microsoft word finance notes

T.Y.BMS Financial Management

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Functions Of Finance Manager & How They Have Changed In

Recent Years

The twin aspects procurement & effective utilization of funds are the crucial

tasks, which the finance manager faces. The financial manger is required to

look into financial implications of any decision in a firm. The finance manager

has to manage funds in such a way as to make their optimum utilization & to

ensure that their procurement is in a manner so that the risk, cost & control

considerations are properly balanced under a given situation.

It is pertinent here to distinguish between the nature of job of the finance

manager and that of the accountant .An accountant is not concerned with

management of funds which is a specialized task though historically many

accountants have been managing funds also. In the modern day business, since

the size of business has grown enormously the finance function in separate &

complex one. The finance manager has a task entirely different from that of an

accountant. He has to manage funds, which involves a number of important

decisions, which are as follows:

Estimating The Requirement Of Funds: In a business the requirement of funds have to be carefully estimated. Certain funds are required for long term

purpose i.e. investments in fixed assets etc. A careful estimation of such funds

& the timing of requirement must be made. Forecasting the requirements of

funds involves the use of technique of budgetary control. Estimates of

requirements of fund can be made only if all physical activities of the

organization have been forecasted.

Decisions Regarding Capital Structure: Once the requirements of funds have been estimated, decisions regarding various sources from where these funds

would be raised have to be taken. Finance manager has to carefully look into

existing capital structure and see how the various proposals of raising funds

will affect it. He has to maintain a proper balance between long-term funds and


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short-term funds. Long-term funds rose from outside have to be in a certain

proportion with the funds procured from the owner. He has to see that

capitalization of company is such that company is able to procure funds .All

such decisions are financing decisions.

Investment Decisions: Funds procured from different sources have to be invested in various kinds of assets. Investments of funds in a project have to be

made after careful assessment of the various projects through capital

budgeting. A part of long-term funds is also to be kept for financing working

capital requirement. The production managers &-finance manager keeping in

view the requirement of production & future price estimates of raw material

availability of funds would determine inventory policy.

Dividend Decision: Finance manager is concerned with the decision to pay or declare dividend .He has to assist management is deciding as to what amount

of dividend should be retained in business. & This depends on whether the

company can make a more profitable use of funds. But in practice trend of

earning, share market prices; requirement of funds for future growth, cash flow

situation, tax position of shareholders has to be kept in mind while deciding

dividend.

Cash Management: Finance manager has to ensure that all sections & units of organization are supplied with adequate funds. Sections, which have an excess

of funds, have to contribute to the central pool for use in other sections, which

needs funds. Even if one of the 200 retail branches does not have sufficient

funds whole business may be in danger. Hence the need for laying down cash

management & cash disbursement policies with a view to supply adequate

funds at all times is an important function of a finance manager.

In the last few years, the complexion of the economic and financial environment

has altered in many ways. The important changes has been as follows:

The industrial licensing framework has been considerably relaxed.


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The Monopolies and Restrictive Trade Practices (MRTP) Act has been

virtually abolished.

The Foreign Exchange Regulation Act (FERA) has been substantially

liberalized.

Considerable freedom has been given to companies in pricing their equity

issues.

The scope for designing new financing instruments has been

substantially widened.

Interest rate ceilings have been largely removed.

The rupee was devalued and, in two stages, has been made fully

convertible on the current account.

Investors have become more demanding and discerning.

The system of cash credit is being replaced by a system of syndicated

loans.

A number of new investment opportunities have emerged in the money

market.

The relative dependence on the capital market has increased.

These changes have made the job of the finance manager more important,

complex and demanding. Here is a sampling of views expressed by leading

finance professionals:

Bhaskar Banerjee of the Duncan Group states, There has been a total

attitudinal change owners towards the finance manager. He is no longer

referred at as my accountant. Instead of being a commodity, the finance

manager is now a part of the top management.

Anand Rathi of Indian Rayon proclaims, The finance managers job has

vastly changed. Earlier it was a support function, now its mainline. And

finance itself has been a profit centre.

Bhaskar Mitter, Corporate Finance Director of ITC asserts, Today and in

the future, finance heads will face a tremendous challenge to shape their

organisations. A challenge to upgrade accounting practices, improve

reporting systems, utilize the international market for sourcing finance,


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operate adeptly in the forex market, as well as aid companies to compete

internationally.

N. Gopalkrishnan, of Shriram Fibres avows, The finance mans job has

become more creative and cerebral than just juggling with figures.

Accounting is no longer means just maintaining log books.

Hemany Luthra of Ballarpur Industries Limited says, In the paper

business, the returns may be 16 per cent while in the Agri-business it

may be 20 per cent. So how much to invest in which sector becomes very

crucial. The finance department tells the management where it should

increase its presence and where it should get out from.

The key challenges for the finance manager in India appear to be in

Investment planning, financial structure, Treasury operations, Foreign

exchange, Investor communication and Management control.

According to Feroz Ahmed and Dilip Maitra in Money from Money,

Business Today, September 22, 1992, Clearly, the clout of the finance

manager is growing along with the change in his role. And as the reforms

in the financial sector gather pace, this trend will only increase. If the

1970s were the age of the Organization Man and the 1980s that of the

Marketing Man, the 1990s will be the age of the Finance Man.

Profit Maximization

It means the rupee income of firms. Firms may function in the market economy

or government economy. In market economy prices are determined in

competitive markets and those are expected to produce goods and services

desired by the society.

In accounting sense it tends to become a long-term objective, which measure

not only the success of the products but also development of the market for it.

The word profit implies a comparison of the operation of the business between

two specific dates, which are usually separated by an interval of one year. In

order to optimize those corporate sources of wealth on which national

prosperity depends, the basic financial objectives of the companies is to


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maximize within socially acceptable limits, profit from the funds use of funds

employed to them.

Wealth Maximization

Wealth Maximization is also known as Value Maximization or Net Present

Worth Maximization. The company, which has profit Maximization as its

objective, may adopt the policies fielding exorbitant profit in the short run

which are unhealthy for the growth survival and overall interest of the

business. Hence it is commonly agreed that the objective of the firm should be

to maximize its value or health of the firm.

Features of Wealth Maximization: It measures the benefit in terms of cash flow and avoids the ambiguity

associated with the accounting profits.

It consider both quality and quantity dimensions of benefits.

It also incorporates the time value of money.

Gross Working Capital

Gross working capital refers to the firms investment in current assets.

Accounts receivables

When goods are sold on credit, finished goods get converted into accounts

receivables in the books of the seller. A firms investment in accounts

receivables depends upon how much a firm sells on credit and how long it will

take to collect receivable. For example, if a firm sells Rs. 1 million worth of

goods on credit a day and its average collection period is 40 days, its accounts

receivables will be Rs. 40 million. Accounts receivables (or sundry debtors)

constitute the third most important asset category for business firms after plant

equipment and inventories. Hence, it behoove a firm to mange its credit well.


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Control of receivables: Monitoring and controlling of accounts receivables is often neither very thorough nor systematic. Very few firms have well- defined

systems for monitoring and controlling accounts receivables. The measures

generally adopted by firms for judging whether accounts receivables are in

control are:

Bad Debt Losses

Average Collection Period

Ageing Schedule.

Room For Improvement: Management of receivables should be accorded the importance it deserves. A senior executive should shoulder this responsibility.

Credit policies need to revise periodically in the light of internal as well a

external changes.

Firms granting credit should examine the published statements of

prospective customers with greater rigors.

Reference provided by the customers should be consulted and necessary

follow-up should be taken.

A well defined programmed must be developed.

Net Worth

While there is no doubt that the preference shareholders are the owners of the

firm, the real owners are the ordinary shareholders who bear all the risk,

participate in the management and are entitled to all the profits remaining after

all possible claims of preference shareholders are met in full.

Thus it can be said that,

Average Ordinary Shareholders Equity = Net Worth Of Company

Return on Net Worth = Net Profit After Tax Preference Dividend

Average Equity of the Ordinary Shareholders Equity or Net Worth


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It is probably the single most important ratio to judge whether the firm has

earned satisfactory return for its equity shareholders or not. Its adequacy is

judge by

Comparing with the past records of the same firm

Inter-firm comparison

Comparison with the overall industry average

Capital Employed

Total resources are also known as total capital employed and sometimes as

gross capital employed or total assets before depreciation. Thus total capital

consists of all assets fixed and current. In other words, the total of the assets

side of the balance sheet is considered as total assets employed.

While calculating capital employed on the basis of assets, following points must

be noted.

Any asset which is not in use should be excluded.

Intangible assets like goodwill, patents, trademarks etc should be

excluded. If they have some potential sales value, they should be

included.

Investments which are not concerned with business, should be excluded

Fictitious assets are to be excluded

Return on Capital Employed (ROCE) or Return on Investment (ROI)

The strategic aim of a business enterprise is to earn a return on capital. If in

any particular case, the return in the long-run is not satisfactory, then the

deficiency should be corrected or the activity be abandoned for a more

favourable one. Measuring the historical performance of an investment centre

calls for a comparison of the profit that has been earned with capital employed.

The rate of return on investment is determined by dividing net profit or income

by the capital employed or investment made to achieve that profit.


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ROI = Net Profit X 100

Capital Employed

Common Size Statement

The common size statement is often called as Common Measurement or

Common Percentage or 100 Percent statement, since each statement is

reduced to the total of 100 and each individual component of the statement is

represented as a percentage of the total, which invariable serves as the base.

This facilitates comparison of two or more business entities with a common

base. In the case of Balance sheet, total assets or liabilities or capital can be

taken as the common base and in the case of income statement, net sales can

be taken as the base.

Thus, the statement prepared to bring out the ratio of each assets or liability to

the tool of the balance sheet and the ratio of each item of expense or revenue to

net sales is known as common size statement.

State Merits/ Limitations of Common Size Statement, Comparative

Statement, trend analysis and ratio analysis

Ratio Analysis

It has been said that you must measure what you expect to manage and

accomplish. Without measurement, you have no reference to work with and

thus, you tend to operate in the dark.

One-way of establishing references and managing the financial affairs of an

organization is to use ratios. Ratios are simply relationships between two

financial balances or financial calculations. These relationships establish our

references so we can understand how well we are performing financially.


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Ratios also extend our traditional way of measuring financial performance; i.e.

relying on financial statements. By applying ratios to a set of financial

statements, we can better understand financial performance.

Limitations of Ratio Analysis Ratios by themselves mean nothing. They must all be compared.

Ratios are calculated from financial statements which are affected by the

financial bases and policies adopted on such matters as depreciation and

the valuation of stocks.

They do not represent a complete picture of business and do not refer to

other facts, which affect performance.

A ratio is comparison between both numerator and denominator. In

comparing both it would be difficult to determine whether differences is

due to numerator or denominator.

They are inter-connected. They cannot be treated in isolation.

Over use of ratios as controls can be dangerous as management might then

concentrate more on simply improving the ratio than on dealing with the

significant issues. For example the return on capital employed can be improved

by reducing the assets than increasing profits.

Remember ratios are result of good performance and not cause of good

performance.

Comparative Financial Statements

One final way of evaluating financial performance is to simply compare financial

statements from period to period and to compare financial statements with

other companies. This can be facilitated by vertical and horizontal analysis.

Advantages They indicate the direction of the movement of the financial position.


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They can be used to compare the position of the firm every month or

quarter.

It presents a review of the past activities and their cumulative effect.

Disadvantages They lose their purpose and significance and tend to mislead if the

accounting principle is not applied consistently.

Constant changes in price levels render accounting statements useless

Inter-firm analysis cannot be made, unless the firm is of the same size,

age, and follow the same accounting principles

Common Size Statement

In this, the figures shown in the financial statements viz. Profit and loss

account and balance sheet are converted in to percentages so as to establish

each element to the total figure of the statement and these statements are

called common size statements. It is useful in analysis of the performance of the

company by analyzing each individual element to the total figure of the

statement. These statements will also assist in analyzing the performance over

the years and also with the figures of the competitive firm in the industry for

making analysis of relative efficiency.

Advantages: It reveals the sources of capital and all other sources of funds and

distribution or use or application of the total funds in the assets.

Comparison of common size statement over a period will clearly indicate

the changing proportions of the various components of assets, liabilities,

costs etc.

Comparisons of two or the firms v/s industry as a whole helps in

corporate evaluation and ranking.


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Disadvantages: It does not show variations in the various account item from period to

period.

It is regarded by many as useless as there is no established standard

proportion of an asset to the total assets or of an item of expense to net

sales.

If the statements are not followed consistently for years then the common

size statement would mislead.

It presents a review of the past activities and their cumulative effect.

Give Any Three Objectives Of Financial Analysis

Financial statement analysis is an integral part of interpretation of results

disclosed by financial statements. It supplies to decision makers crucial

financial information and points out the problem areas which can be

investigated. Financial statements may be analyzed with a view to achieve the

following purposes:

Profitability Analysis: Users of financial statements may analyze financial statements to decide past and present profitability of the business. Prospective

investors may do profitability analysis before taking a decision to invest in the

shares of the company.

Liquidity Analysis: Suppliers of goods, moneylenders and financial institutions may do liquidity analysis to find out the ability of the company to meet its

obligations. Liquid assets are compared with the commitments in order to test

liquidity position of a company.

Objectives of Financial Statement

Analysis

Profitability Analysis

Liquidity Analysis

Solvency Analysis


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Solvency Analysis: It refers to analysis of long-term financial position of a company. This analysis helps to test the ability of a company to repay its debts.

For this purpose, financial structure, interest coverage are analyzed.

Comparative Common Size Analysis

In comparative size analysis, the items in the balance sheet are stated

percentages of total assets and the items in the income statement are expressed

as percentages of total sales. Such percentage statements are called common

size statements. Common size analysis reinforces the findings of time series

analysis. These 2 kinds of analysis provide a useful perspective & facilitate

better understanding. They may be viewed as a valuable adjustment to the

traditional financial ratio analysis. They are useful aids in sensitizing the

analyst to secular changes & emerging.

Ratio Analysis Is Only A Tool And Not A Final Decision

Ratio analysis is a powerful tool of measuring a companys performance, but it

has certain limitations, which doesnt bring out any final decision. There are

certain limitations of which care has to be taken which are as follows:

Development of benchmarks: Many firms, particularly the larger ones have operations spanning a wide range of industries. Given the diversity

of product lines it is difficult to find out suitable benchmarks for

evaluating the financial performance and condition. Hence it appears

that meaningful benchmarks may be available only for firms, which have

a well-defined industry classification.

Window dressing: Firms may resort to window dressing to project favorable financial picture. For example. A firm may prepare its balance

sheet when its inventory level is low. As a result it may appear that he

firm has a very comfortable liquidity position and high turnover of

inventories.

Price level changes: financial accounting as it is currently practiced in India and most other countries does not take into account price level


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changes. As a result, balance sheet figures are distorted and profits are

misreported. Hence financial statement analysis can be vitiated.

Variations in accounting policies: business firms have some latitude in the accounting treatment like depreciation, valuation of stocks, research

and developmental expenses, foreign exchange transactions installment

sales, preliminary and pre-operative expenses, provision of reserves, and

revaluation of assets. Due to diversity of accounting policies comparative

financial statement analysis may be vitiated.

Interpretation of ratios: though industry averages and other yardsticks are commonly used in financial ratios, it is somewhat difficult to judge

whether a certain ratio is good or bad. E.g. a high current ratio may

indicate a strong liquidity position. Likewise, a high turnover of fixed

assets may mean efficient utilization of plant and machinery. Another

problem is that, in interpretation when a firm has some favorable and

some unfavorable ratios. In such a situation, it may be somewhat

difficult to form an overall judgment about its financial strength and

weakness.

Correlation among ratios: in view of ratio correlations it is often confusing to employ a large number of ratios in financial statement

analysis. Hence it is necessary to choose a small group of ratios,

consisting of say six to nine ratios, from the large set of ratios. Such a

selection requires a sharp understanding of the meaning and limitations

of various ratios and a good judgment about the business of the firm.

Financial statements do not represent a complete picture of the business but

merely a collection of facts expressed in monetary terms. These may not refer to

other factors, which affect performance of the company.


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Explain Various Components Of The Given Ratios With Illustrative

Examples

Current Ratio1. Inventories of Raw Materials, Finished goods, work in progress, stores

and spares

2. Sundry Debtors

3. Short-term loans, Deposits & advances

4. Cash in hand and Cash at bank

5. Prepaid Expenses & Accrued Income

6. Bills Receivable

7. Marketable Investments and short-term securities

Liquid RatioQuick Assets and quick liabilities are the two elements of this ratio. All current

assets with the exception of inventories and prepaid expenses are considered as

quick assets. Deposits with customs, excise are not quick assets. All current

liabilities with an exception of bank overdraft and incomes recd in advance are

regarded as quick liabilities.

Proprietary RatioProprietary Ratio includes equity share capital, preference share capital, capital

reserves, revenue reserves, securities premium, surplus and undistributed

profits.

Stock to Working Capital RatioThis ratio includes stock (closing inventory & working capital) i.e. current

assets less current liabilities.

Capital Gearing RatioThis Ratio includes fixed interest or dividend bearing capital & comprises of

debentures, secured and unsecured loans & preference share capital. Capital

that does not bear fixed interest or dividend is the equity share capital.


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Debt equity RatioShareholders funds consist of preference share capital, equity share capital,

capital reserves, revenue reserves and reserves representing earmark surplus.

The amount of fictitious assets is deducted from the above.

Debts represent long-term debts. It includes mortgage loans and debentures.

Gross Profit RatioThis Ratio includes the gross profit, net sales & cost of goods sold.

Operating RatioThe components of this ratio are operating cost and net sales. Net sales is gross

sales less returns, allowances and trade discounts on sales. Operating cost is

the total of cost of goods sold and other operating expenses like office and

administrative expenses and selling & distribution expenses. They do not

include finance expenses & other non-operating cost like taxes on income, loss

on sale of asset etc.

Net Operating Profit RatioThis ratio includes net operating profit and net sales.

Stock Turnover RatioThis ratio includes cost of goods sold and average stock.

Return On Equity Share CapitalThe components of this ratio are net profit after tax, financial charges and

preference dividend. Ordinary share capital without adding the reserves or

deducting the miscellaneous expenditure items.

Debtors Turnover RatioThe components of this ratio are Sundry debtors, Accounts Receivables like

bills receivables and average daily sales. For computing this ratio, average

collection period is to be ascertained.


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What is Common Size Statement, Comparative Statement & Trend

Analysis? When & Why are they used?

Until about the turn of the century, preparation of financial statements was a

part of the work to be done by a bookkeeper. In due course of time, bankers

began to request balance sheets of applicants obviously with a view to consider

the desirability of granting credit. In spite of this, the statements were hardly

used, analyzed and interpreted in the real sense of these terms. However, in

due course of time, they started to prescribe certain minimum current and

liquid ratios for the purpose of lending and which eventually led to the practice

of analysis and interpretation of financial statements. The growth and

development of management as a science and decision making accepted as the

most important function of management, have contributed to the extensive use

of analysis of financial statements.

Analysis of financial statements means a systematic and specialized treatment

of the information found in financial statement so as to derive useful conclusion

on the profitability and solvency of the business entity concerned.

Objective Of Financial Statement AnalysisFinancial statement analysis is an integral part of interpretation of results

disclosed by financial statements. It supplies to decision makers crucial

financial information and points out the problems areas, which can be

investigated. Financial statements may be analyzed with a view to achieve the

following purpose

Objectives of Financial Statement

Analysis

Profitability Analysis

Liquidity Analysis

Solvency Analysis


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Methods and devices used in analysis of financial statements1. Comparative Financial Statement

2. Common Size Statement

3. Trend Analysis

4. Cash Flow

5. Fund Flow And Many More

Comparative Financial StatementComparative financial statements are statements of the financial position of a

business so designed as to facilitate comparison of different accounting

variables for drawing useful inferences.

Financial statements of tow or more business enterprises may be compared

over a period of years. This is known as inter-firm comparison.

Common Size Statements

With a view to overcome the serious limitations of comparative financial

statements common size statements came into use.

The common size statements are prepared to bring out the ratio of each asset or

liability to the total of the balance sheet and the ratio of each item of expense or

revenue to net sales is know as the common-size statements.

The analysis, which employs these statements as a tool, is called vertical

analysis or static analysis because it is a study of relationship between

accounts as existing at a particular date.

Trend Analysis

Study of one years financial statements in isolation hardly serves any purpose.

An analyst should study three to five years financial statements and compare

the trend of sales, cost of production and different ratios etc. during the year.


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The trend will reveal whether the unit is prospering or deteriorating year after

year. Such analysis of the trend is known as trend analysis. For example by

comparing the sales figures of last 5-6 years one can find out what is the

growth pattern of the sales and what is the percentages of increase year after

year. Similarly by studying trend of cost of sales, cost of production and other

parameters one can infer whether the business is progressing or deteriorating.

Explain The Implication Of An Improvement In Current Ratio From

1 In 1999 To 2.5 In 2000

Current ratio indicates the short-term solvency of any type of company whether

it is trading, manufacturing or service provider. But the ratio varies from

industry to industry.

As per the banking norms, the minimum current ratio should be 1:3:1. It

means the current ratio should be 1.33 times more than current liability, to pay

for the current liability in the short-term period.

But in this question its not mentioned which type of industry is to be taken, so

we will take as general and all the banking norms applies on it.

Firstly, the current ratio was 1:1, which means that the current assets are

equal to current liabilities, which is less than the limit mentioned by the RBI.

So, it indicates that company wont be able to pay its short-term creditors in due

course and it may face problem of liquidity in near future. This bad ratio will

also pose negative impression on the creditors and they may not give any credit

facility. Even if the company applies to bank for loan facility to fund their

working capital requirement, they may not give the loan due to bad ratio i.e. 1:1

Now the ratio of the company has improved to 2.5:1 i.e. current asset are 2.5

times more than current liability which is approximately double of 1:3:1, as per

the banking norms.


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By 2.5:1, we can say that company would be easily able to pay its creditors in

due course of time. Company is solvent and liquid. Company wont be able to

face any problem of liquidity if its creditors demand for money, as current

assets are 2.5 times more than current liability. If the company ants to increase

its operation or want to go for expansion, them to fund its working capital

requirement, bank would without any problem will shell out money from their

surplus to fund the working capital requirement.

So, at last this improvement in ration is good for the company, which shows

that company is trying to improve their short-term solvency. This improvement

in current ration also indicates that companys operations are increasing day-

by-day.

Explain The Precautions To Be Taken In Trend Analysis

Trend percentages as a tool of analysis, are employed when it is required to

analyze the trend of data shown in a series of financial statements of several

successive years. The trend obtained by such an analysis is expressed as

percentages.

Trend percentage analysis moves in one direction either upward or downward-

progression or regression. This method involves the calculation of percentage

relationship that each statement bears to the same item in the base year. The

base year may be any one of the periods involved in the analysis but the earliest

period is mostly taken as the base year.

Method of Calculation Any of the statements is taken as the base.

Every item in the base statement is stated as 100.

Trend ratios are computed by dividing each amount in the statement

with the corresponding item in the base statement and the result is

expressed as a percentage.


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Precautions to be takenWhile calculating trend percentages, following precautions should be taken:

There should be consistency in the principles and practices followed by

the organization through out the period for which analysis is made.

The base should be normal i.e. representative of the items shown in the

statement.

Trend percentages should be calculated only for the items which are

having logical relationship with each other.

Trend percentages should be studied after considering the absolute

figures on which they are based.

Figures of the current year should be adjusted in the light of price level

changes as compared to the base year before calculating trend

percentages.

Classify & Explain Profitability/ Solvency ratios etc.

Solvency Ratio/Liquidity RatioLiquidity refers to the ability of a firm to meet its obligations in the short run

usually one year. Liquidity ratios are generally based on the relationship

between current assets & current liabilities. The important solvency ratios are: -

Current Ratio = Current Assets/Current LiabilitiesCurrent assets include cash, marketable securities, debtors, inventories, loans

and advances and prepaid expenses. Current liabilities include loans &

advances, trade creditors, accrued expenses and provisions. The current ratio

measures the ability of the firm to meet its current liabilities-current assets get

converted into cash in the operating cycle of the firm and provide the funds

needed to pay current liabilities. Apparently the higher the current ratio, the

greater the short term solvency.

Quick Ratio/Acid Test RatioQuick ratio = Quick Assets (Current Assets - Stock)/current liabilities


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The acid test ratio is a fairly stringent measure of liquidity. It is based on those

current assets which are highly liquid inventories are excluded from the

numerator of this ratio because inventories are deemed to be the least liquid

component of current assets.

Cost Of Preference Shares

The computation of the cost of preference shares is conceptually difficult as

compared to the cost of debt. In the case if debt, the interest rate is the basis of

calculating cost, as payment of a specific amount interest is legal commitment

on the part of the firm. There is no such legal obligation in regard to preference

dividend. It is true that a fixed dividend rate is stipulates on preference shares.

It is also true that holders of such shares have a preferential right as regards

payments of dividend as well as return of principal, as compared to ordinary

shareholders. But unlike debt there is no risk of legal bankruptcy if the firm

doesnt pay the dividend due to the holders of such shares. Nevertheless, firms

can be expected to pay the stipulated dividend, if there are sufficient profits, for

a number of reasons. First, the preference shareholders, as already observed,

carry a prior right to receive dividends over the equity shareholders. Unless,

therefore, the firm pays out the dividend to its preference shareholders, it will

not be able to pay any thing to its ordinary shareholders. Moreover, the

preference shares are usually cumulative which means that preference dividend

will get accumulated till it is paid. As long as it remains in arrears nothing can

be paid to the equity holders, further the non-payment of preference dividend

may entitle their holders to participate in the management of the firm as voting

rights are conferred on them in such cases. Above all, the firm may encounter

difficulty in raising further equity capital mainly because the non-payment of

preference dividend adversely affects the prospects of ordinary shareholders.

Therefore, the stipulated dividend on preference shares, like the interest on

debt, constitutes the basic for the calculation of the cost of preference shares.

The cost of preference capital may be defined as the dividend expected by the

preference shareholders.


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However, unlike interest payments on debt, dividend payable on preference

shares is not tax-deductible because preference dividend is not charge on

earnings or an item of expenditure; it is an appropriation of earnings. In other

words, they are paid out of after-tax earnings of the company. Therefore, no

adjustment is required for taxes while computing the cost of preference capital.

There are two types of preference shares: i) irredeemable and ii) redeemable.

Cost Of Debt

The cost structure of a firm normally includes the debt component also. Debt

may be in the form of debentures, bonds, term loans from financial institutions

and banks etc. The debt is carried a fixed rate of interest payable to them,

irrespective of the profitability of the company. Since upon rate is fixed, the firm

increases its earnings through debt financing. Then after payment of fixed

interest charges more surplus is available for the equity shareholders and

hence EPS will increase. An important point to be remembered that dividends

payable to equity shareholders and preference shareholders is an appropriation

of profit, where as the interest payable on debt is a charge against profit.

Therefore any payment towards interest payable on debt is a charge against

profit. Therefore, any payment towards interest will reduce the profit and

ultimately the companys liability would decrease. This phenomenon is called

Tax shield. The tax shield is viewed as a benefit accrued to the company which

is geared. To gain the full tax shield the following conditions apply:

The company must be able to show a taxable profit every year to take full

advantage of the tax shield.

If the company makes loss, the tax shield goes down and cost borrowings

increases.


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Discuss Cash Budget As A Management Tool With Illustrative

Examples

Cash budget is a statement showing the estimated cash inflows and cash

outflows over the planning horizon in other words. The net cash position of a

firm as it moves from one budgeting sub period to another is highlighted by the

cash budget.

The various purposes of cash budget are:

To coordinate the timing of cash need.

It pinpoints the period when there is likely to be excess cash.

It enables the firm which has sufficient cash to take the advantage of

cash discount on its account payable to pay the obligations when due to

formulate the dividend policy.

It help to arrange needed funds so that the most favourable terms and

prevents the accumulation of excess funds.

The principle aim of cash budget as a tool to predict cash flows over a given

period of time is to ascertain whether at any point of time there is likely to be an

excess or shortage of cash.

The preparation of cash budgets involves various steps and is called the

element of cash budgeting system. The first element is selection of period of

time to be covered by the entire budget. It is referred to as the planning horizon

which mean the time span and the sub period within that time span and the

sub period within that time span over which the cash flows are to be protected.

The second element of cash budget is the selection of the factors that have a

bearing on cash flows. The items included in the cash budget are only cash

items. The factors that generate cash flows are generally divided for the

purposes of preparing cash budget into two broad categories: (a) operating (b)


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financial. While the former category includes cash flows generated by the

operations of the firms and are known as operating cash flows.

Distinguish Between Cash Budget And Cash Flows Statement

MeaningCash budget is a statement showing the estimated cash inflows and cash

outflows over the planning horizon in other words. The net cash position of a


cash budget.

Cash Flow Statement generally prepared annually, which shows the sources

and the uses of cash during that period. It measures the changes in the

financial position on each basis.

ObjectivesCash Budget

To coordinate the timing of cash need.

It pinpoints the period when there is likely to be excess cash.

It enables the firm which has sufficient cash to take the advantage of

cash discount on its account payable to pay the obligations when due to

formulate the dividend policy.

It help to arrange needed funds so that the most favourable terms and

prevents the accumulation of excess funds.

Cash Flow Statement

Cash Flow Statement is useful for the management to assess its ability to

meet the obligation to trade creditors and to pay bank loan to pay

interest to debenture holders and dividend to its shareholders.

Cash Flow Statement can also be prepared month wise which is useful in

presenting the information of excess cash in some months and shortage

of cash in other months.


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State The Need For Preparing A Cash Budget

Cash budget is a statement showing the estimated cash inflows and cash

outflows over the planning horizon. In other words, the net cash position of a


cash budget.

The principle aim of preparing a cash budget, as a tool to predict cash flows

over a period of time is to ascertain whether at any point of time there is likely

to be an express or shortage of cash. The preparation of cash budget involved

various steps. They may be described as the elements of the cash budgeting

system.

Cost of Capital

The cost of capital is the rate of return the company has to pay to various

suppliers of funds in the company. There are variations in the costs of capital

due to the fact that different kinds of investment carry different levels risk

which is compensated for by different levels of return on the investment.

Opportunity Cost of Capital

When an organization faces shortage of capital and it has to invest capital in

more than one project, then the company will meet the problem by rationing the

capital to projects whose returns are estimated to be more. The firm might

decide to estimate the opportunity cost of capital in other projects.

Financial Leverage

This ratio indicates the effects on earnings by rise of fixed cost funds. It refers

to the use of debt in the capital structure. Financial leverage arises when a firm

deploys debt funds with fixed charge.


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Operating Leverage

Operating leverage is concerned with the operation of any firm. The cost

structure of any firm gives rise to operating leverage because of the existence of

fixed nature of costs. This leverage relates to the sales and profit variations.

Sometimes a small fluctuation in sales would have a great impact on

profitability. This is because of the existence of fixed cost elements in the cost

structure of a product.

Combined Leverage

The operating leverage has its effects on operating risk and is measured by the

percentage change in EBIT due to percentage change in sales. The financial

leverage has its effects on financial risk and is measured by the percentage

change in EPS due to percentage change in EBIT. Since both these leverages

are closely concerned with ascertaining the ability to cover fixed charges, if they

are combined, the result is total leverage and the risk associated with combined

leverage is known as total risk.

How is Weighted Average Cost of Capital calculated? What weights

should be used in its calculation?

Weighted Average Cost of Capital (WACC) is defined as, The weighted average

of the cost of various sources of finance, weight being the market value of each

source of finance outstanding cost of various sources of finance refers to the

return expected by the respected investors.

The Weighted Average Cost of Capital of a company is calculated in two ways:

Based on weight of costs by the book value of the different forms of

capital.

Based on weight of market value of each form of capital.


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The market value approach is more realistic for the reasons given below:

The cost of funds invested at market prices is familiar with the investors.

Investments are generally rated by the reference to their earnings yield,

and the company has a responsibility to maintain that yield.

Historic book values have no relevance in calculation of real cost of

capital.

The market value represents near to the opportunity cost of capital.

Explain The Dividend Approach To Calculate Cost Of Equity

The funds required for the project are raised from the equity shareholders,

which are of permanent nature. These funds need not be repayable during the

lifetime of the organization. Hence it is a permanent source of funds. The

equity shareholders are the owners of the company. The main objective of the

firm is to maximize the wealth of the equity shareholders. Equity share capital

is the risk capital of the company. If the companys business is doing well the

ultimate beneficiaries are the equity shareholders who will get the return in the

form of dividends from the company and the capital appreciation for their

investment. If the company comes for liquidation due to losses, the ultimate

and worst sufferers are the equity shareholders. Sometimes they may not get

their investment back during the liquidation process.

Profits after taxation, less dividends paid out to the shareholders, are funds

that belong to the equity shareholders which have been reinvested in the

company and therefore, those retained funds should be included in the category

of equity, the cost of retained earnings is discussed separately from cost of

equity capital. The cost of equity may be defined as the minimum rate of return

that a company must earn on the equity financed portion of an investment

project so that market price of the shares remain unchanged. The following

methods are used in calculation of cost of Equity.

Dividend yield method: The dividend yield per share is expected on the current

market price per share


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KE = Dividend X 100

Market price

The company is expected to earn at least this yield to keep the shareholders

content. The main drawback with this method, as it does not allow for any

growth rate. Normally a shareholder expects the returns from his equity

investment to grow over time. This approach has no relevance to the company.

What Are Marketable Securities?

Marketable securities are short-term investment instruments to obtain a return

on temporarily idle funds. In other words, they are securities, which can be

converted into cash in a short period of time, typically a few days. The basic

characteristics of marketable securities affect the degree of their

marketability/liquidity and are a ready market and safety of principal.

Policies Of Collection Of Receivables

Policies of collection of receivables refer to the procedures followed to collect

accounts receivables when, after the expiry of the credit period, they become

due. These policies cover two aspects:

Degree of effort to collect the over dues, and

Type of collection efforts

The collection policies of a firm may be categorized into

Strict

Lenient

A tight collection has implications which involve benefits as well as costs. In

case of lenient collection policy the cost benefit trade off is affected.


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Types of Risk

Systematic Risk

Systematic risk refers to that portion of variation in return caused by factors

that affects the price of all securities. The effect in systematic return causes the

prices of all individual shares/bonds to move in the same direction. This

movement is generally due to the response to economic, social and political

changes. The systematic risk cannot be avoided. It relates to economic trends

which affect the whole market.

When the stock market is bullish, prices of all stocks indicate rising trend and

in the bearish market, the prices of all stocks will be falling. The systematic risk

cannot be eliminated by diversification of portfolio, because every share is

influenced by general market trend. This type of risk will arise due to the

following reasons.

Risk

Systematic Risk Unsystematic Risk

Market Risk

Interest Rate Risk

Inflation Risk

Business Risk Financial Risk

Internal External


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Market RiskVariations in price sparked off due to real social, political and economic events

is referred to as market risk.

Interest Rate RiskThe uncertainty of future market values and the size of future incomes, caused

by fluctuations in the general level of interest is known as interest Rate Risk.

Generally, price of securities tend to move inversely with changes in the rate of

interest.

Inflation RiskUncertainties of purchasing power is referred to as risk due to inflation. If

investment is considered as consumption sacrificed, then a person purchasing

securities foregoes the opportunity to buy some goods or services for so long as

he continues to hold the securities. In case, the prices of goods and services,

increases during this period, the investor actually looses purchasing power.

Unsystematic Risk

Unsystematic risk refers to that portion of the risk which is caused due to

factors unique or related to a firm or industry. The unsystematic risk is change

in the price of stocks factors unique or related to a firm or industry. The

unsystematic risk is the change in the price of stocks due to the factors which

are particular to the stock. For example, if excise duty or customs duty on

viscose fibre increases, the price of stocks of synthetic yarn industry declines.

The unsystematic risk can be eliminated or reduced by diversification of

portfolio. The unsystematic risk will arise due to the following reasons:

External Business RiskExternal business risk arises due to change in operating conditions caused by

conditions thrust upon the firm which are beyond its control such as

business cycles, government controls etc.


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Internal Business RiskInternal business risk is associated with the efficiency with which a firm

conducts its operations within the broader environment imposed upon it.

Financial RiskFinancial Risk is associated with the capital structure of a firm. A firm with no

debt financing has no financial risk. The extent of financial risk depends on the

leverage of the firms capital structure.

Collection Cost

Collection costs are administrative costs incurred in collecting the re from the

customers to whom credit sales have been made. Included in this category of

costs are

Additional expenses on the creation and maintenance of a credit

department with staff, accounting records, stationery, postage and other

related items.

Expenses involved in acquiring credit information either through outside

specialist agencies or by staff of the firm itself. These expenses would not

be incurred if the firm does not sell on credit.

Default Cost

The firm may not be able to recover the over dues because of the mobility of the

customers. Such debts are created as bad debts and have to be written off, as

they cannot be realized. Such costs are known as default costs associated with

credit sales and accounts receivable.

Capital Cost

The increased level of account receivable is an investment in assets. They have

to be financed thereby involving a cost. There is a time lag between the sale of

goods to, and payment by, the customers. Meanwhile, the firm has to pay


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employees and suppliers of raw materials, thereby implying that the firm

should arrange for additional funds to meet its own obligations while writing for

payment from its customers. The cost on the additional capital to support credit

sales, which alternatively could be profitably employed elsewhere, is, therefore,

a part of the cost of extending credit or receivables.

Delinquency Cost

This cost arises out of the failure of the customers to meet their obligations

when payment on credit sales becomes due after the expiry of the credit period.

Such costs are called delinquency costs. The important components of this cost

are: (1) blocking up of funds for an extended period, (2) cost associated with

steps that have to be initiated to collect the over dues, such as, reminders and

other collection efforts, legal charges, where necessary, and so on.

Del-Credre Commission/Agent

An agent who bears the risk of nonpayment by a customer to whom the agent

sold goods on behalf of a principal

An extra commission paid by a principal to a del credre agent to cover the risk

of nonpayment by a customer to whom the agent has sold goods on behalf of

the principal.

Various Collection Methods from Receivables

Sometimes a customer fails to pay on the due date. The following procedure will

help in efficient collection of overdue receivables:

A reminder

A personal letter

Several telephone calls

Personal visit of sales man

A telegram


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A visit from salesman responsible to customer

A reminder to the sales person that commission is based on cash

received not on invoiced sales.

Restriction of credit

Use of collection agencies

Legal action, as a last resort

Treasury Bills

It is a type of marketable security, which is an obligation of government. These

bills are sold on discount basis. Here, the investor does not receive an actual

interest payment so the return is nothing but the difference between the

purchase price and the face value of the bill. The treasury bills are issued only

in bearer form so we can say that ownership is easily transferable.

Bills Discounting

Under this system, a borrower can obtain credit from the bank against the bills.

The amount provided under this system is covered within the overall cash

credit or overdraft limit. Before purchasing or discounting the bills, the bank

satisfies itself as to the creditworthiness of the drawer. Though the term bills

payable implies that the bank becomes owner of the bills but in practice the

bank holds bills as security for the credit. A bill discounted, the borrower is

paid the discounted amount of the bill. A bank collect full amount of maturity.

Inter Corporate Deposits

A deposit made by one company with another, normally for a period up to six

months, is referred to as inter corporate deposit. Such deposits are usually of

three types;

Call Deposits: A call deposit is withdrawable by the lender on giving a days notice. In Practice, however the lender has to wait for at least three

days. The interest rate on such deposit may be around 16% p.a.


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Three Months Deposit: These are more popular in practice. These deposits are taken from borrowers to tide over a short term cash

inadequacy that may be caused by one or more of the following factors:

disruption in production, excessive imports of raw materials, tax

payment, delay in collection, dividend payment and unplanned capital

expenditure. The interest rate on such deposits is around 18% p.a.

Six Months Deposits: Normally, lending companies do not extend deposits beyond this time frame. Such deposits usually made with first

class borrowers. These deposits carry an interest rate of around 20% p.a.

Objectives of Cash Management

A sound cash management scheme maintains the balance between the twin

objective of liquidity and cost. These are two basic objectives of cash

management.

To meet the cash disbursement needs as per the payment schedule In the normal course of business, firms have to make payment in cash on a

continuous and regular basis to the suppliers of goods, employees and so on. At

the same time there is constant flow of cash through collection of debtors. Cash

is, therefore aptly described as the oil to lubricated the ever-turning wheels of

business: without the process grinds to a stop.

To minimize the amount locked up as cash balance The second objective of cash management is to minimize the cash balances. In

minimizing the cash balances, two conflicting aspects to be reconciled. A high

level of cash balances ensures prompt payment together with all the

advantages. But it also implies that large funds will remain idle as cash is the

non-earning asset and the firm will have to forego profits. A low level of cash

balances, on the other hand, may mean failure to meet the payment schedule.

The aim of cash management therefore should be to have an optimal amount of

cash balances.


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What is Cash Operation Cycle?

The need for working capital (gross) or current assets cannot be

overemphasized. Given the objective of financial decision making to maximize

the shareholders wealth, it is necessary to generate sufficient profits. The extent

to which profits can be earned will naturally depend, among other things, upon

the magnitude of the sales. A successful sales programme is, in other words,

necessary for earning profits by any business enterprise. However, sales do not

convert into cash instantly; there is invariably a time lag between the sale of

goods and the receipt of cash. There is, therefore, a need for working capital in

the form of current assets to deal with the problem arising out of the lack of

immediate realization of cash against the goods sold. Therefore, sufficient

working capital is necessary to sustain sales activity. Technically, this is

referred to as the operating or cash cycle. The operating cycle can be said to be

at the heart of the need for working capital. The continuing flow from cash to

suppliers, to inventory, to accounts receivable and back into cash is what is

called the operating cycle. In other words, the term cash cycle refers to the

length of time necessary to complete the following cycle of events:

1. Conversion of cash into inventory;

2. Conversion of inventory into receivables;

3. Conversion of receivables into cash.

The operating cycle, can further be understood with the help of following chart:

Receivables

Cash

InventoryPhase 1

Phase 3

Phase 2


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The operating cycle consists of three phases. In phase 1, cash gets converted

into inventory. This includes purchase of raw materials, conversion of raw

materials into work-in-progress, finished goods and finally the transfer of goods

to stock at the end of the manufacturing process. In the case of trading

organizations, this phase is shorter as there would be no manufacturing activity

and cash is directly converted into inventory. This phase is totally absent in the

case of service organizations.

In phase 2 of the cycle, the inventory is converted into receivables as credit

sales are made to customers. Firms, which do not sell on credit, will not have

phase 2 of the operating cycle.

The last phase, phase 3 represents the stage when receivables are collected.

This phase completes the operating cycle. Thus, the firm has moved from cash

to inventory, to receivables and to cash again.

Motives For Holding Cash

The term Cash with reference to cash management is used in two senses. In a

narrower sense it includes coins, currency notes, cheques, bank drafts held by

a firm with it and the demand deposits held by it in banks. In a broader sense it

includes near-cash assets such as marketable securities and time deposits

with banks. Such securities or deposits can immediately be sold or converted

into cash if the circumstances require.

A distinguishing feature of cash as an asset, irrespective of the firm in which it

is held, is that it does not earn substantial return for the business. In spite of

this fact cash is held by the firm with the following motives: -

(1) Transaction MotiveAn important reason for maintaining cash balances is the transaction motive.

This refers to the holding of cash to meet routine cash requirements to finance

the transactions, which a firm carries on in the ordinary course of business. A


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firm enters into a variety of transactions to accomplish its objectives, which

have to be paid for in the form of cash. For example, cash payments have to be

made for purchases, wages, operating expenses, financial charges like interest,

taxes, dividends and so on. Similarly, there is a regular inflow of cash to the

firm from sales operations, returns on outside investments, etc.

(2) Precautionary MotiveA firm keeps cash balance to meet unexpected contingencies such as floods,

strikes, presentments of bills for payment earlier than the expected date,

unexpected slowing down of collection of accounts receivables, sharp increase

in prices of raw materials, etc. The more is the possibility of such contingencies;

more is the amount of cash kept by the firm for meeting them.

(3) Speculative MotiveA firm keeps cash balance to take advantage of unexpected opportunities,

typically outside the normal course of the business. Such motive is, therefore,

of purely a speculative nature. For example, a firm may like to take advantage

of an opportunity of purchase raw materials at the reduced price on payment of

immediate cash or delay purchase of materials in anticipation of decline in

prices. Similarly, it may like to keep some cash balance to make profit by

buying securities in times when their prices fall on account of tight money

conditions, etc.

(4) Compensation MotiveBanks provide a variety of services to business firms, such as clearance of

cheque, supply of credit information, transfer to funds, and so on. While for

some of these services banks charge a commission or fee, for others they seek

indirect compensation. Usually clients are required to maintain a minimum

balance of cash at the bank. Since this balance cannot be utilized by the firms

for transaction purposes, the banks themselves can use the amount to earn a

return. Such balances are compensating balances.


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Options For Investing In Surplus Funds

Companies often have surplus funds for short periods of time before they are

required for capital expenditures, loan repayment, or some other purpose.

These funds may be deployed in a variety of ways. At one end of the spectrum is

the term deposit (to be made for the minimum period of 46 days) in a bank,

virtually a risk free investment that offers a relatively modest rate of interest: at

the other end of the spectrum is the investment in equity shares, which can

produce highly volatile returns. In between lie units, public sector bonds,

treasury bills, Intercorporate and bill discounting.

Some of the options for investing surplus funds are as follows: -

(1) Ready ForwardsA commercial bank or some other organization may do a ready forward deal

with a company interested in deploying surplus funds on a short-term basis.

Under this arrangement, the bank sells and repurchases the same securities

(this means the company, in turn, buys and sells securities) at the prices

determined before hand. Hence the name Ready Forward. Ready Forwards are

permitted only in certain securities. The return on a ready forward deal is

closely linked to money market conditions.

(2) Badla FinancingA company providing badla financing is essentially lending money to a stock

market operator who wishes to carry forward his transaction from one

settlement period to another. Typically such finance is security of shares

bought by the stock market operator. For example, a company may provide Rs.

5 crores of badla finance through a broker with an understanding that it is only

meant for the forward purchases of, say Reliance shares. Based on the demand

and supply funds, the badla financing ratio are determined on the last day of

the settlement. Badla financing offers attractive interest rates.


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(3) Treasury BillsIt is a type of marketable security, which is an obligation of government. They

are sold on discount basis. The investor does not receive an actual interest

payment. The return is the difference between the purchase price and the face

value of the bill.

(4) Bill DiscountingSurplus funds can be deployed to purchase/discount bills. Bills of Exchange

are drawn by seller (drawer) on the buyer (drawee) for the value of goods

delivered to him. During the pendency of the bill, if the seller is in needs of

funds, he may get it discounted. On maturity, the bill should be presented to

the drawee for payment.

Types of Marketable Securities

Marketable securities are short-term investment instruments to obtain a return

on temporarily idle funds. In other words, they are securities, which can be

converted into cash in a short period of time.

The more prominent marketable/near-cash securities available for investment

are as follows: -

(1) Treasury BillsIt is a type of marketable security, which is an obligation of government. They

are sold on discount basis. The investor does not receive an actual interest

payment. The return is the difference between the purchase price and the face

value of the bill.

(2) Negotiable Certificates of DepositThese are marketable receipts for funds that have been deposited in a bank for

a fixed period of time. The deposited funds earn a fixed rate of interest. When

the certificates mature, the owner receives the full amount deposited plus the

earned interest.


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(3) Commercial paperIt refers to a short-term unsecured promissory note sold by large business firms

to raise cash. As they are unsecured, the issuing side of the market is

dominated by large companies, which typically maintain sound credit ratings.

Commercial paper can be sold either directly or through dealers.

(4) Bankers AcceptanceThese are drafts (order to pay) drawn on a specific bank by an exporter in order

to obtain payment for goods he has shipped to a customer who maintains an

account with that specific bank. They can also be used in financing domestic

trade.

(5) Repurchase AgreementsThese are legal contracts that involve the actual sale of securities by a borrower

to the lender with a commitment on the part of former to repurchase the

securities at the current price plus a stated interest charge. The securities

involved are government securities and other money market instruments.

(6) UnitsThe units of Unit Trust of India (UTI) offer a reasonably convenient alternative

avenue for investing surplus liquidity as (a) there is a very active secondary

market for them, (b) the income form units is tax-exempt up to a specified

amount and (c) the units appreciate in a fairly predictable manner.

(7) Inter Corporate DepositsIt is also a type of marketable security. Intercorporate deposits are short-term

deposits as compared to other companies with a fairly attractive form of

investment of short-term funds in terms of rate of return, which currently

ranges between 12 to 15 per cent.

(8) Bills DiscountingSurplus funds can be deployed to purchase/discount bills. Bills of Exchange

are drawn by seller (drawer) on the buyer (drawee) for the value of goods


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delivered to him. During the pendency of the bill, if the seller is in needs of

funds, he may get it discounted. On maturity, the bill should be presented to

the drawee for payment.

(9) Call MarketIt deals with funds borrowed/lent overnight/one day (call) money and notice

money for the period upto 14 days. It enables corporates to utilize their float

money gainfully. However, the returns (call rates) are highly volatile.

Factors Determining Cash Needs

The factors that determine the required cash balances are:

1. Synchronization of Cash Flows

2. Short Costs

3. Excess Cash Balance

4. Procurement and Management

5. Uncertainty

Synchronization of Cash Flows: The need for maintaining cash balance arises from the non-synchronization of the inflows and outflows of the cash: if

the receipts and payments of cash perfectly coincide or balance each other,

there would be no need for cash balances. The first consideration in

determining the cash need is, therefore, the extent of non-synchronization of

cash receipts and disbursements. For this purpose, the inflows and outflows

have to be forecast over a period of time, depending upon the planning horizon,

which is typically a one-year period with each of the 12 months being a sub

period.

Short Costs: Another general factor to be considered in determining cash needs is the cost associated with a shortfall in the cash needs. Every shortage

of cash - whether expected or unexpected - involves a cost depending upon the

severity, duration and frequency of the shortfall and how the shortage is

covered. Expenses incurred as a result of shortfall are called short costs.


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Following the various Short Costs:

Transaction costs associated with raising cash to tide over the shortage. This is usually the brokerage incurred in relation to the sale of some short-term

near-cash assets such as marketable securities.

Borrowing costs associated with borrowing to cover the shortage. These include items such as interest on loan, commitment charges and other

expenses relating to the loan.

Loss of cash discount, that is, a substantial loss because of a temporary shortage of cash.

Cost associated with deterioration of the credit rating, which is reflected in higher bank charges on loans, stoppage of supplies, demands for cash

payment, refusal to sell, loss of image and the attendant decline in sales and

profits.

Penalty rates by banks to meet a shortfall in compensating balances.

Excess Cash Balance Costs: The cost of having excessively large cash balances is known as the excess cash balance cost. If large funds are idle, the

implication is that the firm has missed opportunities to invest those funds and

has thereby lost interest, which it would otherwise have earned. This loss of

interest is primarily the excess cost.

Procurement and Management: These are the costs associated with establishing and operating cash management staff and activities. They are

generally fixed and are mainly accounted for by salary, storage, handling of

securities, and so on.

Uncertainty and Cash Management: The impact of uncertainty on cash management strategy is also relevant, as cash flows cannot be predicted with


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complete accuracy. The first requirement is a precautionary cushion to cope

with irregularities in cash flows, unexpected delays in collections and

disbursement, defaults and unexpected cash needs.

The impact of uncertainty on cash management can, however, be mitigated

through:

1. Improved forecasting of tax payments, capital expenditure, dividends,

and so on; and

2. Increased ability to borrow through overdraft facility.

Working Capital

Working capital is defined as the excess of current assets over current

liabilities. Current assets are those assets which will be converted into cash

within the current accounting period or within the next year as a result of the

ordinary operations of the business. They are cash or near cash resources.

These include:

Cash and Bank balances

Receivables

Inventory

Raw materials, stores and spares

Work-in-progress

Finished goods

Prepaid expenses

Short-term advances

Temporary investment

The value represented by these assets circulates among several items. Cash is

used to buy raw materials, to pay wages and to meet other manufacturing

expenses. Finished goods are produced. These are held as inventories. When

these are sold, accounts receivables are created. The collection of accounts

receivables brings cash into the firm. The cycle starts again.


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Current liabilities are the debts of the firms that have to be paid during the

current accounting period or within a year. These include:

Creditors for goods purchased

Outstanding expenses i.e., expenses due but not paid

Short-term borrowings

Advances received against sales

Taxes and dividends payable

Other liabilities maturing within a year

Working capital is also known as circulating capital, fluctuating capital and

revolving capital. The magnitude and composition keep on changing

continuously in the course of business.

Permanent and Temporary Working Capital

Considering time as the basis of classification, there are two types of working

capital viz, Permanent and Temporary. Permanent working capital represents

the assets required on continuing basis over the entire year, whereas temporary

working capital represents additional assets required at different items during

the operation of the year. A firm will finance its seasonal and current

fluctuations in business operations through short term debt financing. For

example, in peak seasons more raw materials to be purchased, more

manufacturing expenses to be incurred, more funds will be locked in debtors

balances etc. In such times excess requirement of working capital would be

financed from short-term financing sources.

The permanent component current assets which are required throughout the

year will generally be financed from long-term debt and equity. Tandon

Committee has referred to this type of working capital as Core Current Assets.

Core Current Assets are those required by the firm to ensure the continuity of

operations which represents the minimum levels of various items of current

assets viz., stock of raw materials, stock of work-in-process, stock of finished

goods, debtors balances, cash and bank etc. This minimum level of current


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assets will be financed by the long-term sources and any fluctuations over the

minimum level of current assets will be financed by the short-term financing.

Sometimes core current assets are also referred to as hard core working

capital.

The management of working capital is concerned with maximizing the return to

shareholders within the accepted risk constraints carried by the participants in

the company. Just as excessive long-term debt puts a company at risk, so an

inordinate quantity of short-term debt also increases the risk to a company by

straining its solvency. The suppliers of permanent working capital look for long-

term return on funds invested whereas the suppliers of temporary working

capital will look for immediate return and the cost of such financing will also be

costlier than the cost of permanent funds used for working capital.

Gross Working Capital

Gross Working Capital is equal to total current assets only. It is identified with

current assets alone. It is the value of non-fixed assets of an enterprise and

includes inventories (raw materials, work-in-progress, finished goods, spares

and consumable stores), receivables, short-term investments, advances to

suppliers, loans, tender deposits, sundry deposits with excise and customs,

cash and back balances, prepaid expenses, incomes receivable, etc.

Gross Working Capital indicated the quantum of working capital available to

meet current liabilities.

Thus, Gross Working Capital = Current Assets

Net Working Capital

Net Working Capital is the excess of current assets over current liabilities, i.e.

current assets less current liabilities.


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This concept of working capital is widely accepted. This approach, however,

does not reflect the exact position of working capital due to the following

factors:

Valuation of inventories include write-offs

Debtors include the profit element

Debts outstanding for more than a year likewise debtors which are

doubtful or not provided for are included as asset are also placed under

the head current assets

Non-moving and slow-moving items of inventories are also included in

inventories, and

Write-offs and the profits do not involve cash outflow

To assess the real strength of working capital position, it is necessary to

exclude the non-moving and obsolete items from inventories. Working Capital

thus arrived at is termed as Tangible Working Capital.

Working Capital Cycle

Alternatively known as Operating Cycle Concept of working capital. This

concept is based on the continuity of flow of funds through business

operations. This flow of value is caused by different operational activities during

a given period of time. the operational activities of an organization may

comprise of:

Purchase of raw materials

Conversion of raw materials into finished products

Sale of finished products and

Realization of accounts receivable.

Material cost is partly covered by trade credit from suppliers and successive

operational activities also cash flow. If the flow continues without any

interruption, operational activities of the company will also continue smoothly.

Movement of cash through the above processes is called circular flow of cash.


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The period required to complete this flow is called the operating period or the

operating cycle.

To estimate the working capital required, the number of operating cycles in a

year is to be calculated. This is calculated by dividing the number of days in a

year by the length of the cycle. Total operating expenses of a year divided by the

number of operating cycles in that year is the amount of working capital

required.

Short Term Sources of Finance

Short-term finance is concerned with decisions relating to current assets and

current liabilities. The main sources of short-term finance are as follows:

Letter of Credit: Suppliers, particularly the foreign suppliers insist that the buyer should ensure that his bank would make the payment if he fails to

honour its obligations. This is ensured through letter of credit (LC)

arrangement. A bank opens a LC in favour of a customer to facilitate his

purchase of goods. If the customer doesnt pay to the supplier within the credit

period, the bank makes the payment under the LC arrangements. This

arrangement passes the risk of supplier to the bank. Bank charges the amount

for opening LC. It will extend such facilities to the financially sound customers.

Cash Credit: cash credit is the arrangement under which a customer is allowed an advance upto certain limits against credit granted by the bank. Under this

arrangement, a customer need not borrow entire amount of advance at one go,

he can only draw to the extent of his requirement and deposits his surplus

funds in his account. Interest is charged not on the full amount of advance but

on the amount actually availed by him. Generally cash credit limits are

sanctioned against the security of goods by way of pledge or hypothecation.

Overdraft: Overdraft arrangement is similar to the cash credit arrangement.Under the overdraft arrangements, the customer is permitted to overdraw upto


48C.H.M College

a prefixed limit. Interest is charged on the amounts overdrawn subject to some

charge as in the case of cash credit arrangements. Overdraft account operates

against security in the form of pledging of share security, assignment of the LIC

policies and sometimes even mortgage of fixed assets.

Bills Discounting: Under this system, a borrower can obtain credit from thebank against the bills. The amount provided under this system is covered

within the overall cash credit or overdraft limit. Before purchasing or

discounting the bills, the bank satisfies itself as to the creditworthiness of the

drawer. Though the term bills payable implies that the bank becomes owner

of the bills but in practice the bank holds bills as security for the credit. A bill

discounted, the borrower is paid the discounted amount of the bill. A bank

collect full amount of maturity.

Factoring: A factor is the financial institution, which offer services related to management and financing of debts arising from credit sales. Factoring provide

resources to finance receivables which could help company in short period to

finance their working capital.

Commercial Paper: Commercial paper represents short-term unsecured promissory notes issued by firms, which enjoy a fairly high credit rating.

Generally, large firms with considerable financial strength are able to issue

commercial paper. The important features of commercial paper are as follows:

i. The maturity period of commercial paper ranges from 90 to 180 days.

ii. Commercial paper is sold at a discount from its face value and

redeemed at its face value. Hence, the implicit interest rate is a

function of the size of the discount and the period of maturity.

iii. Commercial paper is either directly placed with investors or sold

through dealers.

iv. Investors who intend holding it till its maturity usually buy commercial

paper. Hence, there is no well-developed secondary market for

commercial paper.


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Inter Corporate Deposits: A deposit made by one company with another, normally for a period up to six months, is referred to as inter corporate deposit.

Such deposits are usually of three types;

a) Call Deposits: A call deposit is withdrawable by the lender on giving a days notice. In Practice, however the lender has to wait for at least

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