,000 20,000 Current assets 24,000 37,500
Reserves 11,000 27,000 Preliminary exp 1,000 500
RDD 1,000 1,500
Current liabilities 7,000 14,500
TOTAL 79,000 1,08,000 79,000 1,08,000
Adjustments
1) A machine costing Rs 7,000(book value Rs 4,000) was sold for Rs 2,500.

2) 15% dividend was paid on equity capital in addition to preference dividend on opening balance
of capital.
3) The preference shares were redeemed at the end at 5% premium.
4) Depreciation written off Rs 7,000 on fixed assets.

Problem 4:
From the following adjustments & balance sheets given prepare fund flow statement.
1) During the year 2008 fixed assets values at Rs 20,000(book value) was sold for Rs 16,000.
2) The proposed dividend of the last year was paid in 2008.
3) During 2008, investment costing Rs 1,60,000 were sold and later in the year investments of the
same cost were purchased.
4) Debentures were redeemed at a premium of 10% in 2008.
5) Tax paid during the year 1,10,000.
6) Bad debts written off against provision Rs 30,000.
Balance sheets
LAIBILITIES 2007 2008 ASSETS 2007 2008

Share capital 12,00,000 14,00,000 Fixed assets 20,00,000 24,00,000
General reserve 4,00,000 5,00,000 Investments 3,60,000 3,60,000
Profit on sale of 20,000 Stock 4,00,000 5,40,000
investment
P & L a/c 2,00,000 4,00,000 Debtors 4,50,000 4,90,000
7% debentures 6,00,000 4,00,000 Bills receivables 80,000 1,30,000
Crs for expenses 20,000 24,000 Pre paid exp 20,000 24,000
Proposed div. 60,000 70,000 Misc. exp 30,000 20,000
Prov. for tax 1,40,000 1,50,000
Dep. Provision 4,00,000 5,00,000
Creditors 3,20,000 5,00,000
TOTAL 33,40,000 39,64,000 TOTAL 33,40,000 39,64,000

Problem 5:
From the following information prepare fund flow statement.
Balance sheets
LAIBILITIES 2005 2006 ASSETS 2005 2006

Share capital 10,00,000 12,00,000 Fixed assets 18,00,000 20,50,000
General reserve 5,00,000 6,00,000 Investments 2,00,000 2,50,000
P & L account 1,00,000 1,50,000 Stock 5,00,000 7,00,000
Debentures 5,00,000 5,00,000 Debtors 5,85,000 6,40,000
Creditors 9,00,000 10,50,000 Cash 15,000 10,000
Proposed div. 1,00,000 1,50,000
TOTAL 31,00,000 36,50,000 TOTAL 31,00,000 36,50,000
Additional information:
1) During the year 2006 depreciation was charged on fixed assets amounted to Rs 2,50,000.
2) Final dividend for the year 2005 was paid in the year 2006 mounting to Rs 1,00,000.
Problem 6:
Given below are the balance sheets of Lucky Ltd.

Capital 10,00,000 10,00,000 Fixed assets 12,00,000 14,00,000
Debentures 7,40,000 9,00,000 Investments 4,00,000 2,00,000
Tax payable 1,54,000 86,000 WIP 1,60,000 1,80,000
Creditors 1,92,000 3,84,000 Stock 3,00,000 4,50,000
Interest payable 14,000 90,000 Debtors 1,40,000 2,80,000
Dividend payable 1,00,000 70,000 Cash 60,000 20,000
TOTAL 22,60,000 25,30,000 TOTAL 22,60,000 25,30,000
Prepare fund flow statement.

Problem 7:
Following are the summarised Balance shees of the Ganges Ltd. as on 31st December, 2005 & 2006
Balance Sheet (Rs.’000)
Liabilities 2005 2006 Assets 2005 2006
Share capital 200 250 Land and building 200 190
General reserve 50 60 Plant and machinery 150 169
Profit and loss account 30.5 30.6 Stock 100 74
Bank Loan 70 - Sundry debtors 80 64.2
Sundry creditors 150 135.2 Cash balance 0.5 0.6
Provisions for taxation 30 35 Bank balance - 8
Goodwill - 5
530.5 510.8 530.5 510.8
The following additional information is available
I) During the year ended 31st December, 2006
i) Dividend of Rs. 23,000 was paid.
ii) Assets of other company were purchased for Rs. 50,000 payable in shares. Assets purchased
were : stock Rs. 20,000; and machinery Rs. 25,000.
iii) Machinery of Rs. 8,000 was purchased in addition to that of (ii) above.
II) Depreciation written off during the year, 2006
Building Rs. 10,000; and machinery Rs. 14,000.
III) The net profit for the year 2006 was Rs. 66,100
IV) Income-tax paid during the year 2006 was Rs. 28,000 and provision of Rs. 33,000 was made to
Profit and Loss Account.
Prepare statement of sources and application of funds for the year ended 31st December, 2006 and
a schedule setting out the changes in working capital.


CHAPTER 3
WORKING CAPITAL
CHAPTER 3
WORKING CAPITAL
A. MEANING OF WORKING CAPITAL
Every company needs the funds for two purposes, long term funds are require for acquiring
fixed assets by means of which company is able to built
The required infrastructure and plant capacity for achieving desire goal. Short-term fund are
required for day to day running of business i.e. for payment to supplier of raw material, wages and
salaries and payment of services taken by company. The fund required for these proposes is called as
working capital of company if this capital is not available the working of company may be disturbed
which may affect business performance. Working capital has following dimension.
1. When we talk of total current asset held by company it is called a gross working capital.
2. The different between current asset and current liability is called as Net working capital. This is
very important concept and working capital of a company is always referred to by this amount
3. When current assets more than current liabilities it is called a +ve working capital.
4 When current liabilities are more than current assets, it is called a - Ve working capital and this
is a bad position of working capital of company.
5. Certain amount of CA are always held by company irrespective of level of business this is called
as permanent or core working capital Generally FA & core working capital is financed out of
long term funds.
6. Working capital required above permanent level of W.C. is called as variable or temporary
W.C. This varies with seasonal requirement of business.
7. If F.A. financed from short-term fund then it is negative W.C.
Vipul Shah / 9881 236 536 Chapter : 3 Working Capital / 45

Thus for all practical purpose working capital =
CURRENT ASSETS - CURRENT LIABILITIES = WORKING CAPITAL
Sundry Debtors Sundry Creditors

Bills receivable Bills payable
Closing stock Outstanding expenses
(R.material, WIP, Short-term loan
Finished goods) Bank over draft
LESS
Cash in hand Advances taken
Cash at bank Provision for tax
Pre paid expenses proposed dividend
Short term advances
Accrued income
B. SIGNIFICANCE OF WORKING CAPITAL
No activity in business can be carried out without sufficient funds. Working capital is the nerve
center of business and in absence of adequate working capital business in paralyzed. Following
aspect of business are affected due to inadequate working capital
1. Solvency of business i.e. various amounts owed by business. If working capital is insufficient
company cannot full fill its promises to various parties. This lowers the image and prestige of
company.
2. When working capital is sufficient company can make various payments on the promised date
this required for maintaining goodwill and image of company.
3. Banks always gives the loan to those company who are having good are standing and with
sufficiency of working capital this is taken care of.
4. When working capital is sufficient purchase can be done on cash basis and discount can be
taken from suppliers.
5. If Payment is given on time then suppliers provides regular supply of raw material, which is
very essential for smooth running of business.
6. If salaries & wages are paid in time labour trouble can be avoided and production comes out
smoothly.
7. Various payments can be done by company as per the commitments
8. Favorable market condition can be exploited by increasing supply to the market.
9. Company develops on ability to face critical situations.
10. By optimizing the investment in current assets and by reducing the level of current liabilities,
the company can reduce the locking up of funds in working capital thereby, it can improve the
return on capital employed in the business.

C. FACTORS ON WHICH WORKING CAPITAL OF COMPANY DEPENDS
1) Nature of business
For e.g. working capital requirement of mfg business will differ from the requirements of
trading business. Trader need small amount of working capital as he carries most of the
business on cash basis. But mfg needs to maintain sufficient inventory in such case amount of
working capital required is higher. The service organisation needs lesser working capital than
trading and financial organisations. Therefore, the requirement of working capital depends
upon the nature of business carried by the organisation.
2) Size of business
Bigger the size of business higher would be requirement of working capital and small business
organisation needs lesser working capital. It also depends upon movement of inventory, faster
the movement lesser the investment & vice versa.
3) Production process
In case of labour intensive industries high working capital is needed. But in case of capital
intensive industries the production process is faster & it requires lesser amount of working
capital.
4) Credit Policy
It depends upon credit allowed to debtors and terms received from supplier.
For e.g. a firm might be purchasing goods and services on credit terms but selling goods only
for cash. The working capital requirement of this firm will be lower than that of a firm, which
is purchasing on cash basis but has to sell on credit basis.
5) Manufacturing cycle
Working capital depends upon production cycle time. Longer this cycle higher will the
requirements of working capital by company. The industries involved in quick conversion of
raw material into finished goods requires lesser amount of working capital.
6) Distribution time
Distribution time involved in supplying goods to customer.
7) After sale service
After sale service facilities provided by company.
8) New Business
If business is at the stage of growth & expansion their working capital requirement will
increase

9) Market competition
Competition plays an important role in the working capital determination. Sometimes firm
have to give extra credit to attract customer. In such case more working capital is needed.
10) Profit Margin
The working capital requirement will depend on profit margin of company higher the margins,
more cash will be available and there would be less pressure on working capital requirement
11) Divided policy
Divided policy of company influence working capital requirement. If policy is liberal then
more dividend is paid & working capital requirement will increase in reverse case working
capital requirement would be less as dividend one paid less.
12) Seasonal Operations

If firm is operating in goods and services having seasonal fluctuation then working capital
requirement will be higher during season.
13) Inventory policy

The traditional production systems generate more stocks of finished goods and level of raw
material and WIP stocks. Whereas the adoption of JIT, supply chain management will drastically
reduce the level of stocks.
14) Business standing

In case of newly established concern the materials are required to be purchased in cash and
sales are to be made on credit basis. Such new concerns require high levels of working
capital. Whereas established companies can negotiate for credit terms with supplier and sell
the product at lesser credit period to customers. Therefore it requires less working capital as
compared to new organisation.
15) Business cycle

Economic boom or recession have their influence on the transactions and consequently on
the quantum of working capital required. More working capital is needed during peak or
boom conditions. But in case of economic recession, the company requires low or moderate
working capital.
D. OPERATING CYCLE
It is a period required by business to convert cash again into cash. The operating cycle is the
length of time between the company's outlay on raw materials, wages and other expenses and inflow
of cash from sale of goods. Operating cycle is an important concept in management of cash and
management of working capital. Quicker the operating cycle less amount of investment in working
capital is needed and it improves the profitability. The duration of operating cycle depends on the
nature of industry and the efficiency in the working capital management. - operating cycle of a mfg.
business has following steps

a) Purchasing raw material from supplier
b) Maintaining stocks of raw material before it is used for production.
c) Semi finished goods or WIP stage.
d) Storing of finish good before they are sold.
e) Sale of finish goods to customer on credit which creates sundry debtors.
f) Receiving payment from S. debtors & thus getting back cash in business.
The operating cycle of mfg. business can be shown as in following chart
CASH RAW WORK IN

MATERIAL PROGRESS

SUNDARY FINISHED
DEBTORS GOODS
Reasons for prolonged operating cycle
Purchase of material in excess/short of requirement

Defective inventory policy
Lack of production planning, coordination and control
Use of outdated machinery, technology
Poor maintenance and upkeep of plant, equipments
Buying inferior, defective materials
Failure to get discount
How to improve operating cycle
Following remedies may be used to reduce the length of operating cycle

Purchase management
Production management
Marketing management
Credit collection policies
External environment
E. TECHNIQUE FOR ASSESSMENT OF WORKING CAPITAL REQUIREMENTS
1. Estimation of components of working capital method

As WC = CA - CL, under this method items and their amount which constitute working capital
i.e. CA & CL need to be find out. Difference between CA & CL indicates working capital
requirement.

2. Per cent of Sales Approach
Under this method ratio between sales and working capital is found out.
According to sales forecast amount needed, as working capital can be determined. The basic
criticism of this technique is that it assumes linear relationship between sales and working
capital, which is not true all the times.
3. Operating cycle approach
According to this approach working capital depend upon operating cycle time of the business.
The duration of the working capital for the purpose of estimating working capital requirements
is equivalent to the sum of the duration of each of these stages less the credit period allowed by
the supplier of the firm.
Symbolically, the duration of working capital cycle can be put as follows:
O = R+W+F+D-C
Where
O = Duration of operating cycle
R = Raw material and stores storage period
W = Work in process period
F = Finished goods storage period
D = Debtors collection period
C = Creditors collection period
Each of above component of the operating cycle can be calculated as follows:
R = Avg. Stock of raw material and stores
Avg. raw material and stores consumption per day
W = Avg. Stock work in process inventory
Avg. cost of production per day
F = Avg. Finish stock
Avg. cost of good sold per day
D = Avg. Debtors
Avg. credit sale per day
C = Avg. Creditors
Avg. credit purchase per day
After computing the period of one operating cycle, the total number of operating cycles that
can be completed during the year can be computed by dividing 365 days with the number of
operating days in a cycle. The total operating expenditure in a year gives the average amount of
the working capital requirements.

4. Regression analysis method
It is a statistical technique applied for forecasting working capital requirements. It establishes

relationship between sales and working capital and its various components in the past years.
F. OPERATING CYCLE DEPENDS ON
Type of business
Credit period allowed by Suppliers
Efficiency of inventory management
Peculiarities of production process
Demand for product
Distribution system sufficiency of company
Credit period allowed to debtors
G. TYPES OF WORKING CAPITAL
1. Permanent / Fixed working capital

It indicate minimum amount of investment in all current assets which is required all times to
carry out minimum level of business activities It represents current assets required on continuous
basis. It depends upon the size of business, greater the size of business, greater the amount of
such working capital. It is the irreducible minimum amount necessary for maintaining the
circulation of current assets. The minimum level of investment in current assets is permanently
locked up in business and it is also referred to as regular working capital. It represents the assets
required on continuing basis over the entire year. Tandon committee has referred to this type of
working capital as core current assets.
2. Temporary / Fluctuating working capital

It represents that amount of working capital, which keeps on fluctuating from time to time on
the basis of business activities. It represents additional current assets required at different times
during the year. It depends upon the changes in production and sales, over and above the
permanent working capital. It is the extra working capital needed to support the changing
business activities.

H. DIAGRAM SHOWING DIFFERENCE BETWEEN PERMANENT AND
TEMPORARY WORKING CAPITAL
Fluctuating WC Fluctuating WC

Avg.

Wc

Permanent WC
Permanent WC
Figure a Figure b
In Fig. a, permanent working capital is fixed over a period of time and temporary working
capital is fluctuating. In fig. b, the permanent working capital is increasing over a period of time with
the increase in the level of business activities. Hence the permanent working capital line is not the
horizontal line with the base line as in fig. a.
I. WORKING CAPITAL FINANCING
This should be financed form long-term sources such as shares, debentures, and long-term loan.
In addition to finance temporary working capital short-term loan is required.
1. Trade Creditors
Business can purchase raw material on credit for one or two or three months. This source is
very convenient as no paper work is involved; however supplier is likely to charge more money.
2. Public Deposit
Company may invite fixed deposit from public at large for a period of 1 to 3 year. This is also
called as medium term loan. However while accepting deposit requirements of company's act
and norm set down by RBI must be followed by the company.
3. Short Term Loan
Business can take short-term loan for a period less thon 1 year from banks for which security of
stock has to be given.
4. Cash credit and overdraft
Under this arrangement company is allowed to draw amount from its a/c up to a certain limit,
even if there is no balance in the account. The difference between cash credit and overdraft is as
under.
Cash credit is permanent facility.
Bank overdraft is temporary facility.
Cash credit is provided on the basis certain documents and hypothecation of stock where as
bank overdraft is provied on the basis of relationship with bank.

5. Purchasing or discounting of bill
By discounting bills with bank company can arrange funds required for short period.
The Tandon committee has suggested three method of working out the maximum amount that
a unit may expect from the bank, which is termed as maximum permissible bank finance (MPBF).
MPBF under three alternative are ascertained as follows
First Method
MPBF = 75% of (Current asset - Current Liabilities other than banks borrowings)
The borrowing firm should provide the remaining 25% from long term sources. The minimum
CR required under this method works out to 1:1.
Second Method
The borrowing firm should raise finance to the extent of 25% of current assets from long term
sources. The minimum CR required under this method works out to 1.33:1.
Third Method
MPBF = [75% of (Current asset - Core current assets)] - Current Liabilities other than banks
borrowings)
The borrowing firm should contribute 100% core current assets and 25% of balance current
assets from long term sources. The minimum CR required under this method works out to 1.5:1.
J. WORKING CAPITAL POLICIES
1. Restricted policy
It involves the rigid estimation of working capital to the requirement of the concern and then
forcing it to adhere to the estimate. The estimates will not provide for any contingencies or for
any unexpected events.
2. Relaxed policy
In involves the allowing sufficient cushion for fluctuation in funds requirement for financing
various items of working capital. The estimate is made after taking into account the provision
for contingencies or for any unexpected events.
3. Moderate policy
The working capital level is estimated in between the two extremes.
K. HINTS FOR SOLVING PROBLEMS
1. If nothing is given regarding degree of completion then assume Material 100%, Labour &
Overhead 50% complete.
2. In nothing is given regarding Material/Labour/ Overhead payment then assume to be paid on
cash basis.
3. Profit & depreciation are to be excluded while calculation working capital.

FORMAT OF STATEMENT SHOWING WORKING CAPITAL
PARTICULARS RS
A) CURRENT ASSETS
Cash and bank balance
Stock of raw material
Work-in-progress
Finished goods
Debtors
Temporary investments
Prepaid investments
= TOTAL CURRENT ASSETS
B) CURRENT LIABILITIES
Creditors for materials
Creditors for wages
Creditors for overheads
Taxes and dividend payable
Other liabilities payable within one year
= TOTAL CURRENT LIABILITIES
C) NET WORKING CAPITAL (A - B)
ADD : provision for contingencies
TOTAL WORKING CAPITAL REQUIRED
Notes :
There are two methods of preparing w.c. statements
a) Cash Cost Method :
In this method ignore profit & dep for working capital estimation.
b) Total Cost Method :
In this method consider profit & dep for working capital estimation.

Liquidity vs. Profitability
The basic objective of working capital is to provide adequate support for the smooth functioning
of the normal business operations of a company. The question then arises as to the determination of
the quantum of investment in working capital of current assets that can be regarded as 'adequate'.
Once we recognize the fact that a company has to operate in an environment permeated with
uncertainty/risk, the term 'adequate working capital' becomes somewhat subjective depending upon
the attitude of the management towards uncertainty/risk. In view of the uncertainty/risk, the quantum
of investment in current assets has to be made in a manner that it not only meets the needs of the
forecasted sales but also provides a built-in cushion in the form of safety stocks to meet unforeseen
contingencies arising out of factors such as delays in arrival of raw materials, sudden spurts in sales
demand etc. Consequently, the investment in current assets for a given level of forecasted sales will
be higher if the management follows a conservative attitude than when it follows an aggressive
attitude. Thus a company following a conservative approach is subjected to a lower degree of risk
than the one following an aggressive approach. Further, in the former situation the high amount of
investment in current assets imparts greater liquidity to the company than under the latter situation
wherein the quantum of investment in current assets is less. This aspect considers exclusively the
liquidity dimension of working capital. There is another dimension to the issue, viz., the 'profitability'
and it is discussed below.
Once we recognize the fact that the total amount of financial resources at the disposal of a
company is limited and these resources can be put to alternative uses, the larger the amount of
investment in current assets, the smaller will be the amount available for investment in other profitable
avenues at hand with the company. A conservative attitude in respect of investment in current assets
leaves less amount for other investments than an aggressive approach does. Further, since current
assets will be more for a given level of sales forecast under the conservative approach, the turnover
of current assets (calculated as the ratio of net sales to current assets) will be less than what they
would be under the aggressive approach. This being so, even if we assume the same level of sales
revenue, operating profit before interest and tax and net (operating) fixed assets, the company following
a conservative policy will have a low percentage of operating profitability compared to its counterpart
following an aggressive approach as can be seen from the numerical illustration 3.1.

Illustration
S.No. Particulars Conservative Policy Aggressive Policy

1. Net Sales Rs.50 lakh Rs.50 lakh
2. Operating Profit Before Rs.5 lakh Rs.5 lakh
Interest and Tax .
3. Net (Operating) Rs.10 lakh Rs.10 lakh
Fixed Assets
4. Current Assets Rs.8 lakh Rs.5 lakh
5. Total Operating Assets
[=(3) + (4)] Rs.18 lakh Rs.15 lakh
6. Net Operating Profit Margin
5
= 10%
50
50 50
7. Turnover of Net Operating = 10% times = 10% times
10 10
Fixed
⎡ (1) ⎤
= ⎢= 3 ⎥
⎣ ( )⎦
Assets
50
8. Turnover of Current Assets = 10 times
8552⎡ ( 2 ) ⎤
50 5
=
= = 0times
== 2.78
10%
0.8 .5
505⎢0(1) ⎥
1
10
18
⎡ (1) ⎤ ⎣ ⎦
⎢= ⎥
⎣ ( 4) ⎦
50
9. Turnover of Total Operating = 3.33 times
15
⎡ (1) ⎤
Assets ⎢ = 5 ⎥
⎣ ( )⎦
10. Rate of Return on Total 27.8% 33.3%
Operating Assets
11. Ratio of Current

5
Assets to Net Operating Fixed = 0.5
10
⎡ ( 4) ⎤
Assets ⎢ = 3 ⎥
⎣ ( )⎦
= 80% = 50%

From the illustration, it can be easily seen from item (10), that the alternative of following a
conservative approach to investment in current assets results in a low profitability of 27.8 percent
compared to the profitability of 33.3 percent obtained under the alternative - an aggressive approach.
The reason for this can be directly traced to the low turnover of current assets leading to a lower
turnover of total operating assets under the conservative approach compared to that under the
aggressive approach. From item (11) it can be seen that current assets comprise 80 percent of net
operating fixed assets resulting in higher proportion of current assets and hence greater liquidity
compared to the corresponding figure of 50 percent indicating low liquidity under the aggressive
approach.

PROBLEMS ON WORKING CAPITAL
Illustration 1
The cost sheet of PQR Ltd. provides the following data:
Cost Per Unit
Raw material Rs. 50
Direct Labour 20
Overheads (including depreciation of Rs. 10) 40
Total cost 110
Profits 20
Selling price 130
Average raw material in stock is for one month. Average material in work-in-progress is for half
month. Credit allowed by suppliers: one month; credit allowed to debtors: one month. Average time
lag in payment of wages: 10 days; average time lag in payment of overheads 30 days. 25% of the
sales are on cash basis. Cash balance to be Rs. 1, 00,000. Finished goods lie in the warehouse for one
month.
You are required to prepare a statement of the working capital needed to finance a level of the
activity of 54,000 units of output. Production is carried on evenly throughout the year and wages
and overheads accrue similarly. State your assumptions, if any, clearly.
Illustration 2
The following information has been extracted from the records of a Company:
Product cost sheet
Raw materials Rs. 45
Direct Labour 20
Overheads 40
Total 105
Profit 15
Selling price 120
Raw materials are in stock on an average for two months.
The materials are in process on an average for one month. The degree of completion is 50% in
respect of all elements of cost.
Finished goods stock on an average is for one month.
Time lag in payment of wages and overheads is 11/ 2 weeks.
Time lag in receipt of proceeds from debtors is 2 months.
Credit allowed by suppliers is one month.
20% of the output is sold against cash.
The company expects to keep a Cash balance Rs. 1, 00,000.

The Company is poised for a manufacture of 1, 44,000 units in the next year.
You are required to prepare a statement showing the Working Capital requirements of The
Company
Illustration 3
Grow More Ltd. is presently operating at 60% level, producing 36,000 units
Per annum. In view of favorable market conditions, it has been decided that from 1st January
2004, the Company would operate at 90% capacity. The following information is available:
i) Existing cost-price structure per unit is given below:
Raw material Rs. 4.00
Wages 2.00
Overheads (Variable) 2.00
Overheads (Fixed) 1.00
Profits 1.00
ii) It is expected that the cost of raw material, wages rate, expenses and sales per unit will remain
unchanged in 2000.
iii) Raw materials remain in stores for 2 months before these are issued to production. These units
remain in production process for 1 month.
iv) Finished goods remain in godown for 2 months.
v) Credit allowed to debtors is 2 months. Credit allowed by creditors is 3 months.
vi) Lag in wages and overhead payments is 1 month. It may be assumed that wages and overhead
accrue evenly throughout the production cycle.
You are required to:
a) Prepare profit statement at 90% capacity level; and

b) Calculate the working requirements on an estimated basis to sustain the increased production
level.
Assumptions made if any, should be clearly indicated.
Illustration 4
Hi-tech Ltd. Plans to sell 30,000 units next year. The expected cost of goods Sold is as follows:
Rs. (Per Unit)
Raw material 100

Manufacturing expenses 30
Selling, administration and financial expenses 20
Total 150
Profit 50
Selling price 200

The duration at various stages of the operating cycle is expected to be as Follows:
Raw material stage 2 months
Work-in-progress stage 1 month
Finished stage 1/2 month
Debtors stage 1 month
Assuming the monthly sales level of 2,500 units, estimate the gross working Capital requirement
if the desired cash balance is 5% of the gross working capital requirement, and work-in-progress
is 25% complete with respect to manufacturing expenses.
Illustration 5
Calculate the amount of working capital requirement for SRCC Ltd. from the following
information:
Rs. (Per Unit)
Raw material 160
direct labor 60
Overheads 120
Total cost 340
Profit 60
Selling price 400
Raw materials are held in stock on an average for one month. Materials are in process on an
average for half-a-month. Finished goods are in stock on an average for one month.
Credit allowed by suppliers is one month and credit allowed to debtors is two months. Time lag
in payment of wages is 1 1/2 weeks. Time lag in payment of overhead expenses is one month. One
fourth of the sales are made on cash basis.
Cash in hand and at the bank is expected to Rs. 50,000: and expected level of production amounts
to 1, 04,000 units for a year of 52 weeks.
You may assume that production is carried on evenly throughout the year and a time period of
four weeks is equivalent to a month.

Illustration 6
On 1st January 2005, the Board of Directors of Dowell Co. Ltd. wishes to know the amount of
working capital that will be required to meet the program of activity they have planned for the year.
The following information is available:
i) Issued and paid-up capital Rs. 2, 00,000.
ii) 5% Debentures (secured on assets) Rs. 50,000.
iii) Fixed assets valued at Rs. 1, 25,000 on 31.12.2000.
iv) Production during the previous year w 60,000 units. It is planned that the level of activity
should be maintained during the present year.
v) The ratios of cost to selling price are-raw materials 60%, direct wages 10% and overheads
20%.
vi) Raw materials are expected to remain in stores for an average of two months before these are
issued for production.
vii) Each unit of production is expected to be in process for one month.
viii) Finished goods will stay in warehouse for approximately three months.
ix) Creditors allow credit for 2 months from the date of delivery of raw materials.
x) Credit allowed to debtors is 3 months from the date of dispatch.
xi) Selling price per unit is Rs. 5.
xii) There is a regular production and sales cycle.
Also prepare an estimated Profit and Loss Account and Balance Sheet at the end of the year.
Illustration 7
Raju brother's pvt ltd sells goods on a GP of 25%. Depreciation is considered in the cost of
production. The following are the annual figures given to you
Sales (2 month credit) 18, 00,000
Material consumed (1 month credit) 4, 50,000
Wages paid (1 month lag in payment) 3, 60,000
Administrative expenses (1 month lag in payment) 1, 20,000
Sales promotion expenses (paid quarterly in advance) 60,000
Income tax payable in 4 equal installments of which one falls in the next year 1, 50,000
Cash mfg. expenses (1 month lag in payment) 4, 80,000
The co. keeps one month's stock each of raw materials and finished goods. It also keeps
Rs 1, 00,000 in cash. You are required to estimate the working capital requirements of the company
on cash basis assuming 15% safety margin.

Illustration 8
A company newly commencing business in 2005 has the under mentioned projected profit &
loss.
Sales 42, 00,000
Less: Cost of goods sold 30, 60,000
= Gross profit 11, 40,000
Less: Administrative exp 2.80.000
Less: Selling expenses 2, 60,000
= Profit before tax 6, 00,000
Less: Provision for taxation 2, 00,000
Profit after tax 4, 00,000
The cost of goods sold has been arrived as under
Material used 16, 80,000
Wages & mfg. exp 12, 50,000
Depreciation 4, 70,000
34, 00,000
Less: stock of Finished goods 3, 40,000
30, 60,000
1. The figures given above relates only to finished goods & not to WIP.
2. Goods equal to15% of the year's production will be in process on the avg. requiring full materials
but only 40% of the other expenses. The company believes in keeping material equal to two
months consumption in stock.
3. All expenses will be paid one month in arrear.
4. Suppliers of material will extend 1.5 months credit & credit given to Drs 2 months.
5. Cash sales 20%.
6. 90% of income tax will be paid in advance in quarterly installments.
7. Required cash balance Rs 1, 00,000.
Prepare statement showing working capital.

Illustration 9
Estimate the working capital requirement form the data of Delhi LTD.
Cost price per unit
Raw material Rs 40
Labour Rs 10
Overheads Rs 30
Projected sales 75000 units @ Rs 100 per unit
Debtors credit period 10 weeks
Credit allowed by supplier 4 weeks
Raw material in stock 6 weeks
Finished stock 8 weeks
Processing time 4 weeks
Wages are paid once in a 4 weeks
Contingency 10% of working capital
Cash balance required Rs 1, 87,500.
Illustration 10
Calculate working capital from the following information.

Annual expenses
Wages Rs 52,000
Stores & material Rs 9,600
Office salaries Rs 12,480
Rent Rs 2,000
Other expenses Rs 9,600
Average amount of stock to be maintained
Raw material Rs 1,600

Finished goods Rs 1,000
Expenses paid quarterly in advance Rs 1600 p.a.
Annual sales
Home market Rs 62,400 (credit allowed 6 weeks)
Foreign market Rs 15,600 (credit allowed 1.5 weeks)
Lag in payment of
Wages 1.5weeks
Materials 1.5months
Office salaries 0.5months
Rent 6 months
Other expenses 1.5months

Illustration 11
The following information has been extracted from the records of a Company:
Product cost sheet
Raw materials Rs. 20
Direct Labour 5
Overheads 15
Total 40
Profit 10
Selling price 50
Raw materials are in stock on an average for two months.

The materials are in process on an average for one month. The degree of completion is 50% in
respect of all elements of cost.
Finished goods stock on an average is for one month.
Time lag in payment of wages is 1 month and overheads is 1.5 weeks.
Time lag in receipt of proceeds from debtors is 2 months.
Credit allowed by suppliers is one month.
Overheads includes depreciation of Rs 5.
25% of the output is sold against cash.
The company expects to keep a Cash balance Rs. 20,000.
The Company is poised for a manufacture of 1, 80,000 units in the next year.
You are required to prepare a statement showing the Working Capital requirements of the
Company & determine MPBF available under the first two methods suggested by Tondon committee.


CHAPTER 4
MANAGEMENT OF RECEIVABLES
Chapter : 4
MANAGEMENT OF RECEIVABLES
1. INTRODUCTION
Business firms generally sell goods on credit, to facilitate sales especially from those customers
who cannot borrow from other sources, or find it very expensive or difficult to do so.
Finished goods sold on credit get converted (from the point of view of the selling firm) into
receivables (book debts) which when realized generate cash. The average balance in the receivables
account would approximately be: average daily credit sales multiplied by average collection period.
For Illustration, if the average daily credit sales of a firm are Rs.300000 and the average collection
period is 40 days, the average balance in the receivables account would be Rs. 12000000. Since
receivables often account for a significant proportion of the total assets, management of receivables
take up a lot of the Finance Manager's time.
2. PURPOSE OF RECEIVABLES
The purpose of receivables can be understood if we can grasp the basic objective of receivables
management. The objective of receivables management is to promote sales and profits until that
point is reached where the returns that the company gets from funding of receivables is less than the
cost that the company has to incur in order to fund these receivables. Hence, the purpose of receivables
is directly connected with the company's objectives of making credit sales, which are:
To increase total sales; because when a company sells goods on credit, it will be in a position to
sell more goods than if it insists on immediate cash payment.
To increase profits; because this results in an increase in sales not only in volume, but also
because companies charge a higher margin of profit on credit sales as compared to cash sales.
To meet increasing competition; and for this the company may have to grant better credit
facilities than those offered by its competitors.
Vipul Shah / 9881 236 536 Chapter : 4 Management Receivables / 66

3. COST OF MAINTAINING RECEIVABLES
Additional fund requirement for the company
When a firm maintains receivables, some of the firm's resources remain blocked in them because
there is a time lag between the credit sale to customer and receipt of cash from them as payment.
To the extent that the firm's resources are blocked in its receivables, it has to arrange additional
finance to meet its own obligations towards its creditors and employees, like payments for
purchases, salaries and other production and administrative expenses. Whether this additional
finance is met from its own resources or from outside, it involves a cost to the firm in terms of
interest (if financed from outside) or opportunity costs (if internal resources, they could have
been put to some other use.)
Administrative costs
When a company maintains receivables, it has to incur additional administrative expenses in the
form of salaries to clerks who maintain records of debtors, expenses on investigating the credit
worthiness of debtors, etc.
Collection costs
These are costs which the firm has to incur for collection of the amounts at the appropriate time
from the customers.
Defaulting costs
When customers make default in payments, not only is the collection effort to be increased but
the firm may also have to incur losses from bad debts.
The size of receivables or investment in receivables is determined by the firm's credit policy and
the level of its sales.
The following aspects of receivables management are discussed in this chapter:
Formulation of credit policy.
Credit evaluation.
Credit granting decision.
Monitoring receivables.
Credit Policy
The credit policy of a company can be regarded as a kind of trade-off between increased credit
sales leading to increase in profit and the cost of having larger amount of cash locked up in the form
of receivables and the loss due to the incidence of bad debts. In a competitive market, the credit
policy adopted by a company is considerably influenced by the practices followed by the industry. A
change in the credit policy of a company, say, by extending credit period to 30 days, when the other
companies are following a credit period of 15 days can result in such a high demand for the company's
product that it cannot cope with. Further, other companies also may have to fall in line in the long

run. It is assumed generally that such factors have already been taken into consideration before
making changes in the credit policy of a company.
The term credit policy encompasses the policy of a company in respect of the credit standards
adopted, the period over which credit is extended to customers, any incentive in the form of cash
discount offered, as also the period over which the discount can be utilized by the customers and the
collection effort made by the company.
Thus, the various variables associated with credit policy are:
Credit standards
Credit period
Cash discount
Collection program.
All these variables underlying a company's credit policy influence sales, the amount locked up in
the form of receivables and some of the receivables turning spur and eventually becoming bad debts.
While the variables of credit policy are related to each other, for the purpose of clarity in understanding,
we shall follow what is technically known as comparative static analysis by considering each variable
independently, holding some or all others constant, to study the impact of a change in that variable
on the company's profit. It is also assumed that the company is making profits and has adequate
unutilized capacity to meet the increased sales caused by a change in some variables without incurring
additional fixed costs like wages and salaries, rent, etc.
Credit Standards
When a company is confronted with the question of the standards to be applied to customers
before deciding whether to extend credit or not, application of very stiff standards for the purpose is
likely to result in a low level of sales, less amount of money locked up in the form of receivables,
virtually no bad debt losses and less amount to be spent for collection. On the other hand, indiscriminate
extension of credit without bothering much about the credit standards expected of the customers is
likely to increase sales. But in its wake, the company is more likely to be saddled with a large
quantum of money locked up in the form of accounts receivable, higher incidence of bad debt losses
and increased expenses on the collection front. In the United States, there are excellent professional
credit rating agencies such as Dun and Brad-street whose services can be utilized for a consideration.
In the Indian situation, no such reputed agencies exist except for credit rating of public issues. Let us
assume for the time being (because we shall consider these aspects in the section on credit evaluation)
that the company has rated the customers into four categories ranging from 'high', 'good', 'fair' and
'limited' in the descending order of credit rating. Let us also assume that the company has been
currently extending credit to only those customers rated as high and good. This way, the company
has been foregoing sales from 'fair' and 'limited' categories. The company has' been contemplating to
increase its sales from its existing level by liberalizing or relaxing its credit standards to some extent.
What course of action should it take - liberalize or not?
The answer to the above question lies in making a comparison of the incremental benefits associated
with a liberalized policy and the associated incremental costs. The decision to liberalize will be
justified only when the net incremental benefits are positive. Before going into the analysis we have
to reckon with the factor that the existing and top-rated customers may take a lenient view in their

paying habit once they come to know that the lowly rated customers of the company are taking a
longer period for payment than what they themselves have been taking to pay. With a view to
facilitating the exposition, it is assumed that the existing customers will not alter their paying habit
even after liberalization of credit by the company (lest they be relegated to the lower rated groups)
and the company can meet the increase in sales demand without incurring additional fixed costs as
stated earlier on.
4. FACTORING
Factoring is the method of financing whereby a firm sells its trade debts at a discount to financial
institutions. He is a agent who collects bill on behalf on his client for certain fee. He is into business
of buying up trade debts or lending money on the security of trade debts.
Services provided by factor
Maintenance of accounts
Collection of receivables
Protections against credit risk
Generation of various reports
Follow up with the customers
Credit investigation
Benefits of factoring
Factor can do sales administrative function which helps org. to reduce administrative costs.
Factor provides finance to the company which reduces working capital requirement.
It improves liquidity position which helps the org. to honour its obligation without any dealy.
The improved credit standing helps the org. to get the benefits of lower purchase price, longer
credit period from supplier, trade discount on bulk purchases etc.
By shifting the functions associated with credit management, the firms save time and they can
focus on more important managerial work.
Disadvantages of factoring
The risk of non-payment by customer is not born by the factor but it is to be borne by selling
firm.
While making credit evaluation, he may follow conservative approach with the purpose of
minimizing the risk of dealy and default, it may restrict the sales growth of the company.
It indicates that company is not able to manage its receivables.


CHAPTER 5
CAPITAL BUDGETING DECISION

CHAPTER 5
CAPITAL BUDGETING DECISION
1. MEANING
Capital budgeting denotes situation where funds are invested immediately and returns are expected
after a year. In growing orgnisation capital budgeting is more or less continuous process and it is
carried out by top management. The role of any Finance Manager is to critically evaluate proposal,
evaluation of alternative proposal and select best one. The following are the some of the cases where
heavy capital investment may be necessary.
A) Replacement of fixed assets :
To replace old Assets.
To buy Asset with latest technology.
B) Expansion :
It means increase in production capacity to meet additional demand.
C) Research and Development :
It is required for those industry where technology in changing rapidly.
D) Diversification :
To set up factories, to fulfill need of various markets.
To reduce dependency on one market
E) Miscellaneous :
To meet legal norms, such as investment in pollution control equipment.
2. FEATURES AND SIGNIFICANCE OF CAPITAL BUDGETING
Capital budgeting includes investment for long firm funds for long term and their utilisation.
Capital budgeting decision affects profitability of firm. Therefore these decisions are very important.
A wrong decision taken by finance manager may affect firm's profitability. The relevance and
significance of capital budgeting may be stated as follows.
Vipul Shah / 9881 236 536 Chapter : 5 Capital Budgeting Decision / 71

A) Involvement of heavy funds :
Capital budgeting decision requires large amount of capital. Therefore it is absolutely necessary
to evaluate investment proposal carefully, to arrange funds in time and to see that they are put
to most profitable ways.
B) Long term effect :
Capital decisions are having long-term impact on the risk, rate of return and growth of
organisation. This decision affects future position of business.
C) Irreversible Decisions:
Most of the capital budgeting decisions are irreversible decisions. A firm cannot cancel decision
unless it is ready to absorb heavy losses due to wrong decision.
D) Most difficult to make :
Capital budgeting decisions are related to future that is uncertain. It is very difficult to estimate
future. It also involves large commitment of funds for a longer period of time.
E) It may affect competence to compete :
If wrong capital budgeting decision is taken if may affect capacity and strength of a firm to face
the competition.
3. PROBLEMS AND DIFFICULTIES IN CAPITAL BUDGETING
A) Uncertainty about future :

All capital budgeting decision involves long period, which is uncertain, even if proper care is
taken exact future forecast is not possible.
The Finance Manager should try to evaluate and judge proposal properly. The uncertainty may
be related to expected profit, cost, competition, demand and legal provision.
B) Time Element
Capital budgeting decision involves long period between initial investment and expected return.
As a result cost and benefit of capital budgeting decision are generally not comparable unless
adjusted for time value of money.
C) It involves high degree of risk.
4) CAPITAL EXPENDITURE BUDGET
Capital expenditure budget / Capital budget is a type of functional budget. This budget is prepared
to find out amount of capital needed to finance proposal. The budget is prepared after considering
available production capacity, and other resources. This type of budget is required to control
expenditure.
5) TYPES OF CAPITAL BUDGETING DECISION
A. New firm may be required to take different decision such as selection of plant to be installed.
Capacity utilization etc.
B. Existing firm may require to take various decision to meet the challenges of competition to
meet demand to reduce cost of production.
C. Other decision

Expansion
Diversification
Replacement
Modernisation
D. Mutually exclusive decision :
Decision said to be mutually exclusive when acceptance of one decision results in automatic
rejection of other proposals. For e.g. selection of one location out of different locations.
E. Accept reject decision :
An accept reject decision occurs when a proposal is independently accepted or rejected without
regard to any other alternative proposal. Such decision is possible only when, this decision does
not affect other proposals.
F. Contingent Decision :
These are the decision where acceptance depends upon acceptance of one or more other proposal.
For e.g. computerization of a bank branch may require not only air conditioning but also transfer
of some staff member to other branches.
6. CAPITAL INVESTMENT PROCESS
To take capital budgeting decision following assumption are required.

A. Certainly with Respect to cost and benefit
It is assume that cost and benefit are known. It is assume that accurate for cast of cost and
benefit of a proposal available for the entire economic life of proposal.
B. Profit motive
It is assumed that capital investment decisions are taken to fulfill primary objective of earning
profit.
Following procedure is followed in capital investment budget.
i. Search for investment opportunities
It is the first step. Company will consider no. Of proposal which are compatible with the firms
objectives.
ii. Screening of alternative
In this step all proposals are checked in details to find out whether proposal is giving expected
return, availability of resources etc.
iii. Evaluation of proposal
The next step is evaluate every proposal in terms of profitability, risk and economic life.
iv. Authorisation
Once evaluation of project is done then next step is to get approval of top management.
v. Implementation
Once top management approves project, it will be implemented. Normally responsibilities are
fixed to carry out proposal and monitor its performance.
vi. Control
This is last step in capital budgeting process. Here actual performance is compared with budgeted
performance. Evaluation is done in terms of funds allocated, resources utilized and benefit
accrued.

6. TECHNIQUE OF EVALUATION
Investment in any proposal depends upon following investment.

A] The amount of investment
B] The expected return
C] Economic life of project
A proper analysis is required before investing in any proposal. There are different techniques
available for evaluation, which are explained as under.
Capital Budgeting Decision
Traditional or Time adjusted or

Non-discounting Discounted Cash Flow
Pay back Accounting Net Profitability Internal

Period Rate of Return Present Index Rate of Return
(1) (2) Value (4) (5)
(3)
Traditional method dose not consider present value of future cash inflow.
1) Payback period
It is period required to recover initial investment in project.

While calculating cash inflow, depreciating is added back to the profit after tax since the
depreciation is not a real cash flow.
Cash inflow = Profit after tax + depreciation
The payback period calculated is compared with targeted payback period. If payback period is
less than targeted recovery period then the proposal should be accepted and if it is more than
targeted period then proposal should be rejected.
Advantages
A) It is easy to understand and simple to calculate.

B) It can be adopted by any firm as it dose not required special skills to calculate.
C) Risk can be measured, and project having less pay back period can be selected.
D) It gives an indication of liquidity, on the basis of cash inflow.
Disadvantages
A) This method ignores cash inflow, which may occur after payback period. In some cases cash
inflow may higher then it was before payback period.
B) This concept ignores time value of money.
C) This method gives more importance to recovery rather than profitability. To recover capital is
not enough but to earn profit is more important.

2) Accounting rate of return or Average rate of return
This method is also known as return on investment or return on capital employed method.
This method takes into account profit rather than cash inflow as a criterion for accepting or
rejecting proposal.
How to calculate A.R.R.
A) Calculate profit after tax and depreciation.
B) Formula
ARR = Average profit after Tax & deprecation
x 100
Avg. Investment
Where,
Average profit = Total profit after Tax & deprecation
No. Of years
Avg. Investment = Initial Investment
2
ARR calculated by using above formula is compared with pre specified rate of return.
If ARR is more than pre specified rate then proposal is likely to be expected and vice versa.
Advantages
A) It is easy to calculate and simple to understand.

B) It considers profitability as a base for taking decision rather than cash in flow.
C) Profit after payback is considered under this method.
Disadvantages
A) It ignores time value of money.

B) It ignores fluctuation in profits.
C) Profit may be affected by different accounting policies followed.
D) It dose not consider economic life of project.
E) This technique also ignores salvage value of the proposal.
F) If ignores amount of funds requires for the project. If may happen that two project are having
different initial cost but may have some ARR.
3) Discounted cash flows or time-adjusted technique
This technique considers time value of money.

Money received today is worth more than received latter.
Difference in value of money received today and latter is due to inflation and interest rate
increase.
This technique-overcome disadvantage of traditional method.
A) Net present value method
The NPV of an investment proposal may be defined as the sum of the present values of all the
cash inflow less the sum of present value of all cash outflow associated with a proposal.

To calculate present value of all cash inflows discounting rate is used.
The discounting rate may be equal to rate of return, the investor expected to get from similar
investment.
How to calculate NPV
NPV = PV of cash inflow - PV of cash outflow

If discounting rate is not given then it can be calculated by using following formula
1
PI =
n
(1 + r)
Where
r = discounting rate
n = year
If NPV is positive then accept proposal.

If NPV is negative then reject proposal.
Advantages
This technique considers time value of money.

NPV of different project can be added to calculate NPV for a business. This feature is not
available for other technique.
The NPV uses the discounted cash flows in terms of current rupees.
Disadvantages
If involves difficult calculations.

The NPV requires the predetermination of the expected rate of return (K), which is very difficult.
Projects return cannot be assessed.
B) Profitability Index (PI)
This technique is also known as benefit cost ratio.

Under this technique profitability of different proposal is assessed and project giving highest
return can be selected.
How to Calculate PI: -
Total present value of cash inflow

Total present value of cash outflow
If PI is more than 1 then accept proposal.

If PI is less than 1 then reject proposal.
NPV and PI technique will give some result because PI will be more than 1 only for that project
which has a positive NPV.
The NPV and PI may give different result if benefits and the initial cost are different.

C) Internal rate of return (IRR)
IRR is that rate at which discounted cash inflows are equal to the discounted cash outflows.
The indication given by IRR that this is the maximum rate at which the company will be able to
pay towards the interest on amount for borrowed in the projects without loosing anything. This
is also called as break even rate.
How to calculate IRR.
IRR = A + C-O x (B - A)
C-D
Where
A = Lower rate of discounting
C = Present value of cash flows at lower rate.
O = Original investment
D = Present value of cash flow at higher rate
B = Higher rate of discounting

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

Illustration 4
A company is planning to buy a machine. Two machines are available A & B. Suggest the
management which one is better with the help of following information. The company is following
straight line method of depreciation.
YEAR Machine A (Earning before tax) Machine B (Earning before tax)
Cost of machine 50,000 80,000
Working life 4 yrs 6 yrs
Tax rate 50% 50%
1 10,000 8,000
2 15,000 14,000
3 20,000 25,000
4 15,000 30,000
5 18,000
6 13,000
Illustration 5
YEAR CASHINFLOWS
1 2,50,000
2 2,80,000
3 3,50,000
4 2,90,000
5 2,50,000
Calculate: 1) Pay back period 2) ARR 3) NPV at 10% 4) PI at 15% 5) IRR

Illustration 6
National Ltd has under consideration two projects X and Y each costing Rs 120 lakhs. The projects
are mutually exclusive and company is considering the question of selecting one of the two.
Estimated life of X is 8yrs & Y 6yrs.
Salvage value is expected to be zero at end of their operational life.
Tax rate applicable to company is 50 % & the cost of capital of company is 15%.
EBIT of both machines is given below. (Rs in lakh)
Year Project X Project Y PV @ 15%
1 25 40 0.870
2 35 60 0.756
3 45 80 0.685
4 65 50 0.572
5 65 30 0.497
6 55 20 0.432
7 35 0.376
8 15 0.327
The company follows straight line method of depreciation assets. Advise the company regarding
the selection of the project.
Illustration 7
XYZ ltd is considering purchase of machine in replacement of an old one. Two models M & Z
are offered at price of Rs 22.50 lakhs & Rs 30 lakhs respectively. Further details are given below
Particulars M Z
Economic life(yrs) 5 6
Scrap value at the end(in lakhs) 2 2.5
Annual cash inflow (in lakhs)
Year 1 5 6
2 7.50 8
3 10 10
4 9 12
5 8.5 10.5
6 9.5
Evaluate proposals under 1) PBP 2) NPV @ 12%.
Which model would you recommend & why ?

Illustration 8
ITC ltd has decided to increase capacity to meet the growing demand. There are 3 machines
under consideration of the management. The relevant data is given to you
Particulars M1 M2 M3
Initial investment required 3,00,000 3,00,000 3,00,000
Estimated annual sales 5,00000 400000 450000
Cost of production (estimated)
Direct materials 40,000 50,000 48,000
Direct labour 50,000 30,000 36,000
Factory overheads 60,000 50,000 58,000
Administrative overheads 20,000 10,000 15,000
Selling overheads 10,000 10,000 10,000
Economic life (yrs) 1 3 3
Scrap value 40,000 25,000 30,000
Find out most profitable machine using pay back period.
Illustration 9
Z ltd is thinking of investing in a project costing Rs 20 lakhs. The life of the project is five yrs &
the estimated salvage value of the project is zero. Straight line method of charging depreciation is
followed. The tax rate is 50%. The expected cash flows before tax are as follows.
Year 1 2 3 4 5
Cash flow before dep & tax 4 6 8 8 10
( Rs lakhs)
You are required to determine the PBP, ARR, NPV @ 10% & benefit cost ratio.
Illustration 10
Y ltd is considering to purchase a machine in order to produce a new product. It is expected that
the new product will generate an annual profit of Rs 15, 00,000 per year for first 5 yrs. The material
cost required for this production is expected to be Rs 4, 50,000 per year, labour of Rs 5, 50,000 and
other expenditure Rs 1, 50,000 p.a. The cost of machine is Rs 5, 85,000, installation expenses Rs
15,000 & scrap value of Rs 1, 00,000. The expected life of machine is expected 5 yrs. The machine
will also require an investment of working capital of Rs 75,000 which will be recovered at the end of
5th year.
Advise the company by using NPV method.


CHAPTER 6
CAPITALISATION
CHAPTER 6
CAPITALISATION
1) INTRODUCTION
In simple terms, the capitalization means the net amount raised by the firm or company through
the long-term sources of the capital (shares, debentures & long term loans).
The firm requires financial help from the internal as well as the external sources. However, the
internal sources may not be sufficient to solve the financial needs & wants of the firm on regular
basis. So the firm has to depend upon the external sources. These external sources are the shares,
debentures & long-term loans. From these sources the firm can generate the required amounts of
funds as its capital.
The need of studying capitalization concept mainly arises due to the tendency of the firms regarding
the fund raising. The capitalization suggests that the firm should have to raise exactly the equal
amount from the external sources which is actually required to fulfill its financial needs & wants. It
means, no firm can raise the excess or less amount than its actual financial requirement. But as we
know that the financial requirements are not steady or constant for the longer period. These show
the fluctuations on regular basis. The firm must have to make proper financial plan for collecting the
funds from the external sources. Before raising the funds, it is essential to determine the capital
structure of the firm.
2) CAPITAL STRUCTURE
Capital Structure: The capital structure shows the overall picture of the capital, which is raised
by the firm through the external sources. It is the classification of the capital as Owned Capital &
Borrowed Capital. The firm-wise financial requirement is different & the capital structure is also
different for firm to firm. The capital structure for two firms which are engaged in similar kind of
business activity & required the same amount of capital, is also entirely different. See the given
example.
Vipul Shah / 9881 236 536 Chapter : 6 Capitalisation / 83

Example of Capital Structure
Sources of Capital A. Ltd (amount in Rs.) B. Ltd. (amount in Rs.)

Equity Share Capital 500000 350000
Debenture Capital 200000 400000
Long Term Loans 250000 175000
Internal Finance 50000 75000
(Reserves & Surplus)
Total Capital 1000000 1000000
From the given example, it is clear that the net capital requirement of both the companies is
exactly the same (Rs. 10 lakhs). But there is a difference in the capital structure.
The Equity Share Capital of A. Ltd is Rs. 5 lakhs, whereas of B Ltd. is Rs.3.5 lakhs. So A. Ltd
has more Owned Capital than B.Ltd.
In case of B.Ltd the total borrowed capital (Debenture & Loans) is more.
But the Debenture Capital of B. Ltd is more & the Loan Capital is less than that of A. Ltd.
The Owned Capital also includes the internal funds used (Reserves & Surplus). Both the companies
use the Reserves but B. Ltd. has more amount of Reserve (Rs. 75 thousand), which can be used as
the capital.
The capital structure of both the companies can be explained in terms of percentage. It is as
under,
Capital Structure (Finance Pattern)
Sources of Capital A Ltd. B. Ltd
(% of total Capital) (% of total Capital)
Owned Capital (Equity
Capital + Reserves) 55% 42.5%
Borrowed Capital 45% 57.5%
(Debentures + loans)
Total Capital 100% 100%
Here the conclusion can be drawn that, any investment in B.Ltd is risky at this stage because it
has more proportion of the Borrowed Capital. Naturally the liabilities of B. Ltd are more than that of
A. Ltd.
3) OVER CAPITALISATION
Over capitalization means existence of excess capital as compared to the level of activity and
requirement. The term 'over capitalization' should not be taken to mean excess funds. There can be
a situation of over capitalization, still the company may not be having sufficient funds.

Causes of over capitalization
The situation of over capitalization may arise due to various reasons as stated below:
i. The assets might have purchased during the inflationary situations. As such the value of assets
is less than the book value of assets.
ii. Adequate provision might not have been made for depreciation on the assets. As such the real
value of the assets is less than the book value of assets.
iii. The company might have spent huge amount during its formation stage or might have spent
huge amount for the purchase of intangible assets like goodwill, patents, and trade marks. As a
result the earning capacity of the company may be adversely affected.
iv. The requirement of funds might not have been properly planned by the company
v. The company might have followed the relaxed dividend policy without bothering much about
the building up the reverses. As a result the retained profits of the company may be adversely
affected.
Advantages of over capitalization
i. The management is assured of adequate capital for present operations.

ii. Ample capital has a beneficial effect on an organization's morale.
iii. Ample capital gives added flexibility and latitude to the corporations operations.
iv. The profit rates tend to discourage possible competitors.
v. For public utility companies when the price of service is based upon a fair 'Return to capital'
High capitalization may be advantageous.
Disadvantages
i. Over capitalization may induce failure and the failure of the company may bring an unhealthy
economic situation.
ii. The ethical atmosphere of a business is not improved by over capitalization.
iii. Due to over capitalization, there may be an inability to pay interest on bonds.
iv. Injury to credit worthiness.
v. Decline in the value of securities.
Effects of over capitalization
Adverse effects of over capitalization can be classified into the following categories:
i. on the company:
a. The market price of the equity shares fall which reduces the credit standing of the company.
b. Due to poor profitability it cannot internally finance the projects.
c. The company fails to maintain the dividend rate.
d. Due to the reduced credit standing the marketability of future issues of capital is jeopardized.
ii. On the shareholders:
a. They do not get fair return on their investment.
b. The market price of the shares of an over capitalized concern falls.

iii. On society:
a. If such units enjoy monopoly, they exploit consumers and employers.
b. The productivity of such unit is less. Thus scarce resources are poorly employed.
c. For survival, they trouble the government for assistance and concessions. This increases
the quantum of public expenditure.
4) UNDER CAPITALISATION
Meaning
Under capitalization is the reverse of over capitalization. It should not be confused with a
condition implying a lack of funds. The situation of under capitalisation indicates the excess of real
net worth of the assets over the aggregate of shares and debentures outstanding. Thus if a company
succeeds in earning abnormally high income continuously for a very long period of time, it indicates
symptom of under capitalization. As such, under capitalization is an indication of effective and proper
utilisation of funds employed in the business. It also indicates sound financial position and good
management of company.
Under capitalization comes as a result of:
i. Under estimation of future earnings at the time of promotion and / or,

ii. An unforeseen in earnings resulting from later developments,
iii. Under capitalization exists when a company a sufficient income to meet its fixed interest and
fixed dividend charges and is able to pay a considerably better rate on its equity shares than the
prevailing rates of similar shares in similar business.
Causes of under capitalization
i. Under estimation of earnings: It is possible that earnings may be under estimated, as a result of
which the actual earning may be much higher than those expected.
ii. Efficiency: A corporation may have optimally utilized its assets and enhanced its efficiency by
exploiting every possibility of modernization and by taking the maximum advantage of market
opportunities.
iii. Under estimation of funds: It may have take place when the total funds required have been
under estimated.
iv. Retained earnings: Because of its conservative dividend policy, a corporation may retain the
earnings which might have accumulated into mass savings. This is bound to improve the financial
health of the corporation.
Effects of under capitalization
Adverse effects of over capitalization can be classified into the following categories:

i. On the company:
a. High EPS indicates that the line of business is very lucrative which may increase
competition.
b. High profit increases tax liability of the company.
c. Higher prices of shares may restrict the market and shares may be traded at prices below
those justified by the usually high earnings.
d. Labour unrest: Employees are of ten organized and become conscious of the fact that
the corporation is making enormous profits. They feel that they have a legitimate right
to share in these profits. This generates a feeling of unfriendliness on the part of the
employees and leads to labour unrest.
ii. On the shareholders :
a. They can earn high rate of dividend.

b. Higher the market value of share.
c. Shareholder can loan on these securities due high credit standing of company.
d. Market for share limited due to high market value.
iii. On society and consumers
a. Consumer dissatisfaction: Consumers feel that the unusual earnings of the corporation
could have been utilized by effecting a price reduction or by improving the product
quality.
b. It may encourage new entrepreneurs to start new ventures. It may increase industrial
production & employment level too.
5) COST OF CAPITAL
The sources through which the firm generates the funds to meet its financial requirements are
Equity & Preference Share Capital, Debentures, and Loans & Reserves & Surplus.
Each of the above sources of capital has its own cost & the firm has to incur it. E.g. if a firm
raises capital of Rs. 500000 by acquiring the bank loan @ 8% interest. Here Rs. 40000 (8% on Rs.
500000) are treated as the amount of Interest, which the firm has to pay to the bank. So Interest is
the cost of bank loan.
Accordingly, the firm has to pay Dividend for the equity & preference share capital & Interest
for the debenture capital. So Interest & Dividend are the costs of capital.
Definition : "Cost of capital may be defined as the cost incurred on the funds raised from
different sources of capital".
More accurate definition can be given as,
"Cost of Capital may be defined as the rate of return that a firm must earn on its investments so
that the expectations of the investors are satisfied".
The cost of capital is highly affected due to the risk factor, which is involved in the capital
investments & funds raising. The firm raises funds from certain short-term sources of finance such as
Short-term bank loans. Bills Discounting, Bank overdraft etc. The minimum risk is involved in such

types of funds raising. So the cost of capital is also minimum. On the contrary, when the firm raises
funds by issuing preference shares or debentures, it is obligatory to pay off the dividend & interest to
the investors. Here more risk is involved & so the cost of capital is also more. Naturally, when the
firm generates the capital funds from the sources like debentures, long term loan & preference
shares, it expects very high rate of return from these investments. It should be noted that, the equity
share capital involves relatively less risk as the obligation of paying dividend can be avoided in case
of such type of share capital.
Estimation Methods of Cost of Capital : Each separate source of capital (shares, debentures,
loans & reserves) has separate method of calculating the cost of capital. The cost of capital has to be
calculated by using various formulae, which are given for each separate source of capital. These are
explained as under
A) Cost of Equity Share Capital : As mentioned earlier, the minimum risk is involved (from the
point of view of the firm) in the borrowings of funds by issuing the equity shares. But the equity
share capital is not a cost-free source. An estimation of the cost on equity share capital is little
difficult, as the exact returns from such a source cannot be ascertained easily. The cost of equity
share capital can be estimated by adopting several sub-methods. These are as follows,
Dividend Price Method : The market price per equity share becomes equal to the present value
(amount) of the dividend, which are expected by the shareholders. The formula is,
Ke = D / P
D share, P - Market price per share)

(ke - Cost of Capital, D - Dividend per
+g
P
Example
R ltd is expected to disburse a dividend of Rs 30 on each equity share of Rs 10. The current
market value is Rs 80 per share. Calculate the cost of equity share.
Dividend Price & Growth Rate Method : When the equity shareholders expect certain increase
(growth) in the dividend rate per share, the cost of capital also expected to be increase.
Ke =
(g - Growth rate)
Example
The equity share of N ltd presently traded in the mkt at Rs 90 each. The is expected current year
dividend is Rs 18 per share. The expected growth rate is 6%. Calculate the cost of equity share.

Earnings Price Method : Instead of considering the dividend rate & the growth in it, the
earnings per share are taken into account while calculating the cost of capital by the earnings price
method. The earnings per share (EPS) are increasing when the firm gets high Net Profits (after
paying all the taxes & interests). The formula is
Ke = EPS / P
Example
Pranab ltd has 50,000 equity shares of Rs 10 each with current mv is Rs 45 each. The profit after
tax is Rs 9, 60,000. Calculate the cost of equity share.
B) Cost of Preference Share Capital : In the case of preference shares, the dividend rate can be
taken as the cost since it is the amount which the company intends paying against preference shares.
As in the case of debt, the issue expenses or the discount / premium on issue/ redemption has also to
be taken into account. Suppose a company issues 13% preference share (face value Rs. 100) at Rs.
102 each. Suppose further that the brokerage and under-writing commission on 1000 shares sold
comes to Rs. 3000. Thus the company realizes Rs. 99,000 in cash by this issue. Against this, its cost
is Rs. 13,000 per annum.
The formula applied is,
Kp = PD + (F - P) / n
--------------------
F+P/2
(Kp = Cost of pref. Capital, PD - Preference Dividend, F - Repayable value, P - Net amount
realized, n= Redemption period of pref. Capital.)
C) Cost of Debt Capital (Debentures) : The explicit cost of debt is the interest rate as per the
contract adjusted for tax and the cost of raising the debt. Suppose a company issues 1000, 15%
debentures of the face value of Rs. 100 each at a discount of Rs. 5. Suppose further, that the under-
writing and other costs are Rs. 5000/- for the total issue. Thus Rs. 90,000 is actually realized, i.e.,
Rs. 1, 00,000 minus Rs. 5000 as discount and Rs. 5000 as under-writing expenses. The interest per
annum Rs. 15,000 is therefore the cost of 90,000, actually received by the company. This is because
interest is a charge on profit and every year the company will save Rs. 7500 as tax, assuming that the
income tax rate is 50%. Hence the after tax cost of Rs. 90,000 is Rs. 7500 which comes to 8.33%.
However, debt has an implicit cost also. This arises due to the fact that if the debt content rises
above the optimal level, investors will start considering the company to be too risky and therefore,
their expectations from equity shares will rise. This rise in the cost of equity shares is actually the
implicit cost of debt. The formula is calculating the cost of loan is,
Kd = I (1 - t)
(Kd - Cost of debenture)
t : tax rate
I : Intest rate

E) Cost of Reserve & Surplus : These are the internal sources of finance. The firm generates
funds to meet its capital requirement from the net profits earned after paying all the taxes & interests.
The reserves & surpluses are those portions of the Net Profits of the firm, which are not distributed
to the shareholders in form of dividend. So these are treated as the undistributed profits or retained
earnings of the firm. The cost of reserve & surplus can be calculated by considering the cost of
equity share capital & the amount of returns, which the firm is expecting to acquire from the reserve
& surplus
6) TYPES OF COST CAPITAL
1) Component cost of capital

It means cost of each element which is part of capital structure. For e.g. cost of equity, cost of
debentures etc.
2 ) Composite cost of capital / Weighted cost of capital
It is the overall cost of capital i.e. cost of all components included in capital structure.
The CIMA defines the weighted average cost of capital "as the average cost of the company's
capital weighted according to the proportion each element bears to the total pool of capital,
weighting is usually based on market valuation currents yield and costs after costs".
Formula to calculate WACC
Total weighted costs X 100
Total weights
OR
(Cost of equity X % of equity ) + (Cost of debt X % of debt)
Illustration
A Ltd has share capital of 60L & debenture of 40L. Their respective costs are 10% & 12%.
Calculate WACC before tax & after tax based on book values.
What will be WACC if market value of equity is 90L & debt is 50L?
7) WHICH ARE THE DIFFERENT CAPITAL STRUCTURE THEORIES
Following are the four theories/ Approaches of capital structure:
i. Net Income Approach (NI) : This approach is given by Durant David. According to this
approach, the capital structure decision is relevant to the valuation of the firm. This approach states
that, with an increase in leverage, the overall cost of capital declines and the value of the firm
increases so that the optimum capital structure would be reached at 99.9% level of debt in the
capitalization.
In short cost of equity and cost of debt remain constant when debt equity ratio changes.
There are three basic assumptions of this approach:
a. Corporate taxes do not exist.
b. Debt content does not change the risk perception of the investors.

c. Cost of debt is less than the cost of equity.
ii. Net Operating Income Approach (NOI) : As per this approach value of the firm is
independent on its capital structure. It believes that the leverage has no effect at all on the overall
cost of capital and the value of the firm. Hence, every capital structure is optimal.
According to this approach, the overall capitalization rate and the cost of debt remain constant
for all degrees of leverage. In short overall capitalization rate and cost of debt remain constant for all
degrees of financial leverage.
Assumptions of this approach :
a. The investors see the firm as a whole and thus capitalise the total earning of the firm to
find the value of the firm as a whole.
b. The overall cost of capital 'Ko' of the firm is constant and depends upon the business
risk which is assumed to be unchanged.
c. The cost of debt 'Kd' is also constant.
d. There is no tax.
iii. Modigliani-miller Approach : This approach is that of Modigliani and Miller. They a r g u e
that the total cost of capital of a particular corporation is independent of its methods and level
of financing. They argue that the average cost of capital of a firm is completely independent of
its capital structure.
Assumptions of this approach :
a. Perfect capital market exists where individuals and companies can borrow unlimited
amounts at the same rate of interest.
b. There are no taxes or transaction cost.
c. The firm's investment schedule and cash flows are assumed constant and perpetual.
d. Firms exist with the same business or systematic risk at different levels of gearing.
e. The stock markets are perfectly competitive.
f. Investors are rational and expect other investors to behave rationally.
iv. Traditional Approach : The traditional theorist argue that a firm can change its overall cost of
capital by increasing or decreasing the debt equity mix i.e. by increasing the amount of loan
content in the total capital or by decreasing the same. This implies that each source of funds
involves cost. They contend that as the ratio of debt to equity increases, the overall weighted
cost of capital decreases, since debt is a cheaper mode of finance.
8) FACTORS THAT DETERMINE CAPITAL STRUCTURE OF THE COMPANY
Following are the factors responsible for determining the capital structure :
i. Trading on equity: In case of Rate of Return (ROI) on the total capital employed i.e.
shareholder's funds plus long term borrowings, is more than the rate of interest on borrowed funds
or rate of dividend on preference shares, it is said that the company is trading on equity.

Example on trading on equity
The capital structure of X Ltd & Y ltd is given to you.
Particulars X Ltd Y Ltd

Equity Share capital of Rs 10 each 2,000 18,000
10% Loan 18,000 2,000
Prepare profitability statement of both companies when sales are Rs 40,000 & Rs 36,000. Variable
costs are 50% of sales & fixed costs are Rs 10,000.
Particulars X Ltd Y Ltd
Sales
Less : Variable costs 40,000 36,000 40,000 36,000
= Contribution
Less : fixed costs
= EBIT
Less : Interest on loan
= EBT
Less : Income tax
= EAT
EPS
ii. Tax consideration: Under the Income tax laws, dividend on shares is not deductible while
interest paid on borrowed capital is allowed as deduction. Owing to these provisions corporate
taxation plays an important role in determining the choice between different sources of financing.
iii. Government policy: Government policies play an important role in determining capital structure.
Monetary and fiscal policies of the government also affect the capital structure decisions.
iv. Legal requirements: The finance manager has to keep in view the legal requirements while
deciding about the capital structure of the company.
v. Marketability: To obtain a balanced capital structure it is necessary to consider the ability of the
company to market corporate securities.
vi. Flexibility: Flexibility refers to the capacity of the business and its management for expected
and unexpected change in circumstances.
Vii Timing: Proper timing of a security issue often brings substantial savings because of the dynamic
nature of the capital market.
Viii. Size of the company: Smaller companies heavily rely on owners funds while large companies
are generally considered to be less risky by the investors and therefore, they can issue different
types of securities.
ix. Purpose of financing: The purpose of financing also to some extent affects the capital structure

of the company.
x. Period of financing: To raise funds either by borrowing or by issue of shares is depend on
period of financing.
xi. Cash flow ability of the company and nature of enterprise.
xii. Requirement of investors: Different types of securities are issued to different classes of investors.
xii. Provision of future: While planning capital structure the provision for future also to be made.
9. LEVERAGE AND TYPES OF LEVERAGES
The term leverage represents the impact of one financial variable over some other related financial
variable. Leverage refers to the ability of a firm in employing long term funds having fixed cost to
enhance return given to the owners.
Management accountants defined leverage "as the ability of a firm to use fixed cost assets or
funds to magnify the returns to its owners".
Leverage and risk
Since leverage is intended to magnify the returns to its owners, obviously, it is intimately connected
with risks. Here risk indicates the degree of uncertainty involved in getting the expected from the
use of fixed cost assets or funds.
Leverage may be favourable or unfavourable. A favourable leverage exists when earnings are
more than the fixed cost of funds. However, if the rate of return remains to be lower, then it may be
a case of unfavourable leverage.
Classification of leverage
a) Operating leverage and b) financial leverage. c) Combined leaverage
a. Operating leverage : Operating leverage refers to the extent to which the firm has fixed
operating costs. A firm with high operating leverage will have relatively high fixed costs in comparison
with a firm having low operating leverage.
Degree of Operating Leverage (DOL) measures the sensitivity of operating income (EBIT) to
change in revenues (or quantity sold).
It is calculated with the help of following formula:
Contribution
Operating leverage = __________________________
Earning before interest and taxes
Here, Contribution = Sales - Variable cost
Earnings before interest and taxes = EBIT = Contribution - Fixed cost
Conclusion
If operating leverage is 2 it means for every 1% increase in contribution will increase the EBIT
by 2% & vice versa.
b. Financial leverage : Financial leverage refers to the extent to which the firms have fixed

financing costs arising from the use of debt capital. A firm with high financial leverage will have
relatively high fixed costs compared to a firm with low financial leverage.
Prof. Kohler defines financial leverage as the tendency of residual net income to vary
disproportionately with net income.
It is calculated with the help of the following formula :
Earning before Interest and Taxes (EBIT)
Financial leverage = _____________________________________
Earnings before Taxes (EBT)
Financial leverage is also termed as Trading on equity. This means that major contribution in
capital structure of the company is of share capital and residual is from outside debt. So that Earning
per Share (EPS) is very much important in this situation. If the effect on EPS is positive (i.e. arising
out of increase in EBIT), the leverage is said to be favorable. On the other hand, if the effect on EPS
(arising out of decrease in EBIT) is negative, the leverage is said to be unfavorable.
Conclusion
If financial leverage is 1.5 then it means for every 1% increase in EBIT will increase EPS by
1.5% & vice versa.
Combined leverage
It is also termed as total leverage and reflects the degree to which a firm has fixed operating cost
and fixed financing cost. The combined effect of operating leverage and financing leverage measures
'the total risk involved' in a firm.
Conclusion
If combine leverage is 2, it means for every 1% increase in contribution will increase EPS by 2%.
DCL = DOL x DFL

The various combinations of the leverages and their effects combined are given below :
No. Operating Financial Combined effect
Leverage leverage
i. High High Combination is risky and should be avoided
ii. High Low Partly good as some advantageous for debt
financing to maximize return of equity can
be taken.
iii. Low High Ideal situation for profit maximisation with
minimum risk.
iv. Low Low Cautious approach but it may be losing good
Investment opportunities.
Applications of leverages :
i. Operating leverage: It helps us to understand as to how EBIT would change with respect to
change in quantity produced and sold. It also helps in measuring business risk.
ii. Financial leverage: It helps us to understand as to how EPS would change with respect to
change in EBIT. It also helps us in assessing and measuring the financial risk.
iii. Combined/ Total leverage: It helps us in measuring total risk involved in a firm.

PROBLEMS ON CAPITAL STRUCTURE AND LEVERAGES
Illustration 1
ACC ltd has the following capital structure.

PARTICULARS MARKET VALUE BOOK VALUE COST %
Equity share capital 80L 120L 18
Preference share capital 30L 20L 15
Debentures 40L 40L 14
Calculate WACC based on book values & market values.
Illustration 2
In considering most desirable capital mix, the following estimates of the cost of debt and equity
capital after tax is given to you.
Debt as % of total capital employed Cost of debt % Cost of equity %
0 7.0 15.0
10 7.0 15.0
20 7.0 15.5
30 7.5 16.0
40 8.0 15.0
50 8.5 19.0
60 9.5 20.0
You are required to determined the optimal debt equity mix for the company by calculating
composite cost of capital.

IIIustration 3
In considering most desirable capital mix, the following estimates of the cost of debt and equity
capital after tax is given to you.
Debt as % of total capital employed Cost of debt % (before tax) Cost of equity %
0 12 16
20 12 16
40 16 20
60 20 24
You are required to determined the optimal debt equity mix for the company by calculating
composite cost of capital .Assume tax rate 50%.
IIIustration 4
From the following information calculate WACC before & after tax.
PARTICULARS RS IN LAKHS
Equity share capital 300
Preference share capital 200
Retained earnings 50
10% debenture 100
12% Term loan 75
TOTAL CAPITAL EMPLOYED 725
A) Returns expected by equity shareholders 15%

B) Dividend payable to preference shareholders at 12%
C) Tax rate 50%
IIIustration 5
H ltd has earned EBIT of Rs 6,00,000 for the year ended 31st March 2010. A company is
planning to raise 30L for expansion. It has got two options
a) Raise entire amount by issuing shares of Rs 10 each.
b) Raise 20L by issuing shares of Rs 10 each & balance by issuing 14% debentures of Rs 100 each..
Advise the management which option is better & why ?
IIIustration 6
A company is considering raising of funds of about Rs 100 lakhs by one of the two options given
below.
a) 14% Term loan
b) 13% debentures

Debenture issued at discount of 2.5% and would involve cost of issue of Rs 1 lakh. Suggest
which option is better.
IIIustration 7
The existing capital structure of ABC Ltd is as under

Equity share capital of Rs 100 each Rs 40L
Retained earnings Rs 10L
9% Preference capital Rs 25L
7% Debentures Rs 25L
The existing rate of return on the company's capital employed is 12% and the income tax rate is
50%. The company requires a sum of Rs 25L to finance its expansion plan for which 3 options are
given below
a) Issue of 20,000 equity share at a premium of 25 per share
b) Issue of 10% preference capital
c) Issue of 8% debentures
It is estimated that P/E ratios in case of equity, preference and debenture financing would be
20,17 & 16 respectively.
Suggest which option is better ?
IIIustration 8
A ltd has following capital structure

Equity capital of Rs 10 each Rs 10L
10% Preference capital of Rs 100 each Rs 1L
13% Debentures of 100 each Rs 5L
14% Term loan Rs 8L
Expected dividend per share is Rs1.50 with the expected growth rate of 7%. Market value per
share is Rs 20. Preference shares and Debentures are selling at Rs 75 & Rs 80 respectively.
Calculate WACC based on Book values & market values.
IIIustration 9
Calculate Financial, Operating and combined leverage from the following information.
Sales Rs 20 L
Variable costs 50% of sales
Fixed costs Rs 5L
Interest Rs 1L
Tax rate 50%

IIIustration 10
Operative leverage and combined leverage of a company is 2 & 3 respectively at the present
level lf sales of 10,000 units. The SP per unit is Rs 12 while its variable cost is Rs 6. Tax rate
applicable is 50%. The rate of interest is 16% p.a. What is the amount of debt in the capital structure
of the company ?
IIIustration 11
The balance sheet of X ltd is given to you.

Equity capital at 10 each 60,000 Fixed assets 1,50,000
10% Long term loan 80,000 Current Assets 50,000
Retained earnings 20,000
Current liabilities 40,000
2,00,0000 2,00,000
The total assets turnover ratio is 3 & fixed costs are Rs 1,00,000.
Variable costs are 40% of sales & tax rates 40%.
Calculate Leverages for the company.
Determine EBIT required is desired EPS is Rs 3.
IIIustration 12
The selected financial data for A,B, & C ltd are given below.
Particulars A B C
Variable expenses as % of sales 66 75 50
Interest expenses Rs. 200 Rs. 300 Rs. 1000
DOL 5 6 2
DFL 3 4 2
Income tax rates 50% 50% 50%
Prepare Income statements.


CHAPTER 7
DIVIDEND DISTRIBUTION
THEORIES
CHAPTER 7
DIVIDEND DISTRIBUTION THEORIES
1. DIVIDEND
Dividend is return given to shareholders for investing money into business. The main objective
of every business is to maximise shareholders wealth & this is possible by two ways, first by paying
dividend and second increasing the market value of share. Dividend payment is treated as cash
outflow therefore it is treated as finance decision. It reduces liquidity of the firm and hence it is a
very important decision. The dividend payable to equity shareholders is depends upon profit of the
company but whereas rate of dividend to preference shareholder is fixed.
2. DETERMINANTS OF DIVIDEND POLICY
Dividend policy is most important decision to be taken by finance manager. It is a distribution of

profits into two parts, retained earnings and distributed profit.
Retained earnings are treated as internal source of finance to achieve desired level of growth,
whereas dividend decision constitute outflow of cash and hence understanding of following factors
are necessary
A. Transaction costs
Whenever funds are required by the org. the borrowing cost is associated with such type of
decision. The costs required to raise new capital are called as floatation costs which can be
reduced by paying less or no dividend.
B. Personal Taxation
High taxation educes the earnings of the company and affects the rate of dividend. Dividend
payment is also subject to personal taxation so shareholder is liable to pay tax on dividend
income.
Vipul Shah / 9881 236 536 Chapter : 7 Dividend Distribution Theories / 101
C. Income of Investors
If income of investor is on higher side then he expects lower dividend and more capital
appreciation whereas lower income investors expect high rate of dividend.
D. Dividend payout ratio
DPR indicate percentage of dividend declared and paid out of the earnings per share. A high
DPR indicate liberal dividend policy whereas low DPR indicates conservative dividend policy,
which helps organization to accumulate funds required for expansion.
E. Liquidity
Dividend decision represents outflow of cash. Therefore before paying dividend every company
must evaluate its financial commitments. It is not necessary that company earning high profit
will have large amount of cash for disposal.
F. Expansion Plan
Rate of expansion is needs to be taken into consideration. If company plans for expansion then
the needs more funds to finance its expansion. In such case company will pay less amount of
dividend and keep maximum amount as a reserve.
G. Rate of return
Profits earn by the oganisation affects dividend / retention policy. If rate or return on assets
employed decide the dividend to be paid and amount to be transfer to the reserve account.
H. Stability of earnings
A firm with relatively stable profits tends to pay higher dividend. This is possible because they
can predict future profits and accordingly decides dividend policies. On the other hand firm
with unstable profits find it difficult its future profitability. Such firms try to keep maximum
amount of reserve than paying dividend.
I. Legal restrictions
The company has to fulfill following provisions before paying dividend.

Company act 1956: As per provision company should earn sufficient profit to distribute profit
as dividend. But before paying dividend company must transfer certain % of profits to reserve
and then if profit is sufficient to pay dividend then only company can pay dividend.
Income Tax act: Dividend is subject to dividend distribution tax which is to be deductible before
paying dividend to shareholders.
Company should fulfill requirements of SEBI before declaring Bonus shares.
J. Cost of financing
Cost of external borrowing may affects dividend payout. If company spends more amount
towards interest then it will affects profitability and ultimately it will affect dividend.
K. Economic stability
If political and economic situation is unstable then company may prefer to pay less amount of
dividend. On the other handPo = favorable then company may follow liberal dividend policy.
if it is
3. DIVIDEND POLICIES
Constant dividend policy
Under this method dividend is paid as fixed percentage of profits of the company. The amount of
dividend varies from year to year as it depends upon profits. This method is also known as constant
payout ratio method.
Constant dividend rate policy
Under this policy dividend is paid at a constant rate even though earnings very from year to year.
For this company has to create dividend equalisation reserve.
Gordon growth valuation model
This model assumes constant level of growth in dividends. The value of share reflects the value
of future dividend accruing to that share. Hence dividend payment and its growth are very important
to value share of the company. This model holds that value of share is equal to the value of future
dividend accruing to that share.
Assumptions :
All financing is done through equity only.
The company has perpetual life and earnings are perpetual.
Corporate tax dose not exist.
Annual growth rate of dividend is assumed to be remain constant.
The firms cost of capital remains constant and same is taken as the appropriate discount rate.
Formula
The value of share under this model is to be calculated as under
Do ( 1 + g )
Po =
Ke - g
Where
Po = Market price of share
Do = Current year dividend
Ke = Cost of equity capital
g = Expected future growth rate of dividend
OR
E1 ( 1 - b )
Po =
Ke - br
Where
E1 = expected earnings per share
b = retention ratio
(1 - b) = dividend payout ratio
Ke = cost of capital
r = rate of earning
OR
rA ( 1 - b )
Po =
K e - br
Where
r = rate of earning
b = retention ratio
(1 - b) = dividend payout ratio
Ke = cost of capital
br = g = growth rate of earnings and dividends
A = Investment per share
The Gordon growth model used to show that the value of the company ultimately depends on its
dividend paying capacity.
Criticism
It is not possible to maintain constant dividend growth and constant earnings growth.
The model ignores personal and corporate taxation.
As per this model if dividend for current year is zero then value of share is nil.
Capital gains are ignored by this model.
Walter's valuation model (Prof. James E. Walter)
According to this model share value reflects present value of expected dividends.
Formula
Ra (E -D)
P=D+
Rc
Rc
Where
P = Current market value of share
E = Earnings per share
D = Dividend per share
(E-D) = Retained earnings per share
Ra = Rate of return on firms investments
Rc = Cost of capital
Assumptions
Retained earnings represent the only source of funds.

Firms IRR and its cost of capital are constant.
The return on investment remains constant.
The firm has an infinite life and is a going concern.
No change in EPS and DPS.
The optimum dividend policy can be determined by the relationship of R and R .
If Ra > Rc if the firm can earn higher IRR than the cost of capital, the firm can retain the
earnings. Such firms are called as growth firms and optimal dividend payout ratio for such firm is nil.
When the rate of return on investment exceed the cost of capital the price per share increases as the
dividend payout ratio decreases.
If Ra < Rc if the cost of capital is more than IRR or when the firm dose not have profitable
investment opportunities, the optimum dividend policy would be to distribute the entire earnings as
dividend. Such firms are called as declining firms'. The optimum payout ratio for such firms is 100%.
If Ra = Rc i.e. If IRR of the firm is equal to its cost capital, it dose not matter whether the
firms retains or distribute its earnings, such firm are called as normal firms. For such companies
share price dose not very with the changes in dividend payout ratio.
Modigliani and Miller's dividend irrelevancy theory
MM has argued that a firm's dividend policy has no effect on its value of assets. For example, if
the rate of dividend declared by a company is less, its retained earnings will increase and so also the
net worth and vice versa. Their argument is that value of he firm is unaffected by dividend policy.
MM asserts that a firm's value is determined by the investment decisions.
Formula
P1 + D1
P0 =
1 + Ke
Where
Po = Prevailing market value of a share
P1 = Market value of share at the end of period one
D1 = Dividend to be received at the end of period one
Ke = Cost of equity capital
Assumption
There are no personal or corporate taxes

There are no stock flotation costs
All investors can lend or borrow at the same rate of interest
Dividend policy has no effect on the firms cost of equity
Investment opportunities and future net income of all companies are known with certainty to all
market participants.
4. TYPES OF DIVIDEND
1. Interim dividend
Interim dividend is a dividend which is declared between two annual general meetings. While
paying such dividend cash availability and future profit should betaken into consideration. Interim
dividend helps company to raise additional capital.
2. Final Dividend
This dividend is paid after financial year is over. The amount of dividend is depends upon profit
earned by the company for that year. Final dividend is declared in the annual general meeting.
3. Preference dividend
Preference shareholders get fix ate of dividend & they get dividend before equity shareholders.
AOA of the company empower the directors to declare and pay dividend.
5. IMPORTANT DATES IN CONNECTION WITH PAYMENT OF DIVIDEND
Dividend declaration date It is the date on which dividend is declared

Record Date
Dividend is paid to the shareholders whose names appear in the register of members on a
particulars date, which is called as record date.
Payment date
The date on which dividend is actually paid.
6. LEGAL PROVISIONS AS TO PAYMENTS OF DIVIDEND (SECTION 205)
Dividend is to be paid from the profit earned for any financial year after providing for depreciation
of that year.
If any dividend is declared or paid out of the past profits of the company, the undistributed
profits available after providing deprecation shall be eligible for payment of dividend.
The company can also pay dividends out of money provided by the central govt or state govt
for payment of dividend in pursuance of a guarantee given by that government.
The central govt. may, in the public interest allows any company to pay dividend for any financial
year even without providing for depreciation.
The amount of interim dividend and the amount of dividend shall be deposited in a separate
bank account within 5 days from the date of declaration of such dividend.
Dividend shall be declared or paid for any financial year only after the transfer of profits of that
yea to reserves not exceeding 10% as may be prescribed by central government.
Dividend shall be payable in cash
Dividend can also be paid by cheque or warrant.
COMPANIES (TRANSFER OF PROFITS TO RESERVES) RULES 1975
Before declaration of dividends a company must transfer a prescribed % of profits to reserve.

The provision of the companies act rules 1975 are as under
A company must transfer certain % of profits of current year to reserve, before declaring a
dividend. A company may transfer higher amount to reserve than prescribed.
The transfer is required only in respect of profits of current year after providing for depreciation.
Transfer in respect of profits of previous years is not required.
The prescribed % of profits to be transferred to general reserve areas follows as per the said
rules
If dividend proposed is upto 10% Nil
If dividend proposed is 10.01% to 12.50% 2.5% of current profits
If dividend proposed is 12.51% to 15.00% 5% of current profits
If dividend proposed is 15.01% to 20.00% 7.5% of current profits
If dividend proposed is over 20% 10% of current profits
COMPANIES (DECLARATION OF DIVIDEND OUT OF RESERVES) RULES 1975

Sometimes current profits are not sufficient to declare dividend. In such cases, a company can
declare dividend out of accumulated reserve subject to the provision of the companies Rules 1975.
The summary of provisions are given below
If, in a particular year, profits are not adequate to declare a dividend, dividend can be declared
out of reserve subject to the conditions prescribed in the said rules.
Such dividend cannot be more than average of rates at which dividend we announced in previous
5 yrs of 10% whichever is less.
Total amount drawn from reserve shall not exceed an amount equal to one-tenth of the sum of
its paid up capital and free reserve.
The amount drawn from reserve shall be first utilized to losses incurred in the current financial
year and then, surplus if any can be utilized towards declaration of dividend on equity and
preference shares.
Balance in reserve account shall not fall below 15% of paid up capital of the company.
Bonus shares
Bonus shares are those shares which are issued to existing shareholders free of cost. If company
is profit making, its accumulated profits and reserves go on increasing. Thus actual capital employed
is much higher than the amount of share capital. To avoid this abnormality in the capital structure,
part of free reserves can be distributed among the existing shareholders by issue of bonus shares.
Advantages
It preserves the company's liquidity as no cash leaves the company.

Company can easily increase their share capital.
It reduces market value of shares, making is more marketable.
It indicates financial soundness of company.
Disadvantages
The future rate of dividend will decline.

The future market value of share will decline.

QUESTION BANK
QUESTION BANK
CHAPTER 1
1) Describe the importance of the finance function in the management of a corporation.

2) Explain the traditional and modern concept of finance function.
3) State the functions to be performed by finance manager.
4) Describe the various forms of business organization.
CHAPTER 2
1) What is ratio analysis ? Explain its advantages & limitations ?

2) Write short notes
a) Liquidity ratios
b) Profitability ratios
c) Solvency ratios
3) Write a detail note on Fund flow statement.
CHAPTER 3 & 4
1) What is working capital? Explain factors affecting working capital.

2) Discuss the importance of working capital.
3) What is operating cycle? Explain factors affecting operating cycle.
4) What are the sources of working capital financing ?
5) Write shot notes
a) Liquidity Vs Profitability
b) Types of working capital
c) Tondon committee
Vipul Shah / 9881 236 536

d) Need for working capital
6) Write detail note on Receivable management & costs associated with it.
7) Write a note on factoring.
CHAPTER 5
1) What is capital budgeting? Explain risk associated with capital budgeting decisions.
2) Discuss capital budgeting techniques.
CHAPTER 6
1) What is capital structure? Explain the factors on which capital structure depends.
2) Which factors are to be considered while deciding debt-equity mix.
3) What is Over capitalization? Explain its causes & effects on company, shareholders & society.
4) What is Under capitalization? Explain its causes & effects on company, shareholders & society.
5) Explain theories of capital structure.
6) What is trading on equity? Explain its merits & demerits.
7) Explain the term Leverage & its types.
CHAPTER 7
1) Which factors affect divided policy decisions of a company ?

2) Discuss various legal and procedural formalities to be compiled with by a company while
paying dividend.
3) Write a note on bonus shares & SEBI guidelines for the issue of bonus shares.

Vipul Shah / 9881 236 536

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FINANCIAL

SR. No. CHAPTER NAME PAGE NO

1 INTRODUCTION TO FINANCIAL MANAGEMENT 4

2 ANALYSIS OF FINANCIAL STATEMENT 14

5 CAPITAL BUDGETING DECISIONS 71

7 DIVIDEND DISTRIBUTION THEORIES 101

QUESTION BANK 110

Notes are designed from syllabus point of view.

Strictly for private circulation

CA, CS & CWA

Finance is lifeblood of every business organization. It is a foundation of all economic activity.

3. MEANING OF FINANCIAL MANAGEMENT

The management of the finances of a business / organisation in order to achieve financial

Vipul Shah / 9881 236 536 Chapter : 1 Introduction to Financial Management / 4

(1) Financial Planning

(2) Financial Control

(3) Financial Decision-making

4. BASIC OBJECTIVES/GOALS OF FINANCIAL MANAGEMENT

(1) Maintenance of liquid asset

Liquid assets are required to meet firms obligation at all times.

Vipul Shah / 9881 236 536 Chapter : 1 Introduction to Financial Management / 5

ii) If ignores timing

Vipul Shah / 9881 236 536 Chapter : 1 Introduction to Financial Management / 6

Steps for wealth maximization

Avoid high level of risky projects

(5) Other objectives

Fair return to share holder

5) SCOPE OF FINANCE FUNCTION

This approach limited the role of finance manager

I) Procurement of fund from financial institution

To keep accurate financial records.

Criticism against traditional approach

i) Outsider looking in approach

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II) Modern Approach

According to modern approach

ii) Investment decision

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iii) Dividend decision.

6) IMPORTANCE / SIGNIFICANCE OF FINANCIAL MANAGEMENT

i) Sound financial Management

7) ROLE & KNOWLEDGE OF FINANCE MANAGER

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8) FORMS OF BUSINESS ORGANISATION

I. PRPPRIETORY FIRMS/ SOLE TRADING CONCERN

This form of organisation is called as One-man business.

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Firm which is formed by minimum 2 or more person and maximum 20 members.

Capital contribution by partners

Difficult to fix up responsibility for common work

III. JOINT STOCK COMPANY

Large capital collection

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Decision making takes time

Types of Joint Stock company

Minimum 2 members required to form and maximum 50 members

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ANALYSIS OF FINANCIAL STATEMENTS

1. INTRODUCTION & MEANING: -